Not all contracts define the various pricing elements and, therefore, specify risk components. In fact, most risk components of financial and non-financial items are not to be contractually specified. While it is certainly easier to determine that a risk component is separately identifiable and reliably measurable if it is specified in the contract, IFRS 9 is clear that there is no need for a component to be contractually specified in order to be eligible for hedge accounting. The assessment of whether a risk component qualifies for hedge accounting (i.e., whether it is separately identifiable and reliably measurable) has to be made ‘within the context of the particular market structure to which the risk or risks relate and in which the hedging activity takes place’.
The relevance of the market structure is that the risk component must have a distinguishable effect on changes in the value or the cash flows that an entity is exposed to. Depending on the situation, the market structure can reflect a ‘market convention’ that establishes, for example, a benchmark interest rate that has a pervasive effect on the value and cash flows for debt instruments. In other situations, the market structure reflects the particular purchasing or selling market of an entity.
For example, this is the case when an entity buys goods from its particular supplier based on a benchmark price plus other charges, as in the examples listed in ‘Contractually specified risk components‘. Even if the pricing under such a supply arrangement is not a wider market convention, its pricing formula represents the exposure of the particular entity to variability in cash flows from its purchases. The assessment is normally straightforward for contractually specified risk components, which can also be a relevant factor in the assessment of the market structure of non-contractually specified risk components such as risk components of forecast transactions.
The following example from the application guidance of IFRS 9 illustrates the ‘separately identifiable and reliably measurable’ assessment. Non-contractually specified risk components
The assessment of whether a risk component qualifies for hedge accounting is mainly driven by an analysis of whether there are different pricing factors that have a distinguishable effect on the item as a whole (in terms of its value or its cash flows). This evaluation would always have to be based on relevant facts and circumstances. Non-contractually specified risk components
The standard uses the refinement of crude oil to jet fuel as an example to demonstrate how the assessment of the market structure could be made to conclude that crude oil in a particular situation is an eligible risk component of jet fuel. Crude oil is a physical input of the most common production process for jet fuel and there is a well-established price relationship between the two.
Extending this example, crude oil is also a major input in the production process for plastic. However, the manufacturing process is complex and involves a number of steps. The process starts with crude oil being distilled into its separate ‘fractions’, of which only one (naphtha) is used for making plastic. Naphtha then undergoes a number of further processes before the various types of plastic are finally produced. Non-contractually specified risk components
Generally, the further downstream in the production process an item is, the more difficult it is to find a distinguishable effect of any single pricing factor. The mere fact that a commodity is a major physical input in a production process does not automatically translate into a separately identifiable effect on the price of the item as a whole. For example, crude oil price changes are unlikely to have a distinguishable effect on the retail price of plastic toys even though, in the longer term, changes in the crude oil price might influence the price of such toys to some degree. Similarly, the price for pasta at food retailers in the medium to long term also responds to changes in the price for wheat, but there is no distinguishable direct effect of wheat prices changes on the retail price for pasta, which remains unchanged for longer periods even though the wheat price changes. If retail prices are periodically adjusted in a way that also directionally reflects the effect of wheat price changes, that is not sufficient to constitute a separately identifiable risk component. Non-contractually specified risk components
Allowing non-contractually specified risk components as eligible hedged items opens up a new area of judgement. The assessment of the market structure will normally require the involvement of personnel with a good understanding of the drivers of market prices (e.g., members of the sales or procurement departments responsible for the underlying transactions).