Accounting for the time value of options
The time value of options contract may be separated from the fair value of options contracts and the entity can designate only the change in the intrinsic value of the option. If the entity chooses to do so, then the time value of the option contract is dealt with in the following manner:
The time value of the option contract should be analysed and classified as:
(i) Transaction-related hedged item; or
(ii) Time-period-related hedged item
Transaction-related hedged item
Change in the fair value of the time value of option that hedges a transaction-related hedged item is recognised in other comprehensive income to the extent it relates to the hedged item. The cumulative change in the fair value arising from the time value of the option shall be accounted for as follows:
- Non-financial item: If the hedged item subsequently results in the recognition of a non-financial item or a firm commitment for a non-financial item the entity shall include the amount it directly in the carrying amount of the asset or the liability. This is known as basis adjustment.
- Others: The amount shall be reclassified from the separate component of equity to profit or loss as a reclassification adjustment in the same period or periods during which the hedged expected future cash flows affect profit or loss (for example, when a forecast sale occurs). This is known as reclassification adjustment.
- Amount not expected to be recovered: The portion of the amount that is not expected to be recovered in future periods shall be immediately reclassified into profit or loss as a reclassification adjustment.
The time value of an option relates to a transaction related hedged item if the nature of the hedged item is a transaction for which the time value has the character of costs of that transaction. An example is when the time value of an option relates to a hedged item that results in the recognition of an item whose initial measurement includes transaction costs (for example, an entity hedges a commodity purchase, whether it is a forecast transaction or a firm commitment, against the commodity price risk and includes the transaction costs in the initial measurement of the inventory). As a consequence of including the time value of the option in the initial measurement of the particular hedged item, the time value affects profit or loss at the same time as that hedged item.
Similarly, an entity that hedges a sale of a commodity, whether it is a forecast transaction or a firm commitment, would include the time value of the option as part of the cost related to that sale (hence, the time value would be recognised in profit or loss in the same period as the revenue from the hedged sale).
Time-period-related hedged item
The change in fair value of the time value of an option that hedges a time-period-related hedged item shall be recognised in other comprehensive income to the extent that it relates to the hedged item and shall be accumulated in a separate component of equity.
The time value at the date of designation of the option is amortised on a systematic and rational basis over the period during which the hedge adjustment for the option’s intrinsic value affects the profit or loss.
In each reporting period, the amortisation amount shall be reclassified from the separate component of equity to profit or loss as a reclassification adjustment. If hedge accounting is discontinued, the net amount (including cumulative amortisation) that has been accumulated in the separate component of equity shall be immediately reclassified into profit or loss as a reclassification adjustment.
An option is considered as being related to a time period if its time value represents a charge for providing protection for the option holder over a period of time.
The time value of an option relates to a time-period-related hedged item if the nature of the hedged item is such that the time value has the character of a cost for obtaining protection against a risk over a particular period of time (but the hedged item does not result in a transaction that involves the notion of a transaction cost that involves a transaction for which the time value has the character of costs of that transaction.
Examples:
- If commodity inventory is hedged against a fair value decrease for six months using a commodity option with a corresponding life, the time value of the option would be allocated to profit or loss (ie, amortised on a systematic and rational basis) over that six-month period. Another example is a hedge of a net investment in a foreign operation that is hedged for 18 months using a foreign-exchange option, which would result in allocating the time value of the option over that 18-month period.
- If an interest rate option (a cap) is used to provide protection against increases in the interest expense on a floating rate bond, the time value of that cap is amortised to profit or loss over the same period over which any intrinsic value of the cap would affect profit or loss: (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 start 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.
- A combination of a purchased and a written option (one being a put option and one being a call option) that at the date of designation as a hedging instrument has a net nil time value (commonly referred to as a ‘zero-cost collar’). In that case, an entity shall recognise any changes in time value in other comprehensive income, even though the cumulative change in time value over the total period of the hedging relationship is nil.
Hence, if the time value of the option relates to: (a) A transaction related hedged item, the amount of time value at the end of the hedging relationship that adjusts the hedged item or that is reclassified to profit or loss would be nil.
A time-period-related hedged item, the amortisation expense related to the time value is nil.
Aligned time value
The accounting for the time value of options applies only to the extent that the time value relates to the hedged item (aligned time value). The time value of an option relates to the hedged item if the critical terms of the option (such as the nominal amount, life and underlying) are aligned with the hedged item. Hence, if the critical terms of the option and the hedged item are not fully aligned, an entity shall determine the aligned time value, ie, how much of the time value included in the premium (actual time value) relates to the hedged item. An entity determines the aligned time value using the valuation of the option that would have critical terms that perfectly match the hedged item.
If the actual time value and the aligned time value differ, an entity shall determine the amount that is accumulated in a separate component of equity as follows:
a) if, at inception of the hedging relationship, the actual time value is higher than the aligned time value, the entity shall:
(i) determine the amount that is accumulated in a separate component of equity on the basis of the aligned time value; and
(ii) account for the differences in the fair value changes between the two time values in profit or loss.
b) if, at inception of the hedging relationship, the actual time value is lower than the aligned time value, the entity shall determine the amount that is accumulated in a separate component of equity by reference to the lower of the cumulative change in fair value of: (i) the actual time value; and (ii) the aligned time value.
Any remainder of the change in fair value of the actual time value shall be recognised in profit or loss.
The time value of forward contract may be separated from the fair value of forward contracts and the entity can designate only the change in the intrinsic value of the forward contract. If the entity chooses to do so, then the time value of the forward contract is dealt with in the following manner.
The time value of the forward contract should be analysed and classified as:
- transaction-related hedged item; or
time-period-related hedged item
