Hedge Specificity Memo: EURO Exposure Risk

Is the hedge designation language specific enough for a third party to know if a specific invoice is a hedged invoice when it’s recognized in the financial statements?

The purpose of the specification is two-fold: 1) to be able to clearly identify which, if any, derivative is hedging the transaction when it is incurred/recorded, and 2) to clearly understand in an overhedge situation which derivative or portion of which derivative is ineffective.

Our Recommendation:

We recommend to our clients who designate hedges of a basket of “like” revenue or expenses (multiple entities hedging the same currency) originating from different entities use the following wording or something similar thereto (the first sentence is standard for our clients, the second a recommended change) Note: This memo uses revenue in all examples. The same principles apply to expenses:

“The first 0 to 1,000,000 EUR denominated revenue on or after September 1, 2015 until September 30, 2015. The Company earns revenues on any particular day in different entities at different times of the day. In the absence of time stamps on revenue recognized across the organization we will assume that revenue is earned/recorded at all entities simultaneously during a single day. For the purposes of layering, revenue will be applied on a daily basis to Germany, followed by France and then Austria.

Background:

Many designation strategies use a single derivative to hedge foreign currency denominated revenue for a given month or quarter. The revenue is often generated in several different countries. In order to meet the specificity requirements above, documentation often will specify the order that entity revenues will be applied to the derivative. For example, a typical designation says “The first 0 to 1,000,000 EUR denominated revenue on or after September 1, 2015 through September 30, 2015. For the purposes of layering, the derivative will be applied to revenue in the following order: Germany followed by France and then Austria.” If there is more than one derivative hedging revenue, the next derivative designation says “The next 1,000,000 to 2,000,000 EUR denominated revenue on or after September 1, 2015 through September 30, 2015. For the purposes of layering, the derivative will be applied to revenue on a daily basis in the following order: Germany followed by France and then Austria.”

Recent discussions with one of the big four audit firms raised a concern that this designation by itself may not be specific enough because it doesn’t address the time of day that the revenue is recorded. It is well understood that if you don’t specify that you are applying the derivative to revenue on a daily basis, you don’t meet the specificity requirements because when you record revenue in France in the middle of the month, you don’t know if it’s hedged until you get to the end of the month and determine how much revenue Germany recorded. The auditor suggested the same issue could be applied to activity within a single day in that if you record revenue in France at 10:00 in the morning, you don’t know if it’s hedged or not until you get to the end of the day and determine how much revenue Germany recorded.

Analysis:

Transactions occurring during a single day are typically recorded by batch in no specific order rather than on a first in first recorded basis. Most Companies don’t keep track of the time of day that revenue is earned and instead record a batch of invoices at a time. In addition, systems use a single rate for the entire day, so there is no difference in the USD value of the foreign-denominated revenue if it’s recorded at 10:00 a.m. GMT as opposed to 3:00 p.m. GMT. When revenue is recorded it is recognized in income at the income statement rate. Since revenue is recorded systematically as described above, as a practical expedient, it’s reasonable to assume that all revenue at all entities is earned or incurred simultaneously (within a given day) and that there is no timing difference between incurring or recording revenue in one country versus another.

The hedge designation language recommended clearly delineates the order that the hedged revenue is applied to the derivatives. There is no room for interpretation. The application is performed based on daily revenue activity. Following the documented hedge designation language it is clear on any given day which revenue from which country is hedged (even when recorded simultaneously) and equally clear if there were an overhedge situation, which derivative or portion thereof is ineffective. 

Conclusion:

We recommend that users add language addressing the time of day concern raised; highlighting the lack of time stamps and the application of a standard process to avoid manipulation of the results. This will address audit concerns that time of day has been contemplated and that it’s clear to any third party when revenue is recorded whether it’s hedged or not. This change may be addressed either in trade level or higher level documentation guidance (accounting guideline documents).

Please contact your consultant with any questions about this recommendation.