4.3 Nonfinancial Assets
4.3.1 Overview
As discussed in Chapter 2, for a cash flow hedge of a
nonfinancial asset, an entity designates a derivative instrument as a hedge of a
specific risk related to the forecasted purchase or sale of such an asset. The
types of risks that may be hedged in a cash flow hedge involving a nonfinancial
asset include:
-
Foreign currency risk.
-
Contractually specified component risk.
-
Total cash flow risk.
In many cash flow hedges involving the purchase or sale of nonfinancial assets,
the hedging derivative is not perfectly effective at offsetting the total
changes in the cash flows related to the hedged item. However, as discussed in
Section 2.5, the ability to designate components of the
purchase or sale price (i.e., specific hedged risks) affects the hedge
effectiveness assessment and, therefore, thoughtful designation of the hedged
risk can make the difference between a hedging relationship that qualifies for
hedge accounting and a relationship that does not. As long as a qualifying cash
flow hedging relationship is highly effective, all components of the change in
the derivative’s fair value that are included in the assessment of hedge
effectiveness are recorded in OCI (see Section 2.5 for a
discussion of hedge effectiveness assessments). In contrast to the treatment of
qualifying fair value hedges, ineffectiveness is not recognized currently in the
income statement. See Section 4.3.5 for a discussion of the
reclassification of amounts out of AOCI related to cash flow hedges of
nonfinancial assets.
Conceptually, hedging the overall cash flows related to the
forecasted purchase or sale of a nonfinancial asset is fairly simple. If an
entity designates overall cash flows of the nonfinancial asset being purchased
or sold in a forecasted transaction, it must use a hedging derivative that is
highly effective at offsetting all changes in the purchase or sale price of the
nonfinancial asset. In some cases, this is the only risk that an entity may
select. For example, if the purchase or sale of the asset will occur in the
functional currency of the entity and there is not a contractually specified
component to the asset’s price, the only risk that may be designated is the risk
of changes in the overall cash flows of the purchase or sale.
Even if the purchase or sale of the nonfinancial asset will
occur at a price denominated in a foreign currency, as discussed in Section 2.3.2.3, an
entity may exclude foreign currency risk from its designation of the hedged risk
in an overall cash flow hedging strategy. In other words, an entity may hedge
the overall price denominated in the foreign currency. An entity may also hedge
the variability in the cash flows that are attributable to changes in foreign
currency risk for a forecasted purchase or sale of a nonfinancial asset if the
price will be denominated in a foreign currency. Such hedges are very common for
organizations that have significant multinational operations and only want to
hedge the risks of changes in foreign currency exchange rates. Foreign currency
hedging is discussed in detail in Chapter 5.
As discussed in Section 2.3.2.1, ASU 2017-12 gave entities
the ability to hedge the risk of changes in a contractually specified component
of the price of a forecasted purchase or sale of a nonfinancial asset. However,
even after the issuance of ASU 2017-12, many entities have been slow to move to
these types of hedges, sometimes because their established hedging strategies
are already highly effective. In addition, as discussed in Section 2.3.2.1.2, there
are still many questions about whether transactions in the spot market actually
have a contractually specified component to the price.
4.3.2 Partial-Term Hedging
As is the case with hedges of forecasted transactions involving
financial instruments (see Section
4.2.1.2.3), when hedging the forecasted purchase or sale of a
nonfinancial asset, an entity is not required to hedge changes in cash flows
that are attributable to the hedged risk for the entire period leading up to the
actual date of the forecasted transaction.
Example 4-23
Hedging Forecasted Purchase With Derivative That
Settles Before Forecasted Purchase
Golden Age plans to make a large gold
purchase in one year but is only really interested in
hedging the price of gold for the next three months. It
decides to enter into a futures contract to purchase
gold that settles in three months and designate the
contract as a hedge of the changes in cash flows over
the next three months related to its forecasted purchase
of gold in one year.
If Golden Age excludes
time value from its assessment of hedge effectiveness,
it would compare the changes in the spot price of gold
underlying the futures contract with the spot price of
gold in the market in which it expects to purchase the
gold in one year. If it does not exclude any components
of the futures contract from its assessment, it could
compare the change in the actual derivative’s fair value
(the three-month futures contract) with the change in
the fair value of a hypothetical forward that settles in
one year at the same location in which it expects to
purchase the gold. For example, if Golden Age performed
effectiveness assessments on a monthly basis, it would
do the following comparison at the end of the first
month:
|
Derivative
|
Beginning of Period
|
End of Period
|
|---|---|---|
|
Actual
|
Three-month futures
|
Two-month futures
|
|
Hypothetical
|
Twelve-month forward settling at expected
purchase location
|
Eleven-month forward settling at expected
purchase location
|
Note that even if the underlying spot price of the forecasted
transaction is the same as the underlying price of the derivative (i.e., the
underlying location and grade of the nonfinancial asset is the same), if an
entity does not exclude any components of the derivative from its hedge
effectiveness assessment, it cannot assume that the critical terms match in a
partial-term hedging relationship because the settlement date of the derivative
does not match the settlement date of the forecasted transaction.
