Under the old rules of IAS 39, hedge accounting could be difficult to achieve in relation to commodity exposures. This was largely due to the fact that IAS 39 did not permit hedging of specific risk components of non-financial items (with the exception of FX risk). Hedge accounting of hedges for commodity risks
For example, a company with a known diesel purchase requirement over the next two to three years may wish to hedge its exposure using a diesel swap. Even though the swap is designed to be a valid economic hedge of the wholesale diesel price risk, the company would not be able to define the hedged risk specifically as such. Instead, the swap would have to be designated as a hedge of the ‘all-in’ purchase price as illustrated below. Hedge accounting of hedges for commodity risks
Due to this restriction, the hedged item is sensitive not only to changes in the wholesale diesel price, but also to changes in other components of the purchase price – e.g. fuel duty, supplier margin, etc. As a result, it may not be possible to apply hedge accounting, either because hedge effectiveness cannot be reliably measured due to the ‘un-hedgeable’ risks included within the hedged item, or because the company cannot show that it expects hedge effectiveness to fall within the required 80% – 125% limits of IAS 39. This issue has often resulted in companies making accounting-driven decisions not to hedge commodity exposures due to the risk of incurring P&L volatility. Hedge accounting of hedges for commodity risks
The change of IFRS 9 to allow specific risk components of non-financial items to be designated for hedge accounting should largely alleviate this problem; it will allow hedge accounting to be applied to many more hedges of commodity exposures and could significantly reduce P&L volatility on existing hedge relationships.
In order to be eligible for separate designation, the risk component must be separately identifiable and reliably measurable. This is the case if the risk component is either:
- Contractually specified in the underlying purchase agreement – e.g. a fuel purchase agreement may include a pricing formula which uses a specific wholesale fuel price reference; or
- Implicit in the pricing structure of the exposure – e.g. for fuel purchases made without a supply agreement (e.g. ‘petrol pump’ purchases), the wholesale fuel price may be an implicit component of the total purchase price. Hedge accounting of hedges for commodity risks
Where the risk of income statement volatility was previously considered a limiting factor to hedging commodity risks, companies have now reviewed their material commodity exposures and determined how the IFRS 9 hedge accounting rules have benefited them.