How to Use Hedge Accounting to Align Derivatives & Currency Gains/Losses
It’s mission-critical for companies to protect their margins, revenues, and expenses from unnecessary volatility. A lot of the time, volatility comes from currency changes — or, foreign exchange risk.
Whether it’s for meeting management targets, street expectations or just for plain planning purposes, most companies want to limit “surprises” and volatility whenever possible. Who wouldn’t?
While it’s easy to just lock in the USD value of future foreign currency transactions, the base case accounting result is undesirable. Accounting rules require derivative gains and losses to be recorded in income as they occur, unless they are subject to special accounting rules. Additionally, without special accounting treatment, the impact is required to be recorded below the operating line in other income.
This poses two distinct problems for hedgers. First, the changes in the derivative will impact earnings over the life of the derivative and not cumulatively when revenue (or another hedged transaction) is recognized. Second, the impact of the derivative is not allowed to be recorded to the revenue line with the forecasted transaction, causing an undesirable mismatch.
Aligning the Derivative & Hedge Item
When a derivative is entered into, it immediately begins to change in value.
For example, a forward foreign exchange contract locks in a price today to exchange currencies in the future. Since the price is fixed today, the value of the contract will increase or decrease based on how the currency pair changes. If the forward contract sold euro at $1.25 per euro, as the euro rate goes above $1.25 the contract becomes a liability and when the rate falls below $1.25 it gains in value and becomes an asset. At the same time, the forecasted revenue in this example has not been recorded and will not be recorded until a future date.
To be able to report the forecasted revenue at the hedge rate, we need to do one of two things. Either accelerate the revenue recognition into the financials to match the derivative or delay the impact of the hedge. Since revenue is “anticipated,” it is not possible to record it early, but we can delay the impact of the hedge. We also need to apply a geography shift to the derivative, otherwise, the hedge won’t accomplish its goal. A cash flow hedge designation under ASC 815 accomplishes both of these goals. It allows the company to store changes in the value of the derivative on the balance sheet and permits the hedge to impact revenue when the hedged item is recorded.
Basic Requirements for Special Hedge Accounting
While it has gotten easier to apply special hedge accounting, the job can still be daunting for those new to it. At its core, there are a few items that are absolutely required:
- A probable forecast of a qualifying hedged item
- Contemporaneous designation documentation
- A completed and passed effectiveness assessment
Fast Tracking a Solution
Sometimes companies hire and maintain special hedge accounting experts strictly for this purpose, but that’s not always easy to do.
If special hedge accounting is required quickly, Hedge Trackers offers to assist companies in implementing and accounting for special hedge accounting without in-house expertise. Consultants are available to set-up hedge programs compliant with ASC 815, outsourcing services can account for and disclose derivative activity and, today, even SaaS applications can turn the team into derivative accountants.
The overall message is that a company can apply hedge accounting quickly (a matter of days if needed) and remain completely compliant and at little risk of misapplication of the guidance with the right support. Even those new to special hedge accounting can get started right away without having to absorb the over one thousand pages of guidance, interpretations, and application methods of ASC 815.
To get started taking special hedge accounting, give us a call.