4.3.3 Changes in Terms of Forecasted Transaction Other Than Timing
As discussed in Section 4.1.4.2, if the terms of a hedged
forecasted transaction change, an entity is required to consider whether the
revised forecasted transaction still meets the definition of the forecasted
transaction in the original hedge designation documentation. If the revised
forecasted transaction no longer meets that definition, the entity must
discontinue hedge accounting and reclassify amounts from AOCI into earnings (see
Section 4.1.5).
However, if the revised forecasted transaction still meets the definition in the
hedge designation documentation, the entity should perform a revised hedge
effectiveness assessment to determine whether it is appropriate to continue
hedge accounting.
ASC 815-20
Contractually Specified Component in a
Not-Yet-Existing Contract
55-26B This guidance
discusses the implementation of paragraphs 815-20-25-22B
and 815-30-35-37A. Entity A’s objective is to hedge the
variability in cash flows attributable to changes in a
contractually specified component in forecasted
purchases of a specified quantity of soybeans on various
dates during June 20X1. Entity A has executed contracts
to purchase soybeans only through the end of March 20X1.
Entity A’s contracts to purchase soybeans typically are
based on the ABC soybean index price plus a variable
basis differential representing transportation costs.
Entity A expects that the forecasted purchases during
June 20X1 will be based on the ABC soybean index price
plus a variable basis differential.
55-26C On January 1, 20X1,
Entity A enters into a forward contract indexed to the
ABC soybean index that matures on June 30, 20X1. The
forward contract is designated as a hedging instrument
in a cash flow hedge in which the hedged item is
documented as the forecasted purchases of a specified
quantity of soybeans during June 20X1. As of the date of
hedge designation, Entity A expects the contractually
specified component that will be in the contract once it
is executed to be the ABC soybean index. Therefore, in
accordance with paragraph 815-20-25-3(d)(1), Entity A
documents as the hedged risk the variability in cash
flows attributable to changes in the contractually
specified ABC soybean index in the not-yet-existing
contract. On January 1, 20X1, Entity A determines that
all requirements for cash flow hedge accounting are met
and that the requirements of paragraph 815-20-25-22A
will be met in the contract once executed in accordance
with paragraph 815-20-25-22B. Entity A also will assess
whether the criteria in 815-20-25-22A are met when the
contract is executed.
55-26D As part of its normal
process of assessing whether it remains probable that
the hedged forecasted transactions will occur, on March
31, 20X1, Entity A determines that the forecasted
purchases of soybeans in June 20X1 will occur but that
the price of the soybeans to be purchased will be based
on the XYZ soybean index rather than the ABC soybean
index. As of March 31, 20X1, Entity A begins assessing
the hedge effectiveness of the hedging relationship on
the basis of the changes in cash flows associated with
the forecasted purchases of soybeans attributable to
variability in the XYZ soybean index. Because the hedged
forecasted transactions (that is, purchases of soybeans)
are still probable of occurring, Entity A may continue
to apply hedge accounting if the hedging instrument
(indexed to the ABC soybean index) is highly effective
at achieving offsetting cash flows attributable to the
revised contractually specified component (the XYZ
soybean index). On April 30, 20X1, Entity A enters into
a contract to purchase soybeans throughout June 20X1
based on the XYZ soybean index price plus a variable
basis differential representing transportation
costs.
55-26E If the hedging
instrument is not highly effective at achieving
offsetting cash flows attributable to the revised
contractually specified component, the hedging
relationship must be discontinued. As long as the hedged
forecasted transactions (that is, the forecasted
purchases of the specified quantity of soybeans) are
still probable of occurring, Entity A would reclassify
amounts from accumulated other comprehensive income to
earnings when the hedged forecasted transaction affects
earnings in accordance with paragraphs 815-30-35-38
through 35-41. The reclassified amounts should be
presented in the same income statement line item as the
earnings effect of the hedged item. Immediate
reclassification of amounts from accumulated other
comprehensive income to earnings would be required only
if it becomes probable that the hedged forecasted
transaction (that is, the purchases of the specified
quantity of soybeans in June 20X1) will not occur. As
discussed in paragraph 815-30-40-5, a pattern of
determining that hedged forecasted transactions are
probable of not occurring would call into question both
an entity’s ability to accurately predict forecasted
transactions and the propriety of applying cash flow
hedge accounting in the future for similar forecasted
transactions.
In the example in ASC 815-20-55-26B through 55-26E, Entity A is hedging the
contractually specified component of a not-yet-existing contract, and the
expected contractually specified component changes before the contract exists.
This example reinforces a few key concepts, one of which is that when the
forecasted transaction changes, the entity needs to assess whether the
designated transaction is still probable.
