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June 2012 Newsletter View in pdf
Preserving a Natural Hedge
by Helen Kane
Hedge programs are generally very effective at locking in (forwards) the value of the company’s revenues or costs or insuring (options) those revenues/costs against negative movements in currencies: but are you locking in or insuring the appropriate rate? Frankly, when you hedge is just as important a decision as if you hedge. Getting the timing right requires delving into operations, cash flows and financial statement presentation. The following is an unusual exposure situation in which a company appears naturally hedged, but the timing of the costs versus the sales invalidates the natural hedge assumption—and a hedge restores it. In fact, the same hedge executed at 3 different points provides 3 different financial statement results.
Company C has an R&D center in a foreign country and expects to continue R&D efforts at that location for many years to come. The company has annual sales equal to the R&D expenses, but most of the sales occur in the last month of the year. The company considers itself “naturally hedged”: cash outflows equal cash inflows for the year. However, both the timing of the conversions and the currency accounting rules (ASC830) will not provide a natural hedge in the financial reporting. (Assume USD reporting currency for entity.)
There are two approaches to hedging these exposures that reflect the company’s desire (or lack of desire) to predetermine the future revenue and cost rates. If the rate isn’t critical, then each time the company purchases currency to pay for expenses, it should execute a swap and sell that currency amount forward as a designated cash flow hedge, locking in the rate experienced on currency costs for the future currency revenues.
This first approach works great economically, but what if the company were sensitive to remeasurement gains and losses? They would have been experiencing FX Gains and Losses on the payable from the time/rate it was recorded through to conversion. To avoid this, they would move the timing back to the payable recording date and execute a forward swap, buying forward to settle the payable at a future date (expected payment date) and simultaneously selling forward as a designated cash flow hedge to the start of next year when receivables would be available to deliver. This locks in the same rate for the cost/payable and revenue/receivable and protects against reporting gains and losses. To move beyond the economics and protect the timing and income statement geography of the strategy, the forward sale in each case would need to be designated as a cash flow hedge.
If management wanted to lock in current rates for both the future costs and the future revenues, the timing of the forward swap would move back in time. At any point prior to the recording of the costs, the simultaneous execution of a forward currency purchase and a forward currency sale both designated as cash flow hedges would lock in the reported values of both the foreign currency costs and revenues at the hedge rate.
At Hedge Trackers we are pressing our clients to step back from their routines and to evaluate their hedge program for economic effectiveness, as well as accounting, effectiveness. This quick example highlights the risks and opportunities of standard hedge programs. Company C is naturally hedged, but a quarterly hedge program or a revenue (only) hedge program would not have preserved the economics.
Cost Plus Strategy: Setting Up Uneconomic Hedges
by Sandra Koch
If your Company’s subsidiaries are local currency functional, and your tax department has executed a cost-plus tax strategy, and you hedge this intercompany exposure—your hedge program may be uneconomic.
A cost plus strategy is typically executed as follows:
- Local subsidiary bills US Parent for all of their operating costs plus some pre-determined markup. Generally the sub invoices in local currency, but could be in dollars at invoice date.
- The US Parent, not wanting to send any more cash outside the US than necessary, will send only the amount of cash the subsidiary needs to handle working capital needs.
- Result is a growing foreign currency liability on the US Parent’s books that is not typically going to be cleared—or when cleared will be returned to parent.
- Non-functional currency assets and liabilities, including intercompanies*, are required to be remeasured with the currency change impact recorded in income each period. Most companies with active hedge programs will execute F/X hedges to offset the risk.
Typically, management is happy with the earnings impact because income volatility is averted. However, when you look through the transactions, the growing “plus” is not an economic exposure. So when the treasury department is executing trades and putting cash at risk for an accounting effect, it is speculating with cash. As “cost-plus” strategies proliferate, the trend in uneconomic hedging is growing. We recommend that companies facing these exposures engage the tax department and start with non-derivative solutions to mitigating these exposures. Hedge Trackers, LLC has worked with a number of companies caught in the uneconomic hedge cycle to align their hedge program with the economics and protect their earnings. To learn more please contact one of our professional consultants.
*Hedge Trackers, LLC does not believe that a Parent’s intercompany payables would qualify as being “of a long-term-investment-nature” (ASC830-20-35-3&4), with the gains and losses accumulating in equity.
What to Do When Commodity Price Risk Intersects Currency Exposure
by Jim Shepard
Companies exposed to commodity, currency, or interest rate risk typically hedge those risks by asset class. Yes, there is the occasional need to use cross-currency swaps or other hybrid products to mitigate multiple risks in a single hedge relationship, but that has not been the norm for corporate hedgers—until recently.
