Own use contracts is one of the other changes from IAS 39 to IFRS 9 in respect of hedge accounting.
What are own use contracts
Generally, a contract to buy or sell a non-financial item is not within the scope of IFRS 9. However, certain contracts to buy or sell a non-financial item may be required to be accounted for in accordance with IFRS 9 if those contracts can be settled:
- net in cash or another financial instrument; or
- by exchanging financial instruments, as if the contracts were financial instruments.
IFRS 9 2.6 provides examples of ways in which a contract to buy or sell a non-financial item can be settled net in cash or another financial instrument or by exchanging financial instruments, some of which look at the entity’s past practice.
The requirement to follow IFRS 9 for contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument or by exchanging financial instruments is subject to a scope exception, commonly referred to as the “own use” scope exception.
This exception is for contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.
Own use contracts are accounted for as normal sales or purchase contracts (i.e., executory contracts). IAS 37 Provisions, Contingent Liabilities and Contingent Assets would apply if the own use contract became onerous.
The change from IAS 39 to IFRS 9
Contracts accounted for in accordance with IAS 39 include those contracts to buy or sell non-financial items that can be settled net in cash, as if they were financial instruments (i.e., they are in substance similar to financial derivatives). Many commodity purchase and sale contracts meet the criteria for net settlement in cash because the commodities are readily convertible to cash.
However, such contracts are excluded from the scope of IAS 39 if they were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. This is commonly referred to as the own use scope exception of IAS 39.
Own use contracts are accounted for as normal sales or purchase contracts (i.e., executory contracts), with the idea that any fair value change of the contract is not relevant given the contract is used for the entity’s own use. However, some participants of certain industries enter into contracts for own use and similar financial derivatives for risk management purposes and manage all these contracts together.
In such a situation, own use accounting leads to an accounting mismatch as the fair value change of the derivative positions for risk management purposes cannot be offset against fair value changes of the own use contracts.
At the inception of a contract, an entity may make an irrevocable designation to measure an own use contract at fair value through profit or loss (FVTPL). Such designation is only allowed to eliminate or significantly reduce the accounting mismatch. On initial application of IFRS 9, an entity may designate own use contracts that exist at that date at FVTPL, but only if it designated all similar contracts based on IFRS 9 7.2.14A (IFRS 9 Transition).
However, hedge accounting in these circumstances is administratively burdensome. Furthermore, entities enter into large volumes of commodity contracts and, within the large volume of contracts, some positions may offset each other. An entity would therefore typically hedge on a net basis.
Processing and brokerage of soybeans and sunflowers
An entity is in the business of procuring, transporting, storing, processing and merchandising soybeans and sunflower seeds. The inputs and the outputs are agricultural commodities which are traded in liquid markets. The entity has both a broker business and a processing business, which are operationally distinct. However, the entity analyses and monitors its net commodity risk position, comprising inventories, physically settled forward purchase and sales contracts and exchange traded futures and options. The target is to keep the net fair value risk position close to nil.
Under IAS 39, the physically settled forward contracts from the processing business have to be accounted for as own use contracts, whereas all other contracts are accounted for at fair value through profit or loss. The resulting accounting mismatch does not reflect how the entity is managing the overall fair value risk of those contracts.
By way of a consequential amendment to IAS 39, the IASB introduced a fair value option for own use contracts. At the inception of a contract, an entity may make an irrevocable designation to measure an own use contract at fair value through profit or loss (the fair value option). However, such designation is only allowed if it eliminates or significantly reduces an accounting mismatch.
On transition to IFRS 9, entities can apply the fair value option on an all-or-nothing basis for similar types of (already existing) own use contracts.
Some entities, especially in the power and utilities sector, enter into long-term own use contracts, sometimes for as long as 15 years. The business model of those entities would often be to manage those contracts together with other contracts on a fair value basis. However, there are often no derivatives available with such long maturities, while fair values for longer-dated contracts may be difficult to determine.
Hence, a fair value-based management approach might only be used for the time horizon in which derivatives are available. The fair value option is, however, only available on the inception of the own use contract. Consequently, the fair value option will mainly be useful for entities that apply a fair value-based risk management strategy for entire contracts, which is more likely to be the case for shorter-term own use contracts.
Own use contracts
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