Embedded derivatives in hybrid financial and non-financial contracts

The bifurcation rule for hybrid financial assets was deliberately removed under IFRS 9 in favor of an all-or-nothing SPPI test on the whole instrument, which is a common source of confusion for anyone trained under the older bifurcation model (IAS 39), attempting to carve out just the embedded equity or commodity feature from a hybrid financial asset host and account for the rest at amortized cost is simply not permitted and produces a materially wrong classification.

Is the host contract a financial asset held by the bank (in which case no bifurcation is permitted and the whole hybrid instrument is tested against SPPI), or a financial liability/non-financial contract (where bifurcation may still apply)? If the host is a financial asset with an equity-, commodity-, or index-linked feature, does the combined instrument fail SPPI, requiring classification of the entire hybrid asset at FVTPL? If the host is a liability or non-financial contract, is the embedded feature not closely related to the host, does the combined instrument sit outside FVTPL already, and does it independently meet the definition of a derivative, such that bifurcation is required?

1. First determine the nature of the host contract: is it a financial asset held by the bank, a financial liability issued by the bank, or a non-financial contract?
2. If the host is a financial asset, do not attempt to bifurcate under any circumstances, apply the SPPI and business model tests to the combined contractual cash flows of the whole hybrid instrument as a single unit of account.
3. If the combined cash flows do not represent solely payments of principal and interest (which is normally the case where an equity-, commodity-, or index-linked feature exists), classify and measure the entire hybrid financial asset at FVTPL.
4. If the host is a financial liability or a non-financial contract, assess whether an embedded derivative requires separation: is it not closely related to the host, does the combined instrument not already sit at FVTPL, and does the embedded feature independently meet the definition of a derivative?
5. If bifurcation applies, separate the embedded derivative and measure it at FVTPL, continuing to account for the host under its own applicable standard.
6. Reassess the classification conclusion if contractual terms of a structured product are subsequently amended.

Measure a hybrid financial asset that fails SPPI at fair value through profit or loss in its entirety, capturing both the host and the embedded feature's value changes together as one instrument, there is no separate carrying amount or separate fair value line for the embedded feature. Where bifurcation applies to a liability or non-financial host, measure the separated embedded derivative at fair value with all changes in profit or loss, and continue to measure and account for the host under the standard otherwise applicable to it (e.g., amortized cost for a debt host, or the relevant standard for a non-financial contract).

Disclose: (1) the nature of structured products issued or held with embedded features; (2) the classification conclusion reached for each material category (FVTPL for the whole hybrid financial asset versus bifurcation for a liability/non-financial host); (3) the valuation approach and significant inputs used to fair value any embedded derivative or FVTPL hybrid instrument; (4) the effect on profit or loss of classifying the hybrid instrument at FVTPL compared to what amortized cost treatment would have produced, where material and estimable.

• Attempting to bifurcate an embedded derivative from a hybrid financial asset host instead of classifying the whole instrument based on SPPI, a leftover habit from the superseded IAS 39 bifurcation model that is simply not permitted under IFRS 9 for financial asset hosts
• overlooking embedded derivatives in commodity- or FX-indexed purchase or supply contracts that are non-financial hosts, where bifurcation may still be required
• failing to reassess classification when contractual terms of a structured product are amended, potentially changing the SPPI conclusion or the closely-related assessment.