Under IAS 32, financial instruments that contain embedded derivatives are required to be separated into their component parts and accounted for separately, as long as certain conditions are met.

To separate an embedded derivative from a host contract, the embedded derivative must meet certain criteria, including:

• The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract.
• The embedded derivative is not contractually transferable independently of the host contract.
• The host contract is not measured at fair value through profit or loss.

If these criteria are met, the embedded derivative is separated from the host contract and accounted for separately at fair value, with any changes in fair value recognized in profit or loss.

Here's an example to illustrate the accounting for financial instruments that contain embedded derivatives:

Suppose a company issues a bond that includes an embedded interest rate swap. The bond has a face value of $1,000 and a maturity of 5 years. The interest rate on the bond is variable, based on LIBOR, with interest paid annually. The embedded interest rate swap allows the company to pay a fixed rate of interest of 4% and receive a variable rate of interest based on LIBOR.

To separate the embedded interest rate swap from the host contract (the bond), the company would assess whether the criteria for separation are met. In this case, the economic characteristics and risks of the embedded interest rate swap are not closely related to the economic characteristics and risks of the bond, as the swap allows the company to effectively convert the variable interest rate on the bond into a fixed rate of interest. Additionally, the embedded interest rate swap is not contractually transferable independently of the bond, and the bond is not measured at fair value through profit or loss.

Assuming the criteria for separation are met, the embedded interest rate swap would be separated from the bond and accounted for separately at fair value. Any changes in fair value of the embedded interest rate swap would be recognized in profit or loss.

The separate accounting for the embedded interest rate swap provides more relevant and reliable information to users of the financial statements, as it reflects the true nature and risks of the financial instrument.