1 Best Application of Hedge of forecast FX purchases

Hedge of forecast FX purchases

presents a complete descriptive case of a hedge, from start to finish. Step-by-step build a file to document a hedge and appropriately account for it under IFRS.

This narrative can also be used as a sort of starting point to the hedge documentation required for each hedging relationship at inception

The Case – Type of hedge: Cash flow hedge

Hedged risk: FX risk – spot component only

Key features: Spot rate designated, Basis adjustment required for inventory, Cost of hedging approach elected – Forward points taken to OCI, Inclusion of time value of money in measuring hedge ineffectiveness

Background and assumptions

Company A is a French company with a EUR functional currency. Its reporting dates are 30 June and 31 December.

Company A produces and sells packaging for the food industry. Company A is going to launch a new product and needs to purchase raw material for its production.

Production is scheduled to start in September 20×6. Company A’s management expects to purchase a significant amount of raw material in July 20×6 for the start of production. An unrelated company based in the US will supply the raw material. Based on A’s production plans and the prices that the supplier is currently charging, Company A’s management forecasts that 5,000,000 units of raw material will be received and invoiced on 31 July 20×6 at a price of USD 2 per unit. The invoice is expected to be paid on 30 September 20×6.

On 1 July 20×5, Company A’s management decides to hedge the foreign currency risk arising from its highly probable forecast purchase. Company A enters into a forward contract to buy USD and sell EUR. On that date, the forecast purchase is considered highly probable, as the board of directors has approved the launch of the new product, management is setting up the new production line, and negotiations with the American supplier are well advanced.

The foreign currency forward contract entered into as a hedge of the highly probable forecast purchase is as follows:

Type

Forward contract

Amount purchased

USD 10,000,000

Amount sold

EUR 7,887,057

Forward rate

EUR 1 = USD 1.2679

Spot rate at inception

EUR 1 = USD 1.2693

Start date

01/07/20×5

Maturity date

30/08/20×6

Market rates on key dates during the hedge are as follows:

01/07/20×5

31/12/20×5

30/06/20×6

31/07/20×6

30/09/20×6

EUR/USD spot rate

1.2693

1.2553

1.2732

1.2823

1.3178

EUR/USD forward rate1

1.2679

1.2526

1.2726

1.2819

1.3178

EUR discount rate

0.9935

0.9961

0.9987

0.9991

1.0000

USD discount rate

0.9946

0.9964

0.9992

0.9994

1.0000

FX risk management – Headlines only

Company A’s functional currency is the EUR. Company A is exposed to foreign exchange risk on its purchases and sales that are denominated in currencies other than EUR. It is therefore exposed to the risk that movements in exchange rates will affect both its net income and financial position, as expressed in EUR.

Company A’s foreign currency exposure arises from:

  • Highly probable forecast transactions (sales/purchases) denominated in foreign currencies;
  • Firm commitments denominated in foreign currencies; and
  • Monetary items (mainly trade payables and receivables) denominated in foreign currencies.

Company A is mainly exposed to EUR/USD risks. Transactions denominated in foreign currencies other than USD are presently considered as not material and are not hedged.

Company A’s policy is to hedge all material foreign exchange risk associated with highly probable forecast transactions, firm commitments and monetary items denominated in foreign currencies.

Company A’s policy is to hedge the risk of changes in the relevant spot exchange rate.

Three accounting approaches for FX hedges

An entity has a choice of three accounting approaches for hedges of a foreign currency risk using a forward contract:

  1. Forward rate designation
  2. Spot rate designation with changes in the value of forward points recognised in P&L
  3. Spot rate designation with changes in the value of forward points deferred in OCI

The choice can be made on a hedge by hedge basis. Ineffectiveness may arise if the timing of the forecast transaction does not match the maturity of the forward contract whichever designation is used. This is because IFRS 9 requires the time value of money to be considered when measuring hedge ineffectiveness; discounted amounts must be used for this purpose.

