This is the last in a series of posts designed to give an overview of the steps required to establish and maintain a balance sheet hedge program.
Once a balance sheet program is established, the next logical step is to focus on protecting company margins. Today, we’ll discuss special hedge accounting as a natural extension of the balance sheet hedge program. You can see past entries at hedgetrackers.com/blog.
There is a widespread perception among those new to foreign currency hedging that special hedge accounting can be extraordinarily complex. While this can be true, there are ways to simplify the process by thoroughly understanding the hedge objective, exposure types, accounting elections and hedge accounting requirements.
There are substantial benefits to balance sheet hedge programs that can come from a well-thought-out cash flow hedge strategy. Frequently, a difficult risk to manage is hedging the non-functional currency assets and liabilities at the rate they are recorded. A cash flow hedge that expires in a period after the hedged item is recorded as dedesignated (stop special accounting treatment) automatically when the hedged item occurs – at the rate it occurs. The derivative is dedesignated at the same rate used to record the hedged item, meaning the accounting smoothly tracks the exposure, creating a balance sheet hedge at the income statement rate. This frequently serves the twin purposes of improving FX Gain/Loss performance and making margin more predictable.
So, how difficult is it to move from balance sheet hedging a transaction to protecting both margin and FX Gain/Loss on the transaction?
The accounting for a balance sheet hedge is actually not too different from that of a cash flow hedge. Whether it’s a balance sheet or cash flow hedge, the fair value requirements on the derivative are exactly the same. At each month-end, ASC 820 requires that you mark your derivative to market at its current fair market value (FMV). This is accomplished by determining the balance sheet forward adjusted rate (balance sheet rate plus market forward points) and comparing it to the forward rate on the derivative contract. The change in value must also be present valued for time (interest rates) and for credit risk.
While a balance sheet hedge takes the change in fair value straight to FX gain and loss, a cash flow hedge gain/loss geography is really all about the hedged item. Depending on the status of the hedged item, the offset to the fair value of a derivative in a cash flow hedge will end up in OCI (equity) or in the P&L given the appropriate documentation, testing and accounting. Special hedge accounting introduces an entirely new set of complexities and documentation requirements to the mix. We have outlined a few of these below:
- Documentation of the hedge relationship
- Effectiveness testing and measurement
- Non-functional currency and other qualification requirements
- Audit committee communication and acceptance
- Auditor scrutiny
- Changes to GAAP and changing interpretations of GAAP
- Strategy development
- Tracking the hedged item through income
- Disclosure reporting
Hedge Trackers has made navigating the complexities of ASC 815 relatively simple. Our expert advisors (complemented by CapellaFX, a specialized software solution) enable less experienced finance organizations to implement, account for and disclose painlessly under the special hedge accounting rules.
So as you finalize your balance sheet hedge strategy, remember that protecting company margins can even be more important to your organization’s success. CapellaFX and our consulting teams stand ready to assist you in progressing from protecting the FX gain and loss line to protecting those critical margins.