TO BE OR NOT TO BE (To split or not to split the fair value of hedging instrument

into time/interest value and intrinsic/spot value components)

In relation to hedging instrument for hedge accounting purposes, FRS 39.74 allows for
the use of its fair value in entirety or just its intrinsic/spot component. Question arises as
to whether (i) to use the fair value of hedging instrument in entirety (referred to as no
splitting) or (ii) to split the fair value of hedging instrument into time/interest and
intrinsic/spot components and just use the intrinsic/spot component for hedging purposes
(referred to as splitting).

(Note that this splitting vs no splitting issue only affects (i) hedge effectiveness (80-
125%) test and (ii) journal entries for cash flow hedge. It does not affect to journal entries
to fair value hedge)

It should be noted that FRS 39.74 provides for splitting as exceptions to the rule. Thus
the norm under FRS 39.74 is no splitting.

To ensure hedge effectiveness, we will try to use the same valuation basis for a hedged
item as that used for the hedging instrument.

Thus, for a hedged item that is a firm commitment or a forecast transaction, we will
use the fair value in entirety, as a norm. (because we adopt no splitting for the hedging
instrument, as a norm).

However, for a hedged item that is a recognized asset/liability, the various FRSs
require the use of spot value (eg FRS 21 requires closing rate, FRS 2 requires spot price).
Thus, we will generally adopt splitting for the hedging instrument and use only its
spot/intrinsic value for hedging a recognized asset/liability. However, in the event that
hedge effectiveness can be achieved without splitting the hedging instrument, we will fall
back to the norm of FRS 39.74, and adopt no splitting for the hedging instrument.

Of course, all the above are subject to the company policy as stated in the hedge
documentation.

In conclusion, whether or not to split depends firstly on the policy as stated in the hedge
documentation. If the hedge documentation is silent (eg in examination situation), then
the norm is no splitting for the hedging instrument. However, if no splitting will
result in the hedge to be not effective and splitting will result in the hedge to be
effective, then adopt splitting. The decision-making process may be summarized below
(in that priority):
Step 1: If policy is stated in hedge documentation, follow the policy stated. Stop.
Step 2: If hedge document is silent, adopt no splitting, as a norm. Adopt splitting if
and only if (i) hedged item is a recognized asset/liability, and (ii) no splitting will cause
the hedge to be not effective.

NEJ/2011