In addition, if the entity uses a spot rate designation with forward points recognise in P&L, changes in the value of these forward points will give rise to volatility in profit or loss.

Hedging accounting policy disclosures – Headlines only

Hedging instruments

Only vanilla forward contracts are used to hedge foreign exchange risk.

All derivatives must be entered into with counterparties with a credit rating of A or higher.

Hedging relationship

Only the spot element of the forward contract is designated as the hedging instrument and therefore only the spot component is included in the hedge relationship (i.e. the forward points are excluded from the hedge relationship and recognised in other comprehensive income).

Hedge documentation

At the inception of a hedging relationship management should formally document the hedging relationship including:

  • Risk management objective and strategy;
  • Identification of the hedging instrument, the hedged item, the nature of the risk being hedged (EUR/USD spot exposure) and potential sources of ineffectiveness; and
  • Description of how management will assess whether the hedging relationship meets the hedge effectiveness requirements, including: (a) that there is an economic relationship between the hedged item and hedging instrument; (b) credit risk does not dominate the value changes that result from the economic relationship; and (c) the hedge ratio in the hedge relationship is the same as the quantity of the hedged item and of the hedging instrument that the entity actually uses for hedging purposes.

Hedge effectiveness

Company A shall assess on an ongoing basis, whether the hedging relationship meets the hedge effectiveness requirements. At a minimum, Company A will perform the ongoing assessment at each reporting date or upon a significant change in the circumstances affecting the hedge effectiveness requirements, whichever comes first.

The assessment relates to expectations about hedge effectiveness and therefore is only forward-looking. Consistent with the risk management policy and nature of risk exposure, hedge effectiveness requirements are demonstrated based on critical terms (amount, currency, maturity date). Under Company A’s policy, management is therefore required to align the characteristics of the hedging instrument to those of the hedged item (nominal amount, currency and maturity). For hedges of forecast transactions, the forward looking assessment should also confirm that the transaction is still highly probable.

In the hedge documentation, management will demonstrate on the basis of a qualitative assessment of those critical terms that an economic relationship exists meaning that the hedging instrument and the hedged item have values that will generally move in opposite directions because of the same risk, which is the hedged risk.

Hedging accounting entries

If the criteria for applying cash flow hedge accounting are met, the hedging accounting entries during the duration of the hedge are as follows:

  • Change in fair value related to the change in spot rate of the hedging instrument (‘change in fair value attributable to spot’) is recognised in other comprehensive income (and in the cash flow hedge reserve in equity). This is the hedged risk. The standard does not prescribe how this should be calculated, but requires time value of money to be considered. As such Entity A calculates this change in fair value by identifying at inception of the hedge which part of the expected cash flows is related to the spot rate (‘the spot component’) expressed in functional currency. At each testing date this spot component is recalculated using the market spot rate at the time of calculation. The movement in the spot component is equal to the change in expected cash flows due to spot rate changes. This change is discounted to identify the part of the fair value change which is related to change in spot risk taking into account time value of money; and
  • Change in fair value of the forward points (‘the forward element’) is recognised in other comprehensive income (and in the cost of hedging reserve in equity) to the extent that it relates to the hedged item.
  • Any ineffectiveness in the relationship is recognised directly in P&L.
  • When the hedged forecast transaction subsequently results in the recognition of a non-financial asset (Raw material inventory), Entity A shall remove the accumulated hedging gain or loss at that date from the cash flow hedge/cost of hedging reserve and include it directly in the initial cost or other carrying amount of the asset. (This is referred to as a basis adjustment).

Consider this  !

The amount that is included as a basis adjustment is limited to the amount that the entity expects will be recovered in profit or loss in one or more future periods. If the change in fair value of the hedging instrument is a loss and the entity expects that all or a portion of that loss will not be recovered in future periods, that amount should be reclassified immediately to profit or loss (either as a reclassification from the cash flow hedge reserve, or if inventory has been recognised, by reducing the carrying value of that inventory).

