Theta plc (Fair Value Hedge)

On 1 March 20X6, Theta plc purchased 250,000 barrels of crude oil for £31.50 per
barrel, so a total of £7,875,000 is held in Theta’s inventory. The management of
Theta plc was concerned that the price of crude oil would fall in the market. In order
to minimise the market price risk, Theta plc entered into a forward contract on 1
March 20X6, at nil cost, to sell 250,000 barrels of crude oil for £33 per barrel for 1
May 20X6 delivery. At 31 March 2016 the forward price of crude oil was £35.50 per
barrel and the spot price (market price) was £34.50 per barrel. Theta plc designated
this transaction as a fair value hedge and needs to carry out hedge effectiveness test
and account for the transaction in accordance with IFRS 9 Financial Instruments.

Required:
Show how these transactions should be reported in the financial statements of Theta
plc as at 31 March 20X6 in compliance with International Financial Reporting
Standards (IFRS).
SOLUTION:
Theta plc - Fair Value Hedge
The hedge relationship aims to protect inventory from a decrease in the
price of crude oil. The hedged item creates an exposure to the price risk of
crude oil. The forward contract is to sell inventory. There is an expectation
that the value of the forward contract and the value of inventory move in
opposite directions as a result of movements in the price of crude oil. This
shows that there is a clear economic relationship between hedged item and
hedging instrument. The hedge ratio is based on 5000 barrels of crude oil,
so there is a hedge of 1:1 (100%).

Hedged item - Inventory:

at 1 March 20X6: 250,000 barrels x £31.50 £7,875,000
at 31 March 20X6:250,000 barrels x £34.50 8,625,000
Gain on inventory (hedged item) 750,000

Hedging item - Forward contract:

At 1 March 20X5 (NO ENTRY)

The forward contract has no fair value at its

inception so is initially measured at £nil.

At 31 March 20X6
Loss on forward: 250,000 barrels x (£35.50-33) 625,000

Re-measured to fair value at 31 March 20X6:

Journal Entries    
DR Inventory 750,000  
CR Income statement (gain on inventory) 750,000
   
DR Income statement (loss on forward contract) 625,000  
CR Financial liability   625,000

Statement of financial position

at 31 March 20X6
Assets - Inventories £8,625,000
Liabilities - Financial liability (forward) 625,000

Income statement
for the year ended 31 March 20X6
Gain on inventory £750,000
Loss on forward contract 625,000
Net gain to be recognised 125,000