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Embedded derivatives and hedge accounting

Embedded derivatives and hedge accounting

A solution when accounting for goods supplied prior to fixing a procurement transaction price pursuant to IFRS?

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It is customary in a number of sectors and for a wide range of commodities to use contracts by which goods are supplied before a final transaction price has been fixed. Once the goods are within the control of the company, they must be recognised as additions to inventories, and a corresponding liability has to also be recognised. However, after initial recognition, the values of these two items are reported very differently in the statement of financial position1

                                                 

1 Due to the revenue recognition requirements of IFRS 15, mirroring the accounting treatment of 'delivered not fixed' sales transactions has become even more complex. We therefore do not address sales transactions any further in this context.

Conflict between cost and remeasured financial liabilities

Inventories for which final prices have not yet been fixed are initially reported at current fair value on the date of transfer of control and are subsequently measured in accordance with IAS 2. They are therefore measured at the lower of cost and net realisable value. The standards fundamentally do not provide for the direct recognition of changes in fair value of commodities as at the measurement and reporting date.

By contrast, trade payables, also measured in the amount of initial recognition of inventories, are subject to the rules for subsequent measurement of IFRS 9. At the latest since clarification by the IASB that the rules for adjusting the carrying amount to changes in estimates pursuant to IFRS 9.B5.4.6 are applicable not only to financial assets but also to liabilities, this means that the financial liability is continuously adjusted in line with current market prices (fair values). The adjustment is recognised in profit or loss as income or expense, resulting in an – at least temporary – imbalance in subsequent measurement between the two items in the statement of financial position resulting from the contract.

To what extent the value of inventories will have to be adjusted again once the final price has been fixed cannot be conclusively answered at the present time. In any event, at the latest on input of materials, by recognising a cost of materials that deviates from the fixed price, the profit or loss presented for the entire period would be correct. 

Treating a price adjustment clause as an embedded derivative in conjunction with fair value hedge accounting: a solution in the case of accounting mismatch?

In order to be able to accurately present the procurement of commodities not only for the entire period, there is a solution that presents itself from a direction not initially expected. The generally rather unpopular topic of 'embedded derivatives' together with hedge accounting according to IFRS 9 presents an accounting alternative that avoids mismatches between the individual reporting periods. 

This is because at closer inspection, a price adjustment clause represents an embedded derivative (forward transaction on the commodity price concerned). When examining it further, it becomes clear that the host contract (i.e. the trade payables) and the embedded derivative (the clause for adjustment to the commodity price) are not closely interlinked. This is because the risk profiles differ in this case: a liability as such is not exposed to commodity risk. As a result, the two contractual components are accounted for separately. Consequently, one would initially recognise a fixed financial liability in the amount of the then applicable fair value and thus also the inventories. In assuming a contract in line with the market, the value of the embedded derivative that must be presented separately would initially be zero. In the event of subsequent changes in commodity price, the embedded derivative would then be measured at fair value (usually the present value of the difference between the value fixed on recognition and the forward price of the underlying commodity or the value derived from the pricing formula).This can result in an accounting mismatch particularly in the event of price rises. While higher measurement of inventories can be excluded in this case, the embedded derivative's fair value will become negative, which would have to be recognised as an expense.

The solution is designation as a fair value hedge pursuant to IFRS 9: while the inventories recognised at cost are exposed to price risk, the price adjustment clause (in the form of an embedded and separate short futures position on the commodity) represents the perfect hedging instrument. Accordingly, a fair value hedge adjustment of inventories would also be recognised in profit or loss, which offsets the derivative's effect on profit or loss. If it is 100% effective, profit or loss for the period would then be zero. The liability in fact recognised at a fixed price as a host contract, contrary to the initial case, is no longer subject to remeasurement pursuant to IFRS 9.B5.4.6, as the volatility was already separated by virtue of the embedded derivative.

A downside of this solution might be seen in the continuous designation and documentation as a fair value hedge for 'delivered not fixed' inventories and disclosures in the notes required for the embedded derivative and hedge accounting. 

Conclusion

In conclusion we find that, all things considered, this solution can result in the most suitable accounting treatment of contracts for commodities supplied prior to fixing prices. Compared to profit or loss that would otherwise be volatile and not attributed to the correct period, the higher administrative expense should be a price well paid for the proper external presentation of operating activities.

Source: KPMG Corporate Treasury News, Ausgabe 82, Juli 2018
Author: Robert Abendroth, Senior Manager, Wirtschaftsprüfer, Finance Advisory, rabendroth@kpmg.com

© 2018 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.

Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm.

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