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A user's guide to currency hedging.

Stop losing sleep over your foreign-currency transactions. Once you know how to qualify them for hedge accounting, you can cut the risk of losses substantially.

Have you been taking care of your hedges lately? If not, now's a good time to shape up your risk-management and accounting strategies. The Financial Accounting Standards Board, as part of a project to develop consistent rules on hedge accounting, has issued an exposure draft requiring more complete disclosure on derivatives activities (see Financial Executive, July/August 1993, p. 42). And the highly publicized losses several companies incurred from their foreign-currency and fixed-income derivatives instruments have thrown more fuel on the fire. Add in continuing market volatility, and it's easy to see that change is undeniably on the way, even if it isn't around the comer yet.

Given the stepped-up regulatory, public and media scrutiny, it's crucial for you to evaluate which risks your company hedges and how you account for your hedging activities. As a financial risk manager, you need to know which techniques you can use to hedge your difficult existing or anticipated foreign-currency exposures and qualify for hedge accounting under current generally accepted accounting principles.

The accounting principles for foreign-currency transactions are defined in Statement of Financial Accounting Standards No. 52, "Foreign-Currency Translation," in addition to several Emerging Issues Task Force papers, including EITF 90-17, "Hedging Foreign-Currency Risks with Purchased Options"; EITF 91-1, "Hedging Intercompany Foreign-Currency Risks"; and EITF 91-4, "Hedging Foreign-Currency Risks with Complex Options and Similar Transactions." Keep in mind that economically prudent hedging transactions don't always qualify for the hedge accounting prescribed in SFAS 52. SFAS 52 allows for hedge accounting when the hedged item exposes the company to risk, the hedging transaction reduces the exposure to risk and the company designates the hedging transaction as a hedge.

Plus, hedge accounting generally recognizes gains and losses from the hedge position in the same accounting period as gains or losses on the hedged item, thus eliminating a source of reported-earnings volatility. While certain hedging strategies and the mathematical analyses supporting them can quickly become exceedingly complex, the exposures that create accounting difficulties and the strategies you can use to correct them fall into only a few broad, recognizable categories.

Existing assets and liabilities -- Accounting for hedges of existing foreign-currency denominated assets and liabilities is usually straightforward. Market-value changes caused by exchange-rate fluctuations should be included in your determination of current-period income and should offset the economic effects of changes in the exchange rates on the hedged asset or liability. Companies use virtually all types of foreign-currency hedging instruments to hedge existing assets or liabilities, including forwards, swaps and other similar contracts. They also use options, although not as frequently because of their up-front cost.

Foreign-currency commitments -- When you're dealing with strategies for hedging firmly committed foreign-currency transactions, such as purchase or sale commitments, it's usually simple to qualify them for hedge accounting, and the entire range of hedging instruments is available. A firm commitment is defined in SFAS 80, "Accounting for Futures Contracts," as "an agreement, usually legally enforceable, under which performance is probable because of sufficiently large disincentives for non-performance." In addition, a company doesn't have to consider whether the exposure created by the firm commitment is offset by other company exposures in the same currency because the SFAS 52 risk test looks only at exposures created by a specific transaction. However, some financial executives believe this test doesn't reflect sound risk-management principles, because it doesn't take into account all the company's exposures to each currency.

Anticipatory or forecasted transactions -- The hedge-accounting difficulties arise when your future transaction is an anticipatory or "forecasted" strategy, because SFAS 52 prohibits hedge accounting for any hedge of a future transaction that isn't "firm." Under SFAS 80, an anticipated transaction has established terms that are considered likely to occur (including timing and amount), a much less strenuous threshold than the rule's firm-commitment test.

CLOSE, BUT NO CIGAR

Therefore, economic hedges of anticipatory transactions involving forward, future, currency-swap and combination-option transactions, including range forwards and participating forwards, won't qualify for hedge accounting, pursuant to SFAS 52 and EITF 91-4. About the only strategy you can use other than a natural hedge is a simple purchased option, provided the future transaction qualifies as anticipatory and your company meets the other SFAS 80 hedge-accounting criteria, according to EITF 90-17.

But even if you opt for a simple purchased-option strategy, your company then faces the more onerous enterprise-risk test prescribed in SFAS 80, rather than the simplified SFAS 52 transaction-risk test. Under the enterprise-risk test, you must prove the anticipated transaction creates a risk that isn't offset by another economic position in the same currency. (The SFAS 52 risk test evaluates risk created by the hedged transaction only.) For instance, your company may buy a sterling put option to hedge an anticipated future stream of sterling revenues regardless of an existing sterling purchase commitment -- the effective "natural" hedge. In that case, you'd have to record market-value adjustments on the put option in the income statement.

