June 2012 Newsletter View in pdf

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:

1. 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.
2. 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.
3. 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.
4. 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.

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.

See our website for upcoming webinars and trainings covering commodity price risk and hedging it under ASC 815.

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.

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

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.

1. Have all derivatives been identified?
2. Are all derivatives recorded on the balance sheet at the appropriate fair market value?
3. 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.

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.