Hedge of forecast foreign currency purchases

This narrative can also be used as a sort of starting point to the hedge documentation required for each hedging relationship at inception. Part 2 of 3

Here is part 1 of 3

and here is part 3 of 3

The CaseIFRS 9 Hedge accounting content

Type of hedge: cash flow hedge

Hedged risk: FX risk – spot component only

Key features: Spot rate designated, Basis adjustment required for inventory, Cost of hedging approach elected – Forward points taken to OCI, Inclusion of time value of money in measuring hedge ineffectiveness

  • Continue: Effectiveness tests and accounting entries

1 July 20×5

Hedge effectiveness assessment

As described in the hedge documentation, critical terms of the hedging instrument and the hedged items perfectly match. Therefore, management can qualitatively assess that there is an economic relationship between the hedging instrument and the hedged item and that they will generally move in the opposite direction.

Furthermore, the forecasted transaction is highly probable to occur.

The hedge ratio is set as described in the hedge documentation.

As the credit rating of the counterparty to the derivative is AA and Company A’s credit risk is considered to be high, the effect of credit risk is considered as neither material nor dominant in the economic relationship.

Conclusion: The hedge effectiveness requirements are met.

Inception of forward

No entry as the fair value of the forward contract is nil, as shown below.

Derivative as at 01/07/20×5

Notional amount in FX

10,000,000

USD

Forward rate

1.2679

EUR equivalent based on valuation date (A)

7,887,057

EUR

EUR contracted amount (B)

-7,887,057

EUR

Total (A+B)

0

EUR

Discount Factor

0.9935

Fair value of derivative in EUR

0

EUR

31 December 20×5

Hedge effectiveness assessment

The hedge continues to meet the effectiveness requirements going forward as no change has occurred in the hedging relationship or hedge ratio (no change in the date of the forecast transaction, no change in notional amount, no change in the credit risk of the counterparties, no change in sources of ineffectiveness).

Furthermore, the forecasted transaction is highly probable to occur.

Conclusion: The hedge effectiveness requirements are met.

Fair value forward

All the criteria for hedge accounting are met for the period ended 31 December 20×5. Cash flow hedge accounting can therefore be applied.

Derivative as at 31/12/20×5

Derivative as at 31/12/20×5

Full Fair ValueChange in fair value attributable to spot

Notional amount in USD

10,000,000

USD

Notional amount in USD

10,000,000

USD

Forward rate at valuation date

1.2526

Spot rate at valuation date

1.2530

EUR equivalent (A)

7,983,395

EUR

Spot component at valuation date (A)

7,980,846

EUR

EUR contracted amount (B)

-7,887,057

EUR

Spot component at inception (B)

7,878,358

EUR

Total (A + B)

96,337

EUR

Difference (A-B)

102,488

EUR

Discount factor EUR

0.9961

Discount factor EUR

0.9961

Fair value of derivative

95,962

EUR

Fair value of spot component1

102,088

EUR

Risks other than foreign exchange risk, including credit risk, have been ignored for simplification purposes.

Therefore it is assumed that the present value of the spot component is the same as the fair value of the hypothetical derivative for effectiveness testing purposes and there is no ineffectiveness to record in the P&L. In reality the standard notes that the hypothetical derivative cannot include anything that is not in the hedged item, such as credit risk.

Derivative as at 31/12/20×5

Forward points

Change in full fair value (FV)

A

95,962

EUR

Change in FV attributable to spot

B

102,088

EUR

Change in value of forward points

A – B=

-6,126

EUR

Separation forward element of a contract

When an entity separates the forward element of a contract it can either recognise changes in the fair value of the forward points in other comprehensive income and accumulate them in a separate component of equity (the cost of hedging model) or record gains and losses related to the forward element directly in P&L (IFRS 9 6.5.15).

Where the cost of hedging model is applied, the forward points should be amortised ‘on a rational and consistent basis’ for a time period hedge, and recorded in the P&L when the hedged item affects P&L for a transaction related hedge.

In this example the forecast purchases are transaction related and therefore the forward points will only be released, first as a basis adjustment to inventory when the inventory is purchased, and then to profit or loss when the inventory is subsequently sold (or impaired).

The journal entry is as follows:

DR

CR

Derivative

95,962

EUR

Other Comprehensive Income – Hedging (equity) reserve

102,088

EUR

Other Comprehensive Income – Forward element

6,126

EUR

GL Description: Cash Flow Hedge – Change in fair value of the forward contract

When an entity excludes forward points from the hedge relationship and does not apply the cost of hedging approach, the accounting entries are as follows:

The journal entry excluding forward points is as follows:

DR

CR

Derivative

95,962

EUR

Other Comprehensive Income – Hedging (equity) reserve

102,088

EUR

Profit or loss – Forward element

6,126

EUR

30 June 20×6

Hedge effectiveness assessment Hedge of forecast foreign currency purchases

The hedge continues to meet the effectiveness requirements going forward as no change has occurred in the hedging relationship or hedge ratio (no change in the date of the forecast transaction, no change in notional amount, no change in the credit risk of the counterparties, no change in sources of ineffectiveness).

Furthermore, the forecasted transaction is highly probable to occur.

Conclusion: The hedge effectiveness requirements are met.

Fair value forward Hedge of forecast foreign currency purchases

All the criteria for hedge accounting are met for the period ended 30 June 20×6. Cash flow hedge accounting can therefore be applied.

Derivative as at 30/06/20×6

Derivative as at 30/06/20×6

Full Fair ValueChange in fair value attributable to spot

Notional amount in USD

10,000,000

USD

Notional amount in USD

10,000,000

USD

Forward rate at valuation date

1.2726

Spot rate at valuation date

1.2732

EUR equivalent (A)

7,857,929

EUR

Spot component at valuation date (A)

7,854,226

EUR

EUR contracted amount (B)

-7,887,057

EUR

Spot component at inception (B)

7,878,358

EUR

Total (A + B)

-29,128

EUR

Difference (A-B)

-24,133

EUR

Discount factor EUR

0.9987

Discount factor EUR

0.9987

Fair value of derivative

-29,090

EUR

Fair value of spot component

-24,101

EUR

Derivative as at 30/06/20×6

Forward points

30/06/20×6

Change in full fair value (FV) Hedge of forecast foreign currency purchases

-29,090 – 95,962 = A

-125,052

EUR

Change in FV attributable to spoteign currency purchases

-24,101 – 102,088 = B

-126,189

EUR

Change in value of forward points foreign currency purchases

A – B =

1,137

EUR

Cumulative change in forward value 

-6,126 + 1,137=

-4,989

EUR

The journal entry is as follows:

DR

CR

Derivative Hedge of forecast foreign currency purchases

125,052

EUR

Other Comprehensive Income – Hedging (equity) reserve

126,189

EUR

Other Comprehensive Income – Forward element

1,137

EUR

GL Description: Cash Flow Hedge – Change in fair value of the forward contract

When an entity excludes forward points from the hedge relationship and does not apply the cost of hedging approach, the accounting entries are as follows:

The journal entry excluding forward points is as follows:

DR

CR

Derivative Hedge of forecast foreign currency purchases

125,052

EUR

Other Comprehensive Income – Hedging (equity) reserve

126,189

EUR

Profit or loss – Forward element Hedge of forecast foreign currency purchases

1,137

EUR

The case is finalised here………

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