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February 2012 Newsletter View in pdf
If the Euro Breaks and its Impact on Designated Hedges
by Helen Kane
The threat of a break from the Euro has been making headlines for the last few months.
Hedge Trackers has been evaluating the implications to your currency risks and specifically
the threats to special hedge accounting under ASC815. We recommend you evaluate any
currency pair involving the Euro in a cash flow hedge program against the following
1. Current documentation should indicate the specific countries whose Euro revenues/expenses are being hedged.
2. If the hedged sales/expenses are not resident in a single entity the layering of countries needs to be clear: e.g. we are hedging the first XXXX of EUR denominated expenses applied (daily) to Germany, then France, then Spain, then Italy.
3. Cash flow hedge probability should contemplate any uncertainty that a defection of the Euro may cause in corporate forecasts. Recall that Euro hedged items must be “probable of occurring” to continue special hedge accounting treatment.
This might be an appropriate time to consider “net investment hedging” under FAS133, as a hedge of assets (especially cash) held in foreign functional subsidiaries that might be at risk.
OIS and Collateral: Impact on Valuations
by Ruth Hardie
In today’s market, even without Dodd-Frank finalized, we are increasingly seeing collateral requirements attached to derivatives—which directly effects period end valuations. When collateral is posted by both parties, there should be no discounting of the derivative market value due to credit (so long as the fair value of the posted collateral meets or exceeds the fair value of the derivative at period end.) It is not uncommon for there to be a lag between month-end reporting and collateral posting or a threshold that must be reached before additional collateral is posted. In these cases, a credit adjustment may be necessary on the portion of the fair value of the derivative that exceeds the fair value of the posted collateral as of the reporting date.
In addition to the impact from the credit valuation adjustment, interest rate swaps and other derivatives collateralized with cash or other highly liquid instruments, LIBOR (London Interbank Offer Rate) rates may no longer be the most appropriate rates to use for discounting. Derivative valuations are determined by taking the projected net cash flows of the instrument and then discounting those cash flows to present value. Traditionally, the LIBOR curve has been used for discounting. However, LIBOR, although one of the two approved “benchmark interest rates” proscribed by the FASB for hedging, is not a “risk-free” rate. There is increasing acceptance in the market place for using alternative rates for discounting when the derivative is fully collateralized with highly liquid assets. Some derivative dealers, where collateralization is standard, have moved to using the overnight indexed swap (OIS) curve. OIS rates are based on Fed Funds rates and historically there is very little difference between Fed Funds and LIBOR. However, since the market dislocation in 2008, the spread between the two rates has been more volatile and at times, particularly at quarter ends, the difference between the two curves was significant. Those dealers using the OIS curve to discount derivatives will typically show larger positions (due to less discounting). To discuss the appropriateness of the OIS curve for valuing your derivatives, please contact your Derivative Accountant.
Translation Risks Associated with an ERP Upgrade
by Jim Shepard
In today’s world of technology, the Enterprise Resource Management (ERP) system is the key to quicker, faster accounting results required by an ever more demanding list of stakeholders. Frequently, these systems require some if not substantial customization to meet a company’s specific accounting requirements. While customization is a good thing when executed properly it can also create risks when future upgrades (from versions 1.X to 2.Y) require similar customizations. This past month a client notified us of an issue that arose in the foreign currency translation process related to their migration to version 2.0 of their ERP software. This flaw may have been in the software upgrade, the local configuration, or both but if it had not been uncovered and rectified it would have improperly stated the Company’s earnings and EPS.
Here’s what happened: A USD denominated transaction was entered on a GBP local currency functional set of books. Under ASC 830 the non-functional monetary asset ($100 A/R for our purposes) is required to be remeasured from the income statement rate at which it was booked to the month end balance sheet rate. The GBP asset value changes and an offsetting entry is recorded in foreign exchange gain/loss in GBP on the local set of books. This step went like clockwork and was recorded properly. Next the local financial statements were translated from GBP into USD to allow the Company to combine numerous foreign subsidiaries’ books into a single consolidated USD set of financial statements. This is where things went awry. The GBP exchange gain/loss (calculated on the USD remeasurement) should have been translated into USD at the income statement rate.
The result should have been a USD exchange gain/loss in the P&L reflecting the original GBP exchange gain/loss recorded on the local set of books at the company’s income statement rate. What did happen was technologically slick (and perhaps the answer to many a Treasurer’s dream) but was the wrong accounting result. The system instead looked to the original $100 A/R transaction and bypassed the required transition through GBP to USD. During the translation process, the original GBP exchange gain/loss and related CTA effect were unwound. As a result the FX gain/loss in consolidation was ZERO (nada, nothing!). The gain or loss had evaporated in processing the translation. (See exhibit A for details.) This result is convenient, but not GAAP.
Misapplication of the debits and credits associated with foreign currency transaction and translation accounting will misstate a global company’s net income/EPS. Fortunately in this case the client reviewed the FX gains and losses and CTA generated by the new system prior to going live. We strongly recommend that when migrating to new software or upgrading existing software that the migration team identify strong technical internal or external resources to assist in evaluating the currency accounting.
If you lack internal resources, Hedge Trackers is able to guide your implementation or migration teams on appropriate testing of currency functionality. ERP consultants are generally familiar with how to program the software, provided the company delivers very clear and concise requirements. Unfortunately, companies frequently assume that the programmers “know” how currency accounting should work, or they just assume the currency elements of the system will work correctly which is not always the case. We encourage our clients to participate in migration or implementation teams to spearhead the effort to validate the impact of currencies on your financial statements.
Need to refresh your understanding of currency accounting under ASC 830: Foreign Currency Matters? We offer basic through advanced classes. Find more information on currently scheduled webinars and training classes.
Exposure Draft Redefines CTA Reclassification Criteria
by Lisa Wallace
On December 8, 2011 the FASB issued an exposure draft that would redefine for many of our clients when amounts from CTA would be reclassified to income. Comments were due on this guidance by February 6, 2012.
The guidance appears to change the model for reclassifying CTA from an “entity” model to a “business” model. Currently amounts are reclassified to earnings upon complete or substantial liquidation of a subsidiary. The proposed guidance will trigger reclassification to income “when a reporting entity ceases to have a controlling financial interest in a group of assets that is…a business (other than a sale of in substance real estate…) within a consolidated foreign entity”. Apparently, each asset sale will involve management judgment to determine if the set of assets sold represent a “business”.
The amount of CTA reclassified to earnings will reflect the asset group’s relative portion of the foreign entity’s CTA: either a pro rata portion of the gain/loss based on the relative proportion of the net assets of the entity at the date of disposition or the gain/loss attributable to specific assets and liabilities of the business. If a parent had hedged the entity holding the “business” in which they no longer hold a controlling financial interest, they would also release into earnings the related amount of accumulated gain/loss from any net investment hedges.
The full text of the Exposure draft as well as the six comment letters received as of February 6th can be found at: www.fasb.org.
Update: FASB Stalled on Hedge Accounting
Based on the recently released 2012 schedule, the FASB has no plans to consider hedge accounting during the coming year. We’ll continue to monitor the situation, but for now it appears to be business as usual, with no progress on proposed simplification or IASB convergence.