Riverton Foods: A Collar That Is Not What the Documentation Says It Is

The technical point. A written option does not qualify as a hedging instrument because its downside is open-ended and it cannot offset a loss in the way a purchased option can. A combination of options (a collar) is eligible only if it is not a net written option - meaning the entity must not receive a net premium on the combination.

Riverton's position. Purchased call fair value $210,000, written put fair value $260,000, net premium received $50,000. On its face the collar is a net written option and the designation fails for the combination. Two further consequences of the net-premium structure:

• The company has financed the call by selling a put that is more valuable, so its downside is larger than its upside protection - economically a partial sale of the hedge, not a hedge.
• Because the instrument is ineligible in its documented form, hedge accounting should never have been applied, and the $180,000 in OCI is unsupported.

Practical fixes, in order of preference:

1. Re-strike the collar so no net premium is received - raise the call strike or lower the put strike until the purchased option costs at least as much as the one sold. Then the combination is eligible.
2. Designate only the purchased call. It is eligible on its own; the written put reverts to fair value through profit or loss. This is cleaner but leaves the put's mark-to-market in earnings volatility.
3. Do nothing accounting-wise and accept the collar as an economic hedge at FVTPL, disclosing the position without hedge accounting.

The correction is prospective as far as possible, but the 31 December OCI balance was not permitted to begin with and should be reversed into earnings or restated. Verify the precise eligibility wording against the standard and your firm's technical guidance before signing the papers.

What changed. Forecast purchases fell from 8,000 tonnes to 6,500 tonnes. The hedged item shrank; the hedging instrument did not. The hedge ratio is now 8,000 / 6,500 = 1.23:1, which fails the 1:1 ratio in the documentation.

Consequences.

• The forecast transaction is no longer highly probable for 1,500 tonnes; that portion must be discontinued as a hedged item.
• The related portion of the cumulative hedging gain in OCI is reclassified to profit or loss: 1,500 / 8,000 = 18.75% x $180,000 = $33,750 recycled immediately.
• The remaining $146,250 stays in the cash flow hedge reserve and is released to inventory/COGS when the 6,500 tonnes are purchased and consumed.
• Prospectively, hedge accounting may continue for 6,500 tonnes only if the hedge ratio is rebalanced and the documentation updated; otherwise designation for the whole instrument fails.

One trap. The recall is not a discontinuation of the whole hedge - the remaining 6,500 tonnes is still highly probable, so the reserve attributable to it should not be recycled. Recycling everything would overstate earnings volatility in the wrong period.

Reporting. The auditor's question should be answered with a memo showing the 18.75% split, the recalculated hedge ratio, the rebalancing trade and the updated documentation. Anything less and the OCI balance looks like an unexplained plug.

The economics.

• Purchased calls at $3,200/t on 8,000 tonnes are worth 8,000 x (3,550 - 3,200) = $2.8 million of intrinsic value; the puts expire worthless.
• Riverton only buys 6,500 tonnes. That purchase costs 6,500 x $3,550 = $23.075 million, but the call gain of $2.8 million reduces the effective cost to about $3,119/t.
• The remaining 1,500 tonnes of call protection is a naked long position: it pays $525,000 (1,500 x $350) with no offsetting physical purchase. That is a speculative gain, not a hedge, and it should be recognised in profit or loss as a derivative at fair value - which flatters reported earnings in exactly the quarter the recall hurt operations.

Accounting presentation.

• 6,500/8,000 of the gain is effective: recognised in OCI and recycled to inventory/COGS as the cocoa is consumed.
• 1,500/8,000 is ineffective: recognised directly in profit or loss, with no offsetting cost of goods line.
• If the collar was never eligible (see the net-premium issue), the entire mark-to-market runs through profit or loss and the OCI presentation is simply wrong.

Recommendation. Sell 1,500 tonnes of the calls (or buy back an equivalent collar) to match the hedge to the revised forecast, update the documentation and the ratio, and stop describing the programme as 100% hedged in investor materials. Leaving the extra 1,500 tonnes on is a directional bet on cocoa that treasury has no mandate to take, and the resulting P&L gain in a quarter damaged by a recall is precisely the kind of earnings quality problem that gets questioned on the next call.