The process of isolating and separating a certain component of an instrument in order to account for both separately. An example is a financial instrument playing a host contract to a derivative component. In other words, a derivative that is embedded into the host contract needs to be “bifurcated”- i.e., isolated and separated, so that the performance of each is accounted for in a manner consistent with its very nature and economic outcome.

Such a financial instrument that meet the criteria of bifurcation is a convertible debt instrument, in which the holder has the option to convert the debt instrument into the equity (share of stock) of the issuer at a pre-defined conversion rate. The embedded component is not closely related to the host contract. The embedded derivative (in which case, a call option) is separately recognized at fair value, and changes will be charged to earnings.