Discover essential FX hedging strategies and currency management best practices from our foreign exchange experts.
3 Key Benefits of Hedge Accounting
Publicly-traded companies go to great lengths to either meet or beat their consensus earnings. If their guidance is accurate and the results look good, this keeps shareholders happy and may reduce stock price volatility.
In the case of privately held firms, accurate forecasting and reporting are also essential so as to avoid nasty surprises - which also serves to keep investors and other stakeholders on-board.
But depending on the type of business model you have, unexpected FX gains and losses can play havoc with the balance sheet. One solution is to hedge. However, even if you’re completely hedging your exposure, problems can still occur at an accounting level.
Why do FX gains and losses occur?
FX gains and losses mainly occur because there is a difference in the exchange rate from the time an invoice in a foreign currency is received, to the time a payment is made. The same is also true for a receivable. But for those businesses - which may include companies in the travel, chemical, food and import/export industries - there is another way. By applying an automated micro-hedging solution combined with hedge accounting, companies will reduce these gains and losses and minimize temporary volatility in the Profit and Loss Statement (P&L).
However, while hedging combined with hedge accounting is a very effective solution, the latter is often underutilized due to its complexity. Simply put, hedge accounting allows a company to prove the correlation between the hedge and the hedged items and record the FX gains and losses of the hedging instrument in Other Comprehensive Income (OCI). That way, they do not affect the P&L.
Hedge accounting was previously covered by the accounting standard IAS 39. This has now been replaced by IFRS 9 Financial Instruments, which came into effect on January 1st, 2018. And while these standards are relatively new, many companies have been slow to adopt them. The good news is that hedges that were previously excluded, or companies that did not qualify under IAS 39, may now qualify.
So what are the main benefits of hedge accounting?
- Enhanced efficiency: Automating repetitive tasks like calculations and formatting saves a considerable amount of time and allows financial teams to focus on higher-level analysis.
- Improved accuracy: Automation ensures consistency and eliminates the potential for human error in data entry and calculations.
- Real-time visibility: Automated solutions offer real-time insights into hedge effectiveness, enabling proactive adjustments as market conditions change.
Additional benefits for your business
- P&L volatility is minimised. Reducing P&L volatility is, by and large, one of the main benefits of hedge accounting. By addressing the timings mismatch associated with standard derivative accounting, hedge accounting removes temporary volatility from the P&L. As a result, the financial statements provide a better picture of the company’s true economic performance. With earnings volatility under control.
- Creditworthiness goes up. Banks and other lending institutions extend credit to companies based on their creditworthiness, which is determined by several factors. Predictability in future earnings is also a positive factor in creditworthiness. However, companies are also more likely to be eligible for credit if they meet certain banking covenants (which may include having a stable P&L).
- Executives can also benefit. Executive compensation is usually tied to company performance, which is often measured in quarterly earnings. When earnings are impacted by FX gains and losses caused by hedging exposure, this can also have an impact on executive compensation. By smoothing out the P&L, compensation can be more accurately calculated.As mentioned earlier, applying hedge accounting is not without its challenges. That’s why Kantox has created an automated hedge accounting solution to help companies take even greater charge of their P&L and access the benefits of hedge accounting.
Hedge Accounting made simple with Kantox
By automating your hedge accounting process and integrating it with a pre-defined FX hedging strategy, you can gain a powerful advantage. With our all-in-one solution you can achieve automatic hedging execution, ensuring proper risk management is reflected in financial statements.
Additionally, this approach minimises profit and loss volatility, while streamlining the creation of hedging documentation, effectiveness testing, and even generating the raw data needed for accurate accounting entries.
