Don’t hide behind IAS39

Achieving hedge accounting for foreign exchange risk management

Don’t hide behind IAS39

Throughout 2009, volatility in the foreign exchange markets was a key theme. Although the financial 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 profitability.

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 profit 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.

“FX risk management is one of the main activities to protect profitability.”

In our definition, 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 management of these exposures is becoming more and more important. However due to the difficulties 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 flows in profit or loss at the same time.

“Under IFRS, derivatives are recorded in the balance sheet at fair value.”

Let us first define forecasted transactions and firm commitments as potential hedged items.

A forecasted transaction is an uncommitted but highly probable future transaction. A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date (or dates). FX hedges of forecasted transactions are designed as cash flow hedges. The cash flow 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 firm commitments, with a number of helpful hints.

Case 1. Hedging a net position

EUR 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 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 hedging

EUR 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 effectiveness 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 flows to specific individual sales transactions. Designate the hedged item as the first X million of highly probable sales in a specific time bucket.

Case 3. Intra-group sales

Subsidiary 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 flow hedge in the consolidated statements?

Solution: Yes, because the external sales result in FX risk affecting the P&L. The gain and loss on the derivative is reclassified to the consolidated income statement as soon as the external sale is recognized.

Case 4. Translation exposure

Assume 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 flow exposure. Similarly, inter-company dividend payments do not qualify as hedged items because they don’t affect reported net profit or loss.

Case 5. Net investment hedge

Parent 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 profits cannot be included in the hedged item because they do not form part of the existing net investment at the time of hedge inception.

Identification and measurement

In 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 identification 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.

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