The critical role of hedging global operations is rarely recognized.
Read on as we examine the importance and how it can save your company’s earnings.
Currency movements – whether overnight surprises like the GBP’s free fall the morning after Brexit (the UK’s vote to withdraw from the EU) or the slow rise of the Euro over the last eight months – will immediately impact international companies and their reported earnings unless the company hedges their international operations. The critical role of hedging global operations is rarely recognized. We’ll use the rising Euro exchange rate to review the benefits of hedge accounting.
The Growth of the Euro
In December of 2016, when many companies were finalizing their 2017 budgets and compensation programs, the Euro was as low as 1.05 USD to the Euro. Over the past six or seven months, the Euro has strengthened to nearly 1.16 (10% increase) against the greenback. For companies that generate revenues (and are not hedging), there has been a windfall.
Unexpectedly, the margin improvement has been a lucky break, however, all news is not good news. Management didn’t know additional revenues would be available and the margin improvement cannot be counted on to repeat in the future. For companies with Euro expenses, costs held constant in Euro have steadily risen this year in USD. If your company’s revenues are USD denominated and you are sourcing out of Europe, you may need to raise prices or experience margin erosion.
Special Hedge Accounting
Why do companies willingly face an uncertain currency market when something can be done to mitigate this risk? Why experience rate movements without a warning? A company can create a predictable rate experience by using a cash flow hedge and buy themselves time to react to large FX market changes.
Under special hedge accounting, a company is able to lock in today’s currency rate for future probable transactions. For example, if you are in the planning cycle, your company could fix the rate today (during the planning phase) that will apply to revenues and/or expenses over the 12 months of the plan year. So when the currency rate swings either up or down, the hedging entity knows it will record the transactions at the hedged rate and your company won’t be immediately impacted by the rate changes. The way special hedge accounting delivers this benefit is in two unique features:
- The company is permitted to record the hedge effect and the hedged revenue/expense at the same time (thus recognizing the activity in earnings at the hedged rate).
- The hedged transaction and the derivative gain/loss are recorded in the same line item so not only is net income preserved but whichever line item (e.g. revenue or COS) you were protecting is delivered at the hedged rate.
Let’s examine how using a forward contract to hedge could have insulated an entity’s British sourced revenues in 2016 (after the Brexit event).
Assume in the 2015 planning cycle, a company hedged GBP revenues for 2016 at the hedge rate of 1.50 using a forward contract. When the GBP plummeted post-Brexit, revenues would have been recorded at prevailing accounting rates of approximately 1.25 together with a derivative gain of .25 for total revenue value of 1.50 (the hedged rate).
This company not only protected margins from a 20% overnight deterioration but also provided time to evaluate pricing strategies and new cost structures as it prepared for the post-Brexit realities of decreasing margins in the future unhedged periods.
The hedge doesn’t eliminate risk; it just gives management a chance to prepare internal and external stakeholders for the new economic environment. Hedging isn’t about getting the best rate, rather having visibility into your shorter-term results and providing lead time to react to currency market fluctuations.
More information on Forward Contracts