In this example, Entity A documents the hedge as
follows:
|
Forecasted Transaction
|
Designated Risk
|
|---|---|
|
Purchase of specified quantity of
soybeans on various dates during June 20X1
|
Variability in cash flows attributable to changes in the
contractually specified ABC soybean index in the
not-yet-existing contract
|
After designating the hedge, Entity A observes that the price of
soybeans it will purchase will be based on the XYZ soybean index, not the ABC
soybean index. Regardless of the price exposure change, Entity A determines that
it is still probable that it will purchase the specified quantity of soybeans on
various dates during June 20X1. This is important because if it becomes no
longer probable that a forecasted transaction will occur, an entity must
discontinue hedge accounting. In addition, if it becomes probable that the
forecasted transaction will not occur, the entity must reclassify amounts
previously recorded in AOCI into earnings. However, in this case, Entity A can
maintain hedge accounting if the hedging relationship is still highly
effective.
In evaluating this next step after a change in the terms of the forecasted
transaction, Entity A needs to assess whether its derivative contract (the
forward contract based on the ABC soybean index) is highly effective at
offsetting the change in cash flows related to the forecasted purchases of
soybeans based on the revised contractually specified component (the XYZ soybean
index). If Entity A is using the hypothetical-derivative method to assess hedge
effectiveness, the hypothetical forward contract would be a forward to purchase
XYZ soybeans with a market-based strike price at the inception of the hedging
relationship (i.e., the hypothetical forward would have a fair value of zero as
of January 1, 20X1).
While this example deals with a hedge of the contractually specified component of
a not-yet-existing contract, the same sort of analysis would be performed for
hedges that involve total cash flow risk or foreign-currency risk if there are
changes in the terms of the forecasted transaction. The first step of the
analysis (i.e., assessing the probability that the forecasted transaction will
occur) is the same regardless of the designated risk. However, if the second
step is necessary (i.e., the forecasted transaction is still probable), the
revised hedge effectiveness assessment is only affected if the change in the
forecasted transaction’s terms have an impact on the designated risk. In a
manner similar to the example above, if the derivative is still highly effective
at offsetting changes in the cash flows that are attributable to the hedged risk
of the revised transaction, the entity may continue hedge accounting. If the
hedging relationship is no longer highly effective, hedge accounting should be
discontinued but amounts previously recorded in AOCI would remain in AOCI until
the forecasted transaction affects earnings.
4.3.4 Delay of Forecasted Transaction
As discussed in Section 4.1.4.1, if the timing of a hedged
forecasted transaction changes, an entity is required to consider whether it is
still probable that the forecasted transaction will occur within the timing
established in the hedge designation documentation.
4.3.4.1 Designated Transaction Is a Single Transaction
If an entity is hedging a single forecasted transaction and
the timing of that transaction changes, the impact of that change in timing
on the hedging relationship depends on whether it is still probable that the
transaction will occur within the period specified in the designation
documentation (see Section
4.1.5.1.2.3 for further discussion). If hedge accounting
needs to be discontinued, the hedging relationship should be
dedesignated.
4.3.4.2 Designated Transaction Is a Group of Transactions
Most hedges of purchases or sales of nonfinancial assets involve multiple
transactions, as opposed to one singular transaction. For example, if an
entity is hedging monthly purchases of raw materials and there is a
reduction in the expected purchases for the given month, some but not all of
the forecasted transactions may still be probable. In that case, the entity
is not required to dedesignate the entire hedging relationship, although it
is permitted to do so. If some of the transactions are still probable, the
entity could dedesignate a proportion of the hedging relationship that
represents transactions that are no longer probable (see Section 4.1.5.1.3.1).
Example 4-24
Alaskan Crude expects to sell 120
barrels of oil to customers in Idaho in June 20X1.
To protect itself against the risk of decreases in
oil prices, Alaskan Crude enters into a futures
contract in January 20X1 to hedge the forecasted
sale of the first 100 barrels of oil in Idaho in
June 20X1. Assume that the futures contract is
highly effective at hedging the change in the total
cash flows from those sales. In May 20X1, some of
Alaskan Crude’s customers notify the company that
they would like to delay their June oil deliveries
until July. Accordingly, Alaskan Crude reduces its
estimated June sales volume in Idaho to 90 barrels
of oil and expects to sell the remaining 30 barrels
in July.
Given the reduction in projected oil
sales in June, it is no longer probable that Alaskan
Crude will sell all of the 100 barrels that month as
originally forecasted; it projects a sales shortfall
of 10 barrels. Alaskan Crude could dedesignate 10
percent of the futures contract from the hedging
relationship and maintain 90 percent of the original
relationship. Because it is still probable that the
10 barrels will be sold within two months of the
documented timeframe, 10 percent of the amounts in
AOCI as of the date the change in projections
occurred should be “frozen” and released when those
sales occur (July 20X1). Alaskan Crude should
prospectively recognize 10 percent of the change in
the futures contract’s fair value in earnings and
the other 90 percent in OCI. All amounts remaining
in AOCI related to the 90 barrels sold in June 20X1
would be reclassified into revenues when they are
sold.