Because being classified as firm has such important accounting consequences, any comprehensive hedging strategy you develop should carefully analyze all future transactions and their classification. To maximize the number of instruments qualifying for hedge accounting, investigate the possibility of restructuring your future transactions to qualify as firm commitments.

Net investments in foreign subsidiaries -- Foreign-currency transactions used to hedge a parent's investment in its foreign subsidiaries, or equity hedges, include virtually all types of foreign-currency transactions, ranging from existing-parent foreign-exchange liabilities to sophisticated derivatives transactions. Provided the hedge qualifies for hedge accounting under SFAS 52, the parent should record the hedge's marked-to-market adjustments directly to stockholders' equity (that is, the current translation account).

If the parent hedges only a portion of its net investment in a subsidiary, it may be able to structure hedges of other same-currency exposures while accounting for that portion as an equity hedge. For example, a company with a subsidiary in Japan, with a net investment balance of $100 million and yen as the functional currency, may also expect yen-denominated export sales unrelated to the subsidiary -- sales that don't qualify as a firm commitment or as an anticipated transaction. To fix the dollar amount of those export sales, the company enters into a series of forward contracts to sell yen for an aggregate $10 million. If the company had no existing equity hedges, it could designate the forwards as an equity hedge, which avoids volatile and adverse charges in the income statement. Companies anticipating the receipt of dividends from a foreign subsidiary may follow a similar strategy -- see the case of Multico below. (Also see the comments in "Net income of foreign subsidiaries.")

Intercompany hedges -- You may be inclined to execute intercompany hedges because the "functional currency" concept underlying SFAS 52 requires that intercompany transactions be marked to market if denominated in a currency other than the reporting currency. For example, if a parent sells products denominated in dollars to its Japanese subsidiary, that subsidiary has an anticipated foreign-currency exposure, which will become an intercompany foreign-exchange payable when the transaction occurs. The subsidiary's management may choose to hedge the anticipated foreign-exchange exposure. EITF 91-1 allows companies to use hedge accounting, as long as the subsidiary can conclude the intercompany commitment is firm.

Companies can demonstrate this via a firm commitment with a third party outside the consolidated group. Suppose the subsidiary has a sales contract with a customer, and in order for it to satisfy the contract, the parent must supply the goods. Without the third-party commitment, a company must assess whether the intercompany commitment qualifies as firm.

Net income of foreign subsidiaries -- Companies often wish to fix the exchange rate on the budgeted future earnings of their foreign operating subsidiaries so they can lock in the dollar amount. This is a vexing problem, because companies may be able to create economically effective hedges using forwards, swaps, options or other similar contracts, but GAAP prohibits hedge accounting in this circumstance. Again, a company may be able to designate an economic hedge of future net income as a hedge of its net investment in that subsidiary. If you run into this problem, try to analyze whether designating an economic hedge of an unintentional but qualifying exposure reflects the action your company undertook and whether the hedge faithfully portrays its financial statements.

Strategic or competitive hedges -- Sometimes companies hedge what they believe is an aggregate business risk. For example, a company that sells consumer electronics might view its principal competition as Japanese, so it would be competitively disadvantaged when the yen value decreases. Therefore, it devises strategies to reduce the impact of this exposure by purchasing yen put options. These hedges wouldn't qualify for hedge accounting because they aren't linked to a specific transaction.

THE CASE OF MULTICO

To illustrate some of these accounting concepts, look at this hypothetical scenario. Joe Smith is the CFO of Multinational Co. (Multico). Multi-co manufactures consumer food products in the United States and has just acquired a German company. Most of its consolidated sales are from the United States, but Multico also generates significant revenues from recently developed export sales and expects its German subsidiary to be profitable. Also, Multico has just signed a letter of intent to acquire a French company.

Mr. Smith is in the process of developing Multico's annual budget, and because of the new acquisition, he wants to minimize the effects of Multico's foreign-currency exposures for next year. He also plans to have the German subsidiary pay a dividend within the next year to supplement Multico's cash needs, but he'd like to hedge the amount, based on prevailing exchange rates. Mr. Smith asks his treasurer and controller to develop economic hedging strategies for this exposure, while minimizing the impacts on reported earnings that speculative accounting methods would create.

