What is hedge accounting?
Hedge accounting is a method of accounting which allows companies that are hedging a forecasted transaction, to shift FX gains and losses to a future period when the forecasted transaction will become an accounting entry.
If your company processes a significant volume of transactions in foreign currencies, it is very likely that you are using financial derivatives like forward contracts to hedge your FX risk. While these products are protecting your margins against adverse exchange rate movements, they may also generate problems at an accounting level.
According to the standard derivative accounting rules, the changes in the fair value of the hedging instrument must be registered in the balance sheet at every reporting period. These variations impact the Profit and Loss Statement (P&L) and can distort the picture of the company’s overall financial performance, even if you are completely hedging your exposure.
Hedge accounting minimizes P&L volatility by allowing companies to park the FX gains and losses of the hedging instrument in the Other Comprehensive Income (OCI) section of the balance sheet. With this accounting treatment, the hedging instrument does not affect the P&L until the hedged item is recorded as an accounting entry.
Why should you implement hedge accounting?
A hedge accounting solution can bring a number of advantages. 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 and forecasting accuracy can incur unintended impacts from earnings volatility.
What’s required to apply hedge accounting?
Substantial requirements must be satisfied to apply hedge accounting under IFRS 9 accounting standards. These are:
- Documentation. 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.
- Effectiveness Testing. The company needs 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 the effectiveness tests determine the accounting entries to be reported.
Proper documentation and effectiveness testing are, in most cases, challenging tasks that require a substantial workload and cost to obtain the different sources of data. This alone often discourages companies from implementing hedge accounting.In addition to the IFRS 9 requirements, companies also need to have sufficient accounting expertise on-hand to apply hedge accounting properly.
Hedge accounting made simple with Kantox
Kantox’s hedge accounting solution makes hedge accounting easy.
Kantox captures rich hedging data from the client via its automated Dynamic Hedging solution.
The Hedge Accounting solution then links hedged items with their respective hedging instruments at the initiation of the hedging relationship, and creates the required documentation.
At initiation, and on every reporting date, the effectiveness of the hedging relationship is also tested to determine eligibility for applying hedge accounting. The solution then determines the effective portion of the hedging relationship. Kantox does this by using relevant market data, which is not readily available to many companies.
With Kantox’s sophisticated Hedge Accounting solution, accounting teams are then able to enter the relevant values into their system.
With the all-in-one automated solution:
- Exposure and hedging data are automatically collected
- FX risk is hedged as per the company’s strategy
- FX risk management is better reflected in the financial statements
- P&L volatility is minimized
- Hedging documentation and effectiveness tests for each hedging relationship are generated, along with data for accounting entries
Dynamic Hedging and Hedge Accounting
Dynamic Hedging is Kantox’s automated FX risk management software.
It reads exposure data received from the client and automatically executes market hedges according to the company’s defined risk management strategy. As such, the solution captures information about both hedged items and their corresponding hedging instruments.
Our flexible solution links to any existing IT infrastructure, by API or FTP.