Alternatively, Alaskan Crude could
dedesignate the entire hedging relationship in May
20X1. Such a dedesignation would not affect the
treatment of amounts in AOCI that are reclassified
into revenues in June 20X1 (90 percent of the amount
in AOCI as of the date of dedesignation) and July
20X1(10 percent of the amount in AOCI at the date of
dedesignation) because the reclassifications are
based on when those forecasted sales affect
earnings. If Alaskan Crude does not redesignate any
portion of the futures contract in a new hedging
relationship, all future changes in the futures
contract’s fair value will be recognized in
earnings.
4.3.4.3 Simultaneous Hedges of Groups of Transactions
Entities that buy or sell nonfinancial assets in connection
with their operations often seek to hedge the price risk related to
recurring transactions on a monthly basis. In fact, it is not uncommon for
an entity to enter into 12 separate hedging relationships to cover a portion
of its monthly purchases or sales over the entire year. For example, an
entity may have a policy of entering into forward contracts to cover 75
percent of its projected monthly purchases of raw materials one year in
advance. In such a case, it would always have 12 active hedging
relationships since each month it would enter into a new 12-month forward
and settle the forward contract it entered into 12 months earlier.
In these types of hedges, it is important to have a strategy for dealing with
probable shortfalls of forecasted transactions in any given month. Entities
should have a documented policy for identifying any transactions in a given
month that are actually delayed transactions from the prior month. Note that
the same transaction cannot simultaneously be the forecasted transaction in
more than one hedging relationship for the same designated risk.
Example 4-25
Delayed Forecasted Transactions Occur in Periods
Already Hedged
Alaskan Crude sells oil to its customers in Nebraska
on a monthly basis. It has a policy of entering into
forward sales contracts to hedge 90 percent of its
estimated monthly sales one year in advance. In
July, one of its major customers in Nebraska
notifies Alaskan Crude that it is temporarily
shutting down operations in October to retrofit
furnaces and related equipment. Below are the
original and revised projections of oil sales in
Nebraska for October through December:
Alaskan Crude’s policy stipulates that a shortfall in
transactions in a given month can only be applied to
previously unhedged transactions that are forecasted
for the following months. The revised estimate of
sales indicates that Alaskan Crude is now overhedged
by 100 barrels for October (900 barrels – 800
barrels). However, for November, its forecasted
sales exceed its hedged sales, and it is underhedged
by 120 barrels (1,080 barrels – 1,200 barrels).
Alaskan Crude believes that it is probable that the
100 barrels of sales that were originally expected
in October will instead occur in November.
Accordingly, in July it will dedesignate 100 barrels
worth of the notional amount of its forward
contracts from the hedging relationship for
October’s forecasted sales. However, amounts in AOCI
related to those 100 barrels will remain in AOCI and
be reclassified into revenues when the delayed sales
occur in November.
4.3.5 Reclassifications From AOCI
In accordance with ASC 815-30-35-38 through 35-41, amounts recorded in AOCI
related to a qualifying cash flow hedging relationship are reclassified into
earnings in the same period or periods during which the hedged forecasted
transaction affects earnings and, in accordance with ASC 815-20-45-1A, such
amounts are presented in the same income statement line item as the earnings
effect of the hedged item. The nature of the hedging relationship dictates the
income statement classification of the reclassified amounts. Below are some
examples of hedged nonfinancial asset transactions and their respective income
statement classifications.
|
Hedged Item
|
Income Statement Classification
|
|---|---|
|
Forecasted purchase of raw materials
|
Cost of sales
|
|
Forecasted sales of products
|
Revenues
|
|
Forecasted purchase of equipment
|
Depreciation
|
Because of the nature of hedging relationships that involve nonfinancial assets,
the amounts in AOCI are not typically reclassified into earnings before the
derivative is settled and the relationship is terminated. For example, if the
hedged item is related to the acquisition of raw materials, amounts will remain
in AOCI until that related inventory is sold. Note that the amounts in AOCI are
not reclassified to adjust the basis of the items acquired through a forecasted
purchase. However, the income statement effects should be the same as if the
basis of the underlying item were adjusted for the results of hedge accounting.
In other words, if the forecasted transaction is the acquisition of raw
materials or inventory, an entity should reclassify amounts from AOCI into
earnings in a manner consistent with the method it uses to recognize inventory
costs (e.g., LIFO, FIFO, or average cost). For example, if the entity uses LIFO
to determine the costs of its inventory, the gain or loss on the derivative
included in AOCI should (1) be matched with a particular LIFO layer when
incurred and (2) recognized in the cost of sales when the LIFO layer is
relieved. The entity should include its method of reclassifying AOCI into
earnings in its formal documentation of the hedge at inception.
In addition, if an asset that was part of a hedged forecasted purchase becomes
impaired, the entity should immediately reclassify all or some amounts from AOCI
into earnings. For example, if an entity hedges the forecasted purchase of
equipment, the entire change in the hedging instrument’s fair value is recorded
in OCI and released into earnings as the company depreciates the equipment
(after the equipment is purchased). If the asset becomes impaired, any net gain
in AOCI should be reclassified from AOCI into earnings in an amount equal to the
lesser of (1) the impairment loss or (2) the amount remaining in AOCI. Note that
those amounts will be reclassified into earnings in the same income statement
line item that is used to present the earnings effect of the impairment of the
equipment.
