1. IAS 39 needs to be clarified in respect to the accounting treatment of futures contracts used to reduce the price volatility of purchasing food-related raw materials. Such transactions should be treated as cash flow hedges, with fair value variation recorded in equity until final delivery. Another interpretation of IAS 39 could result that these instruments are recorded as trading positions, thereby affecting the P&L.
2. In the following example reference has been made to green coffee but the comments and rational apply equally to other raw materials (cocoa, wheat, oils and fats, etc.). It demonstrates that cash flow hedging methodology should be applied.
3. Based on forecasted sales, companies establish in advance their upcoming needs of green coffee quantities and frequently enter into derivative transactions to hedge against potential green coffee price fluctuations.
4. This consists in purchasing futures contracts on regulated exchanges for above forecasted quantities (step 1). The main end product is soluble coffee which blend is composed of different specific types and origins of green coffees. However a roaster of green coffee cannot use the coffee available on exchanges as their origin, type and quality are unknown, and deliveries are made only 5 or 6 times a year.
5. Further, to produce soluble coffee of constant taste and quality, the blend is regularly adapted so as not to be impacted from the volatile green coffee qualities subject to unforeseeable natural events in the various regions where it grows. Therefore, the qualitative aspects are not known until each crop season. It is usually at this stage that the green coffee blend needed for production can be determined.
6. Companies can place their firm purchase orders at fixed negotiated differential prices with suppliers for physical delivery of the final green coffee blends (step 2). These contracts are for physical delivery of green coffee and refer to specific origins and types for shipment conditions or delivery dates. Hence a premium or discount to the value of the futures market is negotiated with the green coffee trader to account for differences between exchange coffees and the qualities and delivery schedules required to produce the finished product.
7. This price difference between the coffee qualities of the standard contracts and that of the final blends is called the "differential". The total price to be paid for the green coffees is then fixed by handing over related futures contracts, i.e. the average price of the futures remitted to the green coffee trader plus the differentials makes out the final billing price. This transaction, called EFP (Exchange for physical) or A/A (apply against actuals) results in an effective sale of the long futures whereby gains and losses are realised (step 3).
8. In order to reflect the economic hedge of the coffee purchases in the accounts, companies should apply hedge accounting, i.e. in accordance with IAS 39, the symmetrical recognition of "the offsetting effects on net profit of changes in the fair values of the hedging instrument and the related item being hedged ". IAS 39 defines hedging instruments and hedged items . A hedging instrument is defined as "a designed derivative or (in limited circumstances) another financial asset or liability whose fair value or cash flows are expected to offset changes in fair value or cash flows of a designated hedged item ". In coffee hedges, the issue is to determine what is the hedged item and what is the hedge instrument.
9. Thus, companies have to designate a hedged item and a hedging instrument as well as to demonstrate that the hedging instrument is effective in offsetting the fluctuation of the hedged item . As regards commodity hedges, IAS 39 § 129 states that a non financial liability, i.e. a commodity, "should be designated as a hedged item either (a) for foreign currency risks or (b) in its entirety for all risks, because of the difficulty of isolating and measuring the appropriate portion of the cash flows or fair value changes attributable to specific risks other than foreign currency risks".
10. As stated above, coffee purchasing include three steps:
I. The purchase of coffee futures (of standard/generic quality) to hedge the price of forecasted coffee needs,
II. the purchase of the specific green coffee qualities/blends (firm commitment for physical delivery through fixed differential contracts), III. cash settlement of above futures contracts, whereby gains and losses adjust the final cost of the green coffee delivered.
11. The purchase of the specific green coffee (step 2) and the resulting differentials are executory contracts that fall out of the scope of IAS 39 because they are to be settled by delivery.
12. Futures contracts meet the definition of derivatives because they are settled against cash and are applied against the coffee cost (step 1 and 3).
13. One could argue that standard quality coffee futures cannot effectively hedge forecasted needs of yet unknown specific quality coffees, even though the quantities remain the same, and concluding that hedge accounting cannot be applied as per IAS 39.
14. However, hedge accounting can and should be applied. The risks attributable to both generic and specific qualities of green coffees are identical; i.e. they are both subject to, for instance, price volatility resulting from natural events, and from supply and demand fluctuations. There is no violation of the rules outlined in § 129 and 130.
15. Hence these futures should be considered as hedge instruments, hedging the forecasted needs of green coffees. As for other cash flow hedges, fair value variations should be recorded in equity without affecting the income statement until the coffee is used in production.
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