Achieving hedge accounting for foreign exchange risk ... · hedging these exposures, ... Forecast...
-
Upload
duongtuyen -
Category
Documents
-
view
220 -
download
0
Transcript of Achieving hedge accounting for foreign exchange risk ... · hedging these exposures, ... Forecast...
Many companies’ FX risk management practices or policies
focus on exposures from account receivables and payables.
These companies manage the FX exposure primarily from an
accounting perspective with the aim of achieving a zero FX
result in the profi t and loss statement (P&L). We argue that,
from an economic perspective, this approach only protects the
company against adverse FX movements in the short-term and
disregards longer-term FX risk from highly probable future
transactions which are not yet recognized in the balance sheet.
In our defi nition, transaction risk is not limited to balance sheet
items but includes any future payment or receipt, committed or
uncommitted, denominated in a foreign currency. The manage-
ment of these exposures is becoming more and more important.
However due to the diffi culties in quantifying and effectively
hedging these exposures, most companies (or treasurers) do
not have a well established approach.
On the other hand, for companies that do hedge forecasted
transactions, understanding IAS 39 hedge accounting is a
critical requirement in order to limit P&L volatility. Although IAS
39 has been in place for more than four years, there is evidence
that some companies decide not to hedge their FX exposures
because they are uncertain of how the resulting hedged
positions will impact their P&L.
The need for hedge accounting When companies hedge FX risk they often use derivatives, such
as FX forwards or FX options. Under IFRS, derivatives are
recorded in the balance sheet (B/S) at fair value and the change
in fair value is recorded in the P&L. The hedged assets or
liabilities are usually measured at (amortized) cost or are
forecasted items which are not recognized in the B/S. This
results in a mismatch in the timing of the gain and loss
recognition, creating possible P&L volatility. Hedge accounting
modifi es the normal accounting treatment of a hedging
instrument and/or a hedged item, in order to recognize their
offsetting changes in fair value or cash fl ows in profi t or loss at
the same time.
Let us fi rst defi ne forecasted transactions and fi rm commit-
ments as potential hedged items. A forecasted transaction is an
uncommitted but highly probable future transaction. A fi rm
commitment is a binding agreement for the exchange of a
specifi ed quantity of resources at a specifi ed price on a
specifi ed future date (or dates). FX hedges of forecasted
transactions are designed as cash fl ow hedges. The cash fl ow
hedge model defers the recognition of gain or loss on the
derivative in equity – or other comprehensive income - until the
forecasted transaction occurs.
The following cases illustrate hedge accounting treatment in
common situations for companies operating in international
markets. The objective of presenting these cases is to show how
companies can achieve hedge accounting for their FX risk
management strategy for forecasted transactions or fi rm
commitments, with a number of helpful hints.
Case 1. Hedging a net positionEUR Company X, has a global treasury center responsible for
managing the group’s FX risks and offsetting the net position
using derivatives with external parties. It forecasts sales of
USD3.5 million and purchases of USD2 million in September
and entered into a forward contract to sell USD1.5 million in the
same month. Can the company apply hedge accounting for this
contract?
Solution: Yes, but IAS prohibits the designation of a net position
Throughout 2009, volatility in the foreign exchange markets was a key theme. Although the fi nancial markets calmed a little, corporate treasurers still face an environment in which their risk management policies are tested. For the multinational company, FX risk management is one of the main activities to protect profi tability.
Achieving hedge accounting for foreign exchange risk management
Don’t hide behind IAS 39
“FX risk management is one of the main
activities to protect profi tability.”
as a hedged item. Therefore, Company X must designate the
hedge instrument to a part of the gross positions, in this case
the USD1.5 million of highly probable sales in September.
Case 2. Macro hedgingEUR Company Y forecasts a large number of similar GBP
receivables and wants to hedge these receivables with a single
hedge instrument. Can the company apply hedge accounting in
this case?
Solution: Yes, a group of similar items in the same category can
be designated as a hedged item, given that this group of similar
items has the same underlying risk profi le. The hedge effective-
ness is tested on a group basis. The fair value movement of the
individual items should be proportional to the fair value
movement of the portfolio of items.
Forecast sales can be designated as a hedged item even when
management is unable to link the future cash fl ows to specifi c
individual sales transactions. Designate the hedged item as the
fi rst X million of highly probable sales in a specifi c time bucket.
Case 3. Intra-group salesSubsidiary A and B belong to EUR parent Z. Subsidiary A is
based in Switzerland and has highly probable USD sales of
inventory to a US located subsidiary B, which sells the products
to external customers in the US. Subsidiary A intends to hedge
the highly probable intra-group sales with a USD/CHF forward.
Can this be accounted for as a cash fl ow hedge in the consoli-
dated statements?
Solution: Yes, because the external sales result in FX risk
affecting the P&L. The gain and loss on the derivative is reclassi-
fi ed to the consolidated income statement as soon as the
external sale is recognized.
Case 4. Translation exposureAssume that in the above case, the parent company decides to
hedge CHF subsidiary A’s USD sales with a USD/EUR contract to
hedge the exposure back to the parent’s functional currency.
Can the company apply hedge accounting to this forward
contract and the subsidiaries USD sales?
Solution: No, because the consolidated P&L is not exposed to
USD/EUR movements. The income statement is exposed to
USD/CHF movements because of the FX result on the sales of
subsidiary A. The exposure to EUR/CHF is a translation risk
instead of a cash fl ow exposure. Similarly, inter-company
dividend payments do not qualify as hedged items because
they don’t affect reported net profi t or loss.
Case 5. Net investment hedgeParent Z intends to hedge the translation FX risk from subsidiary
A under a net investment hedge. What amount should the
parent include under a net investment hedge?
Solution: Parent Z can include under the net investment: (i) the
equity investment in subsidiary A, and (ii) inter-company loans
of a permanent nature. Forecasted profi ts cannot be included in
the hedged item because they do not form part of the existing
net investment at the time of hedge inception.
Identifi cation and measurementIn order to satisfy IAS 39 requirements companies need to
assess the probability of forecasted transactions with objective
information. The measurement of transaction and economic
exposure is done by combining internal sources (sales
forecasts, purchase records, order books) and external sources
of information (such as economic data) and applying a number
of measurement techniques (e.g. sensitivity analysis, market
scenario analysis, simulation analysis). A sales budget on its
own is generally not persuasive evidence for a forecast
transaction being highly probable unless there is additional
supporting evidence.
In a more strategic approach, Zanders advises, depending on
the industry, to identify, measure and manage transaction and
economic risks up to a time horizon of two years or even
beyond. Zanders has extensive experience on applying the
mechanics of IAS 39 to corporate risk management, starting
with risk identifi cation and applying best market practice risk
measurement techniques. In addition, Zanders assists
companies during the defi nition and execution of the hedging
strategy, supporting the setting up of hedge documentation,
execution of trades, periodic effectiveness testing and
accounting. <
IF YOU WISH TO KNOW MORE ABOUT
ZANDERS’ SERVICES RELATED TO HEDGE
ACCOUNTING, PLEASE CONTACT JOB WOLTERS
ON +31 (0)35 692 89 89 OR
“Under IFRS, derivatives are recorded in
the balance sheet at fair value.”