Example 4-26
Hedged Item
Subsequently Becomes Impaired
Fluff Heads hedges the forecasted
purchase of cotton by entering into a forward contract
on January 1, 20X1. On June 30, 20X1, it takes delivery
of the cotton and closes out the forward contract, which
currently has a fair value of $2 million. Fluff Heads
properly leaves the $2 million gain in AOCI pending the
sale of the cotton. On December 31, 20X1, the company
determines that the cotton inventory is impaired, and
the amount of impairment is calculated as $1.5 million.
In this case, Fluff Heads should reclassify $1.5 million
of the gain remaining in AOCI into earnings to directly
offset the impairment loss on the inventory at the
income statement line-item level.
Alternatively, assume that Fluff Heads
hedges the forecasted sale of cotton by entering into a
futures contract on January 1, 20X2. On April 1, 20X2
(three months before the sale), the futures contract has
a fair value of $2 million and Fluff Heads determines
that its cotton was impaired by $1 million. Fluff Heads
records an impairment loss of $1 million. The derivative
gain that offsets part or all of the loss should be
reclassified into earnings in the same period and income
statement line-item in which the impairment is recorded.
Thus, Fluff Heads should reclassify $1 million of the
gain on the futures contract from AOCI into earnings to
offset the $1 million impairment loss on the cotton.
Section 4.1.5 discusses the accounting for discontinued cash
flow hedging relationships, including the treatment of amounts in AOCI.
Examples 4-28 and 4-29 provide
detailed illustrations that address both the initial recognition of gains and
losses in OCI and the reclassification of amounts out of AOCI after the hedging
relationship is discontinued.
4.3.6 Illustrative Examples
Example 4-27
Futures Hedging
Forecasted Purchase of Materials for Overall Changes
in Cash Flows
Mercury Provisions is a producer of
high-quality outdoor equipment. It is starting a new
line of “unbreakable” nets made of galvanized steel. On
January 2, 20X1, Mercury enters into futures contracts
to purchase 1,000 tons of U.S. Midwest Domestic
Hot-Rolled (HR) Coil Steel on March 15, 20X1, at a price
of $503 per ton. It designates the futures contracts as
a hedge of its forecasted purchase of 1,000 tons of
hot-dipped galvanized (HDG) coil steel in the spot
market on March 15, 20X1, for changes in cash flows that
are attributable to changes in the overall purchase
price of the HDG coil steel. The price of HDG coil steel
is higher than that of HR coil steel, but there is a
high volume of futures contracts on HR coil steel and
Mercury believes that the futures contract will be
highly effective at hedging changes in the price of the
HDG coil steel it is purchasing. Mercury will assess the
effectiveness of the hedge by using the
hypothetical-derivative method to compare the changes in
the fair value of a forward to purchase HDG coil steel
to the changes in the prices of its futures contract on
HR coil steel.
For this example, assume that the
creditworthiness of Mercury does not call into question
whether it is probable that it will perform under the
futures contract. Because of the nature of a futures
contract (i.e., it is entered into with a regulated
exchange), counterparty performance risk is minimal.
Also assume that it remains probable throughout the
hedging relationship that the forecasted purchase of HDG
coil steel will occur.
The table below shows (1) the spot and
futures rates for both HR coil steel and HDG coil steel,
(2) the fair value of the futures contract at the end of
each period, and (3) the results of hedge effectiveness
testing for the life of the hedging relationship.
The journal entries for the life of the
hedging relationship are as follows:
January 2, 20X1
No entry is required because the futures
contracts were entered into at-market and have an
initial fair value of zero.
January 31, 20X2
February 28, 20X2
March 15, 20X2
Note that the $35,000 loss in AOCI will
be reclassified into cost of sales when the steel
inventory affects earnings (see Section
4.3.5).
Example 4-28
Futures Hedging Contractually Specified Component of
Monthly Forecasted Purchases of Materials From
Annual Supply Contract
Fuego Power operates a coal-fired power
plant. On the basis of its average usage, it appears to
have the capacity to store about 46 days’ worth of coal.
Fuego likes to maintain some excess inventory, so it
orders monthly deliveries of coal on the basis of its
expected usage during the following month. In November
of each year, Fuego enters into a variable-price supply
contract for the upcoming year with Fordham Industries.
The contract has monthly scheduled deliveries with
specified minimum purchases for each month, but Fuego
notifies Fordham of the actual quantity needed for a
given month on the first day of the prior month. On
November 15, 20X1, Fuego enters into the supply contract
with Fordham for 20X2 in which each month it will pay a
price per ton based on the monthly average Platts CAPP
rail (CSX) OTC price plus $4.00. The supply contract is
not accounted for as a derivative because Fuego elects
to apply the normal purchases and normal sales scope
exception in ASC 815-10-15-22 (see Section 2.3.2 of
Deloitte’s Roadmap Derivatives).
