Cash Flow Hedging of Future FX Sales: Best Practice Under IAS 39

Congratulations to those listed corporates with 31 December 2005 year-ends that successfully navigated their first full-scope audit under International Financial Reporting Standards (IFRS). For now, the time for protest over how well the standards – especially IAS 39 – have been written, and the delay of EU endorsements for IFRS amendments, is passed. And, for […]

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May 15, 2006 Categories

Congratulations to those listed corporates with 31 December 2005 year-ends that successfully navigated their first full-scope audit under International Financial Reporting Standards (IFRS). For now, the time for protest over how well the standards – especially IAS 39 – have been written, and the delay of EU endorsements for IFRS amendments, is passed. And, for their part, the Big Four accountancy firms can no longer defer firm judgements on the trickier hedge structures.

Success in 2005 was, in many cases, based on a highly circumspect approach to some transactions or financial positions that may lead to ‘accounting volatility’ under IFRS. The challenge now is for corporates to return to full confidence, in hedging especially, and shoot for economic best practice. The new standards must be made to help rather than hinder that goal.

Case Study Scenario

Let’s take a look at a scenario where a sterling company hedges US$1m of sales using vanilla forward foreign exchange contracts (FX forwards). The company, Whizzkid plc, a company reporting in sterling, expects foreign currency revenues in US dollars (US$) which – based on past patterns, market research and internal budget agreements – can be now viewed as ‘highly probable transactions’, therefore qualifying as the underlying item in a cash-flow hedge (CFH) relationship.

Payment is typically received two months after an invoice is raised. Whizzkid hedges its exposure to GBP/US$ when the sale becomes highly probable. It will be assumed, for simplicity, that:

  1. FX forwards are used and these are matched to the expected timing of receipt of the foreign currency; and
  2. this instrument meets the requirements of IAS 39, paragraph 88, and therefore qualifies as a hedging instrument in a CFH relationship (e.g. criteria for documentation requirements and hedge effectiveness testing).

Providing effectiveness can be demonstrated, there are no specific rules in IAS 39 that disqualify vanilla forward contracts as a hedging instrument. And in the absence of basis risk – namely the currency pairs in the hedged item and the forward contract being the same – these instruments are indeed highly effective.

Furthermore, designating the forward rate as the hedged risk rather than the spot rate can reduce income statement volatility. This allows forward points to be taken to the income statement only upon maturity of the contract, rather than reporting that element of fair value movements relating to forward points in the income statement – a potential cause of non-cash volatility if the forward contract straddles a reporting period-end. The hedge relationship should therefore be highly effective providing that:

  1. the expectation of the timing of underlying cash-flows does not change, for instance via a hold-up in the financial supply chain; and
  2. the forward contracts were designated to mature on the date the cash flows are expected or, when the bucket method is used (refer to the section ‘Timing is Everything’), month-end of the relevant month.

In cases where the spot rate is the designated hedged risk, a test of hedge effectiveness can be achieved via a comparison between the timing and amount of underlying cash flows, and the face value of the hedging instrument.

A Timeline For Hedge Accounting

We will now consider hedge designation and journal entries (see figure 5 at end) during the life of the hedging instrument, assuming the spot rate is the designated hedged risk. Assume the following (see also figure 1 below):

Timeline of events

Source: Lloyds TSB Financial Markets
30 November 2005

Whizzkid entered into a forward contract to sell US$ against sterling on 31 July 2006 at 1.75. The initial fair value of the forward contract is zero, as it was dealt at a market rate. Whizzkid designates the forward contract as a cash-flow hedge of the risk that changes in the spot exchange rate will cause variability in the expected US$ cash inflow on 31 July 2006. No accounting entries required.

31 December 2005

At year-end, US$ weakened to 1.82. Interest differentials remained roughly similar, but along with the passage of time forward points are lower (reduced from 500 to 400).

31 May 2006

The transaction occurs and the invoice is raised for US$1m. The US$ weakened further to 1.87. Interest differentials remained roughly similar, but along with the passage of time forward points are lower (reduced from 400 to 200).

From the date on which the sale is invoiced, and the receivable comes onto the balance sheet, the hedge could be accounted for in one of three ways:

  1. As a cash-flow hedge of a future cash receipt (i.e. continue current designation).
  2. As a fair value hedge of the balance sheet receivable.
  3. The hedge designation can be revoked. In this case hedge accounting is ceased prospectively. The accounting entries would be exactly the same as for a fair value hedge of the spot rate. For hedges of the forward rate the difference would be that if the hedge designation is revoked, the income statement is prospectively exposed to volatility due to the forward points.

