Hedged item – Risk components – Separately identified

Q: What is the necessary evidence to document that changes in cash flows or fair value attributable to changes in a hedged component are separately identifiable? Does a risk component that is an input in the manufacturing process of a non-financial item suffice?

Considerations:

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).

An entity wishes to hedge a non-contractually specified risk component of a non-financial item. If the risk component is an input in the manufacturing process of the non-financial item, is this sufficient for the risk component to be a separately identifiable hedged item?

Consequential Explanation and Reasoning:

No. In general, it will be necessary for the risk component to be an input in the manufacturing process in order to be considered as ‘separately identifiable’, and so meet the criteria in IFRS 9. However, merely being an input in the manufacturing process is not, in itself, sufficient. Paragraph B6.3.9 of IFRS 9 requires that the qualifying criteria for an eligible risk component should be assessed in the context of the particular market structure to which the risks relate and in which the hedging activity takes place.

For example, wool is an input in the manufacturing process for woollen sweaters. Whether the wool price is a hedgeable risk component of the total price of the sweater depends on the market structure for the particular sweater. In the luxury apparel market, the price of the raw material (wool) will often have a low impact on the price of a woollen sweater that will instead mainly reflect the perceived value of the brand. In such a market, the wool price is unlikely to be an eligible risk component for a retailer. On the other hand, the price of a ‘no frills’ sweater of a generic design might be driven by the cost of the inputs into the manufacturing process (such as raw materials, labour and overheads) and a production margin. This is likely to give rise to a hedgeable risk component for the wool price component.

While it will, in general, be necessary for the risk component to be an input into the manufacturing process, there might be rare cases where the market structure is clear that a non-financial risk component is a separately identifiable component, even in the absence of a physical presence. For example, in some markets a long-term supply contract for natural gas may be based on a contractually specified formula that refers to indices including, inter alia, the price of crude oil. If a supply contract is in place, the crude oil price component would be considered to be an eligible risk component, because it is ‘explicitly specified’ in the contract.

Equally, if a supply contract is not yet in place but the market commonly prices purchases of natural gas under long-term contracts in this manner, the crude oil price component would still be a hedgeable non-contractually specified risk component. This would be true for a highly probable forecast purchase of natural gas beyond the period for which liquid derivatives are available, despite crude oil not being an input in the manufacturing process for natural gas, when such pricing mechanism for natural gas (that is, the linkage to the crude oil prices) is the ‘industry norm’. A different conclusion may be reached in a jurisdiction where pricing for natural gas is not based on crude oil, for example, where there is a liquid spot and forward market for natural gas for the period being hedged.

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