14.5.1 Principles and types of hedging Entities often manage exposure to financial risks (including commodity price risks) by deciding to which risk, and to what extent, they should be exposed, by monitoring the actual exposure and taking steps to reduce risks to within agreed limits, often through the use of derivatives.
The process of entering into a derivative transaction with a counterparty in the expectation that the transaction will eliminate or reduce an entity’s exposure to a particular risk is referred to as hedging. Risk reduction is obtained because the derivative’s value or cash flows are expected, wholly or partly, to move inversely and, therefore, offset changes in the value or cash flows of the ‘hedged position’ or item. Hedging in an economic sense, therefore, concerns the reduction or elimination of different financial risks such as price risk, interest rate risk, currency risk, etc, associated with the hedged position.
Once an entity has entered into a hedging transaction,
it will be necessary to reflect the transaction in the financial statements of the entity. Accounting for the hedged position should be consistent with the objective of entering into the hedging transaction, which is to eliminate or reduce significantly specific risks that management considers can have an adverse effect on the entity’s financial position and results. This consistency can be achieved if both the hedging instrument and the hedged position are recognised and measured on symmetrical bases and offsetting gains and losses are reported in profit or loss in the same periods. Without hedge accounting mismatches would occur under recognition and measurement standards and practices set out in IFRS. Hedge accounting practices have been developed to avoid or mitigate these mismatches.
Hedge accounting rules therefore allow modifying the normal basis for recognising gains and losses (or revenues and expenses) on associated hedging instruments and hedged items so that both are recognised in profit or loss in the same accounting period. Hedge accounting therefore affords management the opportunity to eliminate or reduce the income statement volatility that otherwise would arise if the hedged items and hedging instruments were accounted for separately.
IAS 39 defines three types of hedge:
1. Cash flow hedge—a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction and (ii) could affect profit or loss. This is the most common type of a hedge in the mining industry.
2. Fair value hedge—a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss.
3. Hedge of a net investment in a foreign operation as defined in IAS 21.
To comply with the requirements of IAS 39 hedges must be:
• Documented from inception of hedge relationship;
• Expected to be highly effective; and
• Demonstrated to have been highly effective in mitigating the hedged risk in the hedged item.
There is no prescribed single method for assessing hedge effectiveness. Instead, a company must identify a method that is appropriate to the nature of the risk being hedged and the type of hedging instrument used. The method an entity adopts for assessing hedge effectiveness depends on its risk management strategy.
A company must document at the inception of the hedge how effectiveness will be assessed and then apply that effectiveness test on a consistent basis for the duration of the hedge. The hedge must be expected to be effective at the inception of the hedge and in subsequent periods and the actual results of the hedge should be within a range of 80-125% (i.e., changes in the fair value or cash flows of the hedged item should be between 80% and 125% of the changes in fair value or cash flows of the hedging instrument). The effective part of a cash flow hedge and a net investment hedge is recognised in Other Comprehensive Income and the effective part of a fair value hedge is adjusted against the carrying amount of the hedged item. Any ineffectiveness of an effective hedge must be recognised in the income statement.
The requirement for testing effectiveness can be quite onerous.
Effectiveness tests need to be performed for each hedging relationship at least as frequently as financial information is prepared, which for listed companies could be up to four times a year. Experience shows that the application of hedge accounting is not straightforward, particularly in the area of effectiveness testing, and a company looking to apply hedge accounting to its commodity hedges needs to invest time in ensuring that appropriate effectiveness tests are developed.
Companies that combine commodity risk from different business units before entering into external transactions to offset the net risk position might not qualify for hedge accounting, as IFRS does not permit a net position to be designated as a hedged item. However it may be possible to obtain hedge accounting by designating the hedged item as a part of one of the gross positions.
The IASB has an ongoing project on hedge accounting.
Two significant expected developments for mining companies are a proposed relaxation in the requirements for hedge effectiveness and the ability to hedge non- financial portions in some circumstances. These may make hedge accounting much more attractive. Entities should monitor the progress on this and assess what the impact on their current accounting will be.
14.5.2 Cash flow hedges and ‘highly probable’
Hedging of commodity-price risk or its foreign exchange component is often based on expected cash inflows or outflows related to forecasted transactions, and therefore are cash flow hedges. Under IFRS, only a highly probable forecast transaction can be designated as a hedged item in a cash flow hedge relationship. The hedged item must be assessed regularly until the transaction occurs. If the forecasts change and the forecasted transaction is no longer expected to occur, the hedge relationship must be ended immediately and all retained hedging results in equity must be recycled to the income statement. Cash flow hedging is not available if an entity is not able to forecast the hedged transactions reliably.
Factors that should be considered when assessing whether a forecasted transaction is highly probable of occurring include:
• Proved and probable reserves: Does the company have proved and probable reserves supporting the forecasted future sale?
• Mine plan: Is the forecasted transaction supported by a mine plan demonstrating that the company will produce at least the hedged quantity on the specified date?
• Infrastructure: Has the company completed the necessary mine development and capital investment to support the future production?
• Percentage of total forecasted production hedged:
The probability of a forecasted sale of 50% of an entity’s expected production is easier to demonstrate as ‘highly probable’ than close to 100%.
• Time to forecasted sale: The further out the forecasted sale, the more evidence is required to demonstrate that the forecasted sale is highly probable.
• Track record of forecasted sales: a past pattern of designated hedge transactions not actually occurring as specified will call into question an entity’s ability to predict forecasted transactions accurately.
Companies that buy or sell commodities (e.g., mining companies) may designate hedge relationships between hedging instruments, including commodity contracts that are not treated as ‘own use’ contracts, and hedged items. In addition to hedges of foreign currency and interest rate risk, mining companies primarily hedge the exposure to variability in cash flows arising from commodity price risk in forecast purchases and sales.
14.5.3 Hedging of non-financial Items It is difficult to isolate and measure the appropriate portion of the cash flows or fair value changes
attributable to specific risks other than foreign currency risks. Therefore, a hedged item which is a non-financial asset or non-financial liability may be designated as a hedged item only for:
a) Foreign currency risks;
b) In its entirety for all risks; or
c) All risks apart from foreign currency risks
In practice the main sources of ineffectiveness in hedging non-financial items arise from differences in location and differences in grade or quality of commodities delivered in the hedged contract compared to the one referenced in the hedging instrument.
14.5.4 Reassessment of hedge relationships in business combinations
An acquirer re-designates all hedge relationships of the acquired entity on the basis of the pertinent conditions as they exist at the acquisition date (i.e., as if the hedge relationship started at the acquisition date). Since derivatives previously designated as hedging derivatives were entered into by the acquired entity before the acquisition, these contracts are unlikely to have a zero fair value at the time of the acquisition. For cash flow hedges in particular, this is likely to lead to more hedge ineffectiveness in the financial statements of the post- acquisition group and also to more hedge relationships failing to qualify for hedge accounting as a result of failing the hedge effectiveness test.
Some of the option–based derivatives that the acquired entity had designated as hedging instruments may meet the definition of a written option when the acquiring entity reassesses them at the acquisition date.
Consequently the acquiring entity won’t be able to designate such derivatives as hedging instruments.