June 2011 Newsletter View in pdf
Common Revenue Hedging Issues
From the Desk of Helen Kane:
Hedging foreign currency denominated revenue in a cash flow hedge program is probably one of the simplest applications of special hedge accounting. However, there are nuances to hedging revenue that Treasury departments need to consider in managing their hedge programs. Please review the nuances associated with the three scenarios outlined below to ensure that you are properly managing the derivative gains/losses associated with revenue hedges.
In cash flow hedge programs corporations are permitted to park derivative gains and losses in Other Comprehensive Income (OCI) for all changes between the designation of the hedge relationship and the recognition of the hedged transactions in the financials. The gain/loss then remains in OCI until the hedged item is reported in consolidated earnings. Note the distinction between the “trigger event” that stops the collection of OCI and the “release event” that controls the release.
Scenario #1: Hedging revenue that is deferred
When deferred revenue is first reported on the financial statements, only the balance sheet is impacted (DR Receivable, CR Deferred Revenue). This recording of the hedged item meets the trigger criteria to stop accumulating gains and losses. However, without an income event, the gain or loss must remain in OCI awaiting the reclass of the deferred revenue to regular revenue in the P&L. Processes must be in place to recognize the reclass of the hedged revenue to income.
Frequently, descriptions of hedged revenue will exclude deferred revenue to eliminate the burden of tracking the reclassification the hedged item from deferred revenue to revenue. This is becoming increasingly difficult as many more companies are (reluctantly) moving to deferred revenue models. Companies hedging deferred revenue may execute separate hedges for the deferred revenue or just bifurcate the hedge gains and losses into portions to be released immediately and those stored and released separately. AcappellaFX® is designed to support the independent “trigger” and “release” functions necessary when hedging deferred revenue.
Scenario #2: Hedging interco transactions where the 3rd party sale by the foreign currency functional subsidiary is in a later period
Many corporations hedge the intercompany transaction between two entities as a proxy for hedging 3rd party revenue. It is important that the gains and losses on these hedges of interco revenue or intercompany inventory purchase are released contemporaneous with the third party recognition of revenue or cost of sales. Few corporate treasury teams focus on how this lag will be reflected in their consolidated financials when the subsidiaries are foreign functional. If the hedge is executed at the subsidiary level to hedge the interco purchases, the hedge will succeed in protecting local currency margin—but will not provide any visibility into theexpected USD value of the consolidated results.
If the hedge is executed at the parent level it provides even less protection of foreign functional earnings. The gain or loss representing the value between hedge designation and recording of interco revenue will give no visibility into the value at which the consolidated margin will be recorded in the period the inventory is reclassed to Cost of Sales. However, if hedging is maintained through the payment of theintercompany, the hedge will succeed in economically protecting cash flows. For the curious few wondering where the delta between cash and the earnings values reported are captured: the answer is the cumulative translation adjustment. This concept will be fully explored in our ASC 830 Advanced Workshop on July 15, 2011.
Scenario #3: Hedging gross revenue impacted by credit memos
For the purposes of this discussion, we will assume that a credit memo is issued and a new invoice is generated for an equal or close to equal amount. Credit memos and currency don’t mix well. They create havoc on remeasurement results as ERP systems frequently reverse original entries at the historic rate at which the original invoice was issued and the new invoice is re-issued at current rates, creating a slippage in value between the FX Gain/Loss and Revenue. The slippage between the lines can be calculated as the revenue value at the income statement rate at first invoice vs. the revenue value at the income statement rate at re-issue.
Things are complicated further when revenue transactions are hedged. The reissued revenue should not be captured in the hedged revenue calculation. This might result in a single transaction being hedged twice: the original revenue recognition event and a second time when the revenue value was included in the “gross revenue” amounts recorded in re-issue period (ASC815 precludes the hedging of “net” amounts). Companies should have processes to identify and exclude the reporting of “re-invoiced revenue”and other credit memos in the values used to trigger cash flow or fair value hedges of revenue. For further information on how your revenue hedges are impacted by these scenarios please contact your Hedge Trackers consultant, or send an inquiry to info@hedgetrackers.com.
Best Practice: Monthly OCI Roll Forward
Rebecca Judge
While derivative accounting is anything but simple, there are just a few simple controls required to assure completeness and accuracy.
First, ensure that you have accounted for all outstanding derivatives. Second, make sure those derivatives are on your balance sheet at fair value. Finally, be sure you have recorded the correct OCI associated with those derivatives. Strong controls in these key risk areas ensure that other derivative values are correctly impacting income. (Additional controls around income statement geography may be advisable).
To help you get comfortable with the OCI balance we recommend you perform an OCI roll forward each month. This will help ensure derivative related values weren’t erroneously posted into or removed from OCI.
This is also a great way to validate known OCI activity. To roll forward start with the prior period ending OCI balance, reverse the prior month OCI entry on open contracts (assumes reversing entries for open contracts) add impact in current period to OCI for open, closed in current period and closed in prior period contracts. The result should tie to your reported ending OCIbalance related to derivatives.
An OCI roll forward is also one of the required quantitative derivative
disclosures mandated by ASC815. The disclosure tracks additions (debits or credits) to OCI and subsequent reclassifications to the effective account. Monthly reconciling of OCI will facilitate this quarter end disclosure preparation.
For clients using AcappellaFX, there is an Accounting Report conveniently named Disclosure-OCI Ending Balance which can be very helpful in troubleshooting any variances you may find in the reconciliation process. This report can also be used as a support for your G/L balance. This report is available to outsourcing clients upon request.
