This is the second of two articles on the topic of financial instruments.
This article covers:
- hedge accounting
According to IFRS 9,Financial Instruments, a derivative is a contract that:
- will be settled at a future date
- requires no (or a low) initial investment, and
- changes value in response to movements in an underlying item (such as commodity prices or interest rates).
Derivatives can be used by companies to manage risk. For example, a company that manufactures bread may reduce its exposure to changes in the price of wheat by entering into futures contracts to buy wheat for a fixed price in six months’ time. These contracts will be settled net in cash: if wheat prices rise, the company will make a gain on the contracts; if wheat prices fall, the company will make a loss.
All derivatives are measured at fair value. Changes in fair value are recognised in profit or loss (unless the entity has elected to apply hedge accounting by designating the derivative as a hedging instrument in an eligible hedging relationship.)
Note that a contract that otherwise meets the definition of a derivative would not be accounted for as a financial instrument if the company entered into it for the purpose of receiving a non-financial item (such as wheat) in accordance with its expected usage requirements.
Insert Co entered into a forward contract to buy fuel, which was to be settled on 31 December 20X7. The fuel was to be physically delivered to the head office and to be used by Insert Co to heat its premises. The fuel was not for resale. The contract could not be settled through net cash settlement. A penalty was payable if Insert Co did not take delivery of the fuel. Insert Co had never failed to take delivery in the past.
Should the contract be accounted for in accordance with IFRS 9 Answer
AnswerIFRS 9 should be applied to those contracts to buy or sell a non‑financial item that can be settled net in cash. The exception are those contracts that are for purpose of the entity’s expected purchase, sale or usage requirements. Therefore, in this case, IFRS 9 does not apply to the fuel contract as it will be physically received and used in the company’s business.
As Insert Co has never failed to take delivery in the past and a penalty is payable if Insert Co did not take delivery of the petroleum, it is unlikely that there will be net settlement of the contract. Therefore, the purchase of the fuel should be accounted for in accordance with IAS 2,Inventories.
As noted above, derivatives are used by companies to manage risk. In the financial statements, they are remeasured to fair value at each reporting date, with the gain or loss recognised in profit or loss. However, the item that was generating the risk may not be recognised in the financial statements (such as a future purchase of wheat), or it may be accounted for in a different way (such as inventories of wheat, which are measured at the lower of cost and net realisable value). This gives rise to an accounting mismatch. This causes volatility in profit or loss that can make the company look like a riskier investment to its shareholders, even though the company has taken proactive steps to manage its risk. This outcome is at odds with the purpose of hedging and can be reduced or eliminated if the company chooses to apply hedge accounting.
The hedge accounting requirements in IFRS 9 are optional. If certain eligibility and qualification criteria are met, hedge accounting allows an entity to reflect risk management activities in the financial statements by matching gains or losses on financial hedging instruments (derivatives) with losses or gains on the risk exposures they hedge.
Hedge accounting can be applied to the following examinable types of hedging relationships:
- fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, that is attributable to a particular risk and could affect profit or loss
- cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction, and could affect profit or loss.
A hedging relationship qualifies for hedge accounting only if all of the following criteria are met:
- the hedging relationship consists only of eligible hedging instruments and eligible hedged items
- at the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge
- the hedging relationship meets all the hedge effectiveness requirements.
In order to qualify for hedge accounting, the hedge relationship must meet the following effectiveness criteria at the beginning of each hedged period:
- there is an economic relationship between the hedged item and the hedging instrument
- the effect of credit risk does not dominate the value changes that result from that economic relationship, and
- the hedge ratio of the hedging relationship is the same as that actually used in the economic hedge.
If a hedging relationship ceases to meet the hedge effectiveness requirement relating to the hedge ratio but the risk management objective remains the same, the company adjusts the hedge ratio of the hedging relationship so that it meets the qualifying criteria again. This is called rebalancing. An entity discontinues hedge accounting prospectively only when the hedging relationship ceases to meet the qualifying criteria after any rebalancing.
