While IFRS 9 is primarily associated with more requirements and higher implementation costs for many banks and corporations whose primary focus is hedging foreign exchange and interest rate risks, IFRS 9 opens up new possibilities for companies that focus on commodity hedging, as it allows them to more easily present financially viable hedges in their financial statements. Commodity hedge accounting pursuant to IAS 39 often involved high implementation costs and major inefficiencies for companies with significant commodity consumption, which frequently was the cause for very limited use of commodity hedging. Many companies now plan an expansion of their hedging activities.
Companies that use commodity hedging generally held the view that hedge accounting pursuant to IAS 39 is only of limited use for the presentation of commodity hedges. The requirements for designation, homogeneity testing and assessment of hedge effectiveness were too inflexible and elaborate. While it is generally easy to identify the designated foreign exchange or interest component of a transaction, this was usually considerably more difficult for procurement and sales transactions relating to commodities.
The entire transaction needs to be designated
According to IAS 39, the entire transaction needs to be designated, which also includes non-commodity components such as transport, insurance and handling. Premiums for certain processing methods or qualities, which were not evident themselves from the related contracts, also had to be designated as part of the hedged item and thus included in the assessment of hedge effectiveness. For sales transactions, the expected gross profit margin (value added) also had to be considered in hedges in addition to the commodity-dependent price component.
Option: Designating individual risk components as part of the hedging relationship
The provisions of IFRS 9, on the other hand, provide the option of also designating individual risk components as part of the hedging relationship. Therefore, the components that can be hedged through financial contracts can be presented separately in hedge accounting for the relevant transactions. The hedged item is therefore homogeneous, for example also in cases of otherwise differing sales transactions, which makes the frequently elaborate homogeneity test redundant.
For example, it is now possible for an automotive supplier to combine its LME-indexed procurement transactions for pre-processed metal products, including all related hedging transactions, into one robust hedge. Due to the separability of price components, hedges of complex energy procurement contracts with complex pricing formulas can now be presented much more easily in the financial statements of energy suppliers, to give just one example.
Particularly interesting in this context is that not only can commodity components explicitly contained in pricing formulas be designated as a hedged item, but also implicit dependencies of the prices of non-financial hedged items on commodity prices, if this interdependence is clearly identifiable, occurs due to economic reasons and is statistically clearly provable.
This means that not only can commodity price indexation clauses (such as alloy surcharges) and price indexing (such as oil prices in natural gas contracts) be hedged, but also fluctuations in the price of commodity components for semi-finished and finished products (such as oil prices relating to petrochemical products for further processing).
Due to the less complex definition of a hedge, measuring hedge effectiveness and determining inefficiencies has become much less elaborate, because it is not necessary to simulate for example the development of prices of components in the contract that are independent of the hedged commodity.
The most important improvement for many companies certainly is that the volume of inefficiencies to be recognised in profit or loss is significantly reduced and the probability of an ineffective hedge is diminished, if unchangeable components (e.g. delivery costs) or components subject to fluctuation independent of the underlying (e.g. premiums) are no longer included in analysis. Due to the increase in expected hedge effectiveness, hedging strategies that had been disregarded in the past due to insufficient probability of continuity (such as proxy hedges) can now be used again with reasonable expectation of effectiveness.
The formal requirements for measuring hedge effectiveness have also changed. Effectiveness now only has to be measured prospectively, additional retrospective measurement is no longer required. IFRS 9 also does not define any fixed limits with regard to the ratio of changes in value (previously: 80-125%). This requirements will certainly be specified further in the coming months. It is conceivable in this regard that the criteria for the formal measurement of effectiveness will become less restrictive for highly effective commodity hedges than under IAS 39.
In the past, many companies conducted feasibility studies for the introduction of commodity hedge accounting and then decided not to pursue it any further because of the above challenges. These companies should carry out a new evaluation within the new framework. Other companies, which did not use commodity hedging at all in the past because of its complex accounting treatment, are now reconsidering their options. In any event, time is running out until mandatory first-time adoption of IFRS 9, so that transition projects should be initiated in the next few months.
Especially the correct entry of pricing formulas and their components should present a challenge given the usual entry in materials management systems without reference to accounting (and based on hard copy files only, in the worst case scenario). Moreover, the unambiguous identification of implicit price components and the calculation of correlations between components and total price also regularly present challenges.
Source: KPMG Corporate Treasury News, Edition 53, March 2016
Autor: Bardia Nadjmabadi, Senior Manager, firstname.lastname@example.org
© 2016 KPMG AG Wirtschaftsprüfungsgesellschaft, ein Mitglied des KPMG-Netzwerks unabhängiger Mitgliedsfirmen, die KPMG International Cooperative (“KPMG International”), einer juristischen Person schweizerischen Rechts, angeschlossen sind. Alle Rechte vorbehalten.