The three alternatives achieve essentially the same income statement result for hedges of the spot rate. For hedges of the forward rate they achieve essentially the same income statement result subject to the comments in the third point above. However, there are three benefits to the third alternative:

  1. Hedge effectiveness no longer has to be tested and if the actual cash flow is somewhat earlier, or somewhat later than expected, no explanation of this is necessary.
  2. The forward contract can be restructured during this period into an instrument which allows some benefit in US$ appreciation with limited impact on the income statement (due to the offset from retranslating the underlying debtor), as hedge accounting is not essential.
  3. Additionally, if at this point Whizzkid has a very strong view that US$ will appreciate, the forward contract can be closed out without having to explain in any hedge documentation why a perfectly valid hedge is being terminated.
30 June 2006

Half-year reporting requires adjustment to the balance sheet and income statement to reflect the position as at 30 June 2006. It is assumed that alternative three above is applied.

31 July 2006

At this point the forward contract matures and the US$ received from the overseas customer is delivered into the forward contract in exchange for the agreed amount of sterling. The following accounting entries are required:

  1. Jnl 7: To recognise the movement in fair value of the forward contract in the income statement.
  2. Jnl 8: To retranslate the US$ receivable at the 31 July 2006 closing rate (i.e. calc 529,101 – 520,833). This offsets the spot element of the derivative fair value movement in the previous entry.
  3. Jnl 9: To record settlement of the derivative (calc: total cumulative fair value movements).
  4. Jnl 10: To record settlement of the trade receivable.

If the forward rate is the designated hedged risk, the accounting entries above will reflect that fact through deferring fair value movements as a result of forward points in the cash-flow hedging reserve. These are recycled to the income statement when the sale is made. If cash-flow hedge accounting is continued after date of sale, forward points occurring after the date of sale are recycled to the income statement when the receivable is collected in cash.

Other hedging instruments (e.g. those allowing the opportunity to participate in future favourable exchange rate movements) could also qualify for hedge accounting and may give a more suitable economic position (this is explored later in this article).

Timing is Everything

For reporting entities with a high volume of transactions, hedging forecast FX exposures on a one-on-one basis is not practical. However, audit firms have been pragmatic in allowing a type of ‘bucket’ method of forecasting. Essentially an entity may forecast its cash flows for each month in the year (as the defined bucket), irrespective of which day of that month the cash flow is expected to occur, and allocate the hedging instruments to each of those months. In this way, even if a cash flow only occurs in a subsequent month, but other cash flows were moved forward, hedge accounting is not compromised, so long as the entity is never over-hedged.

The Problem of Probability

Many companies are finding it hard to convince their auditors that their forecast cash flows from sales or purchases are sufficiently highly probable to meet the IAS 39 criteria for a hedged item. Example F3.7 in IAS 39 provides helpful guidance in this respect. A robust budgeting process, involving all areas of the business is critical. However, the risk of over-hedging still exists and could cause the entire hedge relationship to fail the effectiveness requirements. In order to get around this problem, a company may define tiered hedge relationships. For example a company may expect to sell US$10m of a product during each month of the following year, and may wish to hedge as indicated in figure 2 below. For all tiers, the entity can demonstrate a high probability of occurrence. However, if for example cash flows fall short by 10 per cent, only tier C of the hedge structure is impacted.

A tiered FX hedge structure (all amounts in US$m)

Source: Lloyds TSB Financial Markets

An entity will have three sets of hedge documentation, which will look almost exactly the same, except for the definition of the underlying hedged item and the hedging instruments (e.g. FX forward contracts) assigned to it.

Hedge Effectiveness Testing

Hedge effectiveness testing under IAS 39 must occur by measurement of changes in the fair values of both the hedged item and the hedging instrument. Compliance with what is known as the 80:125 rule amounts to a hedge where the changes in fair value of the hedging instrument offsets changes in fair value of the hedged item by at least 80 per cent. This is the minimum requirement. Calculation of changes in the fair value of the hedging instrument must encompass all changes in the instrument. However, changes in the fair value of the hedged item must only be calculated in respect of the hedged risk. The hedged risk may well be the entire fair value (or cash-flow variability) of the hedge item, but is very often only the fair value or cash flow variability due to, for example, FX movements.