Fair value hedge accounting
If the fair value hedge meets the qualifying criteria, the hedging instrument is re-measured at fair value. The gain or loss is recognised in profit or loss. The carrying amount of the hedged item is adjusted for the gain or loss attributable to the hedged risk only and is also recognised in profit or loss. Thus, all gains and losses attributed to the hedged risk are recognised in the statement of profit or loss, with the result that there is no net profit and loss effect, other than any hedge ineffectiveness.
Note that if the hedged item is an equity instrument designated to be measured at FVOCI, then the gains and losses on the hedged item and hedging instrument are both reported in other comprehensive income.
Cash flow hedge accounting
If the cash flow hedge meets the qualifying criteria, the hedging instrument is re-measured at fair value. Gains or losses on the effective portion of the hedging instrument are recognised in OCI. These amounts will be taken to a ‘cashflow hedging reserve’ as a separate component of equity. The ineffective portion of the gain or loss on the hedging instrument is recognised in the statement of profit or loss.
When cash flows relating to the hedged item are reported in profit and loss, amounts in OCI are reclassified (‘recycled’) to the statement of profit or loss.
Where a hedge of a forecast transaction results in the recognition of a financial asset or liability, the gains or losses on the hedging instrument that have previously been recognised in OCI are reclassified (‘recycled’) in the same period as the asset or liability affects profit or loss (for example, in the periods when interest expense or income is recognised). If a hedged forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, the company removes that amount from the cash flow hedge reserve and includes it directly in the initial cost or other carrying amount of the asset or the liability. This is not a reclassification adjustment and hence it does not affect other comprehensive income. However, if a company expects that any of a loss recognised in OCI will not be recovered in future periods, it should reclassify to profit or loss the amount that is not expected to be recovered.
As a result of economic turmoil, Mailings Co has stopped purchasing raw materials. The ability of customers to buy from Mailings Co has also been adversely affected by the economic difficulties. Highly probable future raw material purchases, and sales of finished goods, were designated as hedged items in cash flow hedging relationships.
What is the potential effect of the economic turmoil on Mailing Co’s ability to apply hedge accounting and the effectiveness of hedging relationships? Answer
AnswerBecause of the economic circumstances, Mailing Co no longer intends to purchase raw materials. Its customers are likely to be in a similar position. These transactions have been designated as hedged items in cash flow hedge relationships. However, if they are no longer highly probable than these are not eligible hedged items and so hedge accounting must cease.
When the expected timing of a designated hedged transaction changes, an entity is required to reassess whether the hedged transaction identified in the entity’s hedge documentation is still the same hedged transaction. In other words, it must assess whether the hedged transaction is still expected to occur.
If Mailing Co decides that a forecasted transaction is no longer highly probable, but is still expected to occur, the entity must discontinue hedge accounting prospectively and defer the gain or loss on the hedging instrument that has been recognised in other comprehensive income accumulated in equity until the forecasted transaction occurs.
If the forecasted transaction is no longer expected to occur the entity must immediately reclassify to profit or loss any accumulated gain or loss on the hedging instrument.
Note that a change in the timing of a hedged forecast transaction, or increases in credit risk, may also cause a hedging contract to fail the hedge effectiveness assessment.
Review Co is preparing its financial statements for the year ended 31 December 20X7. Review Co wishes to protect itself against the foreign exchange risk arising on 3 million dinars which it expects to receive on 31 January 20X8.
Review Co enters into a forward currency contract on 1 November to sell 3 million dinars on 31 January 20X8, designating the contract as the hedging instrument in a cash flow hedging relationship. Management assesses the hedge to be effective. On 31 December 20X7, the currency contract has a positive fair value of $100,000 which is matched by a decrease in the fair value of the forecast cash flow of $98,000. The source of hedge ineffectiveness was analysed, and it was deemed that the hedge effectiveness criteria were still met and that no rebalancing was required.
