In case a change in fair value of a hedging instrument results in a cumulative loss position and the entity expects that all or a portion of that loss will not be recovered in future periods by a gain on the hedged position, that amount is recognised immediately in profit or loss (either as a reclassification from the cash flow hedge reserve or recognition of the amount held off-balance sheet in a cost price hedge). In our view, a company should develop a systematic and rational method, based on its risk management objective, for determining the amounts to be recognised in profit or loss in each reporting period.

What’s the issue?

For cash flow and/or cost price hedges of a forecasted transaction, the effective portion of the accumulated gains and losses recorded in equity or held off-balance sheet, respectively, is recognised in profit or loss in the same period or periods during which the related hedged transaction affects the profit and loss account. Due to the COVID-19 outbreak, the risk of losses not being recoverable may have increased. In which case the question arises how to account for a cumulative loss on the hedging instrument which is no longer expected to be recovered.

Fred Versteeg

Partner Department of Professional Practice

KPMG Nederland

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Getting into more detail

The effective portion of changes in fair value of a hedging instrument in a cash flow hedge or cost price hedge is recognised in equity or is held off-balance sheet, respectively, when the hedged position of the expected forecasted transaction has not yet been recognised, in order to achieve that these changes in value are recognised in the same period in the result as the changes in value which they are intended to hedge. 

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Recognition change in value

Cash flow hedge

Cost price hedge

1.

Hedge instrument value: -100

 

Hedged position value: +90

Net loss of 10 in profit and loss account (‘over-hedged’)

 

Result (Dt)                                 10

Cash flow hedge reserve (Dt)    90

Derivative liability (Cr)              100

Net loss of 10 in profit and loss account*

 

Result (Dt)                    10

Derivative liability (Cr)  10              

 

Off-balance: 90 Derivative loss

2.

Hedge instrument value: -90

 

Hedged position value: +100

Profit and loss account is not affected (‘under-hedged’)

 

Cash flow hedge reserve (Dt)   90

Derivative liability (Cr)               90

 

Profit and loss account is not affected

 

No entries recorded

 

Off-balance: 90 Derivative loss

 

* Recognition under cost price hedge only insofar the ineffectiveness per balance sheet date results in a loss on a cumulative basis (since the start of the hedge relationship).

 

In case the change in fair value of a hedging instrument results in a cumulative loss (as stated above) and the entity expects that all or a portion of that loss will not be recovered in future periods by a gain from the hedged position, that amount is recognised immediately in profit or loss (either as a reclassification from the cash flow hedge reserve or recognition of the amount held off-balance in a cost price hedge). In the above situations, the maximum amount to be charged to profit or loss, in case nothing would be recoverable in future periods from the hedged position, would be 90. In our view, a company should develop a systematic and rational method, based on its risk management objective, for determining the amounts that it does not expect to be recoverable to be recognised in profit or loss in each reporting period.

Example

Airline Company X has in place a cash flow hedge of a future purchase of jet fuel with a forward contract. The exercise price of the forward contract is 1,000. Due to COVID-19 outbreak, the market price of jet fuel declines to 800 at the reporting date and X recognises a loss of 200 in the cash flow hedge reserve (CFHR). At the reporting date, X evaluates whether the loss is recoverable. The following information is relevant for the analysis:

  • Expected payment for fuel 800
  • Expected other variable costs of flight 190
  • Allocation of non-variable costs to flight – e.g. aircraft depreciation 600
  • Expected revenue from ticket sales 1,300

In our view, the amount recoverable from the purchase of the fuel is 510 (= 1,300 -/- 600 -/- 190) and as this is lower than the cost of jet fuel (which is 800), the loss of 200 in CFHR should be immediately reclassified to profit or loss. In case the loss were not reclassified now, then technically – when the fuel is delivered – X would be required to record the inventory purchase at 800, increase the carrying amount of the fuel asset by 200 and subsequently immediately include the 200 in what would be a 490 write-down to the net realisable value, which would demonstrate that the loss is not recoverable.

Actions for management to take now

  • Assess whether cumulative losses on hedging instruments are no longer expected to be recovered.
  • Develop a systematic and rational method, based on the company’s risk management objective, to determine the amounts to be recognised in profit or loss in each reporting period.