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When should a business adopt Hedge Accounting?

Published April 17, 2019

 

It depends, hedge accounting allows businesses to keep the fluctuations of their foreign exchange contract values off the income statement until the hedged exposures are realized. Hedge accounting does not change the cash flows or tax implications of contracts. Many businesses who have external stakeholders or covenants based on net income adopt hedge accounting in order to present an income statement that is less susceptible to market

movements.

Businesses who engage in hedging their foreign exchange exposure by purchasing foreign exchange forward or option contracts are presented with two options, adopt hedge accounting or not. If not, businesses will follow the accounting treatment of financial instruments. In my previous article, I address the recognition and accounting treatment of forwards and options contracts for businesses who chose not to adopt hedge accounting. To be clear, the majority of small and medium-sized enterprises (SMEs), will not adopt hedge accounting.

In Canada, the most common financial reporting framework for Small or Medium Enterprises (SMEs) is Accounting Standards for Private Enterprises (ASPE), so we will follow ASPE for this article and the following examples.

Why would a business adopt hedge accounting?

With hedge accounting, ASPE section 3856 provides relief from the market to market measurement of derivatives, such as forward contracts, only if they qualify and are designated as hedging instruments. This means that a company would adopt hedge accounting to account for the forwards off balance sheet with the realized gains and losses recognized in the carrying amount of the hedged exposure.

How does hedge accounting work?

The relationships which hedge accounting can be applied are limited to “Qualifying Hedging Relationships” that meet specific, documented, “Hedging Conditions.”

Qualifying Hedging Relationships

Under ASPE, a business may designate a foreign exchange forward or option contract as a hedge of an anticipated foreign currency cash flow when and only when:

  1. The forward contract is for the purchase or sale of the same amount of the same currency designated as the hedged anticipated cash flow;
  2. The forward contract matures within 30 days of the date of the hedged anticipated cash flow;
  3. It is probable that the anticipated foreign currency cash flow will occur at the time and in the amount expected; and
  4. The fair value of the forward contract at the inception of the hedging relationship is zero

Hedging Conditions

In addition to the relationship requirements, a business requires certain conditions to be met to apply hedge accounting.

Under ASPE, the business must designate that hedge accounting will be used and formally document the relationship by specifying the hedged exposure, and the related forward or option contract. In addition, the business must specify the nature of risked exposure and the intended term of the relationship.

An example of this documentation would be: 

On May 1st, 201X, XYZ Inc. has designated that hedge accounting will be applied to the following hedge relationship:

·Hedged item: $1,000,000 USD Equipment Purchase on July 31, 201X; and

·Hedging item: $1,000,000 USD/CAD Forward Contract, Rate:1.2800, expiring July 31, 201X

The critical terms and conditions of the purchase and forward match.

The hedging relationship was entered into by XYZ Inc. to mitigate the currency risk associated with the purchase of equipment denominated in USD over the 3 month period from when the equipment was ordered to when payment is expected to be issued to the vendor. XYZ Inc’s reporting currency is the Canadian dollar and this hedging relationship will provide certainty as to the Canadian cost of the equipment purchase. 

Disclosure

Under ASPE, the requirement for disclosures is to describe the nature and terms of the hedged items, the nature of terms of the hedging instrument, the fact that hedge accounting applies and the net effect of the hedge relationship.

 

Example 1: Without Hedge Accounting

Consider the following example where hedge accounting is not applied:

Your company enters into a forward contract with EncoreFX on May 1st, 201X, to cover the purchase of a $1,000,000 USD machinery purchase with payment due by July 31, 201X.

Details of the contract are as follows, your company has the right to purchase $1,000,000 USD for $1,280,000 CAD on July 31, 201X.

At May 31, 201X, the position of the forward contract is out of the money, trading at $1,250,000 CAD.

At June 30, 201X, the position of the forward contract is out of the money, trading at $1,240,000 CAD.

Notice that although the contract has not reached expiry, the mark to market position has negatively impacted net income by $40,000 as of June 30, 201X.

Now, let’s assume the equipment purchase occurs a week earlier than expected, on July 24, 201X, it is recognized at the $1,250,000 CAD paid (Assume the prevailing USD/CAD spot rate at July 24, 201X is 1.2500).

The forward contract is not recognized until its maturity on July 31, 201X (Assume the prevailing USD/CAD spot rate at July 31, 201X is 1.2400).

The foreign exchange liability will also be extinguished at the conclusion of the contract:

 

Example 2: With Hedge Accounting

Now, let’s review the treatment with hedge accounting applied:

Your company enters into a forward contract with EncoreFX on May 1st, 201X, to cover the purchase of a $1,000,000 USD machinery purchase with payment due by July 31, 201X. Assume the contract meets the qualification requirements and conditions and is documented so.

Details of the contract are as follows, your company has the right to purchase $1,000,000 USD for $1,280,000 CAD on July 31, 201X.

As the forward contract is in a qualifying hedging relationship and has not reached expiry, there is no mark to market position and it is recorded “off balance sheet.”

Now, let’s assume the equipment purchase occurs a week earlier than expected, on July 24, 201X, it is recognized at the $1,250,000 CAD paid (Assume the prevailing USD/CAD spot rate at July 24, 201X is 1.2500).

The forward contract is not recognized until its maturity on July 31, 201X (Assume the prevailing USD/CAD spot rate at July 31, 201X is 1.2400).

Note: If a forward/options contract matures before the hedged item is recognized, the gain or loss on the forward contract is recognized on the balance sheet as a separate component of shareholder’s equity until the hedged item is recognized. Then when the hedged item is recognized, the gain or loss on the contract is transferred from equity to the carrying amount of the hedged item or into net income and is included in the same category of revenue or expense in the income statement.

Conclusion

While the above is not a comprehensive overview of hedge accounting, we hope it illustrates the fundamentals. By adopting hedge accounting, companies can recognize offsetting gains, losses, revenues and expenses of the hedged item and the hedging instrument in net income in the same period. When considering adopting hedge accounting in relation to foreign exchange contracts, consider the users of the financial statements and what the business is trying to achieve. Often, hedge accounting is not required, if the financial statement users are educated as to the current contracts and their effects on the presented financial statements. If considering adopting hedge accounting, please consult with an accounting professional.