New Course Offerings—Foreign Currency Accounting
Jim Shepard
Continuing education provides a cornerstone for developing and maintaining best practices within your finance organization. In the past, Hedge Trackers provided several half day courses on ASC 830 (FAS 52) which took participants from basic concepts to advanced topics in accounting and hedging of foreign currency transactions.
Recently, we’ve revamped our ASC 830 (FAS 52) foreign exchange education track in order to provide a series of courses that can be utilized over a year’s time to bring participants from an introduction to the basics of remeasurement and translation to an advanced understanding of the topic. An advantage of the new educational track is that course material has been split into four manageable courses to accommodate all levels of expertise and to optimize time spent in the classroom.
Whether you need a refresher on the basics or a deep dive into the details, you can select the course specific to your needs. At Hedge Trackers we take commitment to competence as seriously as you do and are excited to offer these new courses.
Our new foreign exchange learning track includes the following new webinar and three new seminars (all qualifying for CPE credits):
Foreign Currency Accounting Basics: This webinar is designed for thosewho are new to foreign exchange and foreign currency accounting concepts. Participants will learn the basics of exchange rates, and ASC 830 (formerly FAS 52) terminology and key concepts: remeasurement and translation.
Introduction to Accounting for Foreign Currency: This 2 ½ hour workshop is designed for those who have taken on responsibility related to foreign currency transactions as well for mid-level managers and above as an introduction to ASC 830 (FAS 52): Foreign Currency Matters. It is applicable whether you need fundamentals to tackle currency accounting issues every day or need to get comfortable with how and why foreign currency transactions and translation impact consolidation. Disclosure requirements and an introduction to hedging remeasurement exposures with forwards round out this course.
ASC 830 – Intermediate Workshop: This 2 ½ hour workshop goes beyond the basics of ASC 830 and adds valuable, practical examples to your foreign currency accounting tool kit. Participants are assumed to have a basic understanding of ASC 830 terminology, functional currency concepts, and accounting for basic foreign currency transactions. Participants work through debits and credits. The course focuses on trouble shooting the FX Gain/Loss line: exploring missteps in currency accounting, capturing hedge impacts, etc.
ASC 830 – Advanced Workshop: Within this 3 hour workshop, we explore through case studies the complexities associated with the foreign functional currency decision. Participants explore the impact on margin from intercompany inventory transfers and foreign based deferred revenue. We make a debit/credit intensive review of the impact of how intercompany transactions and hedge accounting converge in consolidations.
Increased Interest in Commodity Hedging by Corporates Subdued by Difficulties in Hedge Accounting
Sandra Koch
In today’s changing global economy, corporate interest in hedging commodity price risk is escalating as commodity price volatility soars. However, the economic decision to hedge commodities and lock in or insure against unpalatable losses is frequently thwarted by the ability to qualify for special hedge accounting treatment under ASC815. Special hedge accounting aligns the timing of the derivative gain or loss with the recording of the hedged item in income. Without that timing benefit, economically effective hedge programs introduce and exacerbate the very earnings volatility that the derivative is executed to protect against. The difficulty for commodity hedgers is the requirement that the derivative provide offset for ALL of the commodity price changes. And the accounting world does not take the term “all” lightly. Frequently it takes significant effort for the corporate client to capture “all” the historical purchases/sales components reflecting the location, grade and other characteristics of the commodity. The company must access this historical data in order to establish the effectiveness of the hedging relationship. Research on the purchasing side generally starts in procurement, understanding how many locations the company receives goods, then how many suppliers are used and how the prices aredetermined under each supplier agreement.
The next hurdle is finding the derivative instrument that will best match the exposure you need to hedge. Is price based on spot, current-month-average or prior-month-average index pricing? You may need to consider a combination of derivatives to get the best price match as well (for instance, an indexed future contract with a location basis swap—if one is even available). While these hurdles are not insignificant, there are opportunities to qualify for hedge accounting when hedging commodity price is economically the right thing to do. The IASB has proposed absolute simplification of commodity hedging: we are crossing our fingers.
Client Q&A
Nichole Krause
“My company is considering including options in its cash flow hedge program. What is the impact of including v. excluding time value for cash flow hedge accounting?”
The value of an option is a combination of both time value and intrinsic value. When an ATM option is purchased, the premium paid is all time value (no intrinsic value exists). Conversely, when the option expires, any value at exercise is intrinsic and no time value exists. Between the purchase date and expiry date the fair value of the option is a combination of both time and intrinsic values. When the time value of an option is included for cash flow hedging, all effective changes in value of the instrument are deferred in OCI until the underlying transaction occurs. When time value is excluded, only changes in intrinsic value (when strike is a better rate than month end spot) are deferred in OCI until the underlying transaction occurs. Current changes in time value impact earnings (the company elects the geography of those impacts at designation).
At a high level, the difference between the cash flow hedge accounting rule sets is that when time value is excluded, there will be more activity in the income statement month-to-month over the life of the option, cumulatively equaling the original premium paid: alternatively, when including time value there will be less income statement activity incrementally but the option premium is recorded to the effective account, along with any intrinsic value when the hedged item occurs. Changes in accounting for option premiums are proposed in both the FASB and IASB exposure drafts. Both proposals are good news for options as hedge instruments.
If you would like your question answered in our next newsletter, email us at: info@hedgetrackers.com.
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