Hi guys,
My company purchased an interest rate CAP to protect us against the risk of rate increases on issued variable rate debt. How would you account ( debits and credits) for premium paid? Premium being basically a time value of an option should be unwinding to zero by expiry. Where in profit and loss would you be booking changes in fair value assuming it expires out of the money?
Interest rate CAP
Re: Interest rate CAP
An option has a certain value even if it is out of the money, and the premium paid upfront usually represents the fair value at inception. Therefore, you will need to measure the cap (including the premium) at fair value every reporting date, and as a result the time value of money element will be naturally expensed over the contract term as part of the change in fair value.
The accounting for the gains and losses arising from the change in fair value depend on how you designate the hedging relationship. You will choose an account from one of: (i) profit or loss if no hedge accounting is applied, (ii) cash flow hedge if you designate the entire cap as a hedging instrument (and you can prove the hedge effectiveness), or (iii) cost of hedging in accordance with IFRS 9.6.5.15.
The accounting for the gains and losses arising from the change in fair value depend on how you designate the hedging relationship. You will choose an account from one of: (i) profit or loss if no hedge accounting is applied, (ii) cash flow hedge if you designate the entire cap as a hedging instrument (and you can prove the hedge effectiveness), or (iii) cost of hedging in accordance with IFRS 9.6.5.15.
Re: Interest rate CAP
Hi - sorry to bring this back up but do you mind explaining why you think this should just be recognised through the P&L (assuming this isn't being hedged)?
Is this because you would define this as a embedded derivative FVTPL and therefore would just recognise the FV?
If it is an embedded derivative (and assuming at inception the current market rate was lower then the agreed upon cap strike rate) would it even need to be recognised on the balance sheet at all?
Lastly, you mention the time value of money element would naturally be expensed. Do you mention this as essentially the FV will be 0 by the end of the contract?
Is this because you would define this as a embedded derivative FVTPL and therefore would just recognise the FV?
If it is an embedded derivative (and assuming at inception the current market rate was lower then the agreed upon cap strike rate) would it even need to be recognised on the balance sheet at all?
Lastly, you mention the time value of money element would naturally be expensed. Do you mention this as essentially the FV will be 0 by the end of the contract?
Re: Interest rate CAP
It is a standalone derivative, not an embedded derivative. Premium paid (time value of on option) is recognised as a derivative when paid and it will unwind to 0 by maturity through PnL. We entered this CAP into hedge relationship designating only changes in intrinsic value into cash flow hedge relationship (under IAS 39)