Learning FX

Balancing FX Hedging Capacity and Hedge Accounting

FX Hedging

When there is a lot of instability in the foreign exchange market and the economy is unpredictable, companies seek ways to expand into foreign markets while diversifying their supply chains and managing financial risk.

Organisations can use hedge accounting to protect themselves from income statement volatility caused by changes in currency rates. By hedging more currencies or higher volumes, they can align their economic objectives with their financial reporting.

The revised hedge accounting guidance may allow organisations to hedge more effectively while still reaping the benefits of hedge accounting.

Why Intentional Over-Hedging Can Help Some Businesses

One strategy that allows for increased hedge volumes is over-hedging. With this strategy, an organisation enters into a derivative contract for a notional amount greater than the amount of the underlying hedged transaction. For example, if a UK firm has a sales forecast of 15 million EUR per month but only wants to hedge 60 per cent or nine million EUR per month of its forecast, it could over-hedge by 10.5 million EUR per month. This would be 70 per cent of its forecast, and the trade would still qualify for hedge accounting.

A company can choose to over-hedge, meaning to hedge more than is needed to offset the hedged risk. This is allowed if the hedge is still effective at offsetting the risk. The effectiveness of the hedge is usually between 80 and 125 per cent. The new accounting standards change when the company recognises the earnings impact of cash flow over-hedges.

Previously, the effects of cash flow over-hedges were not effective and were recognised in earnings immediately. Now that ineffectiveness is no longer measured or presented, what was previously considered ineffectiveness is now recognised in Other Comprehensive Income (OCI). This means it is reclassified to earnings simultaneously as the underlying hedged transaction.

3 Things Businesses Consider When Over-Hedging

While effective, over-hedging must be done but not without considering three important factors:

1. Accounting Implications

The long-haul method of hedge accounting allows companies to account for the time value of money when hedging transactions with derivatives. This method is more complex than the critical terms match method, but it provides a more accurate representation of the true economic effectiveness of the hedge.

The most common method of assessing the effectiveness of a long-haul hedge is regression analysis. This technique can be used to show, every quarter, that the hedge relationship remains effective. Technology can be used to perform regression analysis, which makes this strategy more scalable. This usually reduces the overall audit risk of using hedge accounting, as the quantitative test is easy to determine and does not require judgment or documentation of qualitative assumptions.

2. Documentation

It is important to document your organisation's intention to over-hedge to avoid the potential assumption that your organisation does not exhibit the ability to forecast accurately. This may preclude the application of hedge accounting. The over-hedging strategy is a way to hedge against more economic risks than you would normally do while still achieving the benefits of hedge accounting. This can be beneficial because it allows you to be more protected against risks, but it can also be more complex to set up and administer.

3. Other Strategies

There are other ways companies save money when hedging that considers seasonality and other factors that make forecasting difficult. These include using the spot method or rolling exposure windows. With either of these strategies, your company can look to a longer period to complete hedged transactions, as long as you document the strategy and test the timing difference appropriately. With the right knowledge and tools, these methods can be helpful alternatives to more traditional hedging programs.

The Importance of Hedge Accounting

Without hedging, a company would be exposed to foreign currency risk, leading to losses in its accounts. Hedging can help protect against this risk, but the accounting treatment of hedges can sometimes result in mismatches between the hedged item and the hedge.

Hedge accounting allows entities to modify the normal accounting rules for hedged items and hedging instruments so that the gains and losses arising from them are matched. UK tax legislation requires that such accounting be effectively recognised for tax purposes.

What Is Short-Cut Hedging?

In most cases, companies must account for their hedges using the full hedge accounting rules. This is because full hedge accounting provides the most accurate reflection of the economic protection achieved from a hedge and provides the most useful information to users of the financial statements.

This means that a company can choose to treat a financial instrument as a fair value through a profit or loss item, which means that changes in the fair value of the instrument will be recorded in the company's profit or loss for the period.

The company in this example has a long-term fixed rate loan but would prefer a variable rate loan. To offset the potential difference in value between the two types of loans, the company enters into an interest rate swap. The loan is designated as an item to be accounted for under the fair value through the profit or loss method, while the swap is designated as an asset or liability at fair value.

This means that if you encounter two sets of fair value debits and credits going through the profit and loss statement in opposite directions, you should not apply any special tax rules.

Conditions Companies Consider when Applying Hedge Accounting

Here are several conditions companies consider when applying hedge accounting:

1. General Conditions

Hedge accounting is an accounting method that allows companies to offset the costs of hedging activities on their financial statements. This accounting method is used to manage the financial risks associated with fluctuations in the prices of commodities, foreign exchange, and interest rates. Hedge accounting can manage both the risks and the costs of hedging.

2. Hedged Financial Instruments

The statement allows several financial instruments to be hedged against one another, which is especially useful for loans denominated in a foreign currency. This means that if the value of the loan changes, the value of the financial instrument used to hedge it will change in the opposite direction, offsetting the loss.

