Derivatives and hedge accounting
- Definition: A derivative is a contract with future settlement, requiring little initial investment, and whose value fluctuates based on an underlying asset.
- Risk Management: Derivatives can help companies manage financial risks, such as fluctuations in commodity prices.
- Fair Value Measurement: All derivatives are valued at fair value, with changes in value typically recognized in profit or loss.
- Hedge Accounting: Companies can elect to use hedge accounting for derivatives designated as hedging instruments in eligible relationships, which can affect how changes in fair value are recognized.
- Non-Financial Purpose: Contracts meeting the derivative definition are not considered financial instruments if acquired for non-financial purposes, such as obtaining a good for expected usage.
Hedge Accounting under IFRS 9
- Purpose: Hedge accounting aims to reflect a company's risk management activities in its financial statements by matching gains/losses on hedging instruments with the risks they are designed to mitigate.
- Objectives: Reduce volatility in profit or loss caused by accounting mismatches between derivatives and the hedged items.
- Eligibility: Hedge accounting is optional. To qualify, a hedging relationship must meet specific criteria regarding eligible instruments, hedged items, and effectiveness.
- Types of Hedges:
- Fair Value Hedges: Hedge exposures to changes in the fair value of recognized assets/liabilities or firm commitments.
- Cash Flow Hedges: Hedge exposures to variability in future cash flows associated with recognized assets/liabilities or highly probable forecast transactions.
- Effectiveness: The hedging relationship must demonstrate effectiveness throughout the hedging period, with criteria including an economic relationship between the hedged item and the hedging instrument, minimal credit risk impact, and an appropriate hedge ratio.
- Rebalancing: Adjustments to the hedge ratio are allowed to maintain effectiveness if the risk management objective remains unchanged.
- Fair Value Hedge Accounting:
- Gains/losses on both the hedging instrument and the hedged item are recognized in profit or loss.
- Effectively neutralizes the impact of the hedged risk on profit or loss.
- Cash Flow Hedge Accounting:
- Gains/losses on the effective portion of the hedging instrument are recognized in Other Comprehensive Income (OCI).
- Amounts in OCI are recycled to profit or loss when the related cash flows occur.
- Ineffectiveness: Ineffective portions of hedge gains/losses are recognized in profit or loss.
- Discontinuation: Hedge accounting is discontinued prospectively if the hedging relationship no longer meets the qualifying criteria after any rebalancing.
5 Examples of Hedging Relationships
- Airline hedging fuel prices: An airline uses fuel derivatives to hedge against rising fuel costs, impacting its operating expenses.
- Manufacturer hedging commodity prices: A manufacturer of electronics hedges the price of copper to protect profit margins on its products.
- Bank hedging interest rate risk: A bank uses interest rate swaps to hedge the risk of changes in interest rates on its loan portfolio, affecting its net interest income.
- Construction company hedging foreign exchange risk: A construction company working on an overseas project hedges the risk of fluctuations in the exchange rate, impacting the profitability of the project.
- Investment company hedging equity portfolio: An investment company uses options to hedge against a decline in the value of its equity portfolio, mitigating potential investment losses.
Contract: A forward contract to purchase cocoa beans for use in their chocolate production process. The contract specifies the physical delivery of the cocoa beans to the company's factory.
Analysis:
- IFRS 9 Applicability: this cocoa bean contract would likely not be accounted for under IFRS 9.
- Reasoning: The company intends to physically receive and use the cocoa beans in its production process, not for resale or speculation. The contract is entered into to fulfill a genuine operational need, not for financial trading purposes.
- Accounting Treatment: The purchase of cocoa beans would be accounted for under IAS 2, Inventories, as they are intended for use in the production process.
illustrations 2:
Story of an Unexpected Downturn
Mailings Co., a small but ambitious manufacturer of handcrafted greeting cards, had meticulously planned its operations for the upcoming holiday season. Anticipating increased demand, they entered into forward contracts to purchase paper and ink, designating these purchases as hedged items in cash flow hedge accounting. They also hedged the anticipated sales revenue from the holiday season.
However, a sudden economic downturn struck. Consumer confidence plummeted, and businesses began to cut back on spending. Mailings Co. found itself facing a drastically reduced demand for its cards. Their customers, facing their own financial pressures, were simply not buying.
The economic turmoil also disrupted the supply chain. Raw material prices fluctuated wildly, and some suppliers went out of business. Mailings Co., recognizing the changing market conditions, decided to significantly reduce their production plans. The highly probable future purchases of paper and ink, which were the foundation of their cash flow hedge, were no longer considered highly probable.
Facing this unexpected turn of events, Mailings Co. had to reassess its hedging strategy. They were forced to discontinue hedge accounting for the affected contracts. The gains and losses on the hedging instruments that had been previously recognized in other comprehensive income had to be immediately reclassified to profit or loss, impacting their financial statements significantly.
The economic downturn served as a stark reminder for Mailings Co. of the importance of continuous monitoring and reassessment of hedging relationships. While hedging can be a valuable tool for managing risk, it's crucial to adapt the hedging strategy to changing market conditions to avoid unintended consequences.
illustrations 3:
Story of a Currency Conundrum
Review Co., a small trading firm, was expecting to receive a significant payment in dinars from a foreign client. Worried about the fluctuating exchange rates, they decided to hedge their exposure using a forward currency contract. This contract allowed them to sell the dinars at a predetermined exchange rate, effectively locking in their expected revenue in their local currency.
Following IFRS 9, Review Co. designated this contract as a cash flow hedge. As the year progressed, the value of the dinar fluctuated, impacting both the value of the forward contract and the expected cash flow from the client. The accounting team diligently tracked these changes, carefully recording the effective portion of the hedge in other comprehensive income (OCI), while recognizing any ineffectiveness in profit or loss.
At year-end, the hedge was largely effective, with only a small portion of the gains and losses recognized in profit or loss. This minimized the impact of exchange rate volatility on their reported earnings.
Finally, the day arrived for the dinar payment. Review Co. received the payment and simultaneously settled the forward contract. The hedge had proven successful, effectively mitigating the exchange rate risk and ensuring a stable and predictable revenue stream. The cumulative gain recognized in OCI was then reclassified to profit or loss, reflecting the successful hedging outcome in their financial statements.
This experience reinforced the importance of effective risk management for Review Co. By utilizing a cash flow hedge and adhering to the principles of IFRS 9, they were able to navigate the uncertainties of the foreign exchange market and maintain a strong financial position.
Key takeaway: Contracts for goods that are intended for the company's own use or consumption, rather than for trading or speculation, are generally not within the scope of IFRS 9.
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