A is permitted to designate changes in the option’s intrinsic value as the hedging instrument to reflect the
one-sided risk in the hedged item. The changes in the intrinsic value of the option provide protection against
the risk of variability in the price of commodity X below or equal to the strike price of the put of £90 per
tonne. For prices above £90 per tonne, the option is out of the money and has no intrinsic value. Accordingly,
gains and losses on the forecast sales of commodity X for prices above £90 are not attributable to the hedged
risk for the purposes of assessing whether an economic relationship exists or not, nor are they relevant when
measuring ineffectiveness.
Therefore, when calculating the cumulative change in fair value (present value) of the hedged forecast sales
for the purposes of measuring ineffectiveness, no present value change would arise for variation in the price
of commodity X above £90 per tonne. Changes in the fair value (present value) of the hedged forecast sales
associated with price declines below £90 per tonne form part of the designated cash flow hedge and hence
are included within the calculation of ineffectiveness.
Assuming there are no sources of ineffectiveness (i.e. including no change in credit risk), those changes are
offset by changes in the intrinsic value of the put, resulting in zero ineffectiveness to be recognised in profit
or loss (see 7.2 above).
Changes in the time value of the put are excluded from the designated hedging relationship and the costs of
hedging guidance is applied (see 7.5.1 below).
When hedging a one-sided risk, the hedged risk cannot include the time value of a
purchased option, because the time value is not a component of the forecast transaction.
[IFRS 9.B6.3.12]. Hence if, a purchased option is designated in its entirety as the hedging
instrument of a one-sided risk arising from a forecast transaction, additional
ineffectiveness will arise, as changes in the fair value of the hedged item will not provide
any offset to changes in time value of the hedging instrument. This is consistent with
the implementation guidance on hypothetical derivatives in IFRS 9 that prohibits the
inclusion of features in the value of the hedged item that only exist in the hedging
instrument (see 7.4.4.A above). [IFRS 9.B6.5.5].
7.4.9
Hedged items with embedded optionality
As described at 3.6.4 above, an entity can exclude the time value of the hedging
instrument from the hedging relationship when hedging with options. Changes in value
of the excluded time value must then be treated as a cost of hedging (see 7.5 below).
Such a strategy is sometimes applied when hedging highly probable forecast cash flows,
in which case excluding the time value of the hedging option would most likely achieve
a lower level of ineffectiveness from an accounting perspective (see 7.4.8 above).
However, if the hedged item contains embedded optionality, which is matched by
optionality within the hedging instrument, including the time value from both the
hedged item and hedging instrument in the hedge relationship may result in a highly
effective hedge. This is because there will be a level of offset from changes in time value
Financial instruments: Hedge accounting 4107
of the hedging option and changes in the embedded time value in the hedged item. The
following fact patterns provide examples of where there may be offsetting changes in
time value:
• Entity A has purchased 10 year fixed rate debt. At the end of years five and seven,
the issuer has the option to prepay the debt at par. Entity A may choose to
eliminate variability in the fair value of the fixed rate debt by transacting a pay
fixed receive floating interest rate swap, with matching prepayment options at five
and seven years.
• Entity B has issued floating rate debt which includes an embedded floor (e.g.
interest is floored at 0%). Entity B could choose to eliminate the variability in the
cash flows above the floor (and lock in current low rates), by transacting a pay fixed
swap with an embedded floor.
In the case of Entity A above, it is relatively easy to conclude that the change in value
of the embedded prepayment option should form part of the effectiveness assessment
and measurement of ineffectiveness, as a fair value hedge. However, it is less clear in
the case of Entity B since the arrangement would be a cash flow hedge.
IFRS 9 provides guidance on hedge accounting for purchased options hedging a one-
sided risk in a forecast transaction. The guidance explains that the hedged risk cannot
include option time value because time value is not a component of the forecast
transaction that affects profit or loss. Therefore, if an entity designates a purchased
option in its entirety, as the hedging instrument of a one-sided risk arising from a
forecast transaction, the hedging relationship will not be perfectly effective. In this
situation, there will be no offset between the cash flows relating to the time value of the
option premium paid and the designated hedged risk. [IFRS 9.B6.3.12].
This might indicate that including the change in the time value of the embedded option
in the hedged item as part of the change in value of the hedged item when measuring
ineffectiveness is also not permitted. However, the above guidance was written
specifically for forecast transactions that do not include time value, whereas hedged
items with embedded optionality do include time value. Therefore, we believe that the
guidance referred to above is not relevant for hedged items that do include optionality.
