As already discussed in a previous newsletter, IFRS 9 expands the hedging options using hedge accounting rules. Instead of hedging the entire fair value or the entire cash flows, often only a part of the risks of the underlying transaction can be hedged financially for commodities, so that a designation of certain components of the underlying transaction (so-called risk component) is desirable. In this article, the specific procedure for the designation of a risk component will be presented in more detail. In general, the designation of a risk component represents a significant change compared to the previous regulations (IAS 39), in which non-financial hedged items could be designated either only against the foreign currency risk or in its entirety for all risks. As a prerequisite for the designation of a risk component under IFRS 9, the component(s) must be separately identifiable and the changes in the cash flows or fair value of the hedged item must be reliably measured (IFRS in conjunction with ifrs 9.b6.3.3). IFRS 9.B6.3.8). It is not permissible to simplistically attribute a risk component equivalent to the hedging instrument to the underlying transaction without further ado.

With regard to the designation of individual risk components according to IFRS 9, a distinction can be made between contractually agreed (explicit risk component) and non-contractually agreed risk components. Non-contractual risk components are (implicitly) included in the cash flow or fair value changes of the total item to which the risk component relates (IFRS 9.B6.3.10). The mere existence of a physical component as part of the overall hedged item is generally not sufficient to fully meet the requirements (i.e. independent identifiability and reliable measurability) as a risk component. In this sense, the existence of a physical component in the underlying transaction can at best represent a starting point for further analysis. If, in addition to the physical component, there is also a contractual specification of the risk component, it is easier to prove the separate identifiability and reliable valuation of the underlying transaction, as it is regularly possible to fall back on a contractually agreed pricing formula or other indexation. In these cases, reliable measurability can often also be regarded as uncritical(er), since observable data can usually be used for the valuation. However, there may also be constellations in which spot rates are available for determining the contractual cash flows, but the forward rates cannot be reliably measured for valuation. In principle, a reliable measurement requires that published prices on active markets are available or that the price factors can otherwise be reliably determined (IFRS in connection with IFRS IFRS 9.B6.3.10). 

However, neither the existence of a physical component as a component nor a further contractual specification of the risk component is explicitly prescribed. Compared to contractually specified risk components, an even more detailed assessment must be made for non-contractually specified risk components to prove separate identifiability. To meet the requirements, this assessment must be made in the context of the respective market structure and the associated facts and circumstances on a case-by-case basis (IFRS 9.B6.3.9f.). 

In connection with the identifiability as well as the valuation, a further analysis of the price structure of the underlying transaction has to be carried out irrespective of the contractually defined or non-contractually defined risk component. A credible presentation and intersubjective verifiability of the extent to which the respective component influences the price of the entire non-financial item in the production process or price determination is required to present the relevant factors and justification of the pricing structure. Merely relying on a correlation of prices between the component and the entire underlying transaction is not considered sufficient. Thus, a direct correlation between the risk component and the pricing structure (for example, explicit or implicit pricing formulas) must be demonstrated. Especially when hedging risk components for products with a higher degree of completion, such as semi-finished and finished products, the proof of the pricing structure can be challenging to difficult to provide. An example of a possible risk component would be the crude oil content of refined products such as paraffin. However, it is necessary to go further and reliably identify the influence of the crude oil price on the paraffin price, as other factors may also (significantly) influence the price formation process. In contrast, hedging the price of rubber as a component of car tyres (in the form of a risk component) seems questionable, despite the physical component. The background here is that the price formation process for car tyres is not determined directly, but apparently only indirectly via the price of rubber.

The following circumstances can be cited as further examples of possible (contractually determined) risk components in the commodity area: 

  • a natural gas price that is contractually linked in part to a gas oil benchmark price and in part to a benchmark price for heating oil, 
  • an electricity price that is contractually linked in part to a coal index price and in part to transmission charges that also include inflation indexation, 
  • the price of a cable, which is contractually linked in part to a copper benchmark price and in part to a variable mark-up depending on the cost of energy,
  • a coffee price contractually linked in part to a reference price for Arabica coffee beans and in part to transport costs indexed to the price of diesel.

The assessment of whether a risk component constitutes a permissible hedged item can be very complex in ambiguous cases in order to provide sufficient qualitative as well as quantitative evidence. The correlation of the risk component to the total price of the underlying transaction (without price formula) must be further substantiated with the help of quantitative or statistical analyses. If no price formula is available, an implicit price formula can be determined as an alternative. For example, a multiple regression analysis can be used to assess the price formation structures in order to determine the corresponding influencing factors and interdependencies between the various input variables with regard to the price formation structure. In order to reduce the effort as well as the evidence for the designation of risk components as underlying transactions in hedge accounting, corresponding adjustments to the operational risk management as well as the contract design are also conceivable. A more transparent pricing of the supply contracts as well as the inclusion of explicit pricing formulas prove to be particularly advantageous, as long as these can be implemented from an economic point of view. 

The need for further analysis means that, in addition to accounting and treasury, other departments such as purchasing and sales, which know the relevant market sufficiently well, must also be involved in any case. Thus, a separation of a risk component seems possible in particular if the component is usually used in national or international trading or is a regularly used element in the pricing structure of the underlying transactions on the market in the respective industry. Taking into account the usual trading practices, this results in an individual assessment that depends on the respective market structure in each individual case (IFRS 9.BC6.176). 

Finally, it should be mentioned that based on the criteria of clear identifiability and separate valuation, the designation of a residual value is excluded. In this respect, a designation of the remaining fair value or the cash flows of a hedged item or a transaction cannot be made if this residual does not have a clearly quantifiable effect on the hedged item. As a further requirement, it should be noted that the risk component must be smaller than the entire position. 

The specific disclosure requirements when applying the designation of specific risk components are also not to be neglected. Thus, on the one hand, an explanation of the determination of the designated risk component is required (IFRS 7.22C(a)) as well as, on the other hand, a description of the relationship between the risk component and the underlying transaction (IFRS 7.22C(b)).

Against the backdrop of volatile commodity prices, the regulations on the designation of risk components offer extensive opportunities to evaluate and designate new types of hedged items for hedging commodity price risks. The Finance and Treasury Management Team is available for a practical exchange and further discussion.

Source: KPMG Corporate Treasury News, Ausgabe 128, Dezember 2022
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG 
Björn Beckmann, Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG