Delay in FX hedging, accounting treatment
The accounting treatment of currency hedging (timing) mismatches remains a major problem that has become more acute in the wake of the health crisis. Many companies have suffered from the effects of the crisis and the drop in their sales, or sometimes they have simply experienced delays in delivery from their suppliers or payment from their customers. When payments were in foreign currencies, this may have affected their results because of currency hedging. The extremely high market volatility during the health crisis, one of the economic consequences of COVID, also forced many companies to review their hedging strategy. We have seen that harbors were blocked, goods could not be delivered, and even commodities or finished products became unavailable (e.g., semiconductors for the automotive industry or for white goods).
This exceptional (but not historic) situation generated significant delivery delays, or even cancellations of purchases or sales denominated in foreign currencies, initially covered by financial derivatives. The idea was to protect against any adverse impact of the exchange rate on the income statement. Many companies use these hedging instruments (derivatives) to protect themselves against a change in the value of the currency against the company's functional currency. But when the underlying currency disappears, the hedge becomes speculative and a real risk.
"Cash-Flow Hedge (CFH) Method applied
Many companies hedge on a budgetary basis and qualify hedges of future cash flows by applying the so-called "cash-flow hedge" method under IFRS 9 (ex-IAS 39). Thus, when circumstances required it, companies had to shift the timing of transactions initially planned for a specific date. They have used currency swaps or "roll-overs" of forward exchange contracts (an extension consisting of a spot purchase of the currency sold, for example, and a forward resale of the same currency to match to the new expected payment date). These roll-overs obviously have an immediate impact on the income statement, at the time of the extension, and modify the new future rate (even if the new rate reflects the exchange rate at the time of the extension - i.e., a more favorable rate implies a less favorable forward rate and conversely a less favorable spot rate at the time of the extension implies a lower future / forward rate).
It appears that an extension of a hedging contract has a "spot" impact that will eventually be neutralized forward (except for the new swap points, due to the extension in time). If the initially hedged transaction has not taken place and is no longer expected to take place, e.g., the cancellation of a hedged order, the extended hedging instrument can no longer be allocated to the cash flow that was initially hedged. In this case, the hedging relationship should be discontinued at the date of disappearance of the hedged underlying and the effects of the hedge initially accumulated in recyclable equity item (i.e., in OCI - "Other Comprehensive Income" or EHR - "Equity Hedging Reserve") should be immediately recycled / released to the income statement (P&L).
Accounting consequences of hedging adjustments
It is possible, at that date (extension date), to qualify the extended hedging instrument in a new hedging relationship. If the initially hedged transaction did not occur on the date initially planned, but is expected to occur later, the occurrence of the related cash flow may remain probable or even "highly probable" (according to IFRS terminology), e.g., a three-month delay in the acquisition of machine tools or in the delivery of electronic components, and consequently in the associated cash flow (underlying flows). The hedging instrument then continues to cover a clearly identified future flow, precisely traced in the information systems (e.g., TMS), and shifted in time. In this case, the time lag does not systematically call into question the accounting hedging relationship. If the expected transaction remains "highly probable" (according to the IAS 39 definition – circa 90% of occurrence), then the hedging relationship can often be maintained.
However, the effect of the timing difference on the effectiveness of the hedge must be assessed and the ineffectiveness (if any) recognized accordingly (into P&L). There is always the question of the acceptable duration of the extension. If the extension is too long, it may have an impact on the assessment of the "highly probable" nature of the cash flow. If the flow is no longer highly probable, but is still expected, the hedging relationship should be discontinued (the derivative no longer qualifies as a hedging instrument, unless it is redesignated in another hedging relationship). But the amount initially accumulated in OCI/EHR (i.e., frozen into equity item) must remain in equity until such time as this cash flow occurs / materializes and affects profit or loss. Therefore, the operational implementation of such strategies must be accompanied by specific internal accounting analyses, about the hedging documentation previously established, with the aim of anticipating their effects on the income statement.
Dynamic hedging of exposures
In such a troubled context, managing dynamically its FX exposures becomes even more essential and requires ad hoc IT solutions on top of the TMS to fully cover the processes and automate them further. One of the problems with FX management is also the lack of adapted IT tools (even TMS’s). These tools are certainly efficient but often cannot produce appropriate reports to manage required adjustments or dynamic portfolio management by linking it to the underlying portfolios (i.e., direct automate link between underlying exposures and designated hedging instruments). The underlying exposures and operational risks to be hedged, are managed elsewhere, in another tool(s) (when this tool exists and when it is not in a simple and unrobust spreadsheet).
Fortunately, there are solutions that allow for a more dynamic and efficient management of foreign exchange risks and their hedging, in a world of economic upheaval that can pose problems of timing and therefore hedging efficiency. For example, KANTOX proposes solutions to fully automate and track hedge relationships to ensure at any moment in time qualification under CFH or at least to assess accounting impacts (if any). The objective is to fill in the gaps left by existing systems or spread sheets.
De-designation and re-designation
Reallocating/re-designating hedges by de-designating and re-designating is possible, although not always perfect. Canceling hedges requires immediate consideration of the results of the accounting impacts in P&L (and/or on balance-sheet). Not covering FX risks may appear as financially dangerous. But hedging is effective if the underlying assets materialize in a timely manner. Any hiccup may require readjustment of the accounting of the transactions, as required by IFRS 9. The management of financial instruments can only be done if it is coordinated with the management of the underlying exposures. Managing one without the other would be risky and inefficient. The art is to be perfectly equipped with a TMS and a dynamic hedge management tool to align everything and to perfectly account for all transactions. When the company manages a lot of hedges at the same time, because it has a lot of underlying’s, coordination becomes potentially problematic and complicated. So, we always advise to be well equipped in solutions to be able to qualify your foreign exchange operations properly and maintain benefits of the hedge accounting treatment during the whole life of all underlying exposures. It is an art, and it requires to be well organized to avoid any problem and impact the results. Implementing state-of-the art solutions helps treasurers to prevent problems at roll-over time and to always keep track records of any operations in a fully automated mode. We may look like pushing at open doors here. However, automation is the best response found (so far) to the crisis to become more resilient and be able to effectively manage these kinds of inevitable delays and adjustments of business operations.
François Masquelier, Chairman of ATEL