Fuego’s risk management policy is to
enter into financially settled futures contracts for the
minimum quantities that must be purchased under the
contracts, which is 80 percent of the forecasted
purchase amounts. The futures contracts are indexed to
the final monthly average CSX price (the same one in the
supply contract). Fuego’s policy is to enter into the
futures contracts by the end of November for all of the
months in the following year.
Accordingly, Fuego enters into futures
contracts for 20X2 on November 30, 20X1, and documents
that the contracts are hedging the first number of tons
of forecasted monthly purchases of coal for each month
in 20X2 that matches the notional amount of the monthly
futures. The hedged risk is the changes in the cash
flows that are attributable to the contractually
specified monthly average CSX price component. Estimated
cash flows for the forecasted purchases of coal will be
based on changes in the forward prices (i.e., in the
same manner as the futures prices). Fuego will assess
hedge effectiveness by using the hypothetical-derivative
method; however, because the critical terms of the
futures contracts match those of the forecasted
purchases of coal (see Section
2.5.2.2.2), as long as there is no change in
the terms of the forecasted purchases, the hedge is
assumed to be perfectly effective and the analysis is
qualitative. The table below shows (1) the expected
quantities to be purchased each month, (2) the notional
amount of the futures contracts for each month, and (3)
the futures price per ton.
For this example, assume that the creditworthiness of
Fuego does not call into question whether it is probable
that it will perform under the futures contract. Because
of the nature of a futures contract (i.e., it is entered
into with a regulated exchange), counterparty
performance risk is minimal. Also assume that it remains
probable throughout the hedging relationship that the
forecasted purchases of coal will occur.
In the monthly journal entries below, it is assumed that
the turnover of coal inventory is one month, meaning
that coal purchased in January is used in February. For
simplicity, all entries for the month are shown on the
last day of the month. Entries for revenues and the
other costs of power production are not included. Also
note that Fuego’s inventory purchases in November and
December 20X1 are not subject to the hedging program
illustrated here, so entries for those activities are
not shown.
No entry is required in November 20X1 because the new
supply contract signed on November 15 is an executory
contract that is not in the scope of ASC 815 and the
futures contracts that are entered into on November 30
have an initial fair value of zero.
December 31,
20X1
The table below shows a
rollforward of the fair value of the futures contracts.
No contracts are settled in December and none of the
forecasted purchases have yet occurred.
January 31,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value that is
attributable to changes in the forward rates is
calculated before any settlement that occurs during the
month (i.e., the monthly settlement is added back to the
ending fair value for calculation purposes).
February 28,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
March 31,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI that is related
to the change in the futures contracts’ fair value
attributable to changes in the forward rates is
calculated before any settlement that occurs during the
month (i.e., the monthly settlement is added back to the
ending fair value for calculation purposes).
April 30,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
May 31,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
June 30,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
July 31,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
August 31,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
September 30,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
October 31,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contract that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
November 30, 20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
December 31,
20X2
The table below shows (1) a rollforward of the fair value
of the futures contracts, (2) the monthly futures
settlement, and (3) the monthly purchase of inventory.
The fair value of the futures contracts at the end of
the period is related only to contracts that are still
outstanding (i.e., any futures contracts that settled
during the month are no longer included in the balance).
Accordingly, the amount recorded in OCI related to the
change in the futures contracts’ fair value attributable
to changes in the forward rates is calculated before any
settlement that occurs during the month (i.e., the
monthly settlement is added back to the ending fair
value for calculation purposes).
January 31,
20X3
Example 4-29
Exchange-for-Physical Transaction — Hedging Forecasted
Purchase of Materials
On January 1, 20X1, Fluff Heads enters
into a futures contract to buy cotton as a hedge of its
expected purchase of cotton for production in December.
In the cotton industry, brokers generally are unwilling
to enter into forward delivery contracts before the
given year’s cotton crop has been planted unless the
buyer pays a premium over the futures price. Futures
contracts do not qualify for the normal purchases and
normal sales scope exception because they require cash
settlements of gains and losses (see Section 2.3.2 of
Deloitte’s Roadmap Derivatives), so Fluff Heads
designates the futures contract as a cash flow hedge of
the forecasted purchase of cotton in December 20X1 for
changes in cash flows that are attributable to changes
in the overall purchase price of cotton.
Entering into this type of a derivative transaction is in
compliance with Fluff Heads’s overall risk management
policy. Under that policy, Fluff Heads must assess hedge
effectiveness quarterly by using a regression analysis
to compare the change in the futures contracts’ fair
value with the change in the cash flows of the
forecasted purchase of cotton based on the forward
prices of cotton at the location in which it will be
purchased. Fluff Heads management performs a
quantitative assessment at inception that shows that the
basis differential between the futures contract and the
entire purchase price of the cotton is not expected to
cause the relationship to be outside the 80 to 125
percent regression parameters. Therefore, it expects the
hedge to be highly effective.
