This narrative can also be used as a sort of starting point to the hedge documentation required for each hedging relationship at inception. Part 1 of 3
|Here is part 2 of 3|
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
Background and assumptions
Company A is a French company with a EUR functional currency. Its reporting dates are 30 June and 31 December.
Company A produces and sells packaging for the food industry. Company A is going to launch a new product and needs to purchase raw material for its production.
Production is scheduled to start in September 20×6. Company A’s management expects to purchase a significant amount of raw material in July 20×6 for the start of production. An unrelated company based in the US will supply the raw material. Based on A’s production plans and the prices that the supplier is currently charging, Company A’s management forecasts that 5,000,000 units of raw material will be received and invoiced on 31 July 20×6 at a price of USD 2 per unit. The invoice is expected to be paid on 30 September 20×6.
On 1 July 20×5, Company A’s management decides to hedge the foreign currency risk arising from its highly probable forecast purchase. Company A enters into a forward contract to buy USD and sell EUR. On that date, the forecast purchase is considered highly probable, as the board of directors has approved the launch of the new product, management is setting up the new production line, and negotiations with the American supplier are well advanced.
The foreign currency forward contract entered into as a hedge of the highly probable forecast purchase is as follows:
EUR 1 = USD 1.2679
Spot rate at inception
EUR 1 = USD 1.2693
Market rates on key dates during the hedge are as follows:
EUR/USD spot rate
EUR/USD forward rate1
EUR discount rate
USD discount rate
FX risk management – Headlines only
Company A’s functional currency is the EUR. Company A is exposed to foreign exchange risk on its purchases and sales that are denominated in currencies other than EUR. It is therefore exposed to the risk that movements in exchange rates will affect both its net income and financial position, as expressed in EUR.
Company A’s foreign currency exposure arises from:
- Highly probable forecast transactions (sales/purchases) denominated in foreign currencies;
- Firm commitments denominated in foreign currencies; and
- Monetary items (mainly trade payables and receivables) denominated in foreign currencies.
Company A is mainly exposed to EUR/USD risks. Transactions denominated in foreign currencies other than USD are presently considered as not material and are not hedged.
Company A’s policy is to hedge all material foreign exchange risk associated with highly probable forecast transactions, firm commitments and monetary items denominated in foreign currencies.
Company A’s policy is to hedge the risk of changes in the relevant spot exchange rate.
Three accounting approaches for FX hedges
An entity has a choice of three accounting approaches for hedges of a foreign currency risk using a forward contract:
The choice can be made on a hedge by hedge basis. Ineffectiveness may arise if the timing of the forecast transaction does not match the maturity of the forward contract whichever designation is used. This is because IFRS 9 requires the time value of money to be considered when measuring hedge ineffectiveness; discounted amounts must be used for this purpose.
In addition, if the entity uses a spot rate designation with forward points recognise in P&L, changes in the value of these forward points will give rise to volatility in profit or loss.
Hedging accounting policy disclosures – Headlines only
Only vanilla forward contracts are used to hedge foreign exchange risk.
All derivatives must be entered into with counterparties with a credit rating of A or higher.
Only the spot element of the forward contract is designated as the hedging instrument and therefore only the spot component is included in the hedge relationship (i.e. the forward points are excluded from the hedge relationship and recognised in other comprehensive income).
At the inception of a hedging relationship management should formally document the hedging relationship including:
Risk management objective and strategy;
Identification of the hedging instrument, the hedged item, the nature of the risk being hedged (EUR/USD spot exposure) and potential sources of ineffectiveness; and
Description of how management will assess whether the hedging relationship meets the hedge effectiveness requirements, including: (a) that there is an economic relationship between the hedged item and hedging instrument; (b) credit risk does not dominate the value changes that result from the economic relationship; and (c) the hedge ratio in the hedge relationship is the same as the quantity of the hedged item and of the hedging instrument that the entity actually uses for hedging purposes.
Company A shall assess on an ongoing basis, whether the hedging relationship meets the hedge effectiveness requirements. At a minimum, Company A will perform the ongoing assessment at each reporting date or upon a significant change in the circumstances affecting the hedge effectiveness requirements, whichever comes first.
