Hedge Accounting Fundamentals

You don’t need an army of accountants to carry out hedge accounting. In this post, we will go through hedge accounting fundamentals and see how the documentation required for performing this complex process can be easily automated, allowing you to save on time and administrative costs.

Hedge accounting fundamentals

Consider a simple commercial transaction: a company with USD as its functional currency signs a contract of sale to a European client (who deals in EUR) to be settled in three months. A hedge is taken by selling the corresponding amount with a forward contract, on the same date, with a value date that matches the settlement of the commercial transaction.

As the exchange rate shifts, mutually offsetting FX gains and losses allow the company to achieve its goal of reducing the variability of its economic performance. If this sounds too good to be true, it is. This is because the financial derivative is a recognisable event from day one, while it’s only when the sale is invoiced that the accounting team recognises the corresponding receivable.

‍And therein lies the rub. While the exposure may be perfectly hedged, in the sense of protecting the cash flow in the underlying commercial transaction, the mismatch between accounting treatments means that large unrealised FX gains/losses may create more, not less, net income volatility. Restoring the matching principle is the purpose of hedge accounting.

Regulated by the standards IFRS 9 and US GAAP, hedge accounting keeps unrealised FX gains and losses out of net income until the hedged instrument is cash-settled at the value date. By placing unrealised FX gains and losses in OCI (Other Comprehensive Income), hedge accounting lets firms achieve the desired outcome of stabilising cash flow by hedging without worrying about unanticipated swings in net income as a side effect.

6 documentation must-haves for hedge accounting  

To qualify for hedge accounting, firms must provide extensive documentation regarding:

1. Risk management objective
2. Type of hedge (cash flow hedge or fair value hedge)
3. Risk exposure being hedged (fx risk, interest rate risk, commodity price risk)
4. Hedged item
5. Hedging instrument (including details on the value date, counterpart, etc.)
6. Hedge effectiveness assessment.

Consider this last point. Hedge effectiveness is assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of the hedged item. That assessment needs to be performed in a ‘prospective’ manner, reassessing the effectiveness of the hedge between reporting periods.

How to automate a costly and time-consuming activity

This points to the most obvious drawback of hedge accounting: it is a time-consuming task that, when manually executed, requires skills in accounting and in the valuation of financial assets. We have seen firms shying away from applying hedge accounting —and even from currency hedging altogether— due to the perceived costs in documentation and compliance.

This is despite the fact that hedge accounting allows companies to take net income volatility out of the equation. This is precisely where Currency Management Automation solutions make a real difference: they will enable you to automate the complete documentation required to perform hedge accounting.

End-to-end traceability for each piece of exposure allows teams to perform all the tasks in compiling the required documentation easily. There is no need to hire an army of accountants and valuation specialists — thanks to Currency Management Automation, the required data is at your fingertips.

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