On May 1, 20X1, when the acreage of cotton planted is
known and the weather patterns are forecasted, brokers
are willing to enter into fixed-price contracts to sell
cotton without requiring buyers to pay a premium. Fluff
Heads assigns the futures contract to a broker, who
“steps into” Fluff Heads’s position and simultaneously
enters into a forward contract with Fluff Heads to
deliver cotton in December. Fluff Heads is relieved of
all rights and obligations under the original futures
contract and, therefore, it cannot continue to account
for the futures contract after the assignment date.
Because the price of cotton increased between January 1
and May 1, the futures contract has a positive fair
value. The inherent gain in the futures contract is
assumed by the broker, and Fluff Heads receives no cash
premium from the broker. However, the price under the
fixed-price forward agreement is adjusted so that the
forward contract has a positive fair value that
approximately equals the fair value of the futures
contract surrendered. Transactions in which a futures
contract is exchanged for a forward contract are
typically called “exchange-for-physical” (EFP)
arrangements.
Fluff Heads designates the forward contract it entered
into in May as a normal purchase contract under ASC
815-10-15-22 because (1) delivery under the contract is
probable and (2) the cotton to be delivered under the
contract will be used in production. Assume that the
purchase of cotton remains probable until it is
purchased on December 31, 20X1, for $1.5 million and
that the shirts made from the cotton purchased are sold
on March 31, 20X2, for total revenues of $2.2 million.
The table below shows (1)
the expected discounted future cash flows from the
forecasted purchase of cotton, (2) the fair values of
the futures contract, (3) the results of the prospective
and retrospective qualitative assessments, and (4) the
likelihood that the forecasted transaction will occur as
of January 1, March 31, and May 1.
Fluff Heads records the following journal entries until
the forecasted purchases affect earnings:
January 1,
20X1
No journal entry is required because the futures contract
has a fair value of zero at inception.
March 31,
20X1
Fluff Heads can apply hedge accounting because both the
initial hedge effectiveness assessment performed at
inception and the subsequent retrospective hedge
effectiveness performed as of March 31 indicate that (1)
the hedging relationship is highly effective and (2) it
is still probable that the forecasted purchase of cotton
will occur.
May 1,
20X1
Fluff Heads can apply hedge accounting because both the
prospective hedge effectiveness assessment performed as
of March 31 and the subsequent retrospective hedge
effectiveness performed as of May 1 indicate that (1)
the hedging relationship is and was highly effective and
(2) it is still probable that the forecasted purchase of
cotton will occur.
June 30, 20X1, and
September 30, 20X1
No entries are required because the forward contract is
not subject to ASC 815 since it meets the normal
purchases and normal sales scope exception. The
forecasted purchase of cotton that was previously hedged
is still probable and has not yet affected earnings, so
amounts in AOCI will remain in AOCI.
December 31,
20X1
March 31,
20X2
Example 4-30
Qualifying Hedge of Forecasted Sale of Inventory Is No
Longer Highly Effective
On January 1, 20X1, FarmHouse Inc. enters into a futures
contract to sell corn inventory on December 31, 20X1. It
designates the futures contract as a cash flow hedge of
the forecasted sale of its corn inventory for overall
changes in cash flows. Entering into this type of a
derivative transaction is in compliance with its overall
risk management policy. At the inception of the hedge,
FarmHouse formally documents the hedging relationship
and indicates that it will assess hedge effectiveness
quantitatively every quarter by using regression
analysis. It also uses regression to perform an initial
quantitative prospective assessment of hedge
effectiveness, which supports its expectation that the
hedging relationship will be highly effective over
future periods at offsetting changes in cash flows.
FarmHouse elects not to exclude any portion of the
change in the hedging derivative’s fair value from its
hedge effectiveness assessment.
The table below shows (1)
the expected discounted future cash flows from the
forecasted sales of the corn inventory, (2) the fair
values of the futures contracts, (3) the results of the
prospective and retrospective regression analyses, and
(4) the likelihood of the forecasted transaction
occurring as of January 1, March 31, June 30, and
September 30, 20X1.
The journal entries as of January 1, 20X1, March 31,
20X1, June 30, 20X1, and September 30, 20X1 are as
follows:
January 1,
20X1
No journal entry is required because the futures contract
has a fair value of zero at inception.
March 31,
20X1
FarmHouse can apply hedge accounting in the first quarter
because both the initial hedge effectiveness assessment
performed at inception and the subsequent retrospective
hedge effectiveness performed as of March 31 indicate
that (1) the hedging relationship is highly effective
and (2) it is still probable that the forecasted sale of
corn will occur.
June 30,
20X1
FarmHouse can apply hedge accounting in the second
quarter because both the prospective effectiveness
assessment performed as of March 31 and the
retrospective effectiveness assessment performed as of
June 30 indicate that (1) the hedging relationship is
highly effective and (2) the forecasted sale of corn is
still probable.
September 30,
20X1
FarmHouse cannot apply hedge accounting in the third
quarter because although the prospective regression
analysis performed as of June 30, 20X1, indicated that
the hedging relationship was expected to be highly
effective in that quarter, the retrospective regression
analysis performed as of September 30, 20X1, indicated
that the hedging relationship is no longer highly
effective. Accordingly, FarmHouse should record the
entire change in the futures contract’s fair value in
earnings. In addition, the prospective regression
analysis performed as of September 30, 20X1, shows that
the hedge is not expected to be effective for the last
quarter of the futures contract, so the hedging
relationship should be discontinued.