If the hedge is discontinued prior to maturity of the derivative (for example because the hedging objective was to hedge to the date the inventory is delivered but the derivative matures when the accounts payable balance is due to be settled) then subsequent fair value movements relating to both the spot and forward components will be recorded directly in P&L.

Hedge documentation – Headlines onlyHedge of forecast foreign currency purchases

Company A’s hedge documentation is as follows:

Risk management objective

In order to comply with Company A’s foreign exchange risk management strategy as described above, the foreign exchange risk arising from the highly probable forecast purchase, payable on 30 September 2006 and detailed below, is hedged.

Hedging relationship

Cash flow hedge: hedge of the foreign currency risk arising from highly probable forecast purchases.

Nature of risk being hedged

EUR/USD spot exchange rate risk arising from a highly probable forecast purchase denominated in USD that is expected to occur on 31 July 20×6 and to be settled on 30 September 20×6.

Identification of hedged item

Hedged amount

USD 10,000,000

Nature of the transaction

Forecast purchase of 5,000,000 units of raw material

Expected timescale for forecast transaction to take place:

Delivery

31/07/20×6

Cash payment

30/09/20×6

Expected price

USD 2 per unit

Rationale for forecast transaction being highly probable to occur:

  • The board of directors has approved the launch of the new product;
  • Management is setting up the new production line which is scheduled to start in September 20×6;
  • Negotiations with the American supplier are well advanced;
  • The process is still on schedule and management expect to take delivery on 31 July 20×6 as planned; and
  • The volume of the purchases is in line with production forecasts.

Identification of hedging instrument

Transaction number: reference number K1121 in the treasury management system.

The hedging instrument is a vanilla forward contract to buy USD 10,000,000 with the following characteristics:

Type Hedge of forecast FX purchases

Forward contract

Amount purchased Hedge of forecast FX purchases

USD 10,000,000

Amount sold Hedge of forecast FX purchases

EUR 7,887,057

Forward rate Hedge of forecast FX purchases

EUR 1 = USD 1.2679

Spot rate at inception Hedge of forecast FX purchases

EUR 1 = USD 1.2693

Start date Hedge of forecast FX purchases

01/07/20×5

Maturity date Hedge of forecast FX purchases

30/08/20×6

Only changes in the spot component of forward contract K1121 are designated as the hedging instrument of the forecast purchase identified as the hedged item.

The forward element that exists at inception is the following:

  • (10,000,000 USD/forward rate)– (10,000,000 USD/spot rate) = (10,000,000 USD/1.2679) – (10,000,000 USD/1.2693) = 8,699 EUR.
  • The terms of the forward contract are fully aligned with the critical terms of the hedged item.

Hedge effectiveness Hedge of forecast FX purchases

In order to qualify for hedge accounting, the following effectiveness requirements have to be fulfilled.

Economic relationship Hedge of forecast FX purchases

As per ‘the cash flow hedge on foreign exchange currency exposure policy’, critical terms shall be applied to

assess qualitatively the economic relationship between the hedging instrument and the hedged items.

The hedged item creates an exposure to sell USD 10m and buy EUR. The forward contract is to buy USD 10m and sell EUR. As the hedged exposure is exactly matched by the USD leg of the forward contract (i.e. they are both the same amount of USD with the same payment date), there is a clear economic relationship between the hedging instrument and the hedged item.

Effect of credit risk Hedge of forecast FX purchases

As credit risk is not part of the hedged risk, the credit risk of Company A only impacts value changes of the hedging instrument.

Credit risk arises from the credit rating of Company A and the counterparty to the forward contract. Group Treasury monitors the company and the bank’s credit risk for adverse changes. The risk associated with Company A and the bank is considered minimal and at inception does not dominate the value changes that result from the economic relationship (i.e. the effect of changes in USD/EUR). This will be re-assessed in cases where there is a significant change in either party’s circumstances.