IFRS 9 defines a cash flow hedge as a hedge of an exposure to variability in cash flows
that could affect profit or loss. [IFRS 9.6.5.2(b)]. Arguably, a change in the time value of an
embedded option within the hedged item does not affect profit or loss, nor does it result
in cash flow variability. However, we believe that cash flow variability and the potential
to affect profit or loss must be demonstrated for the designated hedged risk, which in
this case is the underlying of the host hedged item and the embedded option. The
measurement of ineffectiveness should incorporate the cumulative change in fair value
(present value) of the expected future cash flows of the entire hedged item, with respect
to the designated hedged risk. [IFRS 9.6.5.11(a)(ii)]. The fair value of the hedged cash flows,
which include the embedded optionality, includes the time value and not just the
intrinsic value.
Furthermore, when calculating ineffectiveness, it is not acceptable only to compare
cash flows, since it is also necessary to consider the time value of money by discounting
the cash flows. [IFRS 9.B6.5.4]. This is despite the fact that the time value of money does
4108 Chapter 49
not affect profit or loss or cause variability in the cash flows in a cash flow hedge, but is
considered a factor in the cumulative fair value (present value) of the future cash flows
(consistent with IFRS 9.6.5.11(a)(ii)). This is also consistent with the requirement that the
time value of any embedded optionality within the hedged item with respect to the
hedged risk should be considered when measuring ineffectiveness, irrespective of
whether the associated hedging instrument also has optionality.
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br /> 7.5
Accounting for the costs of hedging
From a risk management perspective, entities typically consider the premium paid on
an option (which, on inception, is often only time value), forward element in a forward,
and foreign currency basis spread as a cost of hedging rather than a trading position.
Economically, these ‘costs’ could be considered as a premium for protection against risk
(i.e. an ‘insurance premium’). [IFRS 9.BC6.387]. The IASB acknowledged these concerns
when developing IFRS 9 and included a specific accounting treatment for changes in
the fair value of the time value, forward element in a forward, and foreign currency basis
spread if not designated in a hedging relationship.
The IFRS 9 hedging model permits the time value of options, forward elements of
forwards, and foreign currency basis spread to be excluded from the hedging instrument
(see 3.6 above). [IFRS 9.6.2.4]. The excluded portions can either remain at fair value
through profit or loss, or be treated as a ‘cost of hedging’. The ‘costs of hedging’ guidance
in IFRS 9 is included in paragraphs 6.5.15 and 6.5.16 and the associated application
guidance in B6.5.29-39, it should not be used by analogy more widely for other portions
not explicitly identified in the guidance. [IFRS 9.BC6.297].
On application of the costs of hedging accounting, fluctuations in the fair value of the
time value of options, the forward element of forwards or foreign currency basis spreads
over time is recorded in other comprehensive income instead of affecting profit or loss
immediately. Although the costs of hedging will ultimately be recognised in profit or
loss, this will be in a manner consistent with the risk management activity.
It is important to note that because this accounting for ‘costs of hedging’ only applies if
the time value of the option, the forward element of forwards or foreign currency basis
spreads are excluded from the designation of the hedging relationship, the amounts
deferred in accumulated other comprehensive income are not part of the cash flow
hedge (or foreign exchange reserve) but instead a different component of equity. The
cash flow hedge reserve (or foreign exchange reserve) only includes amounts that are
gains or losses on hedging instruments that are determined to be an effective hedge (i.e.
amounts that are included in the designation of a hedging relationship).
7.5.1
Time value of options
The fair value of an option consists of its intrinsic value and its time value. An entity can
either designate an option as a hedging instrument in its entirety, or it can separate the
intrinsic value and the time value and designate only the intrinsic value (see 3.6.4 above).
[IFRS 9.6.2.4(a)].
If the option is designated in its entirety as a hedge of a non-option item, changes in the
portion of the fair value attributable to the option time value result in ineffectiveness.
This is because only changes in the intrinsic value of the option will provide offset to
Financial instruments: Hedge accounting 4109
the fair value changes attributable to the hedged risk (the situation is different if the
hedged item also includes optionality, see 7.4.9 above, or if a delta-neutral hedging
strategy is applied, see at 6.3.2). Depending on the level of ineffectiveness from changes
in the time value, an entity may have difficulty determining that an economic
relationship existed between the hedged item and the hedging option (see 6.4.1 above).
