Time value of forward points in hedge accounting
How is the time value of forward points in a derivative contract treated in hedge accounting?
An entity is allowed to designate only the change in the intrinsic value of an option contract in a hedging instrument. Similarly, an entity can also designate only the change in the spot value of a forward contract in a hedging instrument. In such cases the time value of the option/forward points is accounted for depending upon the type of the hedged item that the option/forward contract hedges. The option/forward contract could be to either to hedge a transaction related hedged item or a time-period related hedged item.
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:
- transaction related hedged item; or
- 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.
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.