Hedge Of Forecast Foreign Currency Purchases – FAQ | IFRS

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 3 of 3

Here is part 1 of 3

and here is part 2 of 3

The Case

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

31 July 20×6

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.

Recognition of delivery

The journal entry is as follows:

DR

CR

Inventory (raw material)

7,798,487

EUR

Trade payable

7,798,487

EUR

GL Description: Purchase of USD 10m at spot rate of 1.2823

As the trade payable is short-term, Company A has determined that the effect of discounting is not material.

The trade payable is therefore recognised at its face value.

Fair value of forward

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 31/07/20×6

Derivative as at 31/07/20×6

Full Fair ValueChange in spot component

Notional amount in USD

10,000,000

USD

Notional amount in USD

10,000,000

USD

Forward rate at valuation date

1.2819

Spot rate at valuation date

1.2823

EUR equivalent (A)

7,800,921

EUR

Spot component at valuation date (A)

7,798,487

EUR

EUR contracted amount (B)

-7,887,057

EUR

Spot component at inception (B)

7,878,358

EUR

Total (A + B)

-86,136

EUR

Difference (A-B)

-79,871

EUR

Discount factor EUR

0.9991

Discount factor EUR

0.9991

Fair value of derivative

-86,059

EUR

Fair value of spot component

-79,799

EUR

Derivative as at 31/07/20×6

Forward points

31/07/20×6

Change in full fair value (FV)

-86.059 (- – =) + 29,090 = A

-56,969

EUR

Change in FV attributable to spot

-79,799 (- – =) + 24,101 = B

-55,698

EUR

Change in value of forward points

A – B =

-1,271

EUR

Cumulative change in forward value

-6,126 + 1,137=

6,260

EUR

The journal entry is as follows:

DR

CR

Derivative

56,969

EUR

Other Comprehensive Income – Hedging (equity) reserve

55,698

EUR

Other Comprehensive Income – Forward element

1,271

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 – conclusion

56,969

EUR

Other Comprehensive Income – Hedging (equity) reserve

55,698

EUR

Profit or loss – Forward element

1,271

EUR

Basis adjustment Hedge of forecast foreign currency purchases – conclusion

The loss on the hedging derivative related to changes in prevailing spot rates and the balance on the cost of hedging reserve is included in the carrying amount of the inventory acquired.

The basis adjustment affects profit or loss on sale of the goods containing the hedged items (the raw material) or on impairment of the inventory.

The journal entry is as follows:

DR

CR

Equity – Hedging reserve

79,799

EUR

Inventory (Raw material)

79,799

EUR

Equity – Forward element

6,260

EUR

Inventory (Raw material)

6,260

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

Basis adjustment – additional information

IFRS 9 requires that a basis adjustment is applied when hedging a forecast transaction that results in the recognition of a non-financial asset or non-financial liability, as is the case here with the recognition of raw material inventory.

The ‘basis adjustment’ approach was optional under IAS39.

A further difference to IAS 39 is that when the basis adjustment is made to inventory (or other non-financial item) it does not go through OCI as it is not a reclassification adjustment under IAS 1. The impact is that the overall gain or loss on the hedging derivative is recorded twice in the statement of comprehensive income (but potentially in different accounting periods) – Once through OCI during the hedging period and once in cost of sales when the inventory is sold.

The amount in the cost of hedging reserve in relation to any fair value movements of the forward element previously deferred in equity via OCI are also transferred directly to inventory.

As the forward contract hedges the cash flow for settlement of the trade payable which occurs after the recognition of the inventory, if material some of the change in value of the forward points recognised in other comprehensive income would not be removed from the costs of hedging reserve at this time. In this example it is assumed that the amount is not material so the entire cumulative change in forward points recognised in the cost of hedging reserve as at the date of recognition of inventory have been included in the initial cost of inventory as a basis adjustment.

30 September 20X6

Translation of trade payable at the spot rate

The trade payable is a monetary item denominated in a foreign currency that must be retranslated at the spot rate under IAS 21, with the resulting currency gain or loss recognised in profit or loss.

