Non-contractually specified risk components – Under IFRS 9, risk components can be designated for non-financial hedged items, provided the component is separately identifiable and the changes in fair value or cash flows of the item attributable to the risk component are reliably measurable. This requirement could be met where the risk component is either explicitly stated in a contract (contractually specified) or implicit in the fair value or cash flows (non-contractually specified).
Not all contracts define the various pricing elements and, therefore, specify risk components. In fact, most risk components of financial and non-financial items are not to be contractually specified. While it is certainly easier to determine that a risk component is separately identifiable and reliably measurable if it is specified in the contract, IFRS 9 is clear that there is no need for a component to be contractually specified in order to be eligible for hedge accounting.
Non-contractually specified risk components Non-contractually specified risk components Non-contractually specified risk components
The relevance of the market structure is that the risk component must have a distinguishable effect on changes in the value or the cash flows that an entity is exposed to. Depending on the situation, the market structure can reflect a ‘market convention’ that establishes, for example, a benchmark interest rate that has a pervasive effect on the value and cash flows for debt instruments. In other situations, the market structure reflects the particular purchasing or selling market of an entity.
For example, this is the case when an entity buys goods from its particular supplier based on a benchmark price plus other charges, as in the examples listed in ‘Contractually specified risk components‘. Even if the pricing under such a supply arrangement is not a wider market convention, its pricing formula represents the exposure of the particular entity to variability in cash flows from its purchases.
The assessment is normally straightforward for contractually specified risk components, which can also be a relevant factor in the assessment of the market structure of non-contractually specified risk components such as risk components of forecast transactions.
The following example from the application guidance of IFRS 9 illustrates the ‘separately identifiable and reliably measurable’ assessment. Non-contractually specified risk components
|The assessment of whether a risk component is separately identifiable and reliably measurable has to be made ‘within the context of the particular market structure to which the risk or risks relate and in which the hedging activity takes place’.
|Hedge of a non-contractually specified risk component – coffee purchases with a benchmark price risk component
An entity purchases a particular quality of coffee of a particular origin from its supplier under a contract that sets out a variable price linked to the benchmark price for coffee. The price is represented by the coffee futures price plus a fixed spread, reflecting the different quality of the coffee purchased compared to the benchmark plus a variable logistics services charge reflecting that the delivery is at a specific manufacturing site of the entity. The fixed spread is set for the current harvest period. For the deliveries that fall into the next harvest period this type of supply contract is not available.
The entity analyses the market structure for its coffee supplies, taking into account how the eventual deliveries of coffee that it receives are priced. The entity can enter into similar supply contracts for each harvest period once the crop relevant for its particular purchases is known and the spread can be set.
In that sense, the knowledge about the pricing under the supply contracts also informs the entity’s analysis of the market structure more widely, including forecast purchases which are not yet contractually specified. This allows the entity to conclude that its exposure to variability of cash flows resulting from changes in the benchmark coffee price is a risk component that is separately identifiable and reliably measurable for coffee purchases under the variable price supply contract for the current harvest period as well as for forecast purchases that fall into the next harvest period.
In this case, the entity may enter into coffee futures contracts to hedge its exposure to the variability in cash flows from the benchmark coffee price and designate that risk component as the hedged item. This means that changes in the coffee price from the variable logistics services charge as well as future changes in the spread reflecting the different coffee qualities would be excluded from the hedging relationship.
The assessment of whether a risk component qualifies for hedge accounting is mainly driven by an analysis of whether there are different pricing factors that have a distinguishable effect on the item as a whole (in terms of its value or its cash flows). This evaluation would always have to be based on relevant facts and circumstances.Non-contractually specified risk components
he standard uses the refinement of crude oil to jet fuel as an example to demonstrate how the assessment of the market structure could be made to conclude that crude oil in a particular situation is an eligible risk component of jet fuel. Crude oil is a physical input of the most common production process for jet fuel and there is a well-established price relationship between the two.
Extending this example, crude oil is also a major input in the production process for plastic. However, the manufacturing process is complex and involves a number of steps. The process starts with crude oil being distilled into its separate ‘fractions’, of which only one (naphtha) is used for making plastic. Naphtha then undergoes a number of further processes before the various types of plastic are finally produced. Non-contractually specified risk components
Generally, the further downstream in the production process an item is, the more difficult it is to find a distinguishable effect of any single pricing factor. The mere fact that a commodity is a major physical input in a production process does not automatically translate into a separately identifiable effect on the price of the item as a whole.
For example, crude oil price changes are unlikely to have a distinguishable effect on the retail price of plastic toys even though, in the longer term, changes in the crude oil price might influence the price of such toys to some degree. Non-contractually specified risk components
Similarly, the price for pasta at food retailers in the medium to long term also responds to changes in the price for wheat, but there is no distinguishable direct effect of wheat prices changes on the retail price for pasta, which remains unchanged for longer periods even though the wheat price changes. If retail prices are periodically adjusted in a way that also directionally reflects the effect of wheat price changes, that is not sufficient to constitute a separately identifiable risk component. Non-contractually specified risk components
Allowing non-contractually specified risk components as eligible hedged items opens up a new area of judgement. The assessment of the market structure will normally require the involvement of personnel with a good understanding of the drivers of market prices (e.g., members of the sales or procurement departments responsible for the underlying transactions).
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