On 31 January 20X8, Review Co receives the expected 3 million dinars and terminates the currency contract which has a fair value of $104,000. As such, there was no hedge ineffectiveness.
(The above example also assumes that the sale is recognised at the same point in time that cash is received).
Discuss the accounting for the above cash flow hedge.
The effective portion of the hedge, that is the ‘matched’ $98,000 increase in fair value, is credited to OCI as the lesser of the cumulative gain on the hedging instrument and the cumulative change in the fair value of the expected future cash-flows. This will be taken to a cash flow hedging reserve, which is an ‘other component of equity’. The ineffective portion ($2,000) is credited to profit or loss. The accounting entries will be:
Dr Currency contract– $100,000
Cr OCI– $98,000
Cr Profit or loss– $2,000
On 31 January 20X8, the fair value of the hedge has increased by $4,000. However, the hedge is now fully effective, so that the cumulative amount in OCI needs to reflect the entire $104,000 increase in fair value.
Dr Currency contract– $4,000
Cr OCI– $6,000
Dr Profit or loss– $2,000
On 31 January 20X8, the cumulative fair value in equity must be ‘reclassified to profit or loss when the transaction is completed. The accounting entries are:
Dr OCI– $104,000
Cr Profit or loss– $104,000
The currency contract is net settled and thus cash of $104,000 will be received.
Dr Cash – $104,000
Cr Currency contract – $104,000
Written by a member of the SBR examining team
As an expert in financial instruments and accounting, I have a deep understanding of the concepts discussed in the provided article. Let's delve into the key points and provide additional insights:
- Definition: A derivative, as per IFRS 9, is a contract that will be settled at a future date, requires no or low initial investment, and changes value in response to movements in an underlying item (e.g., commodity prices or interest rates).
- Purpose: Derivatives are used by companies to manage risk, such as hedging against price fluctuations of raw materials.
2. Hedge Accounting:
- Definition: Hedge accounting is an optional feature under IFRS 9 that allows entities to reflect risk management activities in financial statements by matching gains or losses on financial hedging instruments (derivatives) with losses or gains on the risk exposures they hedge.
- Types of Hedging Relationships:
- Fair Value Hedge: Hedge of changes in fair value of a recognized asset, liability, or an unrecognised firm commitment.
- Cash Flow Hedge: Hedge of exposure to variability in cash flows related to a recognized asset, liability, or highly probable forecast transaction.
- Eligibility Criteria: Hedge relationships must meet specific criteria, including an economic relationship between the hedged item and hedging instrument and hedge effectiveness requirements.
- Rebalancing: Adjusting the hedge ratio if a hedging relationship ceases to meet effectiveness requirements.
3. Question 1 - IFRS 9 Application:
- The fuel contract entered by Insert Co is for the purpose of expected usage and cannot be settled net in cash, thus exempt from IFRS 9 application.
- Instead, the purchase of fuel should be accounted for under IAS 2, Inventories.
4. Question 2 - Economic Turmoil Impact on Hedge Accounting:
- Mailing Co, due to economic turmoil, no longer intends to purchase raw materials, impacting hedge accounting.
- If forecasted transactions are no longer highly probable, hedge accounting must cease. The gain or loss on the hedging instrument is deferred until the forecasted transaction occurs or reclassified to profit or loss if it no longer expects to occur.
5. Question 3 - Cash Flow Hedge Accounting:
- Review Co enters into a forward currency contract as a cash flow hedge.
- On December 31, 20X7, the hedge is effective, and the fair value gain is credited to OCI and a part to profit or loss.
- On January 31, 20X8, as the hedge is fully effective, the cumulative fair value in OCI is reclassified to profit or loss.
This comprehensive overview should provide a clear understanding of the concepts related to financial instruments, derivatives, and hedge accounting, supporting the information provided in the article.