For cash flow hedges of nonfinancial items, an entity may designate the variability in cash flows attributable to changes in a contractually specified component as the hedged risk. This would be good news for manufacturers who buy raw materials and lock in the prices with derivatives.
Current GAAP: Total-Price-Risk Hedge· Except for foreign exchange risk, an entity is prohibited from designating changes in fair value or cash flows of a component of a nonfinancial item as the hedged risk. For example, if an entity wants to hedge the price risk related to the forecasted purchase or sale of a commodity, it is required to designate changes in the total price of the commodity as the hedged risk.
· Because derivative instruments are often only available at the component level, the total-price-risk hedge results in hedge ineffectiveness being recorded in current period earnings.
· Portfolio hedging of commodities on a total-price-risk basis is extremely challenging, particularly for situations in which an entity has suppliers for the same commodity in various locations. Although the contracts are priced based on the same traded commodity, the basis differentials related to the location and/or the grade of the commodity involved (e.g., transportation costs, quality, supply and demand) often create too much variability on a total-price-risk basis to enable an entity to hedge these forecasted purchases on a portfolio basis. As a result, many entities choose not to hedge at all because of the cost and effort of separately hedging each contract from each supplier.
New Standard: Specific Risk Component Hedge· An entity may designate the variability in cash flows attributable to changes in a contractually specified component as the hedged risk for cash flow hedges of nonfinancial items (e.g., forecasted purchase or sale of a nonfinancial item).
· This avoids the hedge ineffectiveness that results from basis differentials because the entity could hedge just the portion of the purchase that is linked to a base price or market index (e.g., New York Mercantile Exchange or the London Metals Exchange) for which there is a matching derivative that would create the “perfect hedge.”
· For portfolio hedging of commodities, an entity would more easily be able to designate the variability in cash flows attributable to changes in a contractually specified component from multiple suppliers as the hedged risk, which would potentially reduce the entity’s costs and more closely align hedge accounting with its risk management activities.
· An entity is even allowed to apply cash flow hedge accounting to a not-yet-existing contract (that is, beyond the contractual period during which the nonfinancial items are expected to be sold or purchased) as long as the requirements in paragraph 815-20-25-22A will be met in the future contract and all other requirements for cash flow hedge accounting are met.
Current GAAP: Total-Price-Risk Hedge· Except for foreign exchange risk, an entity is prohibited from designating changes in fair value or cash flows of a component of a nonfinancial item as the hedged risk. For example, if an entity wants to hedge the price risk related to the forecasted purchase or sale of a commodity, it is required to designate changes in the total price of the commodity as the hedged risk.
· Because derivative instruments are often only available at the component level, the total-price-risk hedge results in hedge ineffectiveness being recorded in current period earnings.
· Portfolio hedging of commodities on a total-price-risk basis is extremely challenging, particularly for situations in which an entity has suppliers for the same commodity in various locations. Although the contracts are priced based on the same traded commodity, the basis differentials related to the location and/or the grade of the commodity involved (e.g., transportation costs, quality, supply and demand) often create too much variability on a total-price-risk basis to enable an entity to hedge these forecasted purchases on a portfolio basis. As a result, many entities choose not to hedge at all because of the cost and effort of separately hedging each contract from each supplier.
New Standard: Specific Risk Component Hedge· An entity may designate the variability in cash flows attributable to changes in a contractually specified component as the hedged risk for cash flow hedges of nonfinancial items (e.g., forecasted purchase or sale of a nonfinancial item).
· This avoids the hedge ineffectiveness that results from basis differentials because the entity could hedge just the portion of the purchase that is linked to a base price or market index (e.g., New York Mercantile Exchange or the London Metals Exchange) for which there is a matching derivative that would create the “perfect hedge.”
· For portfolio hedging of commodities, an entity would more easily be able to designate the variability in cash flows attributable to changes in a contractually specified component from multiple suppliers as the hedged risk, which would potentially reduce the entity’s costs and more closely align hedge accounting with its risk management activities.
· An entity is even allowed to apply cash flow hedge accounting to a not-yet-existing contract (that is, beyond the contractual period during which the nonfinancial items are expected to be sold or purchased) as long as the requirements in paragraph 815-20-25-22A will be met in the future contract and all other requirements for cash flow hedge accounting are met.
815-20-25-22AIf the price for the purchase or sale of a nonfinancial asset includes a contractually specified component, the variability in cash flows attributable to changes in that component may be designated as the hedged risk in a cash flow hedge if all of the following are met:Source:Proposed Accounting Standards Update—Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging ActivitiesFASB in FocusTentative Board Decisions Reached to Date (as of June 7, 2017)Need to Know: The Upcoming Hedging Standard
a. The purchase or sale contract for the nonfinancial asset creates an exposure related to the variability in cash flows attributable to changes in the contractually specified component throughout the life of the hedging relationship.
1. If the variability in cash flows attributable to changes in the contractually specified component of the hedged forecasted transaction is limited by a cap or floor, an entity may designate a derivative as the hedging instrument that does not have a limited exposure to the contractually specified component risk. However, to make that designation, the entity shall establish that the hedging relationship is expected to be highly effective in achieving offsetting changes in cash flows attributable to changes in the contractually specified component during the period in which the hedging relationship is designated in accordance with paragraph 815-20-25-75.
b. The stated components of the price of the nonfinancial contract all relate to the cost of purchasing or selling the nonfinancial asset in the normal course of business in a particular market. The following are examples of items that may be individually stated price components or aggregated to form a single stated price component:
1. Transportation costs
2. Labor costs
3. Quality or grade differentials between the hedged component and standard market prices that are quoted in purchases or sales contracts for the nonfinancial asset in the normal course of business
4. Local supply and demand factors for the purchase or sale of the nonfinancial asset in the normal course of business.
c. All of the stated components of the price of the nonfinancial contract reflect market conditions at contract inception. For example, labor costs stated in the contract are in line with local markets, and transportation costs reflect market conditions for the distance between the supplier and the customer.
