This is the second in a series of posts designed to give a top-line overview of the steps to establishing a balance sheet hedge program. In part two, we’ll focus on exposure validation. You can see past entries above or speak to us directly at AFP 2015 this October.
Many finance professionals assume that their ERP systems are handling remeasurement correctly. Unfortunately, they’re often wrong.
Once the process for collecting the key data for great balance sheet hedging is in place, it is critical to validate that information. Recall from earlier in this series that the drivers of FX Gains/Losses are:
- Existing exposures
- Knowledge that new activity is going to create new exposures in the period
- The rate setting mechanism for the new activity
- Control of the conversion activity, or immediate knowledge when conversions occur
Given that this is all the information you should need to understand your FX Gain/Loss line, we now need to ensure that we do, in fact, have the data that is driving the FX Gain/Loss – and not just theoretically. This exercise is easiest for companies using a single rate (an average for the month or prior month rate) to record all new activity, but it works for all scenarios.
To validate, we quantify the net monetary position (consisting of net assets and liabilities) for each currency for the month end prior to the month being validated, and again at the end of that month. We take the balance at the end of the prior month and convert it to functional currency using the prior month end balance sheet rate, then take that same value by the current month end balance sheet rate. The difference between these two values captures the FX associated with bringing last month’s values forward to this month end. But this month’s ending exposure is different from last month’s – so you tackle the changes next.
To capture the change from last month’s balance to this month’s balance, take the change and convert it to functional currency using the rate the activity was supposed to be recorded at (prior month, average or weighted average daily) and again convert the same change amount using the current month end rate. The difference between these two values captures the FX associated with bringing the new activity in this month to the month end value. But all the exposure changes did not happen at one rate. One more piece to go.
The only activity that shouldn’t be happening at the accounting rates is cash conversion activity, where one currency is converted to another. Take the conversion activity for the currency we are evaluating at the bank conversion rate(s) and compare that to the accounting rate assumption in your accounting system for all the change activity; these cash conversions didn’t happen at that rate. The difference between these two values is the third and final piece needed to validate the reported gain/loss.
Summing the gains and losses from the prior three calculations will provide the number we expect to be recorded in FX Gain/Loss for this one currency (excluding any derivative gains/losses). This series of steps needs to be repeated for each currency, then for each entity. (As an alternative to manually calculating all these values, Hedge Trackers offers a software solution that prepares all these calculations for all entities in just a few seconds, providing a SOX control for the FX gains and loss line.)
When all the gains and losses for each currency are summed together and all the entity gains and losses are summed, the total should equal the gains and losses from the remeasurement in consolidation. Note that this does not include the gain or loss from hedges; those need to be calculated separately.
If the value calculated doesn’t equal the amounts reported in consolidation, there are problems in the accounting. This calculation will not identify shadow balance issues described in the first article. Even though the shadow balance transactions were closed in prior periods, those exposures will show up in the trial balance and a gain/loss calculated as described above will show up in earnings.