We look at the different hedge accounting models and criteria for Natural Resources companies, and provide examples of typical scenarios.
Hedge accounting under IFRS 9 Financial Instruments provides a comprehensive framework for managing financial risks that arise from fluctuations in interest rates, foreign exchange rates, commodity prices, and other market variables.
The aim of hedge accounting is to reflect, in the financial statements, the effect of an entity’s risk management activities that use financial instruments to manage exposures arising from particular risks. This helps companies to reduce the volatility in profit or loss caused by the accounting mismatch between the hedged item and the hedging instrument.
It’s important to understand the specific IFRS accounting requirements for hedging arrangements. This is because applying them can often lead to accounting mismatches. These occur when the gains or losses on a hedging instrument are not recognised in the same period or in the same place, in the financial statements, as the gains or losses on the hedged exposure. So hedge accounting should minimise these mismatches by adjusting either the measurement or, in some cases, the recognition of the hedged exposure, or by altering the accounting for the hedging instrument.
There are broadly three models for hedge accounting in IFRS 9:
Fair value hedge
A fair value hedge is used to mitigate the risk of changes in the fair value of an asset, liability, or firm commitment. The changes could arise from fluctuations in interest rates, foreign exchange rates, equity prices, or commodity prices.
Accounting treatment:
- The hedged item (eg the fixed-rate bond or inventory) is remeasured to reflect changes in its fair value attributable to the hedged risk. Any resulting gain or loss is recognised in profit or loss.
- The hedging instrument (eg a derivative such as an interest rate swap) is also measured at fair value, and changes in its value are similarly recognised in profit or loss.
- The result is that gains or losses on the hedged item and the hedging instrument offset each other in the profit and loss.
| Example: A mining company hedging the risk of fluctuations in the market price of its inventory, using forward contracts, could apply a fair value hedge. If the company holds copper, which is subject to price fluctuations, it may hedge this risk by entering into copper futures contracts. The changes in the market value of the copper inventory and the futures contract would both be recognised in P&L. |
Cash flow hedge
A cash flow hedge is used to hedge exposure to variability in cash flows that are attributable to a particular risk (eg future interest payments, forecast sales or purchases in foreign currency) and could affect P&L.
Accounting treatment:
- The effective portion of changes in the fair value of the hedging instrument is initially recognised in other comprehensive income (OCI) and accumulated in equity (hedging reserve).
- When the forecasted transaction affects profit or loss (eg when the forecasted sale occurs or when interest payments are made), the amounts previously recorded in OCI are reclassified to profit or loss.
- The ineffective portion of the hedge, if any, is recognised immediately in profit or loss.
| Example 1: A natural gas producer with exposure to volatile gas prices anticipates selling 100,000 units of gas over the next year, but fears prices may drop. The company could enter into futures contracts to lock in a favourable price. If prices do fall, the losses on the gas sales will be offset by the gains on the futures contracts, recorded in OCI and reclassified to P&L when the sale happens. |
| Example 2: A UK mining company, GoldCo, uses an interest rate swap to manage its exposure to floating interest rates on a £10m loan it took to finance new mining operations. Hedging instrument: GoldCo enters into a swap agreement where it pays a fixed interest rate of 2% and receives a floating interest rate based on LIBOR. Fair value hedge: GoldCo is concerned about fluctuations in the fair value of its fixed-rate loan due to changes in interest rates. It uses a fair value hedge, adjusting both the loan’s carrying amount and the swap for changes in fair value. Gains and losses on both are recorded in P&L, offsetting each other. Cash flow hedge: If GoldCo is more concerned about variability in future interest payments due to fluctuating LIBOR rates, it would designate the swap as a cash flow hedge. In this scenario, changes in the swap’s fair value would be recorded in OCI until the interest payments affect profit and loss. |
Net investment hedge
A net investment hedge addresses the risk associated with foreign operations. Natural Resources companies with foreign subsidiaries or branches often hedge against the currency risk that arises when translating the net assets of these foreign operations into the parent company’s functional currency.
Accounting treatment:
- Similar to a cash flow hedge, the effective portion of the foreign exchange gains or losses on the hedging instrument is recognised in OCI and accumulated in the currency translation reserve.
- The amounts remain in OCI until the net investment is sold or liquidated, at which point they are reclassified to profit or loss.
- The ineffective portion, if any, is recognised in profit or loss immediately.
| Example: A UK-based mining company with a subsidiary in Brazil might hedge against the risk of the Brazilian real depreciating against the pound sterling. By using foreign exchange forward contracts, the company can protect itself from unfavourable currency movements, deferring any resulting gains or losses in OCI until the subsidiary is sold. |
What are the qualifying criteria for hedge accounting?
Under IFRS 9, hedge accounting is permitted only when the hedging relationship meets specific qualifying criteria.
Designation
Formal designation and documentation must be in place at the start of the hedge relationship. This includes the entity’s risk management objective underlying the hedging relationship and how that fits into the overall risk management strategy.
The documentation must include an identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the entity will assess whether the hedging relationship meets the hedge effectiveness requirements.
