3 Hurdles to Overcome When Starting a Cash Flow Hedge Program

The thought of applying hedge accounting can be daunting for those unfamiliar with the requirements for qualifying for special hedge accounting treatment under ASC 815. In this post, we will discuss the basic requirements for qualifying and applying special hedge accounting.

The focus will be specifically on the advantages of hedge accounting and how to qualify for “Cash Flow” hedge accounting of anticipated transactions — the most common type of special hedge accounting used by corporates.

Cash Flow Hedge Accounting 101

Companies that implement Cash Flow hedge programs are protecting their anticipated margins, revenue and/or expenses. Why do they start a Cash Flow hedge program in the first place?

A few different common reasons:

• To provide certainty around a forecast/budget
• To fix the value of margin on a specific transaction
• To smooth rate impacts
• To provide time to react to exchange rate changes

Ultimately, companies apply Cash Flow hedge accounting to “match” the timing and income statement geography of the hedged item and the hedge itself.

Per ASC 815, default accounting for a derivative is to fair value the instrument and record any changes in value through other income and expense (OI&E) in the current period. The default accounting for the anticipated foreign revenues or expenses is to wait until the exposure occurs to record it on the financial statements at the then current rate. Therefore, following default accounting results in timing and geography mismatches. Matching up the timing and geography between the hedge and hedged item is exactly what a Cash Flow hedge achieves.

When a derivative is designated in a Cash Flow hedge relationship and locks in the value of an anticipated foreign transaction in USD, any changes in value of the hedge can be deferred on the balance sheet in Other Comprehensive Income (OCI). Once the hedged item is recorded in income, amounts deferred in OCI are reclassified from OCI into income in the same account and at the same time. The hedged item and impact of the hedge together produce revenue or expense at the hedge rate.

3 Key Requirements to Qualify for Cash Flow Hedge Accounting

There are a series of hurdles you must overcome in order to qualify for special hedge accounting.

(1) Identify A Qualifying Cash Flow Exposure

Before qualifying for hedge accounting, you have to identify a qualifying Cash Flow exposure. For example, anticipated yen denominated revenue at a Japanese local functional subsidiary does not qualify as a Cash Flow exposure. Anticipated yen denominated revenue recognized in a USD functional entity does qualify as a Cash Flow exposure.

The requirement: the hedged item must be denominated in a currency other than the entity’s functional currency, and it must be probable that the hedged item occurs in the time period defined.

(2) Complete Cash Flow Hedge Designation Documentation

Once you’ve identified qualifying cash flow exposures, you will need to complete Cash Flow hedge designation documentation.

This documentation includes:

• Definition of the specific hedged item
• Whether to include or exclude time value in the hedge relationship
• The time frame in which you anticipate the anticipated transaction, as well as the current “expected date” within that timeframe
• Type of hedged risk (in this case, FX)
• Derivative details
• Effectiveness test description and results

This documentation must be completed contemporaneously with the hedge designation — generally two business days. If a quantitative effectiveness test is selected it can be performed any time prior to the first reporting period after the hedge relationship is established (or earlier should something impact the hedge relationship prior).

(3) Pass Initial Prospective Effectiveness Assessment

Next, you must pass the initial prospective effectiveness test. This is a qualitative or quantitative test that establishes that the change in value of the hedged item will be highly effective in offsetting changes in the value of the derivative. If the relationship cannot be supported via an effectiveness test (typically a regression test), or assertions that the relationship is a perfect match, then hedge accounting will not be permitted.

Getting Started

Now that you know what to expect in setting up a Cash Flow hedge program, you can get started.

Companies either handle the qualifying steps themselves, or hire a vendor that understands all of the requirements and can help identify and appropriately describe exposures, document hedge relationships, perform the required testing and set up the hedge program.

Special hedge accounting advisors can also provide more value than just the setup of a hedge program. They support their clients from the initial forecast to be hedged through disclosures and audit. Vendors also have software that automate designation documentation, accounting and disclosure processes, which allows companies to handle hedge accounting in-house without adding headcount or hiring a niche expert full-time.

Some companies choose to outsource all or part of the hedge accounting process to professional accountants that provide journal entries, disclosures and audit support as needed.

Hedge Trackers helps treasury and accounting teams build and transform corporate Cash Flow hedge programs to effectively mitigate FX risk. Learn more about how we can help you get started.