FarmHouse will (1) continue to report the $105,000 net
loss on the futures contract related to the discontinued
hedge in AOCI and (2) recognize that amount in earnings
when the corn inventory sale occurs (unless it becomes
probable that the forecasted corn inventory sale will
not occur, in which case the related amounts in AOCI
would be immediately recognized in earnings).
Example 4-31
All-in-One Hedge of Forecasted Purchase of
Commodity
On January 1, 20X1, Golden Age enters
into a forward to purchase 1,000 ounces of gold for
$1,450 per ounce on March 31, 20X1. The current price of
gold is $1,320 per ounce. The forward contract meets the
definition of a derivative, and Golden Age chooses not
to elect the normal purchases and normal sales scope
exception from derivative accounting (see Section 2.3.2 of
Deloitte’s Roadmap Derivatives). Accordingly, it
will account for the forward contract as a derivative,
but it will use the contract as a hedge of the
forecasted purchase of the 1,000 ounces of gold
underlying the contract (i.e., it is an all-in-one
hedging relationship). Golden Age is hedging the changes
in the cash flows of the forecasted purchase for the
risk of changes in the overall purchase price of gold.
It will assess those changes in the cash flows on the
basis of the changes in the forward price of gold. The
critical terms of the forward match those of the
forecasted transaction, so Golden Age expects the hedge
to be perfectly effective.
For this example, assume that the creditworthiness of
both Golden Age and the counterparty to the forward
contract do not call into question whether it is
probable that they will perform under the contract.
Accordingly, it remains probable throughout the hedging
relationship that the forecasted purchases of gold will
occur.
When the forward contract settles, the spot price of gold
is $1,500 per ounce. The journal entries for the hedging
relationship are as follows:
January 2, 20X1
No entry is required because the forward contract has a
fair value of zero at inception.
March 31,
20X1
The $50,000 gain in AOCI will be reclassified into cost
of sales when the gold inventory or related products are
sold, effectively creating a cost of $1.45 million for
this gold inventory. If the 1,000 ounces of gold
inventory is impaired before the sale, an amount equal
to the lesser of the amount of the impairment or $50,000
should be reclassified out of AOCI and into impairment
charges.
Example 4-32
Purchased Option Hedging Forecasted Purchase of
Inventory (Terminal Value Method)
On January 1, 20X1, Golden Age enters into an option
contract that gives it the right to purchase 1,000
ounces of gold at $1,275 per ounce on December 31, 20X1
(the option’s expiration date). Golden Age pays $10,000
(fair value) for the option, which cannot be exercised
before its maturity. Golden Age designates the option as
a cash flow hedge of its forecasted purchase of 1,000
ounces of gold on December 31, 20X1. Its overall risk
management policy permits the use of a purchased option
to hedge its exposure to changes in the price of gold.
Golden Age formally documents the hedging relationship
at the inception of the hedge. In accordance with its
policy, it will assess hedge effectiveness (1) on the
basis of the total changes in the hedging option’s cash
flows (i.e., it will not exclude any components of the
option contract from its assessment) and (2) by
comparing the option’s terminal value (i.e., the
expected future pay-off amount on the maturity date)
with the expected change in the cash flows when gold
prices exceed $1,275 per ounce.
Golden Age may assume that this cash flow hedge will be
perfectly effective because all of the criteria in ASC
815-20-25-126 and ASC 815-20-25-129 are met, specifically:
-
The hedging instrument is a purchased option.
-
The exposure being hedged is the variability in the expected future cash flows attributed to a price beyond a specified level (i.e., $1,275 per ounce).
-
The assessment of effectiveness will be made on the basis of the total changes in the option’s cash flows (i.e., the total change in the option’s fair value).
-
The critical terms of the option (e.g., its notional amount, underlying, and maturity date) perfectly match the related terms of the hedged forecasted purchase of gold.
-
The strike price of the option matches the specified level ($1,275 per ounce) beyond which Golden Age’s exposure is being hedged.
-
The option’s inflows and outflows on its maturity date will completely offset the change in the cash flows of the forecasted purchase of gold for the risk being hedged (i.e., changes in cash flows that are attributable to changes in the price of gold above $1,275 per ounce).
-
The option cannot be exercised before its maturity (i.e., it can only be exercised on its contractual maturity date).
Assume that Golden Age makes the forecasted purchase of
1,000 ounces of gold on December 31, 20X1, and that it
sells the product made from the gold on March 31, 20X2.
The table below shows (1) the market price of gold per
ounce and (2) the fair values of the option as of
January 1, March 31, June 30, September 30, and December
31, 20X1.
The journal entries are as follows:
January 1,
20X1
March 31,
20X1
June 30,
20X1
September 30,
20X1
December 31,
20X1
March 31,
20X2