Best short read – IFRS 9 Basis adjustment

Basis adjustment

is used in hedge accounting and is the adjustment on an individual asset basis of the hedged item or portfolio basis of hedged items using a systemic and rational method for changes in business risks (for example interest rate risk, foreign currency risk)  occurring throughout the hedging relationship’s life. The name comes from the fact that the (measurement) basis of the hedged item is always amortised costs

Basis adjustments are accounted for in the same manner as other components of the amortized cost basis of the hedged item. Partial dedesignation is permitted when expectations about the last of layer have changes such that the remaining amount is expected to be outstanding at the end of the hedging relationship is less than the hedged item. Partial dedesignation is required for the amount no longer expected to be outstanding. The basis adjustment associated with the amount of the hedged item dedesignated is allocated to all remaining assets in the closed portfolio using a systemic and rational method.

When the last layer is breached, full dedesignation is required. An entity would recognize a portion of the basis adjustment immediately on profit or loss. The remaining outstanding basis adjustment would be allocated to all remaining individual assets in the closed portfolio using a systemic and rational method.

The basis adjustment was introduced in IFRS 9. Under IAS 39, an entity could elect, as a policy choice, either use the treatment of using a basis adjustment or maintain the accumulated gains or losses in equity and reclassify them to profit or loss at the same time that the non-financial item affects profit or loss. This choice is no longer allowed on the the treatment of using a basis adjustment is valid under IFRS 9. basis-adjustment


Basic explanation fair value hedge accounting model

A fair value hedge is a hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk. basis-adjustment

In general, the fair value hedge accounting model has two main elements: Basis adjustment in hedging

Hedging instrument

Hedged item

A derivative hedging instrument is recognized at fair value on the balance sheet with changes in fair value recognized in profit or loss, other than amounts related to excluded components that are recognized through an amortization approach.

basis-adjustment

Changes in the fair value of the hedged item that are attributable to the hedged risk are recognized on the balance sheet as an adjustment to the amortized cost basis of the hedged item (the ‘basis adjustment‘). The offsetting entry is a gain or loss that is recognized in profit or loss.

The effect is to offset gains or losses on the hedging instrument with gains or losses on the hedged item that are attributable to the hedged risk within one line item of the income statement. Or in a summary: basis-adjustment

basis adjustment


Basis adjustment

Basis adjustment limitation

The amount that is included as a basis adjustment is limited to the amount that the entity expects will be recovered in profit or loss in one or more future periods. If the change in fair value of the hedging instrument is a loss and the entity expects that all or a portion of that loss will not be recovered in future periods, that amount should be reclassified immediately to profit or loss (either as a reclassification from the cash flow hedge reserve, or if inventory has been recognised, by reducing the carrying value of that inventory).

If the hedge is discontinued prior to maturity of the derivative (for example because the hedging objective was to hedge to the date the inventory is delivered but the derivative matures when the accounts payable balance is due to be settled) then subsequent fair value movements relating to both the spot and forward components will be recorded directly in P&L.


Case – Purchased option as a hedging instrument

Q: Can an entity use a purchased option as a hedging instrument in a cash flow hedge?

Entity A operates a mail–order business. Its functional currency is the euro, but it purchases approximately 20% of its merchandise from the USA. basis-adjustment

Entity A issues the mail–order catalogue for the coming year, incorporating its price list, before entering into a firm purchase commitment with US suppliers. Entity A, therefore, sets the prices in the catalogue based on expected exchange rates of EUR 1 = USD 1.25. It is highly probable that the entity will make purchases of at least EUR 500,000 from the USA in the first six months.

The entity’s documented risk management policy requires it to hedge the risk that exchange rates will be higher than expected by purchasing a call option to buy US dollars for euros, with a strike price equal to the expected exchange rate. Entity A, therefore, purchased a call option at a rate of EUR 1 = USD 1.25, for EUR 500,000 in six months’ time at a cost of EUR 60,000. The purchases will be settled in cash at the date of delivery. The spot rate at the time of entering into the option contracts was EUR 1 = USD 1.1.

Accounting for this situation

Yes. Entity A can designate the intrinsic value of the purchased option as a hedge against movements in the exchange rate on the forecast purchases. The exposure being hedged is the variability in cash flows that arises if the US dollar exchange rate exceeds the expected level of EUR 1 = USD 1.25. To the extent the hedge is effective, fair value movements on the intrinsic value of the option are recorded through other comprehensive income and deferred in equity until the hedged item (the forecast purchases) occur.

