The financial statements must present the entity's model to reflect source as faithfully as possible.
Ideally, the entity's business model presented by the financial statements allows appropriate analyses on the entity to be conducted and even management decisions to be made.
As the literature has already described many times, the rules of IFRS 9 hedge accounting serve to present the economic considerations of a chosen hedging strategy more easily, and more faithfully reflecting source, in the financial statements (cf. IDW Auditing and Accounting Board Statement on Accounting 48 item 332). At the same time, the rules of the standard must be fully taken into account (c.f. ibid and IFRS 9.BC6.291). As the new IFRS 9 standard not only contains many practical expedients (for example discontinuing the minimum effectiveness requirement under IAS 39.AG105) but also several challenges (for example the calculation of currency basis spreads and aligned values; cf. IFRS 18.104.22.168), many entities have exercised the option and are continuing to apply their existing IAS 39 hedge accounting (IFRS 22.214.171.124).
However, the option to retain hedge accounting based on IAS 39 will exist until the endorsement of the standard for macro hedge accounting at the latest, at which point it will be removed. Ideally, entities will use the time before mandatory transition to make sure they don't end up with scarce (advisory) resources and are not under time pressure to implement the rules. This is one of the main reasons why a number of entities are currently transitioning their hedge accounting from IAS 39 to IFRS 9.
In the transition projects we have assisted on, we have identified various matters that typically create challenges. While some challenges are larger in nature, there are several others that can be solved easily. In this article, we present you with some helpful points for hedge accounting in the context of procurement transactions.
Hedge accounting for procurement transactions typically involves hedging of currency risks through FX forwards or of commodity price risks through commodity forwards, with both cases ensuring a fixed calculation basis of procurement prices economically. In almost all cases, entities apply cash flow hedge accounting for these transactions.
The basic approach: according to IFRS 9, the derivative is measured separately in OCI (other comprehensive income) until the good whose price has been hedged has been received [I]. On receipt of the good, the costs are adjusted by the hedging success, the 'basis adjustment' [II]. The good is subsequently assessed for net realisable value (IAS 2.33) and utilised through profit or loss at its adjusted cost [III].
Potential sources of error:
With the derivative being recognised using cash flow hedge accounting [I], OCI is then determined as a debit or credit entry. This addition must be shown in the OCI reconciliation in the consolidated statement of profit or loss and other comprehensive income. Although the basis adjustment represents the usual case and this does not constitute a reclassification under hedge accounting rules, this allocation must be shown in the OCI item 'Allocation to OCI that may be reclassified'. The reason for this presentation is that the hedged item may cease to exist during the term of the hedge or an overhedge situation may arise. Such an exceptional situation would then lead to reclassification to profit or loss and requires the stated form of presentation (cf. IFRS 126.96.36.199, 6.5.15, IAS 1.82A(a)).
In general, however, the situation of the hedged item ceasing to exist or overhedging does not arise, and the procurement occurs normally. While IAS 39.98 included the option to continue to present the OCI or to make a basis adjustment, the basis adjustment approach is now mandatory [II]. However, this procedure must no longer affect OCI in the statement of profit or loss and other comprehensive income (IFRS 188.8.131.52 (d)(i)). Therefore, while the case described of hedge accounting for procurement transactions does result in an addition to OCI (and thus an adjustment to total comprehensive income), the OCI option via the basis adjustment must not be shown in the statement of profit or loss and other comprehensive income. Correspondingly, the total comprehensive income no longer reconciles the equity carried forward to the equity closing balance! But since the equity closing balance has been established, a further position must be added in the equity reconciliation (for example 'Gains and losses from hedging transactions that have been reclassified to inventories'). Indeed, these effects should be explained to the internal and (as required) also to the external users of the financial statements. This applies especially if the circumstances described transpire not just for derivatives held as at the last reporting date but also for derivatives held during the year. There is a particular effect if the good procured during the year has already been utilised [III]:
The procured good is included in the cost of materials (or the cost of goods sold) and so becomes part of EBIT in the statement of profit or loss and other comprehensive income. Gross profit is recognised at the hedging rate. Furthermore, the allocation to OCI during the year must be shown in the OCI reconciliation within the statement of profit or loss and other comprehensive income. The hedging gain or loss must therefore be included twice in the statement of profit or loss and other comprehensive income. For equity to be correct as at the reporting date, the hedging gain or loss must then be shown a third time, in the equity reconciliation statement.
As well as the stated error sources, the biggest challenges generally remain to calculate the currency basis spreads (CCBS) and the associated disclosure requirements in the notes (in this case especially IFRS 7.24).
The Finance and Treasury Management Team can help you to solve this challenge and others in hedge accounting, both in an advisory and auditing context.
Source: KPMG Corporate Treasury News, Edition 102, June 2020
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