Gathering Balance Sheet Exposures

Balance Sheet Exposures 

Balance sheet exposures are the drivers of the FX Gains and Losses that impact earnings every month. They are monetary accounts like cash, accounts receivable, accounts payable, inter-company balances and more that are denominated in foreign currencies, so their values fluctuate and they are reported as gains/losses on a company’s financials. The noise associated with balance sheet exposures are not welcomed (especially the losses), and they are typically hedged away by treasury practitioners so that the impacts to income are eliminated.

But in order to mitigate balance sheet exposure risk, one must first identify transaction level balances and then quantify and evaluate those exposures. Part of identifying exposures is knowing when they come onto and off of the balance sheet. Timing and amount of the exposure must be matched by the hedge to mitigate balance sheet risk. Once a net exposure position by transaction currency is known, a hedge can be placed to protect the income statement from unnecessary income volatility.

How to Gather Balance Sheet Exposures

There are many ways to gather information on balance sheet exposures.

Using third party technology to pull in global exposures from an Enterprise Resource Planning (ERP) system is one of the most efficient ways to gather balance sheet exposures. Some companies have reporting capabilities within their ERP systems to identify all of the non-functional balances by entity, while others may have to consolidate information from several different systems or directly from entities.

In each case, the objective of balance sheet exposure gathering is to aggregate all foreign currency monetary account balances by entity by currency. This includes pulling balances on Cash, Accounts Receivable/Payable, Taxes Payable, Inter-company Receivable/Payable and so forth. It is important to gather all of the exposures for every entity, since oftentimes a positive balance in one entity (Cash) will be offset by a negative balance in another (A/P).

After all of the exposures are consolidated, you have all the relevant data for hedging. One additional step helps you convert that data into useful information for hedging decisions. It’s important to validate the exposure information gathered. This can be done by comparing balances from prior periods to gauge the correct magnitude and direction of your exposures. You can also validate the actual vs. expected currency gain/loss posted in the income statement by comparing rate changes to the balances gathered.

As an example, CapellaFX’s RTZ software prepares a monthly validation for each entity, which can be used as a control point around the FX gain/loss line. If the gain/loss expected is reasonably close to the actual amount recorded, then you know you have all of your exposures. 

The Pitfalls of Exposure Gathering

Unfortunately, things can (and do) go wrong when gathering balance sheet exposures.

A typical ERP system has three ledgers. The first is in the reporting currency (USD), the second is in the currency of the country or functional currency (EUR for example) and last, and most important for this topic, is the transaction currency ledger which captures transactions recorded in a currency other than the functional currency of the entity. If the incorrect ledger is used in an ERP system, the results will show exposures in the wrong currency. If accruals are made in USD but paid out in a foreign currency, then those exposures could be missed. If some entities are on different systems or have manual processes that are not accounted for when gathering exposures, then natural offsets could be missed. If one were to hedge more than the true global exposure position due to incomplete information, the hedge could actually create more currency exposure than reduce it.

The Benefits of Exposure Gathering

When balance sheet exposures are gathered for all legal entities at the transaction currency level, then certain benefits arise.

Corporations can net down negative and positive exposures, reducing hedging costs and transaction sizes. Hedges do not have to be placed by each individual entity. Instead, they can be placed by centralized treasury personnel, saving time, improving the exchange rates, and providing better controls over the company’s derivative activities. Also, hedge decisions can be evaluated and analyzed by trending global exposures over time. Seasonality and other factors that change balances become more apparent.

The Bottom Line: Gather Your Balance Sheet Exposures

The key to gathering balance sheet exposures is to identify all monetary account balances by currency and by entity. This can be done manually in a spreadsheet, but new technologies make this process more efficient for many firms.

Avoid the pitfalls, including missing exposures and accessing incorrect ERP ledgers by using validation practices. If you don’t, the wrong currency types might be gathered — disrupting the effectiveness of your hedge, or worse, creating exposures with derivatives.

Once all exposures are gathered by currency and by entity, a global balance sheet exposure position will be created. This allows for fewer trades, better trending and a centralized control point for derivatives.

You’ve identified your balance sheet exposures. Now what? Let us help you implement a comprehensive hedge program to take care of your FX and IR risk — and secure your margins. Contact us today.