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Hedge accounting

Example 2

An entity owns inventories of 10,000 tons of steel which cost $100,000 on
1 December 20X5.

If the price of steel falls, the entity will suffer a loss when it sells the steel.

To minimise this risk, it enters into a forward contract to sell 10,000 tons of
steel for $120,000 on 1 February 20X6 i.e. at a price of $12 per ton.

At the year end of 31 December 20X5, the market value of the steel is $9 per
ton and the forward price for 1 February 20X6 has moved to $11 per ton.

Required:

Show the impact of the fair value hedge on the financial statements of
the entity at 31 December 20X5, assuming that the conditions for hedge
accounting are satisfied.

Solution

The hedged item is the steel. The hedging instrument is the forward contract
(a derivative).

At the year-end both the hedged item and hedging instrument will be
measured at fair value and gains or losses recorded in the statement of profit
or loss.

Hedged item (steel)

10,000 tons × $9 per ton $90,000
Cr Inventory $10,000
Dr P&L (loss) $10,000

Hedging instrument (forward contract)
10,000 × (12 – 11) $10,000

Dr Derivative (financial asset) $10,000
Cr P&L (gain) $10,000

The overall effect on profit is nil (gain of $10,000 on derivative less loss of
$10,000 on inventory).

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