To: CEO, Thomas Foods
From: Hayley Wicks, Technical Accountant
Date: August 23, 2015
RE: Implementing and Reporting for Hedge Accounting
Facts:
Thomas Foods wishes to insulate the company from the financial blow of large increases in the prices of produce from local farmers. The main factor that would cause this unexpected change in price that Thomas Foods should be concerned with is the possible fluctuation of weather conditions. Thomas Foods is interested in determining whether or not hedge accounting would be the best solution to protect the company’s operating income. If the company elects to implement a hedge accounting system, the Controller of the company must be informed of the accounting treatments involved when dealing with cash flow and fair value hedge accounting, the two most common forms of hedge accounting.
Issues:
1. Will implementing a hedging strategy help to alleviate the risks of price increases and benefit Thomas Foods financially when it comes to purchasing produce from local farmers?
2. Which hedge accounting strategy or alternative method will be most beneficial to Thomas Foods and ensure minimal loss in operating income?
3. How can the accounting treatments of the newly implemented strategy be best explained to the Controller of Thomas Foods?
Conclusions:
1. Hedge accounting strategies are best implemented when dealing with transactions from the original source. In this particular situation, the local farmer would be considered the original source because he determines the selling price of the produce.
2. Developing a purchase order system rather than executing a hedge accounting strategy would be the most advantageous solution for Thomas Foods.
3. The Controller of Thomas Foods will require minimal training in accounting for a purchase order system, regardless of whether it is recorded on a cash basis or accrual basis.
Authorities on Hedge Accounting:
The uncertainty of changes in weather seems to be a trigger for many entities to look into hedge accounting strategies. The FASB Codification even explains weather derivatives and how to account for them in ASC 815-45. A weather derivative is described as “a forward-based or option-based contract for which settlement is based on a climatic or geological variable” (ASC 815-45-20, 2013). When it comes to accounting for weather derivatives, cash flow hedging is the recommended method to be used.
Two types of hedging strategies that the Controller should become familiar with are cash flow hedges and fair value hedges. Cash flow hedges relate to forecasted transactions where the effective portions of the hedge is initially reported in other comprehensive income and are later reclassified into earnings any portion of the hedge that is ineffective is reported currently in earnings (FASB ASC 815-30, 2010).
Fair value hedges can be associated with either a recognized asset or liability, or an unrecognized commitment of the entity. The gains and losses from a fair value hedge are recognized currently in earnings. The ultimate goal of a fair value hedge is for the gains and losses to fully offset each period. However, this does not happen often and the difference is recorded as a residual credit or charge to earnings each period while the hedge is in effect (FASB ASC 815-25, 2010).
Application of Authorities:
When estimating the effectiveness of a hedging strategy, Thomas Foods must refrain from estimating the value of the produce solely based on the current price. The company should also factor in the physical condition of the growing crops, additional production and harvesting costs, as well as weather predictions for the next two months. This will help Thomas Foods to determine if the chosen hedging strategy is best suitable to their needs and will accomplish the goal of mitigating the risk of increased prices on the farmer’s crops.
If done correctly, implementing hedge accounting in order to offset potential fluctuations in the market price can be very advantageous for an investor. In order to successfully exploit a hedging strategy, there must be control over one aspect. In this particular situation, the control for Thomas Foods would be the resale value because their business operates by purchasing produce from the local farmers and then reselling the produce to local grocery stores. Thomas Foods has control of the selling price of the goods that are purchased, but the farmer determines the original selling price of the produce. Therefore, Thomas Foods is left with uncertainty when it comes to determining the company’s profit because the base price of the produce is not concrete.
Thomas Foods cannot sell produce to local grocery stores unless they can guarantee a certain amount of produce in stock. This means that if Thomas Foods wishes to successfully implement a hedging strategy, they must first establish a contract with each farmer they purchase from. The contract will be used to establish a set purchase price for certain quantities of produce. Doing so will help Thomas Foods gain more control of the selling prices determined by the farmers. Given that Thomas Foods is a third party entity, it is recommended that the company execute a Purchase Order system rather than reworking their accounting procedures in order to better suit the elected hedging strategy. With a Purchase Order in place, the farmer guarantees to sell a set amount of goods to Thomas Foods for a set price over a set amount of time. This will allow Thomas Foods to account for their purchase costs and also utilize the savings when reselling the produce to the local markets.
If Thomas Foods agrees to apply a purchase order system, the company’s accounting system would not suffer any significant costs to train the current Controller. This is because Thomas Foods will be able to simplify their budgeting system when applying the purchase order system. Thomas Foods can take comfort in knowing that there will be a set price that they will purchase the crops for, and from there they will be able to decide on a resell price.
References
FASB (Financial Accounting Standards Board). (2010). ASC 815-20-25.
Retrieved August 8, 2015, from FASB Accounting Standards Codification database.
FASB (Financial Accounting Standards Board). (2010). ASC 815-20-35.
Retrieved August 8, 2015, from FASB Accounting Standards Codification database.
FASB (Financial Accounting Standards Board). (2010). ASC 815-25-35.
Retrieved August 8, 2015, from FASB Accounting Standards Codification database.
FASB (Financial Accounting Standards Board). (2010). ASC 815-30. Retrieved
August 8, 2015, from FASB Accounting Standards Codification database.
FASB (Financial Accounting Standards Board). (2010). ASC 815-45-20.
Retrieved August 8, 2015, from FASB Accounting Standards Codification database.
Self-Study Guide to Hedging with Grain and Oilseed Futures and Options.
(2014). Retrieved August 8, 2015.
Wisner, R., & Hofstrand, D. (2015, July 1). Grain Price Hedging Basics | Ag
Decision Maker. Retrieved August 8, 2015.
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