Instead of hedging the total changes in fair values or cash flows, risk managers often enter into derivatives to only hedge specific risk components. Managing a specific risk component reflects that hedging all risks is often not economical and hence not desirable, or not possible (because of a lack of suitable hedging instruments). Risk components – General requirements
However, under IAS 39, a non-financial item can only be designated as the hedged item for its foreign currency risk or all its risks in their entirety. There is no such restriction for financial items, therefore creating an inconsistency in hedge accounting for risks of financial and non-financial items. This results in many risk management activities, in particular those of non-financial services entities, not qualifying for hedge accounting under IAS 39, or else hedge ineffectiveness being artificially overstated.
The hedge accounting requirements in IFRS 9 now permit an entity to designate a risk component of a non-financial item as the hedged item in a hedging relationship, provided the risk component is separately identifiable and reliably measurable. This is likely to enable many more common risk management strategies to qualify for hedge accounting and will result in less ineffectiveness in profit or loss. Risk components – General requirements
A risk component may be contractually specified or it may be implicit in the fair value or the cash flows of the item to which the component belongs. However, the mere fact that a physical component is part of the make-up of the whole item does not mean that the component necessarily qualifies as risk component for hedge accounting purposes. A physical component is neither required nor by itself sufficient to meet the criteria for risk components that are eligible as a hedged item. However, depending on the market structure, a physical component can help meet those criteria (see ‘Non-contractually specified risk components’ in link below). For example, just because rubber is a physical component of car tyres that does not mean that an entity can automatically designate rubber as a risk component in a hedge of forecast tyre purchases or sales, since the price of tyres, may be related only indirectly to the price of rubber. Further analysis of the pricing structure of the whole car tyre would be required.