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Hedge accounting allows companies to recognise gains and losses on hedging instruments and the exposure they are intended to hedge, with both being registered in the same accounting period. This procedure reduces income statement volatility that would otherwise arise if both elements were accounted for separately.The financial instruments standard that deals with the accounting of FX hedges is called IFRS 9. Issued by the International Accounting Standards Board (IASB), IFRS 9 requires firms that implement hedge accounting to provide detailed documentation on their risk management objectives, hedging instrument, hedged item and the nature of the risk hedged, as well as the results of tests that determine the effectiveness of the hedging relationship and the sources of ineffectiveness.
Hedge effectiveness is the extent to which changes in the value of a given exposure (the hedged item) are offset by an opposing change in the value of the financial derivative (the hedging instrument). Under hedge accounting, hedge effectiveness is measured with three criteria: Economic relationship. There must be an inverse relationship between the change in the value of the hedged item and the change in the value of the hedging instrument. Credit risk. Changes in the credit risk of the hedging instrument or hedged item should not be large enough as to dominate the value changes associated with the economic relationship. Hedge ratio. The appropriate hedge ratio should be maintained throughout the life of the hedge.
The hedge effectiveness ratio —in a typical cash flow hedge of a forecast transaction— measures the accuracy of a hedge by comparing, at each reporting date, the fair value of the forecasted transaction and the fair value of the hedging item. For example if, three months after inception, the fair value of the forecast transaction increased by 100 and the fair value of the hedging instrument decreased by 110, hedge ineffectiveness was the fair value change of the forward was 10 because the fair value change of the forward was higher (by 10) than the fair value change of the forecast sale.
Hedge effectiveness testing is the set of procedures that firms implementing Hedge Accounting under IFRS 9 are allowed to implement to test the effectiveness of their hedges.The two most commonly used methods of hedge effectiveness testing are the ‘Dollar offset method’ and the ‘Critical match method’. The dollar offset method is a quantitative method that involves comparing the variation in the fair value, present value or cash flow expectation of a hedged item, with the variation in the fair value, present value or cash flow expectation of the hedging instrument. The critical terms match method involves comparing the key terms of the hedging instrument and the hedged item, providing that both elements meet a set of specific criteria.
The hedge ratio is the ratio of a hedged exposure to the entire corresponding exposure. A firm with high forecast accuracy can apply a higher hedge ratio to distant exposures than a firm with low forecast accuracy. In hedging programs that combine budget hedging with hedging based on SO/POs, a given hedge ratio is applied while hedging is based on forecasts. As soon as certainty from the business is increased with sales/purchasing orders (SO/PO), a higher hedge ratio (for example, 90%) is applied on those firm commitments. The treasury team is in effect ‘switching programs’ and starts to hedge based on SO/PO. Such a combination can be supplemented by adding balance sheet items with (for example) a100% hedge ratio. The implementation and management of cash flow hedging programs may be quite burdensome for treasury teams that rely on manual execution and spreadsheets. However, Currency Management Automation solutions allows firms to run them smoothly, on a fully automated basis.
The hedge relationship is an accounting term that describes the accordance between all the key components of FX hedging, including: the firm’s objectives and strategies, the nature of the hedge, the hedging instrument, the hedged item, how the hedge ratio is determined and the analysis of possible sources of ineffectiveness. When applying Hedge accounting, the firm must provide documentation regarding all the elements of the hedge relationship. This documentation needs to be updated if the hedge ratio is rebalanced, when sources of expected ineffectiveness change and for changes to the effectiveness methods used.
Under Hedge accounting, a hedged item can be a recognised asset or liability (AR/AP, account receivable/payable), an unrecognised firm commitment (SO/PO, sales order/purchase order), a forecast transaction or a net investment in a foreign operation. The hedged item can be a single item (for example, an individual transaction) or a group of items (for example, the sum of forecast transactions). A hedged item can also be a component of such an item or group of items. The hedged item must be reliably measurable.
A hedging instrument is a financial derivative, usually a forward contract, used in FX hedging. When currency rates change, the hedging instrument creates an offsetting financial position that compensates the corresponding change in the hedged currency exposure. In Hedge Accounting, companies must provide documentation regarding the inverse relationship between the change in the value of the hedged item and the change in the value of the hedging instrument.
Hidden FX exposure is the amount of accounting, transaction or operating exposure that is not properly identified by the treasury team. Most FX surveys show that lack of visibility and reliability of FX forecasts is the biggest challenge in managing FX risk. Sources of hidden FX exposure include: manually executed data gathering and consolidation, use of spreadsheets gathered from many different sources, lack of transparency of internal processes, errors in the definition of the appropriate currency for translation purposes, difficulty in processing numerous intercompany transactions, and inaccurate or untimely monitoring of FX markets. To the extent that they automate the process of exposure collection and monitoring, Currency Management Automation solutions allow managers to mitigate the risks stemming from hidden exposures.
Hidden FX risk is the amount of accounting, transaction or operating exposure that is not properly identified by the treasury team. Most FX surveys show that lack of visibility and reliability of FX forecasts is the biggest challenge in managing FX risk. Sources of hidden FX risk include: manually executed data gathering and consolidation, use of spreadsheets gathered from many different sources, lack of transparency of internal processes, errors in the definition of the appropriate currency for translation purposes, difficulty in processing numerous intercompany transactions, and inaccurate or untimely monitoring of FX markets. To the extent that they automate the process of exposure collection and monitoring, Currency Management Automation solutions allow managers to mitigate the pitfalls created by hidden FX risk.