An embedded derivative is a term used in financial contracts to describe a component that modifies the cash flows or performance of the hybrid contract based on the changes in an underlying reference rate, index, or value. These derivatives are not standalone instruments but are embedded within the host contract, making the overall product a hybrid. Examples include bonds payable in a foreign currency or loans with embedded interest rate caps. Often, such components are required to be separately accounted for if certain criteria are met, such as the derivative affecting the economic risks of the host contract significantly. For example, consider a bond issued which includes a component that links its repayment terms to the movement in a stock market index; the linking mechanism is an embedded derivative. When preparing financial statements especially during year-end processes, accountants must carefully evaluate financial contracts to identify and account for embedded derivatives appropriately. Proper understanding and treatment of embedded derivatives are crucial for ensuring compliance with applicable accounting standards, such as IFRS or GAAP, and for providing accurate financial disclosures. This is particularly useful during financial audits or reconciliation processes.