The assessment relates to expectations about hedge effectiveness and therefore is only forward-looking. Consistent with the risk management policy and nature of risk exposure, hedge effectiveness requirements are demonstrated based on critical terms (amount, currency, maturity date). Under Company A’s policy, management is therefore required to align the characteristics of the hedging instrument to those of the hedged item (nominal amount, currency and maturity). For hedges of forecast transactions, the forward looking assessment should also confirm that the transaction is still highly probable.
In the hedge documentation, management will demonstrate on the basis of a qualitative assessment of those critical terms that an economic relationship exists meaning that the hedging instrument and the hedged item have values that will generally move in opposite directions because of the same risk, which is the hedged risk.
Hedging accounting entries
If the criteria for applying cash flow hedge accounting are met, the hedging accounting entries during the duration of the hedge are as follows:
- Change in fair value related to the change in spot rate of the hedging instrument (‘change in fair value attributable to spot’) is recognised in other comprehensive income (and in the cash flow hedge reserve in equity). This is the hedged risk. The standard does not prescribe how this should be calculated, but requires time value of money to be considered. As such Entity A calculates this change in fair value by identifying at inception of the hedge which part of the expected cash flows is related to the spot rate (‘the spot component’) expressed in functional currency. At each testing date this spot component is recalculated using the market spot rate at the time of calculation. The movement in the spot component is equal to the change in expected cash flows due to spot rate changes. This change is discounted to identify the part of the fair value change which is related to change in spot risk taking into account time value of money; and
- Change in fair value of the forward points (‘the forward element’) is recognised in other comprehensive income (and in the cost of hedging reserve in equity) to the extent that it relates to the hedged item.
- Any ineffectiveness in the relationship is recognised directly in P&L.
- When the hedged forecast transaction subsequently results in the recognition of a non-financial asset (Raw material inventory), Entity A shall remove the accumulated hedging gain or loss at that date from the cash flow hedge/cost of hedging reserve and include it directly in the initial cost or other carrying amount of the asset. (This is referred to as a basis adjustment).
Consider this !
The amount that is included as a basis adjustment is limited to the amount that the entity expects will be recovered in profit or loss in one or more future periods. If the change in fair value of the hedging instrument is a loss and the entity expects that all or a portion of that loss will not be recovered in future periods, that amount should be reclassified immediately to profit or loss (either as a reclassification from the cash flow hedge reserve, or if inventory has been recognised, by reducing the carrying value of that inventory).
If the hedge is discontinued prior to maturity of the derivative (for example because the hedging objective was to hedge to the date the inventory is delivered but the derivative matures when the accounts payable balance is due to be settled) then subsequent fair value movements relating to both the spot and forward components will be recorded directly in P&L.
Hedge documentation – Headlines only
Company A’s hedge documentation is as follows:
Risk management objective
In order to comply with Company A’s foreign exchange risk management strategy as described above, the foreign exchange risk arising from the highly probable forecast purchase, payable on 30 September 2006 and detailed below, is hedged.
Cash flow hedge: hedge of the foreign currency risk arising from highly probable forecast purchases.
Nature of risk being hedged
EUR/USD spot exchange rate risk arising from a highly probable forecast purchase denominated in USD that is expected to occur on 31 July 20×6 and to be settled on 30 September 20×6.
Identification of hedged item
Nature of the transaction
Forecast purchase of 5,000,000 units of raw material
Expected timescale for forecast transaction to take place:
USD 2 per unit
Rationale for forecast transaction being highly probable to occur:
- The board of directors has approved the launch of the new product;
- Management is setting up the new production line which is scheduled to start in September 20×6;
- Negotiations with the American supplier are well advanced;
- The process is still on schedule and management expect to take delivery on 31 July 20×6 as planned; and
- The volume of the purchases is in line with production forecasts.
Identification of hedging instrument
Transaction number: reference number K1121 in the treasury management system.