For cash-flow hedges the underlying hedged item may be calculated from first principles, but a commonly used method is the ‘hypothetical derivative method’. Using this method the hedged item is defined as the derivative that would provide the perfect hedge of the underlying risk factor, usually a forward based instrument. The hypothetical derivative would have the same critical terms as the underlying, including (but not limited to) principal, reference rate (e.g. a currency pair or a LIBOR rate), reset dates and frequencies (in case of an interest rate instrument), settlement dates, and day-count convention.

Forward-based Hedging Instruments

Forward-based hedging instruments tend to achieve a high degree of hedge effectiveness more easily than option based instruments and tend to cause less income statement volatility. The reason for this can be demonstrated with the use of pay-off diagrams. Assume the basic facts from the earlier case study. Figure 3 below is the pay-off profile of the underlying unhedged position (blue line) against the hedging instrument (black line), ignoring forward points and assuming an on-market hedge. The two positions are inversely related and since their critical terms match, their response to market value movements should be roughly equal and opposite. This means that the graph for the combined position should be a flat line (i.e. gradient of zero) and y-axis intercept of zero. It follows logically that if the hedging instrument contains any ineffectiveness (e.g. if a currency pegged to the US$ is hedged using a £/US$ hedging instrument), the combined position would no longer be as described.

Pay-off diagram – hedging with an FX forward

Source: Lloyds TSB Financial Markets

Option based hedging instruments

Figure 4 below is the pay-off diagram of an instrument very similar to a vanilla FX forward. The instrument guarantees a worst-case scenario (the ‘protected rate’), but allows some participation in favourable movements of the exchange rate. However, if a certain rate (called the ‘trigger rate’) is touched (typically during the last month of the contract), the hedger has to deal at the rate originally protected. This product can be described as an FX forward extra (because of the one extra feature above a vanilla FX forward).

Pay-off diagram – hedging with an FX forward extra

Source: Lloyds TSB Financial Markets

Between the trigger rate and the protected rate, movements in the intrinsic value of the hedging instrument do not mirror the fair value movements of the underlying item. In order to achieve hedge accounting for this product, one could designate the hedge relationship in respect of intrinsic value movements (as permitted by IAS 39, paragraph 74(a)) for all movements in the forward rate except between the trigger rate and the protected rate at inception. However, the time value movements of the optionality around these points may cause too much volatility in the income statement.

A different way to approach this type of product is to designate the entire fair value of the hedging instrument in the hedge relationship. Using the dollar offset method (periodic or cumulative) it is unlikely that a sufficiently high degree of effectiveness (80 per cent) can be demonstrated prospectively. The calculation using the cumulative dollar offset method generally indicates a very high degree of effectiveness during the early months of the deal across the spectrum of possible market movements. However, during the later months, ineffectiveness arises if the market forward rate hovers around the protected rate. This is due to the more rapid reduction in time value in the options. This problem generally does not arise when the market forward rate gets close to the trigger rate.

Because of these phenomena, it would be possible to demonstrate hedge effectiveness both prospectively and retrospectively by using simple regression analysis. This is an acceptable method under IAS 39 and is recognised by major accounting firms. In broad terms, regression analysis indicates the statistical relationship between two variables. The key challenge is to measure a sufficient number of data points for the retrospective test in order that meaningful conclusions may be drawn from the statistical variables. (The detail behind such a regression analysis is beyond the scope of this article.)

The trigger rate is active throughout the contract (this can be adjusted according to a client’s requirements). Constant volatilities were used and calculations across a range of forward rates were performed in respect of each month to maturity. In this example (as in many others we have tested) the statistically important variables (e.g. the slope of the regression line, the correlation coefficient and R squared) easily met the minimum acceptable levels. The required journals to account for ineffectiveness were insignificant in relation to the hedged exposures.

Hedging Intra-Group Forecast Transactions

It took the EU more than six months, but in the nick of time – on 21 December 2005 – they managed to endorse an April 2005 amendment to IAS 39. This amendment allows entities to apply hedge accounting to derivatives dealt to hedge intragroup forecast transactions that result in FX exposures upon consolidation. It represents a conversion with US GAAP – in this case a good one! The amendment is mandatory for entities with financial years starting on or after 1 January 2006, but earlier adoption was encouraged (meaning that entities with 31 December 2005 year-ends could cut another piece of unnecessary volatility from their income statement, if they wanted to).

Conclusion

Hedging forecast FX exposures is administratively challenging. However, once the initial process has been defined and information flow from the business areas settles down, much can be done to protect the income statement from volatility and improve the mix of hedging instruments used.

Journal entries and financial statements

Source: Lloyds TSB Financial Markets
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