Basis adjustment

[IFRS 9 Fair value hedge] The adjustment to the amortized cost basis of the hedged item from applying fair value hedge accounting is referred to as a basis adjustment. Basis adjustments are accounted for in the same manner as other components of the amortized cost basis of the hedged item. 

Explanations: Basis adjustment in hedging

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.

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.

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.

Basis adjustment 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.

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.

Basis adjustment

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