The hedging instrument is a vanilla forward contract to buy USD 10,000,000 with the following characteristics:
Type Hedge of forecast foreign currency purchases
Amount purchased Hedge of forecast foreign currency purchases
Amount sold Hedge of forecast foreign currency purchases
Forward rate Hedge of forecast foreign currency purchases
EUR 1 = USD 1.2679
Spot rate at inception Hedge of forecast foreign currency purchases
EUR 1 = USD 1.2693
Start date Hedge of forecast foreign currency purchases
Maturity date Hedge of forecast foreign currency purchases
Only changes in the spot component of forward contract K1121 are designated as the hedging instrument of the forecast purchase identified as the hedged item.
The forward element that exists at inception is the following:
- (10,000,000 USD/forward rate)– (10,000,000 USD/spot rate) = (10,000,000 USD/1.2679) – (10,000,000 USD/1.2693) = 8,699 EUR.
- The terms of the forward contract are fully aligned with the critical terms of the hedged item.
Hedge effectiveness Hedge of forecast foreign currency purchases
In order to qualify for hedge accounting, the following effectiveness requirements have to be fulfilled.
Economic relationship Hedge of forecast foreign currency purchases
As per ‘the cash flow hedge on foreign exchange currency exposure policy’, critical terms shall be applied to
assess qualitatively the economic relationship between the hedging instrument and the hedged items.
The hedged item creates an exposure to sell USD 10m and buy EUR. The forward contract is to buy USD 10m and sell EUR. As the hedged exposure is exactly matched by the USD leg of the forward contract (i.e. they are both the same amount of USD with the same payment date), there is a clear economic relationship between the hedging instrument and the hedged item.
Effect of credit risk Hedge of forecast foreign currency purchases
As credit risk is not part of the hedged risk, the credit risk of Company A only impacts value changes of the hedging instrument.
Credit risk arises from the credit rating of Company A and the counterparty to the forward contract. Group Treasury monitors the company and the bank’s credit risk for adverse changes. The risk associated with Company A and the bank is considered minimal and at inception does not dominate the value changes that result from the economic relationship (i.e. the effect of changes in USD/EUR). This will be re-assessed in cases where there is a significant change in either party’s circumstances.
Hedge ratio Hedge of forecast foreign currency purchases
To comply with the risk management policy, the hedge ratio is based on a forward contract with a notional amount of USD 10,000,000 for the purchase of 5,000,000 units of the raw material with an expected purchase price of USD 10,000,000. This results in a hedge ratio of 1:1 or 100%.
In this example the hedge ratio is 1:1 but in some cases it will not be possible to purchase the perfect hedging instrument – for example the forward contract might have a slightly different notional or maturity date.
Providing the hedge ratio does not result in an imbalance that would create hedge ineffectiveness that could result in an accounting outcome inconsistent with the purpose of hedge accounting (IFRS 9 para 6.4(c)(iii) and there is a clear economic relationship between the hedging instrument and hedged item this would not prevent hedge accounting.
Sources of ineffectiveness Hedge of forecast foreign currency purchases
The following potential sources are identified:
- Changes in timing of the payment of the hedged item;
- Reduction in the amount of the hedged purchase considered to be highly probable or its price; and
- A change in the credit risk of Company A or the bank counterparty to the forward contract.
The impact of foreign currency basis spreads has been ignored for simplification purposes. However, in reality this would represent a source of ineffectiveness in the relationship [IFRS 9 B6.5.5] unless it is excluded from the designated hedging instrument.
Frequency of assessing hedge effectiveness Hedge of forecast foreign currency purchases
Hedge effectiveness is assessed at inception of the hedge, at each reporting date (30 June and 31 December), and upon a significant change in the circumstances affecting the hedge effectiveness requirements.
Although retrospective testing is not required, Company A must document the hedge effectiveness requirements are still expected to be met at each reporting period and post ineffectiveness in P&L.
Items excluded from the assessment of hedge effectiveness Hedge of forecast foreign currency purchases
All changes in fair value of the derivative instrument attributable to changes in the forward rate between the USD and EUR will be excluded from assessment of hedge effectiveness as the hedged risk has been designated as changes in the spot rate. Such amounts will be deferred as a component of OCI.