Hedge ratio Hedge of forecast FX purchases

To comply with the risk management policy, the hedge ratio is based on a forward contract with a notional amount of USD 10,000,000 for the purchase of 5,000,000 units of the raw material with an expected purchase price of USD 10,000,000. This results in a hedge ratio of 1:1 or 100%.

Hedge ratio

In this example the hedge ratio is 1:1 but in some cases it will not be possible to purchase the perfect hedging instrument – for example the forward contract might have a slightly different notional or maturity date.

Providing the hedge ratio does not result in an imbalance that would create hedge ineffectiveness that could result in an accounting outcome inconsistent with the purpose of hedge accounting (IFRS 9 6.4.1(c)(iii) and there is a clear economic relationship between the hedging instrument and hedged item this would not prevent hedge accounting.

Sources of ineffectiveness Hedge of forecast FX purchases

The following potential sources are identified:

  • Changes in timing of the payment of the hedged item;
  • Reduction in the amount of the hedged purchase considered to be highly probable or its price; and
  • A change in the credit risk of Company A or the bank counterparty to the forward contract.

The impact of foreign currency basis spreads has been ignored for simplification purposes. However, in reality this would represent a source of ineffectiveness in the relationship [IFRS 9 B6.5.5] unless it is excluded from the designated hedging instrument.

Frequency of assessing hedge effectiveness Hedge of forecast FX purchases

Hedge effectiveness is assessed at inception of the hedge, at each reporting date (30 June and 31 December), and upon a significant change in the circumstances affecting the hedge effectiveness requirements.

Although retrospective testing is not required, Company A must document the hedge effectiveness requirements are still expected to be met at each reporting period and post ineffectiveness in P&L.

Items excluded from the assessment of hedge effectiveness Hedge of forecast FX purchases

All changes in fair value of the derivative instrument attributable to changes in the forward rate between the USD and EUR will be excluded from assessment of hedge effectiveness as the hedged risk has been designated as changes in the spot rate. Such amounts will be deferred as a component of OCI.

  1. If Company A were to hedge its forecast purchases with options under the cost of hedging methodology, the time value would not be included in the designated one sided risk of a non-optional hedged item because time value is not a component of a forecast transaction that will affect profit and loss. All movements in time value will be recorded initially in the cost of hedging reserve and subsequently included in the initial cost of the inventory when it is recognised.
  2. Where the entity chooses not to apply the cost of hedging methodology for dealing with forward points i.e. deferring movements in forward points in OCI, the hedge documentation will have to be adjusted to state that movements in the forward points’ component will be recorded directly in P&L.

1 July 20×5

Hedge effectiveness assessment

As described in the hedge documentation, critical terms of the hedging instrument and the hedged items perfectly match. Therefore, management can qualitatively assess that there is an economic relationship between the hedging instrument and the hedged item and that they will generally move in the opposite direction.

Furthermore, the forecasted transaction is highly probable to occur.

The hedge ratio is set as described in the hedge documentation.

As the credit rating of the counterparty to the derivative is AA and Company A’s credit risk is considered to be high, the effect of credit risk is considered as neither material nor dominant in the economic relationship.

Conclusion: The hedge effectiveness requirements are met.

Inception of forward

No entry as the fair value of the forward contract is nil, as shown below.

Derivative as at 01/07/20×5

Notional amount in FX

10,000,000

USD

Forward rate

1.2679

EUR equivalent based on valuation date (A)

7,887,057

EUR

EUR contracted amount (B)

-7,887,057

EUR

Total (A+B)

EUR

Discount Factor

0.9935

Fair value of derivative in EUR

EUR

31 December 20×5

Hedge effectiveness assessment

The hedge continues to meet the effectiveness requirements going forward as no change has occurred in the hedging relationship or hedge ratio (no change in the date of the forecast transaction, no change in notional amount, no change in the credit risk of the counterparties, no change in sources of ineffectiveness).

Furthermore, the forecasted transaction is highly probable to occur.

Conclusion: The hedge effectiveness requirements are met.

