Time value of options
(paragraphs 33, B67-B69, BC143-BC155)
The use of options as hedging instruments has been one of the most frequently mentioned hedge accounting topics by investors and preparers. This topic has been addressed by the IASB in the past and it is an area where the current accounting in accordance with IAS 39 has a severe impact on business decisions. In many cases the hedge accounting has skewed risk management practice towards the use of non-option derivatives (such as forward contracts or swaps) rather than option-type derivatives.
What is the problem?
For hedges involving option-type derivatives, entities have the choice either to designate the option-type derivative as a hedging instrument in its entirety or to separate the time value of the option and designate as the hedging instrument only the option�s intrinsic value. However, this choice, in effect, separates the time value of an option. The reason is that without separation, hedge effectiveness would be determined by comparing the fair value change of the entire option (ie including the change in its time value) with the change of the value of the hedged item. However, many typical hedged transactions (such as firm commitments or forecast transactions) do not involve a time value of an option and hence they do not have a change in their value that offsets the one related to the time value in the option hedging instrument.
If the time value of an option is separated and not designated as part of the hedging relationship it is treated like a trading derivative, which gives rise to volatility in profit or loss. This accounting consequence has discouraged many entities from using options. For entities that use options it has resulted in an accounting treatment that is disconnected from risk management, which considers the time value of an option (at inception, ie included in the premium paid) as a cost of hedging.
What are the proposals?
The exposure draft proposes that an entity should distinguish the time value of options by the type of hedged item that the option hedges as either �transaction related� hedged items or �time period related� hedged items.
For transaction related hedged items, the change in fair value of the option�s time value would be accumulated in other comprehensive income and reclassified in accordance with the general requirements (eg like a basis adjustment if capitalised into a non-financial asset or into profit or loss when hedged sales affect profit or loss).
For time period related hedged items, the change in fair value of the option�s time value that relates to the current period should be transferred from accumulated other comprehensive income to profit or loss on a rational basis (eg amortisation of the time value paid over the time for which commodity inventory is protected against a decline in fair value by a put option).
The accounting for the time value of options would apply to the extent that the time value relates to the hedged item. This is called the �aligned time value� in the exposure draft. It is determined using the valuation of an option that would have critical terms that perfectly match the hedged item.
However, in order to avoid accounting for more time value of an option than was actually paid, if the actual time value (ie that actually paid as part of the option premium) is lower than the aligned time value, the amount recognised in accumulated other comprehensive income would be determined by reference to the lower of the cumulative fair value change of:
(i) the actual time value; and
(ii) the aligned time value.
Follow this link for examples that illustrate the mechanics of how to account for the time value of an option. The examples illustrate the mechanics for a transaction related hedged item and a time period related hedged item using three scenarios for each type of item:
- Actual time value = aligned time value.
- Actual time value > aligned time value.
- Actual time value < aligned time value.
As part of our due process, discussions of technical issues take place during public IASB meetings. For these meetings, the staff prepare technical papers on the specific technical topics. The IASB then uses these papers as a basis for its proposals.
The papers that have been prepared for the IASB to discuss risk components are listed below. Click on the paper reference number to access the specific paper. Click on the related date to access the summary of decisions taken at that date�s IASB meeting.
How to get involved
The exposure draft specifically asks for your views on this (and other) topics. Question 10 of the invitation to comment in the exposure draft asks:
- Do you agree that for transaction related hedged items, the change in fair value of the option�s time value accumulated in other comprehensive income should be reclassified in accordance with the general requirements (eg like a basis adjustment if capitalised into a non-financial asset or into profit or loss when hedged sales affect profit or loss)? Why or why not? If not, what changes do you recommend and why?
- Do you agree that for period related hedged items, the part of the aligned time value that relates to the current period should be transferred from accumulated other comprehensive income to profit or loss on a rational basis? Why or why not? If not, what changes do you recommend and why?
- Do you agree that the accounting for the time value of options should apply only to the extent that the time value relates to the hedged item (ie the �aligned time value� determined using the valuation of an option that would have critical terms that perfectly match the hedged item)? Why or why not? If not, what changes do you recommend and why?
You may choose to answer all the questions in the invitation to comment or only some of them and you are welcome to comment on any other matter that you think we should consider in finalising the proposals. Comment letters will be posted on our website.
We will carefully consider all feedback and will discuss responses to the proposals in public meetings. We plan to issue the new standard in mid-2011.