In a previous newsletter, we discussed how IFRS 9 broadens the hedging options available under hedge accounting rules. Rather than hedging the entire fair value or the entire cash flows, in the case of commodities it is often possible to hedge only part of the risks of the hedged item, making it desirable to designate certain components of the hedged item (so-called risk components). This article will focus on the specific procedure used to designate a risk component. As a general rule, designating 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 foreign currency risk or in their entirety for all risks. The prerequisite for designating a risk component under IFRS 9 is that 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 9.6.3.7(a) in conjunction with IFRS 9.B6.3.8). It is not permissible to simply attribute a risk component equivalent to the hedging instrument to the hedged item as well.
As far as the designation of individual risk components under IFRS 9 is concerned, it is possible to distinguish between contractually agreed risk components (explicit risk components) and non-contractually agreed risk components. Non-contractual risk components are (implicitly) contained in the cash flow or fair value changes of the total item to which the risk component relates (IFRS 9.B6.3.10). The sole existence of a physical component as part of the entire hedged item is usually not sufficient to fully meet the requirements (i.e., independent identifiability and reliable measurability) as a risk component. In this respect, the existence of a physical component in the hedged item can at best represent a starting point for further analysis. Insofar as the risk component is contractually specified in addition to the physical component, it is easier to prove that the hedged item can be separately identified and reliably measured, since it is regularly possible to fall back on a contractually agreed pricing formula or other indexation. In such cases, reliable measurability can often be viewed as (less) critical, as observable data can typically be used for the valuation. However, in some cases spot prices are available for determining the contractual cash flows, but the forward prices cannot be reliably measured for valuation purposes. As a general rule, a reliable measurement requires that published prices on active markets are available or that the price factors can otherwise be reliably determined (IFRS 9.6.3.7(a) in conjunction with IFRS 9.B6.3.10).
But neither the existence of a physical component as a component nor a further contractual specification of the risk component is explicitly required. As opposed to contractually specified risk components, for risk components that are not contractually specified, an even more detailed assessment must be made to prove separate identifiability. For compliance purposes, this assessment must be made on a case-by-case basis in the context of the respective market structure and the associated facts and circumstances (IFRS 9.B6.3.9f.).
In the context of identifiability and measurement, a subsequent analysis of the hedged item's pricing structure must be performed irrespective of the contractual or non-contractual risk component. A credible presentation and intersubjective verifiability of the degree to which the corresponding component affects the price of the entire non-financial item in the production process or price determination is required in order to present the relevant factors and justify the price formation structure. The mere reliance on a correlation of prices between the component and the entire underlying transaction is not considered sufficient. Consequently, a direct correlation between the risk component and the pricing structure (for example, explicit or implicit pricing formulas) must be proven. It can be challenging or even difficult to provide evidence of the pricing structure, especially when hedging risk components for products with a higher degree of completion, such as semi-finished and finished products. One conceivable example of a possible risk component would be the crude oil content of refinery products such as kerosene. However, a more extensive evaluation is required to reliably identify the influence of the crude oil price on the kerosene price, as other factors may also have a (significant) impact on the price formation process. This contrasts, for example, with the hedging of the price of rubber as a component of car tires (in the form of a risk component), which seems questionable despite the physical component. Here, the background is that the price forming process for car tires is not determined directly, but apparently only indirectly via the price for rubber.
Among the other examples of possible (contractually defined) risk components in the commodity area are the following:
- a natural gas price contractually linked in part to a gas oil benchmark price and in part to a heating oil benchmark price,
- an electricity price 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 contractually linked in part to a copper benchmark price and in part to a floating surcharge depending on energy costs,
- a coffee price contractually linked in part to a reference price for Arabica coffee beans and in part to transportation costs indexed to the price of diesel.
Assessing whether a risk component represents a permissible hedged item may require a great deal of effort in ambiguous cases in order to provide sufficient qualitative as well as quantitative evidence. Any correlation of the risk component with the overall price of the underlying transaction (without a pricing formula) must be further substantiated with the help of quantitative or statistical analyses. For this purpose, it is useful to determine an implicit price formula if no price formulas are available. For instance, when assessing pricing structures, multiple regression analysis can be used to identify the relevant influencing factors and interdependencies between the various input variables relating to the pricing structure. With a view to reducing the effort and evidence required to designate risk components as underlying transactions in hedge accounting, it is also conceivable to make corresponding adjustments to operational risk management and to the design of contracts. Particularly advantageous in this regard are more transparent pricing of supply contracts and the inclusion of explicit pricing formulas, provided that these can be implemented from a business perspective.
This need for further analysis results in the fact that, in addition to Accounting and Treasury, other departments such as Purchasing and Sales, which are suitably familiar with the relevant market, must also be involved in any case. In this way, it seems possible to separate a risk component in particular if the component is commonly used in national or international trading or constitutes an element regularly used in the pricing structure of the underlying transactions on the market in the respective industry. Given 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).
In conclusion, it is worth mentioning that based on the criteria of unique identifiability and separate evaluation, it is not possible to designate a residual. Accordingly, a designation of the residual fair value or cash flows of a hedged item or transaction cannot be made if this residual has no clearly quantifiable effect on the hedged item. A further requirement is that the risk component must be smaller than the entire position.
Likewise, the specific disclosure requirements when applying the designation of specific risk components should not be neglected. On the one hand, this requires an explanation of the designation of the designated risk component (IFRS 7.22C(a)) and, on the other hand, a description of the relationship between the risk component and the hedged item (IFRS 7.22C(b)).
In the light of volatile commodity prices, the regulations on the designation of risk components provide ample opportunities to evaluate and designate new types of hedged items to hedge commodity price risks. Our Finance and Treasury Management team will be happy to meet with you for a hands-on exchange and further discussion.
Source: KPMG Corporate Treasury News, Edition 128, December 2022
Authors:
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