The use of options as hedging instruments under IAS 39 was limited due to the need to record fair value movements in the time value through profit or loss. IFRS 9 requires the costs of hedging model to be used when an entity designates as the hedging instrument only the change in intrinsic value of an option. The benefit of the costs of hedging model is that the fair value movements in time value are recorded through other comprehensive income and deferred in equity until the purchases are made.

When the purchases are made and Entity A recognises inventory it transfers the balance in the hedging reserve to inventory (known as a basis adjustment). The balance in the costs of hedging reserve is also transferred to inventory at the same time. Note that these are not reclassification adjustments and the transfers do not go through other comprehensive income.


Case – De-designation of hedge relationships

Q: Is it possible to de-designate a hedge of foreign currency exposure on forecast purchases or sales under IFRS 9?

Entity A has highly probable forecast purchases of EUR10 million on 31 May 20X7 with payment due on 31 July 20X7. The entity’s risk management strategy is to hedge the foreign currency risk on foreign currency sales and purchases.

On 1 April 20X7, a EUR forward maturing on 31 July 20X7 is taken out and designated in a hedge relationship to offset EUR cash outflows on 31 July 20X7. The EUR cash flow on the derivative matches the cash flow on the hedged item.

Hedge accounting is applied from inception of the hedge with the designated foreign currency risk being movements in the forward foreign exchange rate. basis-adjustment

How could hedge accounting be applied in the above scenario, in particular in the period after the inventory has been recognised?

Accounting for this situation basis-adjustment

Yes. Entity A has a risk management strategy whereby it manages the foreign currency risk of forecast purchases and resulting receivables. In this regard Entity A designates the hedging strategy as mitigating volatility in cash flows arising from foreign currency risk on forecast purchases of EUR 10 million and the resulting accounts payable balances. However, Entity A has a choice of how to implement that strategy via its documented risk management objective for the hedge, which, which will determine the accounting required after recognition of the inventory purchased.

Risk management objective 1: The entity’s documented hedging objective is to mitigate volatility in cash flows arising from foreign currency risk on forecast purchases of EUR 10 million and the resulting accounts payable balances using a EUR forward.

In these circumstances: basis-adjustment

  • For the period up to 31 May 20X7 the movement in the fair value of the derivative (assuming the hedge is 100% effective) is taken to the cash flow hedge reserve. basis-adjustment
  • On 31 May, when inventory is recognised, a basis adjustment is required. Therefore the gain/loss in the cash flow hedge reserve relating to the period from 1 April 20X7 to 31 May 20X7 is transferred to inventory.
  • For the period from 31 May 20X7 to 31 July 20X7 the hedged item is foreign currency movements on the accounts payable balance. Changes in the fair value of the derivative (assuming the hedge is 100% effective) are taken to the cash flow hedge reserve, however the movement in spot rate is recycled to profit or loss to offset the IAS 21 translation of the accounts payable balance. basis-adjustment

Risk management objective 2: The entity’s documented hedging objective is to manage foreign currency risk of forecast purchasesFinancial instruments Basic risks and resulting payables, the entity manages foreign currency risk as a particular relationship only up to the point of recognition of the payable. After that date Entity A manages together the foreign currency risk from the EUR payables and EUR forward.

In these circumstances: basis-adjustment

  • For the period up to 31 May 20X7 the movement in the fair value of the derivative (assuming the hedge is 100% effective) is taken to the cash flow hedge reserve. basis-adjustment
  • On 31 May, when inventory is recognised, a basis adjustment is required. Therefore the gain/loss in the cash flow hedge reserve is transferred to inventory. basis-adjustment
  • Once inventory has been recognised, there is a ‘natural’ hedge because the gains and losses from the foreign currency risk on the derivative and payables are immediately recognised in profit or loss. Consequently, the hedging objective of the original hedge relationship no longer applies and Entity A can no longer apply hedge accounting (see IFRS 9 para B6.5.24).
  • Hence fair value movements on the derivative for the period from 1 June 20X7 to 31 July 20X7 are recorded directly in profit or loss. basis-adjustment
  • However, on 31 May an accounts payable balance is also recognised. Because this balance will be retranslated under IAS 21 with the foreign currency impact recorded in profit or loss this provides a natural offset to the gains and losses on the derivative and there is no need for hedge accounting. basis-adjustment

Note: The analysis would be similar for a forecast sale on credit which results in recognition of an accounts receivable balance (except that no basis adjustment would be required). basis-adjustment

Basis adjustment

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