Fair value forward

All the criteria for hedge accounting are met for the period ended 31 December 20×5. Cash flow hedge accounting can therefore be applied.

Derivative as at 31/12/20×5

Derivative as at 31/12/20×5

Full Fair Value Change in fair value attributable to spot

Notional amount in USD

10,000,000

USD

Notional amount in USD

10,000,000

USD

Forward rate at valuation date

1.2526

Spot rate at valuation date

1.2530

EUR equivalent (A)

7,983,395

EUR

Spot component at valuation date (A)

7,980,846

EUR

EUR contracted amount (B)

-7,887,057

EUR

Spot component at inception (B)

7,878,358

EUR

Total (A + B)

96,337

EUR

Difference (A-B)

102,488

EUR

Discount factor EUR

0.9961

Discount factor EUR

0.9961

Fair value of derivative

95,962

EUR

Fair value of spot component2

102,088

EUR

Risks other than foreign exchange risk, including credit risk, have been ignored for simplification purposes.

Therefore it is assumed that the present value of the spot component is the same as the fair value of the hypothetical derivative for effectiveness testing purposes and there is no ineffectiveness to record in the P&L. In reality the standard notes that the hypothetical derivative cannot include anything that is not in the hedged item, such as credit risk.

Derivative as at 31/12/20×5

Forward points

Change in full fair value (FV)

A

95,962

EUR

Change in FV attributable to spot

B

102,088

EUR

Change in value of forward points

A – B=

-6,126

EUR

Separation forward element of a contract

When an entity separates the forward element of a contract it can either recognise changes in the fair value of the forward points in other comprehensive income and accumulate them in a separate component of equity (the cost of hedging model) or record gains and losses related to the forward element directly in P&L (IFRS 9 6.5.15).

Where the cost of hedging model is applied, the forward points should be amortised ‘on a rational and consistent basis’ for a time period hedge, and recorded in the P&L when the hedged item affects P&L for a transaction related hedge.

In this example the forecast purchases are transaction related and therefore the forward points will only be released, first as a basis adjustment to inventory when the inventory is purchased, and then to profit or loss when the inventory is subsequently sold (or impaired).

The journal entry is as follows:

DR

CR

Derivative

95,962

EUR

Other Comprehensive Income – Hedging (equity) reserve

102,088

EUR

Other Comprehensive Income – Forward element

6,126

EUR

GL Description: Cash Flow Hedge – Change in fair value of the forward contract

When an entity excludes forward points from the hedge relationship and does not apply the cost of hedging approach, the accounting entries are as follows:

The journal entry excluding forward points is as follows:

DR

CR

Derivative

95,962

EUR

Other Comprehensive Income – Hedging (equity) reserve

102,088

EUR

Profit or loss – Forward element

6,126

EUR

30 June 20×6

Hedge effectiveness assessment Hedge of forecast FX purchases

The hedge continues to meet the effectiveness requirements going forward as no change has occurred in the hedging relationship or hedge ratio (no change in the date of the forecast transaction, no change in notional amount, no change in the credit risk of the counterparties, no change in sources of ineffectiveness).

Furthermore, the forecasted transaction is highly probable to occur.

Conclusion: The hedge effectiveness requirements are met.

Fair value forward Hedge of forecast FX purchases

All the criteria for hedge accounting are met for the period ended 30 June 20×6. Cash flow hedge accounting can therefore be applied.

Derivative as at 30/06/20×6

Derivative as at 30/06/20×6

Full Fair Value Change in fair value attributable to spot

Notional amount in USD

10,000,000

USD

Notional amount in USD

10,000,000

USD

Forward rate at valuation date

1.2726

Spot rate at valuation date

1.2732

EUR equivalent (A)

7,857,929

EUR

Spot component at valuation date (A)

7,854,226

EUR

EUR contracted amount (B)

-7,887,057

EUR

Spot component at inception (B)

7,878,358

EUR

Total (A + B)

-29,128

EUR

Difference (A-B)

