Restoring Economic Integrity When Hedging Non-Economic Accounting Risk

Motivational speaker Brian Tracy said: “Incorrect assumptions lie at the root of every failure. Have the courage to test your assumption”.

Testing your assumptions is exactly what we plan to do.

All too often, balance sheet hedge strategies are implemented and then forgotten. They run on autopilot without reflecting on the true objectives.

You may say to yourself: “Of course we know the objective of the balance sheet hedge program. Mitigate foreign currency gains and losses.”

But what if that was only half the answer? Could it be possible to have missed a critical element in your program?

While mitigating foreign currency gains and losses is certainly the obvious objective of a balance sheet hedge program, one must be mindful of a deeper goal. Most corporations want to protect USD cash flows too. An interesting thing happens when you hedge un-economic risk. While objective 1a (mitigate FX) is achieved, objective 1b (protect cash flow) may not.

Economic vs. Accounting Risk

For this discussion, an economic risk is defined by transactions that result in generating non-dollar denominated assets and liabilities. The value of all assets and liabilities held in a currency other than USD are at risk of decreasing (assets) or increasing (liabilities) in USD terms, which results in increased risk to overall enterprise value.

Accounting risk differs from economic risk. Accounting risk is created solely by applying accounting concepts to financial statements rather than true risk to USD cash flows. For example, if a U.S. company holds dollars in France and its French subsidiary is euro functional, then an accounting risk exists, but an economic risk does not.

The accounting risk is created by re-measuring the USD cash balance to the month end euro accounting rate in France. The change in rate appears on the income statement as a currency gain/loss (EPS impact). When the French sub’s books are translated to USD, the euro cash amount calculated is converted back to USD in consolidation and a gain/loss equal to and offsetting the P&L impact is recorded in equity as a translation gain/loss (no EPS impact).

So, $100 is converted to euro, re-measured and then translated back to $100 in consolidation, but the gain/loss recorded in France is not zeroed out in consolidation on the income statement. The result is an income statement impact for simply holding dollars even though the company holds exactly $100 the entire time.

Uneconomic Currency Hedges

Treasurers are responsible for mitigating the foreign currency gain/loss line. “No surprises” is a common mantra from senior management regarding currency gains and losses. Given the focus on this line item, treasurers typically hedge away theses gain and losses with a balance sheet hedge strategy.

A balance sheet hedge also impacts the currency gain/loss line, but in the opposite direction of the asset or liability, to provide necessary mitigation of the currency risk. When hedges are applied to foreign USD holdings (or liabilities in foreign currency that may never be paid out), the gain/loss on the hedge will settle with the bank in cash. The gain/loss on the hedge is equal to an amount paid to or received by the company.

Meanwhile, in our USD example, the $100 didn’t result in more or less USD. Essentially, the company is paying out cash to offset the income statement impact of a non-changing USD amount (synthetically converting these USD holdings into EUR). The size of these uneconomic hedges can generate significant cash outflows to protect the gain/loss line.

An uneconomic hedge strategy favors optics over economics. If your organization records any of the following transaction types you may be hedging non-economic risks:

• USD functional treasury center that sweeps foreign cash from subs and converts to USD to pay down debt or invest.
• USD cash held in local currency functional foreign subsidiaries
• FIN 48 tax liabilities denominated in foreign currency
• Inter-company balances that are eliminated in consolidation but never paid off in spite of tax assertions
• Contingent liabilities denominated in a foreign currency on the US books
• Cost plus balances in excess of next month’s cash needs

Restoring Economic Integrity 

Whether hedging USD cash held in a foreign subsidiary or hedging a cost plus liability to mitigate gains and losses in the income statement, each circumstance utilizes real cash flows to offset changes in value that is likely not an economic risk to the organization. For American companies, USD cash and profits repatriated early through inter-company arrangements provide no economic risk to the organization but can generate unwanted income statement impacts as a result of applying U.S. GAAP.

Hedge Trackers, LLC recommends restoring the economic integrity of the balance sheet hedge by utilizing hedge accounting techniques to unwind uneconomic hedges without compromising the balance sheet hedge’s desired result (mitigation of P&L impacts).

When subsidiaries hold net positive equity positions (assets>liabilities), there is an ability to hedge that position. The hedge of a positive net investment goes in the opposite direction of an uneconomic balance sheet hedge, but with one difference. The net investment hedge impacts equity and not the income statement.

By combining both a net investment and balance sheet hedge strategy, a company may be able to restore the economics of its uneconomic hedge position. A “Restoration Swap©” can achieve the desired result by hedging away income statement impacts AND preserving USD cash flows as well.

Here’s how the restoration swap works. The standard sell USD buy euro balance sheet hedge impacts cash and the income statement. The accounting risk is mitigated, but an economic risk is created by the hedge itself (the cash).

What the company wants to do is economically nothing. By nothing, we mean to achieve zero (or close to zero) impact on cash and also have the currency risk go away. By having two hedges go in the opposite direction of each other, they achieve this goal of doing “nothing”. The accounting treatment of the hedges is the key for the strategy to work.

Here’s an example: If a similar but opposite hedge is entered simultaneously, the cash risk is mitigated because hedge #1’s cash losses would be offset by hedge #2’s cash gains and vice versa. The second hedge can be designated under ASC 815 as a Net Investment hedge, which moves the gain/loss from hedge #2 to the equity section of the balance sheet (special accounting exception). The final result is that cash flows from both hedges net to near zero (nearness reflects banking relationships with your firm) and the income statement is offset as desired. The Company has “done nothing” (buying and selling the same position), but, like the exposure it is protecting, it impacts the P&L on one side and CTA (in equity) on the other side.

Summary

Certain foreign currency transactions result in an accounting risk that impacts earnings but do not impact cash flows. These types of currency risks are considered “uneconomic” and, were it not for quarterly reporting of earnings, they would be ignored entirely.

Treasurers protect the foreign currency gain/loss line (and impact cash) by entering into forward currency hedges to offset changes in value of these foreign currency transactions. When balance sheet hedges are used to offset uneconomic transactions, the hedges themselves create “risk” for the company. If the organization decides to hedge away these paper FX gains and losses, they can restore the economic integrity of the hedge by entering into a restoration swap. The restoration swap eliminates the cash flow changes from the forward contracts while continuing to provide income protection.

For this strategy, like any hedge strategy, it is critical to understand both the economics and the accounting treatment of the currency exposure as well as the derivative.