Foreign Currency Hedging for Projects
Global infrastructure spending is expected to top one trillion US dollars in 2010, according to CIBC World Markets. As companies begin to take on capital projects, they will want to be aware of the benefits of project hedge accounting, which allows treasury departments to recognise revenue and hedge relationships with as much fluidity as a project timeline. While purchases of foreign components are often at play in constructing bridges, roads and schools, upgrading power plants or building new facilities, multiple foreign currency exposures can be difficult to track over a project’s lifetime. Financial professionals can use hedge accounting at the project level to achieve a good hedge accounting outcome and minimise forecast errors in situations where payments or receipts are certain, but the timing is not.
Both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) allow project hedge accounting. Although project accounting varies for different industries, it enables for recognition of expenses and revenue that are related to a new project to be accounted for by various methods, e.g at the time incurred, by project milestone, etc. Derivatives entered into to hedge project cash flows are also project costs/income, and so revenue recognition of hedging expenses/revenues may also be accounted for by any of the methods described in this article.
The basic rules for foreign currency hedging of forecast foreign exchange (FX) payables and receivables are very well known:
Less well known are FAS DIG G16 and IAS 11, which clarify the application of cash flow hedging applying to designated risks that occur within a time period and related to one project. This is very common in the construction, oil and gas, and engineering industries where projects are undertaken. Both standards clarify hedge accounting treatment for exposures where the date of payment/receipt is uncertain, although the amount and period of payment/receipt is certain.
To illustrate, consider a company that plans to build a factory and needs foreign-made components to do the job. The factory will take one year to build, and it is estimated that foreign components will be needed prior to a particular project milestone. The cash flow amounts and timing can be estimated, although, as estimates, they may slip. The company can choose to specify the designated risk to be all payments of foreign currency for foreign-sourced components needed to build the factory over the one-year period. It need not worry about slippage of the payments within the life of the project or within a reasonable period after the expected completion date. The key is to document that each exposure will occur during the life of the project and hedge the expected cash flow date of each exposure.
If expected cash flow dates of exposures slip, then no de-designation is needed. The only limitation under FAS 133 is that they not slip past 60 days, or under IAS 39, not past a reasonable time after the forecasted end of the project.
The following table shows the different assessment methods available for project hedge accounting along with the impact of each on earnings and commentary.
Spot undiscounted assessment is the most conservative approach. It is often adopted to cater to slippage of exposures and does not require the automatic rolling or pre-delivery of hedging derivatives to maintain effectiveness. Even though this creates timing mismatches, a spot assessment method will ensure effectiveness and qualification for hedge accounting. Earnings are limited to the time value of derivatives using cumulative dollar offset (CDO).
A forward method can be used, although there is a greater risk of a hedge being ineffective as slippage occurs and timing mismatches create differences in fair values. In this case, regression is the preferred assessment method.
Entities that consider using a forward or discounted method will often do a pre-hedge analysis to gain an understanding of how much time slippage can be tolerated while still maintaining effectiveness.
A project has multiple exposures, derivatives and hedge designations, and during its life, a changing OCI/equity balance, being the sum of the cumulative effective components of all hedges. During the project, derivatives and exposures are maturing and the project progresses toward completion. OCI/equity will be released and revenue recognised.
There are multiple ways to recognise revenue, based on:
Adopting project hedge accounting requires the following information to be kept on each project:
Project name, type and entity.
This at-inception information, along with a hedge designation, is enough to perform assessment and measurement of all hedges associated with the project and enough to manage recognition of revenue over the life of a project. All a hedger needs to do is update the percentage of a project’s completion over the lifetime of the project. A system can then fairly value derivatives, perform hedge assessment and measurement, re-calculate revenue recognition and generate accounting entries.
Project hedge accounting is a very useful means of applying hedge accounting to hedges of multiple exposures related to a common project. It gives users the flexibility to recognise revenue that is suited to the project’s cash flows and minimises the book-keeping and documenting of changing hedge relationships.