The accounting treatment for option contracts permitted by Ind AS 109 represents a significant enhancement from earlier standards.
By Muzammil Patel & Ruchi Shukla
The transition to Indian Accounting Standards (Ind AS) has been a landmark change for Indian industry, bringing about a paradigm shift in accounting and reporting practices. The new standards are increasingly principle-based and enable alignment of accounting with an entity’s risk management practices. By reducing the emphasis on statistical hedge effectiveness testing, Ind AS 109 allows for hedging instruments to qualify as effective hedges based on their economic relationship with the underlying exposure. Removal of the bright line (i.e. the 80:125 rule) puts the focus on actual economic offset as opposed to a theoretical statistical offset between hedges and underlying exposures. The standard also recognised that an entity may choose to hedge only part of its price risk (for example, the pricing benchmark portion) and allows for effectiveness to be assessed only against this component of the entire exposure.
So, how does Ind AS 109 make life easier for hedgers? One major change introduced by Ind AS 109 over earlier standards is with respect to time value of options. Risk managers widely recognise that, for an initial outlay, options can be a very effective risk management instrument in terms of flexibility, cost and no commitment to giving up upside in a hedging transaction. The price for an option contract is the option premium, i.e. the price that the option buyer pays, and the option seller receives for the rights granted under the option. This option premium has two components: intrinsic value and time value. Intrinsic value is determined in terms of the difference between the strike price and the current market price of the underlying, while the remaining value of the option is time value that reflects the volatility of the price of the underlying, interest rates and the time remaining to maturity. From an accounting perspective, however, time value of options, whether on plain vanilla options or option structure, had the propensity of introducing volatility to earnings. This is because earlier hedge accounting standards required time value to be reassessed at each reporting date. Change in time value was required to either be recognised in the earnings statement or treated as part of statistical hedge effectiveness testing depending on whether time value was split or not at the time of hedge designation.
Where time value was not split, volatility in time value could impact adherence to the bright line, thereby causing far greater volatility to earnings. Hedging is supposed to reduce earnings volatility and this asymmetric accounting treatment, at times, deterred risk managers from engaging in option transactions, thereby taking away a significant instrument from the risk management toolbox.
Under Ind AS 109, where hedge accounting is applied, option premium can be either amortised over the life of the hedged item (i.e. underlying exposure) or can be included in the carrying value of the hedged item depending on the nature of the hedged item. Both these accounting treatments allow for reduction in earnings volatility and a more accurate depiction of the risk management strategy of the organisation.
In the first scenario, an entity can amortise time value (i.e. cost of hedging) over the life of the hedged item where the intention of the hedging transaction is to obtain protection over a period. Where an entity holds inventory whose value may fluctuate and impact earnings, such an entity may buy an option with the intention to protect earnings statement from volatility in inventory revaluation. In such cases, it is possible for the entity to amortise time value of options in a systematic manner. This allows for greater stability and predictability in reported earnings.
In the second scenario, an entity can carry the change in the fair value of the time value component in ‘other comprehensive income (OCI)’, i.e. as part of equity. When the hedged item is recognised in the books, the amount is recycled from the OCI to the carrying value of the hedged item in case of non-financial hedged items. In case of financial hedged items, the amount is recycled to the earnings statement at such time where the hedged item impacts the earnings statement.
This removes any interim volatility in earnings and recognises time value of options as a cost that can be adjusted in the carrying value of a hedged item. Where an entity hedges the forecast purchase of gold using options whose intrinsic value is zero (i.e. strike price is equal to market price) and time value is `1,00,000, the entire `1,00,000 and any subsequent changes in the value of `1,00,000 can be carried in the OCI. Once the physical gold is actually procured, the amount carried in the OCI will be added to the value of the gold procured. This treatment enables elimination of earnings volatility. More importantly, it allows for accounting to align with the risk management intention, i.e. pay for protection against rise in future prices at a predetermined cost, thereby effectively procuring in the future at a price adjusted for time value of options.
In both the scenarios, however, it is important for organisations to consider aligned time value, i.e. time value should only relate to the hedged item in such a way that it aligns all critical terms of the hedged item and hedging instrument.
The accounting treatment for option contracts permitted by Ind AS 109 represents a significant enhancement from earlier standards. It also allows risk managers to execute their hedging strategy without worrying about asymmetrical accounting treatment as per earlier standards.
Where organisations are ready to incur an initial outlay to ensure downside protection without giving up upside, Ind AS 109 removes accounting vagaries associated with option transactions. In a nutshell, Ind AS 109 provides for delivering the value of commodity risk management appropriately on the balance sheet and to make risk management a culture amongst commodity ecosystem stakeholders.