If you’re expecting to receive a foreign currency cash flow on a future date, it’s easy to calculate what that cash flow would be worth based on today’s exchange rate. But what you don’t know is how exchange rates will move in the meantime. Depending on the markets, the cash flow could be worth more than expected – or it could be worth a lot less.
The good news is that companies can mitigate this risk by entering into a hedging instrument. For example, companies looking to buy or sell foreign currency on a future date can lock in the exchange rate using a forward foreign exchange contract. The benefits of hedging future cash flows are clear: the company is protected from the possible impact of exchange rate movements, bringing greater certainty over the value of those flows.
But that isn’t the end of the story. The way in which cash flow hedging is accounted for also needs to be considered. Companies have two choices when accounting for cash flow hedges: they can use either standard derivative accounting or hedge accounting techniques. While hedge accounting brings numerous benefits, many companies are put off by the complexity of the process. However, it’s important to remember that the challenges are not insurmountable – especially if you’re using the right tools for the job.
What is hedge accounting?
The goal of hedge accounting is to align the treatment of the hedging instrument – such as a forward FX contract – and the exposure that the instrument is intended to hedge.
The challenge lies in the fact that the value of the hedging instrument may change at different points during the sales cycle. The hedging instrument is purchased when there is a probable or forecasted sale, but is settled later when the future cash flow occurs. During this time, the value of the hedging instrument may change.
Under standard derivative accounting rules, changes in the derivative’s value are recorded in the P&L between the purchase date and the date of the future cash flow. However, the hedged item may be recognised in a different reporting period – resulting in a P&L mismatch between the hedging instrument and the item that is being hedged.
In contrast, hedge accounting avoids this mismatch by treating the hedging instrument and the hedged item as a single item for accounting purposes. The company can therefore recognise the gains and losses from both the hedged item and the hedging instrument in the same period. The changes in valuation are thereby offset, leading to lower earnings volatility.
Hedge accounting was previously covered by accounting standard IAS 39. This has now been replaced by IFRS 9 Financial Instruments, which came into effect on 1st January 2018.
Types of hedge accounting
Hedge accounting can be used for three types of hedge:
- Cash flow hedging. One of three types of hedge which are covered by hedge accounting. As outlined above, cash flow hedging is used to address volatility in a company’s cash flows which can result from factors like interest rate or exchange rate changes. This mitigates the risk that the company will need to pay more or receive less than expected in the future – for example, by purchasing forward contracts to lock in a price in the future.
- Fair value hedge. Hedges the change in fair value of an existing asset or liability. These changes may arise as a result of changes such as interest rate or exchange rate changes.
- Net investment hedge. Hedges the currency risk associated with translating overseas net assets held by foreign operations into the group’s currency.
Benefits of using hedge accounting
Hedge accounting can bring a number of advantages over traditional accounting methods. The core benefit is that 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 will better reflect the company’s true economic performance.
Reducing the volatility in earnings results in a number of additional benefits:
- Enterprise value. Earnings volatility is negatively perceived by investors.
- Creditworthiness. Predictability in future earnings is a positive factor in creditworthiness.
- Risk management. Statements reflect better and more accurately how FX risk is managed.
- Executive compensation. Compensation tied to performance, for example measured based on quarterly earnings, can incur unintended impacts from earnings volatility.
Challenges in adopting cash flow hedge accounting
While hedge accounting can benefit companies in a number of different ways, it’s also associated with certain challenges – leading some companies to avoid pursuing this technique. So where can difficulties arise?
In order to apply hedge accounting, companies need to consider three things:
Satisfying the relevant documentation requirements is essential if hedge accounting is to be applied. Documentation should be in place for each hedged item and hedging instrument, and should include descriptions of the following:
- The type of hedge
- The hedged item and hedging instrument
- The hedged risk
- The hedging relationship
- The hedging strategy
Documentation should also be in place outlining the company’s risk management objectives at a global level.
2. Effectiveness testing
Another prerequisite of hedge accounting is the need to measure the effectiveness of the hedge. This involves demonstrating that an economic relationship exists between the hedged item and the hedging instrument. A test must also be run to assess the extent of the relationship – an exercise which requires valuation skills, as well as an understanding of IFRS 9 requirements and access to market data. The results of effectiveness tests determine the accounting entries to be reported.
3. Accounting expertise
Following on from the requirement for effectiveness testing, accounting expertise is needed in order to report the results of the test correctly. However, this expertise may not be available in-house, and may be costly to outsource.
In practice, many companies struggle with these requirements – particularly the documentation and effectiveness testing stages. Where effectiveness testing is concerned, compiling the different sources of data can be a challenge. Corporate accounting teams will need to collate a range of data relating to markets, interest rates, previous accounting entries and the hedge itself, in order to carry out effectiveness testing.
Completing the necessary documentation also brings a significant administrative burden. It’s essential to get this part of the process right: without adequate documentation for each hedging relationship, companies may not be able to apply hedge accounting.
Additionally, challenges can arise when it comes to relating hedging instruments to hedged items. For example, linking the hedged item and hedging instrument can be difficult if a single hedge is created to cover a number of different exposures.