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IFRS Question 006: Accounting for own-use contracts under IFRS 9

Our company produces metal products and we buy lots of raw materials, like lead, nickel, copper iron. We often enter into contracts for future delivery, for example, to purchase 10 tons of nickel with delivery in 6 months.

The price is usually fixed, but sometimes there’s a clause that if we don’t actually need the physical delivery, we can opt to pay or receive the difference between agreed price and the current market price of nickel in cash.

Also, our CFO was worried about constant movement of raw metal prices and started to hedge them with purchases of commodity forwards.
How can we account for this type of the contract?

IFRS answer 006

Excellent question.

OK, normally, you should account for similar contracts as for purchases of inventory, that’s clear.

But sometimes, there’s derivative inside the contract.

It meets all three conditions:

  1. There is no initial investment,
  2. The contract is based on an underlying variable which is the price of nickel this time, and
  3. It will be settled in the future date.

IFRS 9 Derivatives

Therefore in this case, the contract is a commodity derivative – it’s a forward contract to purchase nickel.

The important question is:

Should you account for this contract as for derivative? Should you apply IFRS 9?

It depends.

IFRS 9 says, more specifically in paragraph 2.5, that you have to apply IFRS 9 for all contracts to buy or sell a non-financial item that can be settled net in cash or in another financial instruments.

So this would mean that yes, you have to account for this order of nickel in question as for a derivative, because the contract said that the buyer can settle the difference between agreed price and market price in cash.

In this case, you need to remeasure the commodity forward to its fair value at each reporting date and recognize the change in profit or loss.

But luckily, IFRS 9 continues:

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The exception are contracts that were entered into and continue to be held for the purpose of the receipt of the non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.

In other words – IFRS 9 does not apply to so-called “own-use” contracts.

In this case, you could simply say that yes, we are buying nickel in the future to make our metal products, we are going to take nickel, so now we don’t need to book it as a derivative, just as simple order contract when nickel is delivered.

The main idea is to produce and therefore, the changes in fair value do not affect us.

Fair enough.

Here, you need to be careful about one thing.

I stress that in order to apply regular purchase accounting for own-use contracts, the contract must truly be for own use, just normal purchase or sale.

Why am I saying that?

When the contract in NOT for own use

It can happen and normally happens, that the contract is NOT an own use contract, despite the fact it is described as such.

Let me list a few examples of such a situation:

  • If there’s a possibility of net cash settlement in the contract and the past practice shows that the contracts are often settled in cash. That could indicate that the contracts are not own use.
  • Or, you would normally enter into offsetting contract with the same counterparty. Let’s say you have a contract to buy nickel and you enter into the contract to sell nickel with the same entity – that’s net settlement, too.
  • Or, you take the nickel or the delivery of other item and you immediately or within some short time sell it to make profit. So you’re not using the commodity for own use, but for making profits.

All these circumstances indicate that the contract is not for own use and therefore, you must account for it as for the derivative.

Example: Own-use contract vs. derivative contract accounting

On 1 November 20X1 ABC made an order to buy 2 tons of nickel for CU 30 000 with physical delivery on 31 January 20X2.

Similar nickel forward contracts with delivery on 31 January 20X2 were offered at the strike price of CU 30 600 as at 31 December.

The spot price of nickel is CU 15 500 per ton on 31 January 20X2.

Own-use contract accounting:

If ABC assesses that the contract is for own use (please see the conditions above), then no accounting is required at 31 December 20X1.

On 31 January 20X2, when the delivery is taken and invoice received, ABC makes journal entry:

  • Debit Inventories of nickel: CU 30 000
  • Credit Suppliers: CU 30 000

Derivative contract accounting

If ABC assesses that the contract not for own use, or simply decides to account for this contract as at fair value through profit or loss (see below), then the change in fair value must be recognized in profit or loss at the reporting date.

For the sake of simplicity, let’s calculate the fair value of the commodity derivative as the difference between the strike price on 31 December 20X1 of 30 600 and the agreed strike price of 30 000, which is CU 600.

At the end of December, the change in fair value is accounted for as:

  • Debit Derivative assets: CU 600
  • Credit Profit or loss – change in fair value of derivatives: CU 600

At the end of January, we have three things to take care about:

  1. Fair value change of a commodity derivative:
    FV change is calculated as a difference between the spot price of CU 31 000 (15 500*2) and the previous fair value of 30 600, which is CU 400.
    The journal entry is:

    • Debit Derivative assets: CU 400
    • Credit Profit or loss – change in fair value of derivatives: CU 400
  2. Physical delivery of inventories at agreed price of CU 30 000:
    • Debit Inventories of nickel: CU 30 000
    • Credit Suppliers: CU 30 000
  3. Settlement of a derivative with physical delivery:
    • Debit Inventories of nickel: CU 1 000
    • Credit Derivative assets: CU 1 000

 

Own-use contracts and hedge accounting

Today’s question is really excellent because there’s one more thing – let me copy that part again:

“Also, our CFO was worried about constant movement of raw metal prices and started to hedge them with purchases of commodity forwards.”

OK, so you have the price risk here and you want to hedge it .

But, in this case, you would need to meet the hedge accounting criteria, and test hedge effectiveness, which is quite a burden, so there’s another way.

You can decide to designate the own use contract at fair value through profit or loss at initial recognition – not later.

Why would you do that?

Well, if you hedge similar contracts with derivatives and you do not apply the hedge accounting, then you would have the accounting mismatch.

The reason is that you would revalue your derivatives via profit or loss, but NOT the own use contract.

So you would see just one-sided profit or loss and that’s not what you want.

Instead, you would designate the own use contract at fair value through profit or loss and you will reach the automatic natural offsetting of profit from own use contract with loss on hedging instrument – derivative or vice versa.

To sum it up – if you want to hedge the price risk in your own-use contracts, you have 2 options:

  1. You apply the hedge accounting, but in this case, there’s additional administrative burden,
  2. You designate the own-use contract at the inception as at FVTPL and the offset or hedging is reached naturally.

Any comments or questions? Please let me know below. Thanks!