Agustin Mackinlay (00:00)
Are you worried about net income variability stemming from unrealised foreign exchange gains and losses? Do you consider it too cumbersome to apply hedge accounting? Welcome to CurrencyCast. My name is Agustin Mackinlay. I'm the Senior Financial Writer at Kantox and your host. In this episode, we discuss some of the main pain points surrounding hedge accounting.
Number one, the problem of unwelcome foreign exchange induced net income variability. And that's for companies that do not apply hedge accounting. And number two, the cost in terms of time and company resources of compiling the documentation required for hedge accounting. Throughout this podcast, we will limit ourselves to cash flow hedge accounting, as we will not consider net investment hedging or fair value hedging.
Agustin Mackinlay (00:48)
Let us imagine the case of a euro-based company that hedges a highly anticipated, GBP-denominated sales transaction with a value date of 6 months and a forward rate of 1.15 euros per pound. At inception, the value of the derivative is zero, therefore it does not feature in the accounts. A few days later, the pound falls to 1.10. From the commercial perspective, this is certainly not good news.
But note that there is an unrealised foreign exchange gain. So from the economic perspective, the hedge does produce its intended offsetting effect. But from the accounting perspective, things can look pretty different. Let us see why.
Agustin Mackinlay (01:33)
Derivatives are fair value accounted from day one. Among other things, this means that changes in the fair value of derivatives must be recognized in net income. Now compare this treatment to how the corresponding commercial transactions are accounted for. It is only when the sales is invoiced that the transaction is finally recognized as an account receivable or payable.
Agustin Mackinlay (01:57)
There is therefore a mismatch between the accounted treatment of derivatives and the treatment of the commercial transactions they are meant to hedge. And this is generally viewed as problematic.
Agustin Mackinlay (02:10)
Managers worry that even though exposures may be perfectly hedged, investors and analysts may not like the net income variability associated with these fair value changes. So here's the paradox. Because of accounting conventions, net income may turn out to be more, not less volatile when hedging. Allow me to put it in slightly different terms. As they hedge, companies reduce cash flow risk. It might do so at the expense of higher net income volatility.
Agustin Mackinlay (02:41)
Two questions remain to be asked before we discuss hedge accounting. Number one, why are derivatives fair valued? And number two, why do business managers pay attention to net income variability? On the first point, authors Jankensgard, Oxelheim, and Alviniussen argue that...
In the past, regulators were worried about instances of creative accounting, whereby unrealised foreign exchange gains were more likely to be reported than unrealised losses. And on the second point, they argued that net income as an indicator of performance matters more in certain industries than in others. In industries that lack a clear indicator of operating performance, net income might be more closely watched by analysts and investors. In this case, achieving net income stability is clearly a plus.
Agustin Mackinlay (03:39)
The purpose of hedge accounting, as it relates to cash flow hedging, is to insulate the company's net income from the effects of unrealised foreign exchange gains and losses from the derivatives that are put in place to hedge the commercial transactions. Now, for this to work, unrealised foreign exchange gains and losses need to be reported differently.
Agustin Mackinlay (04:00)
So let's review two points about the example that I mentioned a minute ago. A) The increase in the fair value of the derivative is reported as an asset. But B) Since equity reflects the difference between the changes between assets and liabilities, so the foreign exchange gain increases the equity account retained earnings.
Agustin Mackinlay (04:22)
On the hedge accounting, the unrealised foreign exchange gains and losses are instead placed in a different income statement, OCI or Other Comprehensive Income. OCI offers a different route for unrealised foreign exchange gains and losses to affect equity. And that's because OCI is linked to another equity account, the hedging reserve.
Agustin Mackinlay (04:44)
Unrealised FX gains and losses are stored in reserves until the settlement of the derivatives contract. Upon settlement, they are released into net income. Note that this should coincide, in terms of timing, with the settlement of the corresponding commercial transaction. And that's how the matching principle is restored.
Agustin Mackinlay (05:04)
With hedge accounting, managers protect company cash flows without having to worry about unpredictable swings in net income. But is that too good to be true? In a sense, yes, it is too good to be true. And that's because transactions must be well documented in order to apply for hedge accounting. Here are some of the main requirements, again, taken from the example that we mentioned a couple of minutes ago.
Agustin Mackinlay (05:30)
First, the objective of risk management has to be explained. In this case, it's about protecting the euro value of a highly anticipated, GBP-denominated, sales transaction. And it's about removing net income variability. And what is the type of hedge? Is it a cash flow hedge? Is it a fair value hedge or a net investment hedge? In this case, as we explained, it is about a cash flow hedge.
And what is the hedging instrument? Is it a forwards contract? Is it an option? Is it a futures contract? As we said, in this case, it is about a forwards transaction which has a given value date, a reference number, and the counterparty that is also referred to. And what is the hedged item? Well, in this case, it is the cash flow stemming from the highly anticipated GBP denominated sale.
Agustin Mackinlay (06:27)
And here comes hedge effectiveness, by far the most troublesome to comply with, as it must be performed both on inception and on an ongoing basis during each reporting period. The dollar offset method is the easiest one. It compares the changes in the fair value of the hedging instrument or the derivative to changes in the cash flows from the hedge item.
Agustin Mackinlay (06:52)
Say that this assessment, namely the ratio of the changes in the fair value of the hedging instrument to the changes in the cash flow from the hedged item, result in a figure of 105%. Well here, the effective part, namely the 100%, would be reported in OCI, while the excess of 5 % would be reported in net income. Under most accounting conventions, firms must use this documentation to prove that there is an economic relationship between the hedge item and the hedging instrument, and that the credit risk element does not dominate that relationship.
Agustin Mackinlay (07:29)
As we can infer from these requirements, hedge accounting can be a pretty burdensome activity when manually executed. That creates obviously the risk of manual errors, of audit risk, and it poses scalability challenges as companies use more currencies in business operations. Now the question is, can FX automation help companies ease the burden of applying hedge accounting? I will only say this. Stay tuned.