Over the past year Hedge Trackers, LLC has noticed a significant increase in the desire (or need) to hedge commodity price risk denominated in a currency other than the Company’s functional currency. This arises in one of two ways. Either the commodity exchange is denominated in a foreign currency, such as canola seed futures traded on the Intercontinental Exchange (ICE) in CAD$, or a local currency functional foreign entity deals in USD denominated exchanges, such as metals (gold, copper) or fuel (diesel, natural gas).
When companies are faced with both commodity price risk and currency risk, the hedge strategy and effectiveness testing increase in complexity. Under ASC 815, the currency component of the commodity bought or sold can be bifurcated and hedged independent of all other risk factors. Not so for commodity price risk. Commodity price risk must be hedged based on the change in the “overall price” of the commodity.
Our experience is twofold in this area. We’ve seen hedgers use two derivatives (one commodity and one currency) to protect against the change in overall price of the commodity, and we’ve seen companies hedge the commodity price risk with a single derivative against the change in the price to the functional currency without executing a currency hedge. In the latter example, the effectiveness test under ASC 815 compared the change in price of the foreign denominated underlying to the change in price of the USD based derivative. As long as the company can show on a statistical basis that the change in prices are highly effective and produce an R2 of >.80, the relationship qualifies for special hedge accounting.
Regression Library Available for Outsourcing Clients
by Lisa Wallace
Beginning this month, Hedge Trackers’ outsourcing clients will be able to access our complete regression library online. On-line access to appropriate effectiveness testing protocols is essential to keep our clients up-to-date on all documentation and hedge accounting requirements. Having access to the entire library ensures that all hedging relationships are represented, even as timing slips or new strategies are employed. FX forwards and options (both exclude time value and include time value) will be available for all currency pairs traded by clients. Additionally, both US GAAP and IFRS compliant regressions are available.
Outsourcing clients will receive access instructions and training related to this powerful new tool. Any questions regarding the regression library may be directed to your derivative accountant.
Deferral of “The Presentation of Reclassifications Out of Comprehensive Income in Interim Periods”
by Melanie Markowski
ASU 2011-12* deferred the requirement of ASU 2011-05* that entities present on the face of the financial statements reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income for interim reporting periods.
An entity must present a total for comprehensive income in its interim statements but is not required to present the individual components of OCI as it would for annual reporting purposes. In addition, entities that select to use a two statement approach in their financial statements may use a single statement approach in their interim reporting.
*effective for fiscal years, and interim periods within those years, beginning after December 15, 2011
Key Controls in a Derivative Environment
by Lisa Wallace
Accounting for derivatives is a complex task with volumes of guidance outlining a myriad of detailed rules and exceptions. However, if you can affirmatively answer the following three questions, you should feel comfortable that your financial statements are materially correct.
- Have all derivatives been identified?
- Are all derivatives recorded on the balance sheet at the appropriate fair market value?
- Have the appropriate amounts been stored in OCI?
Have all derivatives been identified?
Appropriate controls around trading, including segregation of duties related to confirmation and reconciliation, facilitate this process. Additionally, “derivatives” executed outside of treasury must be considered, namely features that might exist in purchasing or other contracts that meet the definition of a derivative. A process to identify such contracts must be in place and consistently followed.
Are all derivatives recorded at the appropriate fair market value?
Once all derivatives are identified they need to be recorded at fair market value based on the appropriate market inputs. Counterparties can be a source for inputs and comparisons, but not for valuations. Valuations should be calculated internally. When calculated by a third party the company should understand the inputs to the valuations. Credit is another consideration, including the company’s own credit as it impacts liabilities.
Have the appropriate amounts been stored in OCI?
Identifying amounts to be stored in OCI is really the heart of hedge accounting; without special hedge accounting all changes in derivative value would be recorded immediately in the income statement. All amounts deferred in OCI must be related to contracts that have met the documentation requirements, including effectiveness testing. Measurement of effectiveness, which directly impacts the OCI balance, has also become an area of increased focus from auditors. Finally, the probability that the underlying anticipated transactions will occur must be assessed and supported.
Capella Spotlight: Integration with FXall
by Rebecca Judge
Are you a user of both Capella and FXall? If so, did you know the two systems can “talk” to each other? By accessing FXall from Capella, you can save significant time and prevent input errors.
The two systems are fully integrated and provide for secure, pass-through processing. With just a few clicks of the mouse, you can send the desired trade details from Capella into the FXall trading portal. Once you execute your trades within FXall, simply click another button and pull the critical terms back into Capella. Quickly and efficiently, your trades are loaded in the system and are ready for month end MTM processing.
To learn more about Capella and FXall integration please contact us and start saving time.