If an entity chooses to exclude the time value from the designated hedging instrument
it must apply the costs of hedging guidance, such that changes in the fair value of the
time value of options to the extent that they relate to the hedged item, are first
recognised in other comprehensive income (OCI). It is worth noting that this treatment
is not an accounting policy choice, as the treatment must be applied for all hedge
relationships for which only the intrinsic value of the hedging instrument is designated
within the hedge relationship. The subsequent treatment depends on the nature of the
hedged transaction.
The standard differentiates between transaction related hedged items and time-period
related hedged items: [IFRS 9.6.5.15, B6.5.29]
• Transaction related hedged items: the time value of an option used to hedge such
an item has the character of part of the cost of the transaction. Examples would be
a hedge of forecast purchases of inventory or property, plant and equipment, and
forecast sales or purchases, as well as purchases or sales resulting from firm
commitments.
The amount that is accumulated in OCI is removed similarly to amounts
accumulated in the cash flow hedge reserve (see 7.2 above). I.e. if the hedged
transaction subsequently results in the recognition of a non-financial item (e.g.
purchase of inventory or property, plant and equipment) the amount becomes a
‘basis adjustment’, otherwise the amount is reclassified to profit or loss in the same
period or periods during which the hedged cash flows affect profit or loss (e.g.
forecast sales);
• Time-period related hedged items: the time value of an option used to hedge such
an item has the character of the cost of protection against a risk over a particular
period of time (rather than a hedge of a transaction for which the transactions costs
are accounted for as part of a one-off event).
The amount that will be accumulated in OCI is amortised on a systematic and
rational basis to profit or loss as a reclassification adjustment. The amortisation
period is the period during which the hedge adjustment for the option’s intrinsic
value could affect profit or loss (or other comprehensive income if the option is
designated as a hedge of an equity instrument accounted for at fair value through
other comprehensive income). The appropriate amortisation period is illustrated
in Example 49.71 below.
Examples are hedges of interest expense or income in particular periods, already
existing inventory hedged for fair value changes or a hedge of a net investment in
a foreign operation. In the case of a forward starting interest rate option, the time
value would be amortised over the interest periods that the option covers (i.e. the
amortisation period would exclude the initial part of the option’s life).
4110 Chapter 49
Example 49.71: Amortisation of time value of an option hedging a time related
hedged item
If an interest rate option (a cap) is used to provide protection against increases in the interest expense on a
floating rate bond, and for which the critical terms of the option and hedged item match, the time value of the
cap is amortised to profit or loss as follows:
a) If the cap hedges increases in interest rates for the first three years out of a total life of the floating rate
bond of five years, the time value of that cap is amortised over the first three years; or
b) If the cap is a forward starting option that hedges increases in interest rates for years two and three out
of a total life of the floating rate bond of five years, the time value of that cap is amortised during years
two and three. [IFRS 9.B6.5.30].
By default, the time value will be zero at expiry of an option
contract. For a transaction
related hedged item, recognising the fair value changes of the time value in OCI means
that on expiry, the time value that existed at designation will have accumulated in OCI.
Once the hedged transaction happens, the accounting for the accumulated time value
follows the accounting for any changes in fair value of the intrinsic value of the option
recorded in the cash flow hedge reserve. [IFRS 9.6.5.15].
Example 49.72: Hedging the purchase of equipment (transaction related)
In the first quarter of a year, a manufacturing entity plans to purchase a new machine for its manufacturing
process. Delivery of the machine is expected in the third quarter and the purchase price will be Swedish Krona
(SEK) 5m. The entity has the Norwegian Krone (NOK) as its functional currency and, therefore, is exposed
to foreign currency risk on this forecast transaction. The entity buys a call option to purchase SEK 5m in the
third quarter, as it wishes to hedge the downside risk only. The terms of the option match the terms of the
forecast transaction. The entity designates only the intrinsic value of the call option in a cash flow hedge of
the highly probable forecast purchase of the machine.
At inception, the time value of the option amounts to NOK 30,000. The time value of the option amounts to
NOK 16,000 at the end of the first quarter, NOK 7,000 at the end of the second quarter and zero at maturity.
Applying the IFRS 9 accounting requirements to the time value of the option results in the following
movement within other comprehensive income (OCI), specifically the reserve within equity for accumulating
amounts in relation to the time value of options associated with transaction related hedged items:
(All amounts in NOK thousands)
Q1
Q2
Q3
Reserve at beginning of quarter
–
(14)
(23)
Change in time value of option
(14)
(9)
(7)
Basis adjustment to machine
30
Reserve at end of quarter
(14)
(23)
–
Effect on OCI for the period
(14)
(9)
23
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 814