-24,133

EUR

Discount factor EUR

0.9987

Discount factor EUR

0.9987

Fair value of derivative

-29,090

EUR

Fair value of spot component

-24,101

EUR

Derivative as at 30/06/20×6

Forward points

30/06/20×6

Change in full fair value (FV) Hedge of forecast FX purchases

-29,090 – 95,962 = A

-125,052

EUR

Change in FV attributable to spoteign currency purchases

-24,101 – 102,088 = B

-126,189

EUR

Change in value of forward points foreign currency purchases

A – B =

1,137

EUR

Cumulative change in forward value 

-6,126 + 1,137=

-4,989

EUR

The journal entry is as follows:

DR

CR

Derivative Hedge of forecast FX purchases

125,052

EUR

Other Comprehensive Income – Hedging (equity) reserve

126,189

EUR

Other Comprehensive Income – Forward element

1,137

EUR

GL Description: Cash Flow Hedge – Change in fair value of the forward contract

When an entity excludes forward points from the hedge relationship and does not apply the cost of hedging approach, the accounting entries are as follows:

The journal entry excluding forward points is as follows:

DR

CR

Derivative Hedge of forecast FX purchases

125,052

EUR

Other Comprehensive Income – Hedging (equity) reserve

126,189

EUR

Profit or loss – Forward element Hedge of forecast FX purchases

1,137

EUR

31 July 20×6

Hedge effectiveness assessment

The hedge continues to meet the effectiveness requirements going forward as no change has occurred in the hedging relationship or hedge ratio (no change in the date of the forecast transaction, no change in notional amount, no change in the credit risk of the counterparties, no change in sources of ineffectiveness).

Furthermore, the forecasted transaction is highly probable to occur.

Conclusion: The hedge effectiveness requirements are met.

Recognition of delivery

The journal entry is as follows:

DR

CR

Inventory (raw material)

7,798,487

EUR

Trade payable

7,798,487

EUR

GL Description: Purchase of USD 10m at spot rate of 1.2823

As the trade payable is short-term, Company A has determined that the effect of discounting is not material.

The trade payable is therefore recognised at its face value.

Fair value of forward

All the criteria for hedge accounting are met for the period ended 30 June 20×6. Cash flow hedge accounting can therefore be applied.

Derivative as at 31/07/20×6

Derivative as at 31/07/20×6

Full Fair Value Change in spot component

Notional amount in USD

10,000,000

USD

Notional amount in USD

10,000,000

USD

Forward rate at valuation date

1.2819

Spot rate at valuation date

1.2823

EUR equivalent (A)

7,800,921

EUR

Spot component at valuation date (A)

7,798,487

EUR

EUR contracted amount (B)

-7,887,057

EUR

Spot component at inception (B)

7,878,358

EUR

Total (A + B)

-86,136

EUR

Difference (A-B)

-79,871

EUR

Discount factor EUR

0.9991

Discount factor EUR

0.9991

Fair value of derivative

-86,059

EUR

Fair value of spot component

-79,799

EUR

Derivative as at 31/07/20×6

Forward points

31/07/20×6

Change in full fair value (FV)

-86.059 (- – =) + 29,090 = A

-56,969

EUR

Change in FV attributable to spot

-79,799 (- – =) + 24,101 = B

-55,698

EUR

Change in value of forward points

A – B =

-1,271

EUR

Cumulative change in forward value

-6,126 + 1,137=

6,260

EUR

The journal entry is as follows:

DR

CR

Derivative

56,969

EUR

Other Comprehensive Income – Hedging (equity) reserve

55,698

EUR

Other Comprehensive Income – Forward element

1,271

EUR

GL Description: Cash Flow Hedge – Change in fair value of the forward contract

When an entity excludes forward points from the hedge relationship and does not apply the cost of hedging approach, the accounting entries are as follows:

The journal entry excluding forward points is as follows:

DR

CR

Derivative Hedge of forecast FX purchases – conclusion

56,969

EUR

Other Comprehensive Income – Hedging (equity) reserve

55,698

EUR

Profit or loss – Forward element

1,271

EUR

Basis adjustment Hedge of forecast FX purchases – conclusion

The loss on the hedging derivative related to changes in prevailing spot rates and the balance on the cost of hedging reserve is included in the carrying amount of the inventory acquired.

