To be eligible for designation as a hedged item, a risk component must be a separately identifiable component, and the changes in cash flows or fair value of the item attributable to change in that component must be reliably measurable (IFRS 9 paragraph B6.3.8).
Company A wishes to designate a risk component as a hedged item. How should company A assess if the ‘reliably measurable’ criterion is met?
Consequential Explanation and Reasoning:
Changes in cash flows or fair value attributable to changes in the hedged component would be considered reliably measurable where the price of a non-contractually specified risk component has a predictable and direct impact on the price of the entire item. A linear relationship, where changes in the price of the risk component have an equivalent (though not necessarily one-to-one) impact on the price of the entire item, in the absence of changes in other inputs, would generally create such a predictable and direct impact.
Nevertheless, a non-linear relationship might also be sufficient for a risk component to be considered an eligible hedged component.
For example, the prices of many items are only updated periodically, or where input prices increase or decrease beyond a reasonable threshold, creating ‘stepped’ changes in the link between the price of the risk component and the price of the entire item. Accordingly, an entity will need to analyse the nature of the non-linear relationship, and the reasons for that relationship, to establish whether the risk component is implicit in the fair value or cash flows of the entire item and hence is an eligible hedged component.
Factors to be considered in making this assessment should include:
- Absolute magnitude of the ‘steps’, before a change in the price of the risk component influences the change in price of the entire item. For example, the price of a luxury wool sweater will have limited correlation with the price of the raw material (wool).
- Frequency of updates to the price of the entire item in response to changes in the price of the risk component.
- Sensitivity of changes in the price of the entire item to its supply and demand (and the supply and demand of substitutes), compared with changes in the price of the risk component.
- Whether changes to the price of the entire item are one-sided (such as increases only) or prices are ‘stickier’ in one direction (for example, price increases occur more frequently or in greater magnitude than decreases).
- The reason that changes in the price of the component are not passed on immediately. For example, where increases in the price of the component are not passed on because the market cannot fully absorb such changes, this might indicate that the market structure is not consistent with a ‘building block’ approach.
Whether or not the impact of a risk component on the price of the entire item is non-linear is factored into the assessment of whether it qualifies as an eligible hedged component of the non-financial item; if an eligible risk component exists, it does not impact hedge effectiveness. Accordingly, once an eligible risk component has been identified, it is assumed to have a linear impact on the hedged item. This is because the non-linear element in the overall pricing reflects the willingness of an entity to absorb certain input price movements within its profit margin rather than pass the increase on to customers. In such circumstances the underlying relationship is linear, but the entity is willing to temporarily reduce or increase its margin. Accordingly, part of the profit margin is inversely correlated with the risk component for short periods and/or small price changes, which does not preclude the use of a linear relationship for assessing hedge effectiveness. If this inverse correlation exists for longer periods or larger price changes, however, it would call into question the original assessment that there is an eligible risk component and the validity of the hedge as a risk management strategy.
Assessing whether a risk component is implicit in the fair value or the cash flows of the entire item, and whether the changes in fair value or cash flows that are attributable to the risk component are reliably measurable is highly judgmental. Practice is likely to develop based on risk management strategies undertaken by entities. Management will need robust evidence, demonstrating the particular market structure, to support its assertion that the risk component qualifies as a hedged item. Given the judgment involved this could be a significant accounting judgment under IAS 1 that would require disclosure in the financial statements (See IAS 1.122).