Forward element of forward contracts and foreign currency basis spread of financial instruments
Under IAS 39, entities using foreign currency forward contracts in hedging relationships can designate the instrument in its entirety or designate the spot element only. Designating the spot element only results in the forward points (often also called the ‘forward element’) to be accounted for at fair value.
When designating the entire instrument, IAS 39 allows the hedged item alternatively to be measured at the forward rate instead of the spot rate. For example, when hedging a highly probable forecast transaction, the hedged item, once transacted, would be measured at the forward rate at designation.
This is often referred to as the ‘forward rate method’. However, IAS 21 requires monetary financial assets and liabilities denominated in a foreign currency to be measured at the spot rate. As a result, the forward rate method does not provide a similar solution for hedges of such monetary items because of how IAS 21 works.
IFRS 9 introduces an optional treatment similar to the accounting for time value of options when the spot element only is designated. This is, however, not an accounting policy choice, but an election for each designation.
When designating the spot element only, the change in fair value of the (actual) forward element is recognised in OCI and accumulated in a separate component of equity. The (aligned) forward element that exists at inception is amortised from the separate component of equity to profit or loss on a rational basis.
As a result of the above accounting, fluctuations in the fair value of the forward element over time will affect other comprehensive income only, while the amount recognised in profit or loss will be stable.