Many companies’ FX risk management practices or policies

focus on exposures from account receivables and payables.

These companies manage the FX exposure primarily from an

accounting perspective with the aim of achieving a zero FX

result in the profi t and loss statement (P&L). We argue that,

from an economic perspective, this approach only protects the

company against adverse FX movements in the short-term and

disregards longer-term FX risk from highly probable future

transactions which are not yet recognized in the balance sheet.

In our defi nition, transaction risk is not limited to balance sheet

items but includes any future payment or receipt, committed or

uncommitted, denominated in a foreign currency. The manage-

ment of these exposures is becoming more and more important.

However due to the diffi culties in quantifying and effectively

hedging these exposures, most companies (or treasurers) do

not have a well established approach.

On the other hand, for companies that do hedge forecasted

transactions, understanding IAS 39 hedge accounting is a

critical requirement in order to limit P&L volatility. Although IAS

39 has been in place for more than four years, there is evidence

that some companies decide not to hedge their FX exposures

because they are uncertain of how the resulting hedged

positions will impact their P&L.

The need for hedge accounting When companies hedge FX risk they often use derivatives, such

as FX forwards or FX options. Under IFRS, derivatives are

recorded in the balance sheet (B/S) at fair value and the change

in fair value is recorded in the P&L. The hedged assets or

liabilities are usually measured at (amortized) cost or are

forecasted items which are not recognized in the B/S. This

results in a mismatch in the timing of the gain and loss

recognition, creating possible P&L volatility. Hedge accounting

modifi es the normal accounting treatment of a hedging

instrument and/or a hedged item, in order to recognize their

offsetting changes in fair value or cash fl ows in profi t or loss at

the same time.

Let us fi rst defi ne forecasted transactions and fi rm commit-

ments as potential hedged items. A forecasted transaction is an

uncommitted but highly probable future transaction. A fi rm

commitment is a binding agreement for the exchange of a

specifi ed quantity of resources at a specifi ed price on a

specifi ed future date (or dates). FX hedges of forecasted

transactions are designed as cash fl ow hedges. The cash fl ow

hedge model defers the recognition of gain or loss on the

derivative in equity – or other comprehensive income - until the

forecasted transaction occurs.

The following cases illustrate hedge accounting treatment in

common situations for companies operating in international

markets. The objective of presenting these cases is to show how

companies can achieve hedge accounting for their FX risk

management strategy for forecasted transactions or fi rm

commitments, with a number of helpful hints.

Case 1. Hedging a net positionEUR Company X, has a global treasury center responsible for

managing the group’s FX risks and offsetting the net position

using derivatives with external parties. It forecasts sales of

USD3.5 million and purchases of USD2 million in September

and entered into a forward contract to sell USD1.5 million in the

same month. Can the company apply hedge accounting for this

contract?

Solution: Yes, but IAS prohibits the designation of a net position

Throughout 2009, volatility in the foreign exchange markets was a key theme. Although the fi nancial markets calmed a little, corporate treasurers still face an environment in which their risk management policies are tested. For the multinational company, FX risk management is one of the main activities to protect profi tability.

Achieving hedge accounting for foreign exchange risk management

Don’t hide behind IAS 39

“FX risk management is one of the main

activities to protect profi tability.”

as a hedged item. Therefore, Company X must designate the

hedge instrument to a part of the gross positions, in this case

the USD1.5 million of highly probable sales in September.

Case 2. Macro hedgingEUR Company Y forecasts a large number of similar GBP

receivables and wants to hedge these receivables with a single

hedge instrument. Can the company apply hedge accounting in

this case?

Solution: Yes, a group of similar items in the same category can

be designated as a hedged item, given that this group of similar

items has the same underlying risk profi le. The hedge effective-

ness is tested on a group basis. The fair value movement of the

individual items should be proportional to the fair value

movement of the portfolio of items.

Forecast sales can be designated as a hedged item even when

management is unable to link the future cash fl ows to specifi c

individual sales transactions. Designate the hedged item as the

fi rst X million of highly probable sales in a specifi c time bucket.

Case 3. Intra-group salesSubsidiary A and B belong to EUR parent Z. Subsidiary A is

based in Switzerland and has highly probable USD sales of

inventory to a US located subsidiary B, which sells the products

to external customers in the US. Subsidiary A intends to hedge

the highly probable intra-group sales with a USD/CHF forward.

Can this be accounted for as a cash fl ow hedge in the consoli-

dated statements?

Solution: Yes, because the external sales result in FX risk

affecting the P&L. The gain and loss on the derivative is reclassi-

fi ed to the consolidated income statement as soon as the

external sale is recognized.

Case 4. Translation exposureAssume that in the above case, the parent company decides to

hedge CHF subsidiary A’s USD sales with a USD/EUR contract to

hedge the exposure back to the parent’s functional currency.

Can the company apply hedge accounting to this forward

contract and the subsidiaries USD sales?

Solution: No, because the consolidated P&L is not exposed to

USD/EUR movements. The income statement is exposed to

USD/CHF movements because of the FX result on the sales of

subsidiary A. The exposure to EUR/CHF is a translation risk

instead of a cash fl ow exposure. Similarly, inter-company

dividend payments do not qualify as hedged items because

they don’t affect reported net profi t or loss.

Case 5. Net investment hedgeParent Z intends to hedge the translation FX risk from subsidiary

A under a net investment hedge. What amount should the

parent include under a net investment hedge?

Solution: Parent Z can include under the net investment: (i) the

equity investment in subsidiary A, and (ii) inter-company loans

of a permanent nature. Forecasted profi ts cannot be included in

the hedged item because they do not form part of the existing

net investment at the time of hedge inception.

Identifi cation and measurementIn order to satisfy IAS 39 requirements companies need to

assess the probability of forecasted transactions with objective

information. The measurement of transaction and economic

exposure is done by combining internal sources (sales

forecasts, purchase records, order books) and external sources

of information (such as economic data) and applying a number

of measurement techniques (e.g. sensitivity analysis, market

scenario analysis, simulation analysis). A sales budget on its

own is generally not persuasive evidence for a forecast

transaction being highly probable unless there is additional

supporting evidence.

In a more strategic approach, Zanders advises, depending on

the industry, to identify, measure and manage transaction and

economic risks up to a time horizon of two years or even

beyond. Zanders has extensive experience on applying the

mechanics of IAS 39 to corporate risk management, starting

with risk identifi cation and applying best market practice risk

measurement techniques. In addition, Zanders assists

companies during the defi nition and execution of the hedging

strategy, supporting the setting up of hedge documentation,

execution of trades, periodic effectiveness testing and

accounting. <

IF YOU WISH TO KNOW MORE ABOUT

ZANDERS’ SERVICES RELATED TO HEDGE

ACCOUNTING, PLEASE CONTACT JOB WOLTERS

ON +31 (0)35 692 89 89 OR

J.WOLTERS@ZANDERS.EU.

“Under IFRS, derivatives are recorded in

the balance sheet at fair value.”