Derivatives in Shipping and IFRS 9 financial accounting and reporting treatment
The last decade a constantly growing number of shipping companies both listed and privately owned are using derivatives for risk management and hedging to protect themselves against adverse market conditions. However, there are also shipping firms that use derivatives for speculation and thus increase their exposure to specific conditions or trends. Bank of International Settlement (“BIS”) estimates that the gross market value of all derivative contracts is approximately US$ 12.7 trillion, whereas the notional amount of these contracts is estimated to US$ 542.4 trillion. In this article we will describe the most commonly used shipping derivatives and the financial accounting and reporting treatment under IFRS 9 “Financial Instruments”.
The broad definition of a derivative is that of a contract between two parties or more whose value depends or is derived from the value of an underlying asset or index. Derivatives can trade either over- the- counter (“OTC”) or on an exchange. The most common shipping derivatives are the following:
- Forward Freight Agreements (“FFAs”)
- Bunker Swaps and
- Interest Rate Swaps (“IRS”)
A Forward Freight Agreement is a derivative whose value is derived from the future level of freight or time charter rates. The end users are usually ship-owners, ship-brokers and commodities houses which use these types of contacts to mitigate risk and hedge against the freight rate volatility. The following example will provide a better understanding on how FFAs work.
Example 1: Company A owns and operates a Capesize Bulker and its existing charter party is expected to be completed towards the end of 2019. Company A wants to secure their revenues for Q1- 2020 as they expect freight rates to further decrease due to an oversupply of vessels and limited demand. The spot rate on November 1, 2019 is around US$ 30,000/day and the FFA for Q1 2020 is valued around US$ 24,000/day. On January 2, 2020 the vessel is fixed at US$ 20,000 for 90 days. The ship-owner by selling the FFA contract for 90 days makes US$ 2.16 million. The vessel fixed on January 2, 2019 will make US$ 1.8 million. This leads to a profit of US$ 360k and thus the ship-owner having predicted the market correct has secured that the company would secure a revenue of US$ 2.16 million. Direct voyage costs have been ignored for simplification purposes.
A Bunker Swap is a contract which allows ship-owners and charterers to fix the cost of their bunkers. The most common bunker swap is the fixed rate bunker swap. Examples 2 and 3 below will allow us to better understand how bunker swaps work.
Example 2: Company B want to carry with its Handymax vessel a cargo of 35,000mt of wheat from Australia to India. Bunker prices at the day the vessel was fixed were US$350/mt. The owners will have to bunker their vessel in Singapore on their way to India but due to global geopolitical tensions they are afraid that the oil price will increase and consequently bunker prices. They decide to buy a bunker swap for 400mt at US$350/mt. When the vessel arrives in Singapore for bunkering the spot price of bunkers in US$ 400/mt. Buying the bunker swap they make a profit of US$ 50/mt. and they have fixed their cost at US$ 350/mt.
Example 3: Company C decides to fix its vessel under a 3-month Time Charter Party(“TC/P”). Per the TC/P owners are delivering 1,000mt of bunker fuel at US$350 and charterers will have to re-deliver the same quantity of bunkers at the same price. Essentially when the bunkers are delivered from owners to charterers, owners sell the bunkers and on re-delivery they buy them back. Usually when bunkers are delivered/re-delivered there is a profit or gain made depending which way bunker prices have moved during the time charter period. The vessel is being re-delivered with 1,000mt of bunkers but the owners pay to charterers US$400/mt. This leads to a loss of US$50,000. In order to hedge against the movement, the Company has bought a bunker swap for 1,000mt at US$350. At the expiration of the contract and with a spot price of US$400, Company C makes a profit of US$50,000 which offsets the loss of the US$ 50,000 from the re-delivery of the bunkers. In this way Company C has effectively fixed the price of bunkers on re-delivery and protected against bunker price volatility.
Shipping companies in order to protect against unexpected interest rate movements but also in order to fix their cost of borrowing they buy an interest rate swap. In an interest rate swap a shipping company agrees to pay a Bank a periodic fixed rate on its borrowings notional principal over the tenor of the swap and receive a floating rate. Most interest rate swaps use Libor as the reference rate for the floating leg of the swap. Usually the swap tenor is identical to the loan’s tenor and the Swap’s notional principal follows the loans amortisation schedule. Payments are made in the same currency, usually US dollar, and only the net payment is exchanged. There are three cash flows involved in an IRS. The Shipping Company pays Libor plus margin to the bank per the loan agreement, receives Libor per the Swap agreement and pays the fixed rate to the bank per the Swap agreement. The total financial cost is the fixed rate plus the margin. In this way the shipping company has effectively eliminated its floating rate liability exposure and converted it to fixed rate exposure.
IFRS requires all financial instruments to be measured at fair value at initial recognition except for trade receivables that do not have a significant financing component. IFRS 9 recognises three categorisation and measurement rules for financial instruments; 1) amortisation cost 2) fair value through Profit and Loss and 3) fair Value through other comprehensive income. In order to determine under which category a financial instrument will be classified, IFRS 9 has established certain criteria that depend on the business model and the characteristics of the contractual cash flow of the financial instruments. IFRS 9 requires all derivatives to be valued at fair value at each reporting date with changes in their value to be recorded in the profit and loss account unless hedge accounting is applied. IFRS 9 provides more flexibility to companies they would elect to apply hedge accounting for some of the derivatives they are using to hedge their exposure in contrast to the old standard. In this way IFRS 9 aligns hedge accounting more closely with an entity’s risk management strategy. It is not our intention to analyse the requirements of hedge accounting in this article but the following should be taken into consideration. Determining the type of the hedge relationship is crucial for hedge accounting. There are three types of hedges 1) fair value, 2) cash flow hedges and 3) hedge of a net investment in a foreign operation. The last one is not applicable for the derivatives we have discussed above. For fair value hedges all changes go through the profit and loss account. For cash flow hedges the effective portion is recorded in the other comprehensive income as a cash flow reserve whereas the ineffective portion through the profit and loss account. IASB has currently introduced guidance on the Libor reform which will affect the hedging relationships due to the uncertainty arising from the impact of the reform on the timing and amount of future cash flows designated. This guidance amends specific hedge accounting requirements in IFRS 9 and IAS 39 to provide exceptions during this period of uncertainty and alleviate any requirements to discontinue hedge accounting due to this uncertainty. A hedging relationship is directly affected if the reform gives rise to uncertainties about the interest rate benchmark designated as a hedged risk and or the timing or the amount of interest rate benchmark-based cash flows of the hedge item or of the hedging instrument. The effective date of these exemptions is January 1, 2020. This is the first phase to address pre-replacement accounting issues. More guidance will follow on replacement issues.
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