Inventory hedge accounting adjustment

Hedge accounting has one awkward corner, and this is it.

In a fair value hedge the hedged item is written up or down to match the derivative. The derivative's loss goes to profit and loss, the item's matching gain goes there too, and the two cancel.

That works when the hedged item is a receivable or a commitment. It does not work cleanly when the hedged item is inventory.

The reason is another accounting standard. AS 2 requires inventories to be carried at the lower of cost and net realisable value. Writing stock up to fair value would break that rule.

So the accountant leaves the AS 2 figure alone. The fair value change is parked in a line of its own, and the workbook calls that line the inventory hedge accounting adjustment.

The balance sheet then shows two numbers for one pile of copper. The inventory at AS 2 cost, and the hedge adjustment beside it.

When the stock is finally sold, the adjustment is released to cost of goods sold.

The workbook's setting. Company Z designates its commodity futures contract as a fair value hedge of a portion of its inventory — 100 tons of copper — and documents it as a hedge of the exposure to changes in the fair value of that inventory due to commodity price risk. As of 31 March 2024 the price of copper has increased, so the fair value of the inventory has risen and the derivative shows a mark-to-market loss.

Two entries on 31 March 2024.

1. Record a derivative liability at the fair value (MTM) of the commodity futures contract, with a corresponding debit to the statement of profit and loss.
2. Record an increase in inventories for the change in fair value as a hedge accounting adjustment through the statement of profit and loss. Because AS 2, Valuation of Inventories, requires inventories to be carried at the lower of cost and net realisable value, this is recorded as a separate hedge accounting adjustment, distinguished from the valuation of inventories under AS 2.

Three lines on the balance sheet, and the third is the whole point:

On sale. When sales of the hedged inventory occur, the hedging-related fair value adjustment to inventory is released to the statement of profit and loss and can be classified as part of cost of goods sold.

The contrast that gets examined. Run the same 100 tons and the same futures as a cash flow hedge of the highly probable forecast sale instead, and the MTM goes to the Cash Flow Hedging Reserve, which sits in the balance sheet until the actual sale date and is then reclassified to profit and loss — potentially in the sales line, so that sales are recorded at the hedged price. So a fair value hedge of inventory lands in cost of goods sold; a cash flow hedge of a forecast sale lands in sales.

Why the future is in scope. The commodity future does not fall within AS 11 and was entered into to hedge exposure to variability in fair values arising from price risk, so it falls within the scope of the ICAI Guidance Note.

A presentation the workbook states two ways. Section 9.1 says that inventory of commodities has to be valued on fair value, along with the valuation of the hedging instrument such as a short sale of futures. Section 9.2.2's worked example instead keeps the AS 2 valuation untouched and puts the change into a separate adjustment. The totals agree; the presentation does not. The worked example is the detailed version, and it is the one that names this line.

Company Z's copper, in rupees. Copper is Rs 8,50,000 per ton when the hedge is placed on 1 January 2024, so the 100 tons are carried at Rs 8,50,00,000. By 31 March 2024 copper has risen 4% to Rs 8,84,000 per ton.

Balance sheet at 31 March 2024:

Profit and loss for FY2023-24: derivative loss Rs 34,00,000 debited; hedge accounting adjustment on inventory Rs 34,00,000 credited; net effect nil. The hedge has done its job and the accounts now show it.

September 2024, when the copper is sold at Rs 8,84,000 per ton for Rs 8,84,00,000, and the futures matures on 30 September 2024:

Cost of goods sold = AS 2 cost Rs 8,50,00,000 + released hedge adjustment Rs 34,00,000 = Rs 8,84,00,000

Gross margin on the hedged stock is nil — which is exactly right, because the margin was fixed when the hedge was placed and the 4% rise in copper was surrendered to the futures short.

Had Company Z designated the same futures as a cash flow hedge of the forecast sale, the Rs 34,00,000 would have sat in the Cash Flow Hedging Reserve for the whole year and been reclassified in September 2024 into the sales line, so sales would read at the hedged price instead. Same tonnage, same derivative, a different line of the profit and loss account.

Chapter 9 (Accounting and Taxation), section 9.2.2, in the second of the two worked Company Z examples — the fair value hedge of forecasted sales using an exchange-traded futures instrument.

This page teaches the inventory-specific basis adjustment; hedge accounting teaches the framework, the conditions and the three hedge types, and the two divide that way deliberately.

Expect: which standard requires inventories at the lower of cost and net realisable value — AS 2; why a separate adjustment is needed — because writing the inventory itself up to fair value would conflict with AS 2; where the adjustment goes on sale — released to profit and loss, classifiable as part of cost of goods sold; and the three-line balance sheet presentation. The examiner's favourite discriminator is the same facts run as a cash flow hedge, where the reserve is reclassified into sales instead.

• AS 2 is the reason the mechanism exists at all. Inventories at the lower of cost and net realisable value cannot simply be written up, so the fair value change needs a separate home.
• The AS 2 inventory figure is not restated. The balance sheet carries inventory at cost with the hedge adjustment beside it, not one blended number.
• Two movements, not one. The adjustment goes through profit and loss now, offsetting the derivative's MTM, and is then released to cost of goods sold on the eventual sale.
• Fair value hedge releases to COGS; cash flow hedge reclassifies into sales. Same 100 tons, same futures, different profit and loss line. This is the discriminating point.
• It is a basis adjustment, not a reserve. The Cash Flow Hedging Reserve belongs to the other model and stays in the balance sheet until the sale.
• The workbook describes the fair value treatment two ways. Section 9.1 says inventory of commodities has to be valued on fair value alongside the hedging instrument; section 9.2.2's worked example keeps AS 2 intact and uses a separate adjustment. Answer from the worked example, which is where this line is named.
• Ineffectiveness still lands in profit and loss. Where the hedge is not 100% effective, the mismatch between the derivative and the hedged item shows up there, and no adjustment line hides it.