Price risks

The elimination of the minimum effectiveness still required under IAS 39 and the option introduced by IFRS 9 to designate individual components from price formulas of non-financial hedged items make it much easier for companies to map their economic hedging strategy for commodity risks using derivatives in hedge accounting.

The need for such solutions is currently particularly evident in the increased conclusion of (virtual) power purchase agreements ((V)PPAs), which increasingly have to be disclosed in the balance sheet and recognized in profit or loss due to the current regulations on own use ("own use exemption"). Hedge accounting for these items is generally very complex, if possible at all. Accordingly, the "all-in-one" hedge described below is not a solution for these situations. However, in addition to this special and in detail challenging individual situation, the question arises as to why the large number of commodity hedges are still not or only hesitantly shown in hedge accounting despite the new designation options.

The need for management has also increased significantly for commodities such as CO-2 rights or non-ferrous metals due to the current market frictions and increased price volatility. In accordance with the general principles of IFRS 9, a derivative entered into for economic hedging purposes is recognized through profit or loss if hedge accounting is not applied. The same applies to any underlying transaction for which the application of the own use exemption must be rejected. The resulting price volatilities to be recognized directly in EBIT increase the pressure on balance sheet preparers to provide explanations. Possible relief can be provided by the hedge accounting rules under IFRS 9, which enable risk management to be presented in a manner appropriate to the cause for a large number of use cases:

• In a number of companies, commodity inventories are hedged with regard to their market price, which basically corresponds to the intention of the fair value hedge.
• In addition, many companies manage their procurement of non-ferrous metals, CO2 rights or co-products from the petrochemical industry, which can generally be mapped using a cash flow hedge as long as the underlying transaction is a planned transaction.
• A common use case 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 therefore, in principle, be recognized as an "all-in-one" cash flow hedge if the other requirements are met (KPMG Insights into IFRS 7.9.480).

A common use case 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 therefore, in principle, be recognized as an "all-in-one" cash flow hedge if the other requirements are met (KPMG Insights into IFRS 7.9.480).

Particularly in the case of commodity price risks, it is common practice to hedge exposures with different maturities using a single derivative (with matching maturities). This circumstance must be taken into account in the determination of effectiveness when designating the total change in value of the hedging instrument. If effectiveness cannot be demonstrated on this basis, the changes in value could be voluntarily designated on a spot rate basis. Ineffectiveness resulting from different maturity structures is thus excluded from the hedging relationship and no longer taken into account when determining effectiveness. However, if the "cost of hedging" approach available under IFRS 9 is not used for the forward component of the hedge, the change in value of the forward component must be recognized in full in profit or loss. For many common commodities, however, this downer is bearable, as the entire forward price structure is usually shifted in parallel with price developments and the structure of the forward price structure only changes marginally (a structural change would be the case, for example, when switching from a contango situation to a backwardation). With these approaches 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 event of high intraday volatility. 

Another common cause of ineffectiveness is the market data and valuation methods used for measurement. If the company calculates effectiveness, the derivatives are often valued by a broker for simplification purposes 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). To determine effectiveness, however, the market data set used should ideally be consistent. If an in-house valuation of the hedging instruments is not possible, an external provider can help with the valuation. Our implementation projects have shown that it is often sufficient to use the broker's market data for the valuation date when valuing the underlying transaction yourself.

The company also needs data on the underlying transaction in order to post the value contributions of the hedging instruments, which were previously accrued via hedge accounting, to profit or loss. There are now a number of established solutions for the challenges in accounting, such as the described allocation of the hedging result to hedged items or the basis adjustment (see also, for example, the newsletter article Oct 2022: Hedging commodity price risks: Making sensible use of options for designating risk components of non-financial hedged items under IFRS 9).

If you are familiar with the playing field, commodity hedges are often mapped in the formal regulations of IFRS 9 or in commercial law valuation units in accordance with Section 254 HGB. Recognizing profit or loss in accordance with the principle of causation helps both external and internal accounting to present the net assets, financial position and results of operations correctly.

Source: KPMG Corporate Treasury News, Issue 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