The treasurer suggests entering into a forward sale of deutsche marks based on the planned amount of the dividend. The controller tells him that SFAS 52 would require marked-to-market adjustments in the income statement, unless they designate the contract as a hedge of the German net investment. And, when the dividend is declared, Multico would record a dividend receivable from the German subsidiary (denominated in deutsche marks), resulting in marked-to-market adjustments when the deutsche-mark exchange rate changes. Then, the controller surmises, Multico could redesignate the forward sale contract as a hedge of the dividend receivable. He's already discussed his plan with his outside auditors, who say his strategy doesn't violate SFAS 52.

The treasurer considers executing a forward-contract strategy to hedge the sterling export sales for the next year. After discussing this idea with the controller, the treasurer learns sterling export sales aren't eligible for hedge accounting because they're not firmly committed transactions. However, Multico's outside auditors advise that if the export sales were at least probable to occur, they could achieve an accounting hedge by employing a simple purchased-option strategy.

But because it's expensive to execute the required option trades, the treasurer asks his banker for other ways of reducing this foreign-exchange exposure. The banker comes back with an option strategy that offers a significantly reduced option premium up-front, because it combines a written call option with a purchased put option. The treasurer likes the idea until the controller warns that under EITF 91-4, Securities and Exchange Commission registrants must classify these "complex option" transactions as accounting hedges only when they're used for firm commitments. While the hedges make economic sense, they both know Mr. Smith won't accept the possible income-statement volatility.

BACK TO THE DRAWING BOARD

The treasurer sends his banker back to the drawing board. A short time later, the banker suggests the company issue a dual-currency bond, in which the principal is payable in dollars but the interest is denominated in sterling. Since the company needs financing and the future sterling interest payments provide at least a partial hedge against the sterling export sales, the treasurer's convinced he's finally solved the hedging problem. But Multico's auditors warn him EITF 93-10 requires the company to treat the future sterling interest payments as a foreign-exchange, forward-currency liability and to mark the payments to market until the bonds mature.

The banker then recommends Multico look for other offsetting currency positions, such as foreign-currency-denominated purchase commitments or foreign-currency-denominated operating lease transactions, and it offers to help the company create these positions. The controller and the treasurer tell the banker to pursue the idea but privately conclude that it's workable only if a real business purpose exists for it. Multico may choose to lease a distribution center in England as part of its overseas sales efforts, and that might fit the bill.

Fortunately, Multico's auditors think the idea won't create any income-statement volatility, because both the purchase commitment and the lease represent foreign-exchange executory contracts that won't be reflected in the financial statement until they occur. But they're also concerned about establishing a legitimate business purpose.

To address their reservations, the controller proposes that Multico's marketing department negotiate with the U.K.-based customers to get them under long-term sales contracts. Some of the sales might then qualify as a firm commitment for accounting purposes, which would allow Multico the use of forward contracts.

Last but not least, the treasurer also wants to fix the dollar cost of the impending French acquisition. The controller says he can defer the gains and losses on a hedge. He knows the anticipated transaction qualifies as firm because the company's signed a purchase contract and the acquisition's well on its way to consummation.

Mr. Smith is pleased with their work and their ability to reduce the company's foreign-exchange exposures, except for the inability to gain hedge accounting for the forecasted sales of the German subsidiary. The controller advises him that SFAS 52 and EITF 90-17 don't consider this exposure hedgeable for accounting purposes. But Mr. Smith decides he might still have the treasurer execute a series of forward sales to fix the dollar amount of income. The controller thinks Multico could qualify for hedge accounting by designating the forwards as a hedge of the net investment in the German subsidiary and plans to discuss this idea with the company's auditors.

In the future, Mr. Smith (and every financial executive) will have to be very careful to keep his hedges in line with current regulatory thinking. While it's impossible to predict how the new rules will work, it's a sure bet that the FASB and the SEC will require much more disclosure about a company's hedging strategies, including the amount of deferred gains and losses and how and when they'll be recognized in the income statement. With that in mind, remember that a good hedging strategy is really an integrated approach to financial risk management that includes identifying risks, controlling the type and amount of hedging strategies and addressing the tax and accounting issues. It's that simple.

Mr. Beier directs Coopers & Lybrand's investment banking advisory practice in New York City. Mr. Herz is Coopers and Lybrand's associate national director of accounting and is a member of the Financial Instruments Task Force of the Financial Accounting Standards Board.
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Title Annotation:Risk Management
Author:Herz, Robert H.
Publication:Financial Executive
Date:Jul 1, 1994
Words:2518
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