Taming FX Volatility with Hedge Accounting

Speaker A: Welcome to currencycast. Are you worried about net income variability stemming from unrealized foreign exchange gains and losses? Do you consider it too cumbersome to apply hedge accounting? Welcome to Currencycast. My name is Austin McKinley. I'm the senior Financial Writer at Cantox and your host. In this episode we discuss some of the main pain points surrounding hedge 1 the problem of unwelcome foreign exchange induced net income variability. And that's uh, for companies that do not apply hedge accounting, the cost in terms of time and company resources, or 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. Let us imagine the case of a euro based company that hedges a highly anticipated GBP denominated sales transaction with a valid date of 6 months and a forward rate of 1.€15 per pound. At inception, the value of the derivative is 0, 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 a unrealized foreign exchange gain. So from the economic perspective the hedge does produce its intended offsetting effect. But ah, from the accounting perspective things can look pretty different. Let us see why 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. Compare this treatment to how the corresponding commercial transactions are accounted for. It is only when the sale is invoiced that the, uh, transaction is finally recognized as an account receivable or payable. There is therefore a uh, mismatch between the account treatment of derivatives and the treatment of the commercial transactions they are meant to hedge, and this is generally viewed as problematic. 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 because of accounting conventions, net income may turn out to be more more, not less volatile when hedging. Allow me to put it in slightly different terms. As they hedge companies reduce cash flow risk, they might be might do so at the expense of higher net income volatility. Two questions remain to be asked before we discuss hedge 1. Why are derivatives fair valued? And Ah, 2 why do business managers pay attention to net income variability? On the first point, authors Jankens, Gad, Oxelheim and Albinissen argue that in the past, regulators were worried about instances of creative accounting whereby unrealized foreign exchange gains were more likely to be reported than unrealized losses. And on the second point, they argue 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. The purpose of hedge accounting as it relates to cash flow hedging is to insulate a company's net income from the effects of unrealized foreign exchange gains and losses from the derivatives that are put in place to hedge the commercial transactions. Now, for this to work, unrealized foreign exchange gains and losses need to be reported differently. 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 changes between assets and liabilities, so the foreign exchange gain increases the equity account retained earnings. Under hedge accounting, the unrealized foreign exchange gains and losses are instead placed in a different income statement, OCI or other comprehensive income. OCI offers a different route for unrealized foreign exchange gains and losses to affect equity. And that's because OCI is linked to another equity account, the hedging reserve. Unrealized 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 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. 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. 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 hedged item. 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 hedge 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. On the 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. 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 Can FX automation help companies ease the burden m of applying hedge accounting? I will only say this. Stay tuned.