To create consolidated accounts, only transactions with other companies or organisations can be hedged; an exception to this rule is when foreign currency risk is involved in a highly probable transaction between different groups, as this risk could affect the consolidated profit or loss.

The focus is usually on individual accounts of entities. If an item between companies meets the requirements for hedge accounting, it can qualify for hedge accounting and the hedging of external exposures to the group.

Hedge accounting may be applied to groups of items or individual components of an item. For example, a specified part of the nominal amount of an item (such as £50 million of a £100 million loan) may be eligible for hedge accounting.

3. Hedging Instrument

The standard defines what can be hedged and what instruments can be used to undertake a hedge. The definition is broad; the instrument must be valued, and for the purposes of consolidated accounts, it must be with a party external to the group. For individual entity accounts, the instrument can be with another group entity.

An item can be designated as in part if it is not entirely available. This means that some aspects of the item may be restricted or unavailable.

To be eligible for a hardship withdrawal, you must have a financial need due to an immediate and heavy financial obligation. You must have exhausted all other reasonable options for meeting that need. Most swaps, like foreign currency and interest rate swaps, can be used as hedging instruments.

To apply hedge accounting, the general conditions must be met. These conditions include having a formally documented risk management strategy, the hedging instrument being designated as a hedge, and the hedging instrument having a positive impact on the company's financial statements. If these conditions are met, then hedge accounting can be applied.

Applying Hedge Accounting

Three types of hedging relationships are allowed for tax purposes: cash flow hedges, fair value hedges, and hedges of a net investment in a foreign operation. Each of these types of hedging relationships has different tax implications.

1. Fair Value Hedge (FVH)

An entity may want to protect itself from changes in the economic value of an asset, liability, or future commitment. For example, if an entity has a loan with a fixed interest rate, it may want to hedge against the risk of interest rates rising. The entity can enter an interest rate swap to convert the fixed interest rate to a floating interest rate.

A fair value hedge is where the risk of interest rate movements affects the economic value of the item being hedged - in this case, a loan. The hedge then economically counteracts any changes in value.

The loan is accounted for at amortised cost, meaning any changes in its fair value are ignored. The fixed coupon, wrapped up into the debits calculated by applying the effective interest rate, is still flowing through the accounts. On the other hand, the derivative is accounted for under FVTPL, which means that changes in its fair value will be recognised in the accounts.

When an entity has a financial instrument designated as a hedge of a particular risk, if the hedge accounting conditions are met, then the entity can account for the hedge using hedge accounting. For a fair value through profit or loss hedge of interest rate risk, the accounting for the hedging instrument is unchanged, but the carrying value of the hedged item is adjusted for changes in its fair value due to the risk hedged. This change is recognised in profit or loss.

2. Cash Flow Hedge

A company may need to buy or sell foreign currency at some point in the future to fulfil a contractual obligation. To protect against the risk that the value of the foreign currency will change between the time the company agrees to the contract and when they need to buy or sell the currency, they can enter into a hedge. A hedge is an agreement to buy or sell a currency at a set price on a specific date.

The derivative would be immediately recognised without hedge accounting, but the underlying transaction might not be recognised until much later. This would cause volatility in the P&L, even though the economic effect is greater certainty.

The standard allows an entity to designate a hedging instrument as a hedge against a future transaction, provided that the general conditions and the conditions for being a hedge-able item and a hedging instrument are met. If these conditions are met, the accounting treatment prescribed by the standard will take gains and losses on the hedging instrument into account through other comprehensive income. These movements will be released to the income statement when the hedged item is realised.

3. Net Investment Hedging

The final hedging relationship allowed is when a group has operations denominated in a currency other than the reporting currency of the consolidated accounts. On consolidation, the net closing assets of these operations will be retranslated at the closing rate for the year. The differences arising between this, the opening value of net assets translated at the opening rate and the profit or loss for the year (generally at an average rate) will be taken through other comprehensive income to a translation reserve.

The group may have chosen to finance the operations through a loan denominated in the currency of the operations to reduce balance sheet volatility and reduce risk by matching the currency of returns on the operations with the currency of the financing. This financing will be usually accounted for as a BFI, but even then, the foreign exchange gains and losses arising each year on the funding will be taken to profit and loss. There is thus a mismatch between the accounting treatment of the assets (differences through OCR) and the financing (differences through profit and loss).

Hedge accounting is accounting for financial instruments and contracts used to hedge investments or other exposures. Under hedge accounting, the hedging instrument (e.g. a loan) may be designated as a hedging instrument. The hedging instrument is an effective hedge for the assets; the foreign exchange gains and losses arising on loan can be taken to other comprehensive income rather than profit and loss.

This means that when an asset is hedged with a derivative, the derivative's gains and losses are not counted towards profit and loss but are instead counted towards Other Comprehensive Income.

Conclusion

It is important for companies to carefully consider both the capacity of their hedging program and the accounting treatment of their hedges. The capacity of a hedging program should be aligned with the company's overall risk management strategy, and the accounting treatment should be consistent with the economic substance of the hedges. Both of these factors can have a significant impact on the financial results of the company.

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