ISRAEL SECURITIES AUTHORITY
Enforcement Decision 08-2
Subject of Enforcement Decision:
Accounting for a Forecast Purchase of Inventory
Date of Enforcement Decision:
July 2008
Period to which Decision Relates:
Periodic report submitted March 31, 2008
Description of issuer treatment:
A company purchases inventory for its ongoing operations. On 30 November 2005,
the company entered into a cylinder transaction composed of a purchased commodity
call option and a written commodity put option, in order to hedge a forecast purchase
of 7.5 million units of inventory during the fourth quarter of 2007.
At the date of transition to IFRS (1 January 2007), the company designated its
hedging relationship as a cash flow hedge of a forecast purchase of inventory and
documented the hedging relationship. The company determined that the hedging
relationship is qualified for hedge accounting in accordance with the provisions of the
IFRS standards and therefore, beginning on that date, it implemented hedge
accounting.
Regulator’s staff decision:
The Authority’s staff view is that the company's documentation of the hedging
relationship, and its method of assessing hedge effectiveness do not comply with
the requirements of International Accounting Standard 39 (“IAS 39” or “the
Standard”) and therefore hedge accounting is not permitted under IAS 39.
IAS 39.88 provides that in order for a hedging relationship to be qualified for hedge
accounting there must be, at inception, a formal designation and documentation of the
hedging relationship and of the entity’s risk management objective and strategy for
undertaking the hedge. This documentation must include:
a.
b.
c.
d.
Identification of the hedging instrument,
Identification of the hedged item or transaction,
The nature of the hedged risk, and
The manner in which the entity will assess the hedging instrument’s
effectiveness in offsetting the exposure to the changes in the fair value
or in the cash flows of the hedged item attributable to the hedged risk.
The Authority’s staff identified a number of deficiencies in the documentation of the
hedging relationship and in the assessment of the effectiveness of the hedging
instrument. The following are the main identified deficiencies:
a. Identification of the hedged transaction
The documentation of the hedge included the following identification of the
hedged transaction:
The consumption of 7.5 million units of inventory during the fourth quarter of
2007, with an expected cost of 18 million U.S. dollars (the company's
functional currency). The expected timetable of the forecast transaction:
fourth quarter of 2007.
IAS 39.IG F.3.10 provides that a defined hedged forecast transaction must be
identified as such, that when the transaction takes place, it is possible to
clearly identify that the transaction which took place is a hedged transaction.
Therefore, as the Standard states, by way of example, a forecast transaction
may be identified as the sale of the first 15,000 units of a certain product
during a three-month period, but it could not be identified as the sale of the
last 15,000 units of that product during a three-month period, since the last
15,000 units cannot be identified when they are sold. Only at the end of the
three-month period is it possible to identify the last 15,000 units sold. In any
case, a forecast transaction cannot be specified solely as a percentage of sales
or purchases during a particular period.
In this case, the hedged transaction was identified as the consumption of 7.5
million units during the fourth quarter of the year 2007. This identification is
not specific enough, as required by the Standard, since at the time that the
purchases take place during that quarter, it is not possible to identify clearly
whether they are the hedged purchases. Furthermore, it became clear that, in
fact, the company has accounted for a purchase of 2.5 million units in each of
the months during the quarter as hedged purchases. However, the company did
not include any documentation relating to this fact.
b. Assessment of prospective effectiveness
The documentation had included the following assessment of prospective
effectiveness:
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A linear regression analysis of the market prices of the commodity and the
prices of the inventory paid by the company in past periods (on a monthly
level, since the year 2002) indicated a correlation of more than 95% between
the two.
IAS 39.IG F.4.4 provides that if the company uses regression analysis to
assess the effectiveness of the hedge, the company's documented policies of
assessing effectiveness must specify how the results of the regression will be
assessed.
In this case, the use of only the correlation coefficient for the purpose of
assessing the effectiveness of the hedge is not sufficient, as it is necessary to
relate to additional parameters of the regression such as the slope of the
regression and the t-statistic. The company argues that in actuality, for the
purpose of assessing the effectiveness, it also examined the slope of the
regression and the t-statistic. Nevertheless, the documentation did not include
a reference to these parameters.
Similarly, the company should have indicated which criteria the company used
in assessing the effectiveness, including the correlation coefficient value above
which the company considers the hedge to be effective, what was the range
within which the slope must lie in order for the hedge to be considered
effective, and what is the value of the t-statistic above which the company
considers the hedge to be effective.
Since the documentation did not include a reference to the manner in which
the company would assess the results of the regression analysis, and did not
refer to any other parameters other than the correlation coefficient, the
documentation of the assessment of hedge effectiveness does not comply with
the Standard’s requirements.
In addition, the regression analysis was carried out on the market price of the
commodity and on the prices of the inventory paid by the company during past
periods, without taking into account the time value of the cylinder transaction.
The company didn't indicate in the documentation that it did not include the
change in the time value of the cylinder transaction in its assessment of
effectiveness, and actually, recorded the change of the cylinder transaction's
time value into the hedge reserves in equity and not to the profit or loss.
Therefore, the regression analysis should have included as a variable all
changes in the fair value of the cylinder transaction, and not just the change in
the price of the underlying asset (the price of the commodity). It is expected
that if the company had carried out the regression analysis in the said fashion,
it would have obtained a lower level of hedge effectiveness.
c. Nature of the hedged risk
According to the documentation, the hedged risk is the “risk of change in the
commodity price.”
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IAS 39.82 provides that “if the hedged item is a non-financial asset or nonfinancial liability, it shall be designated as a hedged item (a) for foreign
currency risks, or (b) in its entirety for all risks, because of the difficulty of
isolating and measuring the appropriate portion of the cash flows or fair value
changes attributable to specific risks other than foreign currency risks.”
Therefore, the hedged risk may be the change in the prices of the specific
forecast purchases of the commodity by the company, but not the change in
the prices of the commodity in general. In this case, the company purchases
the commodity in a specific place and of a certain kind, which is different
from that of the commodity that is the underlying asset of the cylinder
transaction. Therefore, the company should have indicated that the hedged risk
is the full price of the expected purchases of the commodity and to specify that
the expected price of the purchases is the expected price for purchases of
commodities of a certain kind and in a certain place.
d. Additional deficiencies in the documentation of the hedge

The documentation did not include the date of the
documentation,

Identification of the hedging instrument was not sufficiently
detailed and did not include its settlement date,

The names of those making the documentation were not
indicated.
Details of corrective action taken:
The Israel Securities Authority staff’s has clarified to the entity its position that the
accounting treatment used in respect to the above-mentioned cylinder transactions as
hedging transactions is not appropriate, and that the cylinder transaction must be
accounted for as a derivative instrument which is not designated for hedge
accounting.
The company has restated its financial statements for the periods ending on 31 March
2008, 31 December 2007 and 31 March 2007 in order to reflect the accounting
treatment of the cylinder transactions as transactions not qualified for hedging, i.e. as
a derivative financial instrument accounted for at fair value through profit and loss.
Effect of restatement:
The said changes led to an increase of 50% in the company’s net profit for the year of
2007 and a reduction of the net loss for the three months ending on 31 March 2007
and on 31 March 2008 of 50% and 2%, respectively.
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