Eligible instruments and items
The hedging relationship consists only of eligible hedging instruments and eligible hedged items. An eligible hedged item must be:
- A recognised asset or liability
- An unrecognised firm commitment
- A highly probable forecast transaction.
Hedge effectiveness
Economic relationship: There must be an economic relationship between the hedged item and the hedging instrument, ie the hedging instrument is expected to offset changes in the value or cash flows of the hedged item caused by the hedged risk. This relationship ensures that the changes in value of the hedged item and the hedging instrument move in opposite directions as a result of the same risk.
Credit risk: The impact of changes in credit risk should not be so great that it dominates the value changes, even if there is an economic relationship between the hedged item and hedging instrument. The hedge should be driven by the hedged risk (eg currency, interest rate, or commodity risk) and not dominated by fluctuations in credit risk. If credit risk becomes the primary driver, hedge accounting might be discontinued.
Hedge ratio: The hedge ratio, which is the proportion of the hedged item to the hedging instrument, must align with the company’s risk management practices. If the quantities of the hedging instrument and the hedged item diverge too much, the company may need to adjust the hedge to maintain effectiveness. This ensures the hedge is proportionate to the underlying exposure.
Assessment of effectiveness: Under IFRS 9, entities must assess hedge effectiveness both at the start of the hedging relationship and on an ongoing basis. The key is that the hedging instrument is highly effective in offsetting the changes in the fair value or cash flows of the hedged item.
IFRS 9 effectiveness testing is simpler than under IAS 39. It allows more flexibility in assessment methods, enabling both qualitative and quantitative testing. Key methods include:
- Dollar-offset method: Compares the changes in fair value or cash flows of the hedging instrument and the hedged item, often used for both retrospective and prospective evaluations.
- Regression analysis: This statistical method is more robust and is often used for prospective hedge effectiveness testing. Regression allows for a more detailed analysis of the relationship between the hedging instrument and the hedged item by estimating the degree of offset provided by the hedge over time.
| Example: A UK-based energy company, EnergyCo, hedges its exposure to rising crude oil prices by entering into a swap arrangement where the company receives floating payments linked to the price of Brent Crude, and makes fixed payments. EnergyCo uses regression analysis to test the hedge’s effectiveness. In regression, the changes in the fair value of the hedged item (expected future oil purchases) are plotted against the changes in the value of the hedging instrument (the swap). A high R-squared value (close to 1) indicates a highly effective hedge, meaning that changes in the hedged item are closely matched by the changes in the hedging instrument. In this case, EnergyCo’s regression model yields an R-squared value of 0.92, showing that the hedge is highly effective. This effectiveness is documented in the financial statements as required by IFRS 9. |
Discontinuation of hedge accounting
Hedge accounting must be discontinued if:
- The hedge no longer meets the hedge effectiveness criteria
- The risk management objective changes, and the hedge is no longer aligned with the company’s strategy.
But if the hedge ratio becomes unbalanced (eg due to a change in the expected volume of the hedged item), IFRS 9 permits rebalancing to adjust the quantities of the hedged item or the hedging instrument. This flexibility allows entities to maintain hedge effectiveness without discontinuing the entire hedge relationship.
This example illustrates a commodity price risk hedge:
A UK-based mining company holds 500 metric tons of copper inventory at £7,500 per ton. To mitigate the risk of falling prices, the company enters into 50 copper futures contracts on the London Metals Exchange, locking in the price of £7,500 per ton.
Hedged item: 500 metric tons of copper.
Hedging instrument: 50 copper futures contracts (10 tons each) at a fixed price of £7,500 per ton.
Risk being hedged: The company seeks to hedge against declines in copper prices, which would reduce the fair value of its inventory.
Hedge designation: The futures contracts are designated as a fair value hedge of the copper inventory, offsetting fluctuations in its fair value caused by changes in market prices.
Hedge effectiveness testing using dollar-offset method: This method compares the change in fair value of the hedged item (copper inventory) to the change in the hedging instrument (futures contracts) to determine effectiveness.
- Price drop: Copper prices fall from £7,500 to £7,200 per ton.
- Fair value change of hedged item: 500 tons × £300 (price drop) = £150,000 loss.
- Fair value change of hedging instrument: 50 futures contracts gain £150,000 as prices fall by £300 per ton.
- Dollar-offset ratio: £150,000 (gain on futures) / £150,000 (loss on inventory) = 1 (100% effective).
This indicates the hedge perfectly offsets the risk, making it highly effective.
Rebalancing: After three months, the company revises its sales forecast, reducing it from 500 metric tons to 400 metric tons due to lower demand. As a result, the hedge becomes over-hedged.
To maintain hedge effectiveness, the company rebalances the hedge by reducing the number of futures contracts from 50 to 40 to match the revised 400 metric tons of inventory. This adjustment means the hedge continues to cover the company’s risk exposure without becoming ineffective.
After rebalancing, if the copper price continues to decline to £7,000 per metric ton, the remaining 400 metric tons of inventory would lose £200,000 in value. On the other hand, the 40 futures contracts would gain £200,000, effectively offsetting the loss, so the hedge remains effective.
If you would like further support on any of the issues raised in this article, please contact Joseph Archer or Lakshmi Upadhyaya.