The calculation of the gain or loss is as follows:

Trade payable USD 10,000,000

– translated at 31 July at 1.2823

A

7,798,487

EUR

– translated at 30 September at 1.3178

B

7,588,405

EUR

Foreign exchange gain to be recognised in profit and Loss

A – B =

210,082

EUR

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

The journal entry is as follows:

DR

CR

Foreign exchange difference – Profit or loss

210,082

EUR

Trade payable

210,082

EUR

GL Description: Revaluation of trade payable to 30/09/20×6 EUR/USD rate

Fair value derivative Hedge of forecast foreign currency purchases – conclusion

Recognition of the change in the fair value of the derivative

Derivative as at 30/09/20×6

Derivative as at 30/09/20×6

Full Fair ValueChange in spot component

Notional amount in USD

10,000,000

USD

Notional amount in USD

10,000,000

USD

Forward rate at valuation date

1.3178

Spot rate at valuation date

1.3178

EUR equivalent (A)

7,588,405

EUR

Spot component at valuation date (A)

7,588,405

EUR

EUR contracted amount (B)

-7,887,057

EUR

Spot component at inception (B)

7,878,358

EUR

Total (A + B)

-298,652

EUR

Difference (A-B)

-289,953

EUR

Discount factor EUR 

1.0000

Discount factor EUR

1.0000

Fair value of derivative

-298,652

EUR

Fair value of spot component

-289,953

EUR

Derivative as at 30/09/20×6

Forward points

30/09/20×6

Change in full fair value (FV)

-298,652 (- – =) + 86,059 = A

-212,593

EUR

Change in FV attributable to spot

-289,953 (- – =) + 79,799 = B

-210,154

EUR

Change in value of forward points

A – B =

-2,439

EUR

Cumulative change in forward value

-6,260 -2,439 =

-8,699

EUR

The journal entry is as follows:

DR

CR

Derivative Hedge of forecast foreign currency purchases – conclusion

212,593

EUR

Other Comprehensive Income – Hedging (equity) reserve

210,154

EUR

Other Comprehensive Income – Forward element

2,439

EUR

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

Recycling hedge reserve

The accounting entry to release the amount in the hedge reserve to hedge FX recognised on the payable:

The journal entry is as follows:

DR

CR

Other comprehensive income – Hedging reserve Hedge of forecast foreign currency purchases – conclusion

210,154

EUR

Foreign exchange difference – Profit or loss1 3

210,154

EUR

Other Comprehensive Income – Forward element

2,439

EUR

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

2,439

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

Hedge accounting alternative

Hedge accounting is not always necessary when a company is hedging the foreign currency risk arising from short-term monetary items such as foreign currency payables and receivables.

A common strategy under IAS 39 was to de-designate the hedge once the purchase had been recognised (30 July 20×6). This achieves a similar result to that achieved under hedge accounting, as:

  1. The derivative, not being designated as a hedging instrument, would have been measured at fair value through profit or loss on 30 September 20×5; and
  2. The foreign currency payable, which is a monetary item, would have been revalued using the spot exchange rate at the balance sheet date.

IFRS 9 does not permit de-designation of a hedging relationship if the hedging objective has not changed; nor does it designation of a derivative for only part of its life. The above designation and de-designation will therefore only be in line with IFRS 9 if it forms part of the company’s risk management strategy and objective for this hedge relationship.

IFRS 9 B6.5.24(c) does envisage such a scenario and notes that within a strategy to manage the foreign currency risk of forecast sales and the resulting receivables (or purchases and payables), the entity may ‘manage’ the currency risk until settlement date or until recognition of the receivable/payable. In the latter case it would have to discontinue at that point even though there is an economic hedge until settlement date.

If the hedge were discontinued early in accordance with IFRS 9 B6.5.24(c) or because the forecast transaction (the purchases in this example) no longer met the hedge objective but were still expected to occur then the balances in equity (hedging reserve and forward element) on this transaction related hedge remain in equity until recognition of the hedged non-financial item or until the hedged item hits P&L.

Balance sheet – summary hedge accounting entries Hedge of forecast foreign currency purchases – conclusion

Statement of profit or loss and other comprehensive income – summary hedge accounting entries

Statement of changes in equity – summary hedge accounting entries Hedge of forecast foreign currency purchases – conclusion

Hedge of forecast foreign currency purchases – conclusion

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