The basis adjustment affects profit or loss on sale of the goods containing the hedged items (the raw material) or on impairment of the inventory.

The journal entry is as follows:

DR

CR

Equity – Hedging reserve

79,799

EUR

Inventory (Raw material)

79,799

EUR

Equity – Forward element

6,260

EUR

Inventory (Raw material)

6,260

GL Description: Cash Flow Hedge – Change in fair value of the forward contract

Basis adjustment – additional information

IFRS 9 requires that a basis adjustment is applied when hedging a forecast transaction that results in the recognition of a non-financial asset or non-financial liability, as is the case here with the recognition of raw material inventory.

The ‘basis adjustment’ approach was optional under IAS 39.

A further difference to IAS 39 is that when the basis adjustment is made to inventory (or other non-financial item) it does not go through OCI as it is not a reclassification adjustment under IAS 1. The impact is that the overall gain or loss on the hedging derivative is recorded twice in the statement of comprehensive income (but potentially in different accounting periods) – Once through OCI during the hedging period and once in cost of sales when the inventory is sold.

The amount in the cost of hedging reserve in relation to any fair value movements of the forward element previously deferred in equity via OCI are also transferred directly to inventory.

As the forward contract hedges the cash flow for settlement of the trade payable which occurs after the recognition of the inventory, if material some of the change in value of the forward points recognised in other comprehensive income would not be removed from the costs of hedging reserve at this time. In this example it is assumed that the amount is not material so the entire cumulative change in forward points recognised in the cost of hedging reserve as at the date of recognition of inventory have been included in the initial cost of inventory as a basis adjustment.

30 September 20X6

Translation of trade payable at the spot rate

The trade payable is a monetary item denominated in a foreign currency that must be retranslated at the spot rate under IAS 21, with the resulting currency gain or loss recognised in profit or loss.

The calculation of the gain or loss is as follows:

Trade payable USD 10,000,000

– translated at 31 July at 1.2823

A

7,798,487

EUR

– translated at 30 September at 1.3178

B

7,588,405

EUR

Foreign exchange gain to be recognised in profit and Loss

A – B =

210,082

EUR

GL Description: Cash Flow Hedge – Change in fair value of the forward contract

The journal entry is as follows:

DR

CR

Foreign exchange difference – Profit or loss

210,082

EUR

Trade payable

210,082

EUR

GL Description: Revaluation of trade payable to 30/09/20×6 EUR/USD rate

Fair value derivative Hedge of forecast FX purchases – conclusion

Recognition of the change in the fair value of the derivative

Derivative as at 30/09/20×6

Derivative as at 30/09/20×6

Full Fair Value Change in spot component

Notional amount in USD

10,000,000

USD

Notional amount in USD

10,000,000

USD

Forward rate at valuation date

1.3178

Spot rate at valuation date

1.3178

EUR equivalent (A)

7,588,405

EUR

Spot component at valuation date (A)

7,588,405

EUR

EUR contracted amount (B)

-7,887,057

EUR

Spot component at inception (B)

7,878,358

EUR

Total (A + B)

-298,652

EUR

Difference (A-B)

-289,953

EUR

Discount factor EUR 

1.0000

Discount factor EUR

1.0000

Fair value of derivative

-298,652

EUR

Fair value of spot component

-289,953

EUR

Derivative as at 30/09/20×6

Forward points

30/09/20×6

Change in full fair value (FV)

-298,652 (- – =) + 86,059 = A

-212,593

EUR

Change in FV attributable to spot

-289,953 (- – =) + 79,799 = B

-210,154

EUR

Change in value of forward points

A – B =

-2,439

EUR

Cumulative change in forward value

-6,260 -2,439 =

-8,699

EUR

The journal entry is as follows:

