As a result of dispensing with the minimum effectiveness still required under IAS 39 and the possibility introduced by IFRS 9 to designate individual components from price formulas of non-financial underlying transactions, it is considerably easier for companies today to map their economic hedging strategy of commodity risks by means of derivatives in hedge accounting.
Demand for such solutions is currently particularly evident in the increased conclusion of (virtual) energy purchase agreements ((V)PPAs), which, due to the current regulations on own use ("own use exemption"), must increasingly be disclosed in the balance sheet and recognized in profit or loss. In general, hedge accounting for these situations is very complex, if possible at all. Accordingly, the "all-in-one" hedge described below is not a solution for these situations. Apart from these special and challenging individual circumstances, however, the question arises as to why the large number of commodity hedges are still not, or only reluctantly, depicted in hedge accounting despite the new designation options.
There is also a significant increase in the need for management for commodities such as CO2 rights or non-ferrous metal due to the current market frictions and increased price volatility. Under the general principles of IFRS 9, without the application of hedge accounting, a derivative entered into for economic hedging purposes is recognized in profit or loss through the income statement. The same applies to any underlying transaction where the application of the "own use exemption" cannot be considered. The resulting price volatilities to be directly recognized in EBIT place greater pressure on those preparing financial statements to provide explanations. This can be remedied by the hedge accounting rules under IFRS 9, which allow risk management to be presented in a way that reflects the source of the risk for a large number of applications:
- Many companies hedge commodity inventories with regard to their market price, which is essentially in line with the intention of the fair value hedge.
- In addition, a large number of companies manage their procurement of non-ferrous metals, CO2 rights or by-products from the petrochemical industry, all of which can generally be accounted for using a cash flow hedge as long as the hedged item is a planned transaction.
One common application is the physical purchase of a commodity that is to be accounted for as a derivative by selling it back ("tainting" of the "own use exemption"). This contract can subsequently be seen as a hedging instrument for the planned purchase and can in principle be accounted for as an "all-in-one" cash flow hedge if the other requirements are met (KPMG Insights into IFRS 7.9.480).
It is particularly common in the case of commodity price risks to hedge exposures with different maturities by means of a single derivative (matching maturities). This must be factored into the designation of the total change in value of the hedging instrument when determining effectiveness. If effectiveness cannot be demonstrated on this basis, the changes in value could be voluntarily designated on a spot rate basis. Any ineffectiveness resulting from different maturity structures is thus excluded from the hedging relationship and no longer taken into account when determining effectiveness. However, to the extent that the cost of hedging approach available under IFRS 9 is not applied to the forward component of the hedging transaction, the change in value of the forward component must be recognized in full in profit or loss. But for many common commodities this drawback is bearable, because in case of price developments usually the whole forward price structure is shifted in parallel and the forward price structure changes only marginally in its structure (a structure change would be the case for example in case of a change from a contango situation to a backwardation). For these solution strategies in particular, care should be taken to ensure that the spot rate is determined at the time the derivative is concluded and not at the daily closing price in order to obtain a correct result in the case of high intraday volatilities.
A further frequent cause of ineffectiveness is the market data and valuation methods used for the valuation. If the company calculates the effectiveness, the derivatives are often valued by a broker and the performance of the underlying transaction is derived from the prices of a market data provider (Refinitiv; Superderivatives, Bloomberg) or other sources (LME, oanda, westmetall). However, it is best to ensure that the market data set used is consistent for the determination of effectiveness. If an in-house valuation of the hedging instruments is not possible, an external provider can help with the valuation. During our implementation projects, we found that it is often sufficient to use the broker's market data for the valuation date for the company's own valuation of the hedged item.
To recognize the value contributions of the hedging instruments, which were previously accrued via hedge accounting, the company also needs data on the underlying transaction. There are now a number of established solutions for the accounting challenges, such as the described allocation of hedging gains and losses to hedged items or the basis adjustment (see also, for example, the newsletter article Oct 2022: Hedging of commodity price risks: Use the possibilities for the designation of risk components of non-financial hedged items under IFRS 9 sensibly!).
Knowing the playing field, it is also possible to map commodity hedges frequently, in the formal regulations of IFRS 9 or in valuation units under commercial law in accordance with § 254 HGB. Both external and internal accounting benefit from the correct presentation of the asset, financial and earnings situation by recording results according to their origin.
Source: KPMG Corporate Treasury News, Edition 137, October 2023
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Felix Wacker-Kijewski, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
