Novation derivate swap

[Jonny]

Hello,
could you please help with the following scenario:

Company X, part of a Group, has a plant that produces 150 tonnes a year of copper wire and sells it to the market.

The company enters into a contract with a bank to sell virtually 100 tonnes year of copper wire at a fixed price (CU200/tonne) for 5 years.

The contract to sell virtually copper wire at a fixed price is derivative. The company applies hedge accounting.

In year 3 the company incorporates a new company Z. The plant and the contracts have been transferred to the company Z.

The novation of the derivate is at Fair value (100).

Can company Z apply hedge accounting at the same value (100) or this would result in some way partially in hedge ineffectiveness?

Can Group apply hedge accounting at the same value (100) or this would result in some way partially in hedge ineffectiveness?

How do I calculate the ineffectiveness?

What happens if the derivate is transferred and the parties agree a lower fixed price (CU195/tonne) for the future?

Thanks

[JRSB]

I turned to jelly just reading the topic

[Marek Muc]

I'm praying for pub_acco and DJP to step in

[Jonny]

yes please!

[pub_acco]

Haha, it is more like a common control transaction issue than IFRS 9, so I am not familiar with it either

I am assuming the following fact pattern. Is my understanding correct?
* There is a standard market price index of copper wire and the bank pays/receives the changes of the price index since the commencement date of the derivative contract.
* Company X designated the derivative contract as a cash flow hedge instrument of the highly probable forecast copper wire sales.
* Company Z is a split-up entity and is wholly owned by Company X.

First, at the group level, the inter-company transactions between X and Z have to be all eliminated as if nothing happened. So, if the economic substance hasn't changed before and after splitting up X, the same cash flow hedge accounting has to be continued in the consolidated statements of X and Z.

Secondly, at Company Z level, the cash flow hedge accounting is initiated on the date of the split (i.e. when the derivative contract is inherited) because, from Z's perspective, it is just a normal cash flow hedge transaction with the initial fair value of derivative being (100).

One thing unclear to me is the place and timing, in separate FS, of the reclassification of the cash flow hedge reserve accumulated through the years 1-3 until the corporate split took place. It is clear that the CFH reserve should be reclassified to P&L through the remaining years 3-5 in the consolidated FS of X and Z as I mentioned in the first point. But IMO the CFH reserve should not belong to Company Z because the gain/loss before the incorporation is not related to Z. Then, the CFH reserve should remain on the separate FS of X but when to realize this?

[DJP]

I agree with pub_acco analysis, but it really depends on how the hedge accounting documentation is written. If the documentation mentions that hedging was done at the consolidated level as well, then you may have an argument to continue hedge accounting at the consolidated level. However, at the entity level, hedge accounting must be discontinued nonetheless and the results parked in the cash flow hedge reserve must be recycled through P&L immediately, because the plant has also been transferred to the new company and, therefore, the future cash flows are no longer expected to occur at Company X (IFRS 9 p6.5.12 (b))

"What happens if the derivate is transferred and the parties agree a lower fixed price (CU195/tonne) for the future" -- the contract must be entered into at arm's length. If the CU195 is not the fair price for this contract, one of the parties must be compensated. Otherwise this will create all sorts of transfer pricing issues and possibly require the off-market value to be accounted for as a capital contribution.

[pub_acco]

I agree that the CFH reserve at Company X should be immediately reclassified to P&L. This would be a natural treatment if Company Z were split out from X and immediately sold to an external party; in such a case, the reclassified gain/loss would adjust the gain/loss on disposal of a business.

And, yeah, of course, hedging documentation and other criteria must be met as a prerequisite of my analysis.

[Jonny]

One thing unclear to me is the place and timing, in separate FS, of the reclassification of the cash flow hedge reserve accumulated through the years 1-3 until the corporate split took place. It is clear that the CFH reserve should be reclassified to P&L through the remaining years 3-5 in the consolidated FS of X and Z as I mentioned in the first point. But IMO the CFH reserve should not belong to Company Z because the gain/loss before the incorporation is not related to Z. Then, the CFH reserve should remain on the separate FS of X but when to realize this?

The swap contract will be transferred only for the future productions. X has realized part of the production (year 1-3) and the cash flow hedge reserve has been recycled through P&L. 100 is the FV at the end of year 3 and refers to the production in year 4 and 5.

Thanks to all!