DR

CR

Derivative Hedge of forecast FX purchases – conclusion

212,593

EUR

Other Comprehensive Income – Hedging (equity) reserve

210,154

EUR

Other Comprehensive Income – Forward element

2,439

EUR

GL Description: Cash Flow Hedge – Change in fair value of the forward contract

Recycling hedge reserve

The accounting entry to release the amount in the hedge reserve to hedge FX recognised on the payable:

The journal entry is as follows:

DR

CR

Other comprehensive income – Hedging reserve Hedge of forecast FX purchases – conclusion

210,154

EUR

Foreign exchange difference – Profit or loss3 3

210,154

EUR

Other Comprehensive Income – Forward element

2,439

EUR

Forward element – Profit or loss Hedge of forecast FX purchases – conclusion

2,439

GL Description: Cash Flow Hedge – Change in fair value of the forward contract

Hedge accounting alternative

Hedge accounting is not always necessary when a company is hedging the foreign currency risk arising from short-term monetary items such as foreign currency payables and receivables.

A common strategy under IAS 39 was to de-designate the hedge once the purchase had been recognised (30 July 20×6). This achieves a similar result to that achieved under hedge accounting, as:

  1. The derivative, not being designated as a hedging instrument, would have been measured at fair value through profit or loss on 30 September 20×5; and
  2. The foreign currency payable, which is a monetary item, would have been revalued using the spot exchange rate at the balance sheet date.

IFRS 9 does not permit de-designation of a hedging relationship if the hedging objective has not changed; nor does it designation of a derivative for only part of its life. The above designation and de-designation will therefore only be in line with IFRS 9 if it forms part of the company’s risk management strategy and objective for this hedge relationship.

IFRS 9 B6.5.24(c) does envisage such a scenario and notes that within a strategy to manage the foreign currency risk of forecast sales and the resulting receivables (or purchases and payables), the entity may ‘manage’ the currency risk until settlement date or until recognition of the receivable/payable. In the latter case it would have to discontinue at that point even though there is an economic hedge until settlement date.

If the hedge were discontinued early in accordance with IFRS 9 B6.5.24(c) or because the forecast transaction (the purchases in this example) no longer met the hedge objective but were still expected to occur then the balances in equity (hedging reserve and forward element) on this transaction related hedge remain in equity until recognition of the hedged non-financial item or until the hedged item hits P&L.

Summary hedge accounting entries Hedge of forecast FX purchases – conclusion

To summarise the result that was achieved through the application of hedge accounting:

  • Inventory was recognised at EUR 7,884,546, which is the spot price on 31 July 20×6 (EUR 7,798,487), plus the change in the discounted spot since inception (EUR 79,799) plus the movement in the fair value of the forward element up to recognition of the inventory (EUR 6,260).
  • Net cash paid was €7,887,057, which is $10 million at the hedged rated of 1.2679.
  • Profit or loss includes the following amounts:
  • EUR 2,439 recognised as an interest expense, which represents the remaining movements on the forward points for the period from 31 July 20×6 to 30 September 20×6;
  • EUR 72 recognised as an FX loss. This is the net of a EUR 210,082 gain on the trade payable and EUR 210,154 loss on the derivative (larger than the gain due to the unwind of the discount of the spot component of the derivative) during the last two months; and
  • The remaining difference between amounts recognised in profit and loss and the settlement on the derivative is the amount of the basis adjustment of 86,059 EUR taken directly from equity to the inventory account that will affect profit or loss when the inventory is sold.
  • The detailed entries are reflected in the tables below.
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Balance sheet and Income Statement – summary hedge accounting entries

Balance sheet and Income Statement - summary hedge accounting entries

Statement of changes in equity – summary hedge accounting entries

Statement of changes in equity - summary hedge accounting entries

Also read: Formal designation and documentation

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Hedge of forecast FX purchases

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