Effective Forex Trading and Reporting
Centralized Forex Hedging and Trading–Buy competitively, with lower transaction costs
Companies that centralize their forex hedging enjoy economies of scale, a better segregation of duties, a reduced number of authorized traders, more economical technology solutions, and a better focus and concentration of skills.
Centralization also enables competitive forex hedge purchase strategies where, ideally, the costs from two or more forex hedge providers can be compared to obtain the most competitive rates. Access to online internet forex trading makes it easy to track rates and see bid ask prices in real time. A centralized, online system will improve your competitiveness because, ideally, you will be able to choose the best quote from the best supplier.
At a minimum, ask for a two-way quote for purchasing forex hedges (obtain both the bid and ask price). Be aware that the forex hedge provider will likely track your historical purchases, so if you typically only sell a currency and the provider is aware of this pattern, then asking for a bid/ask price may not work as effectively over time.
Forex Hedge Reporting
Measuring and reporting your forex hedge performance helps manage overall performance and identify any forecast errors or data capture errors. As your Forex Hedge Policy should state up front, hedge performance is not about whether the hedge makes money (if you enforced this performance measure, you would be held accountable for worldwide forex rate movements). Rather, it measures how changes in foreign currency rates affect both the hedge value and the underlying asset/liability value. Performance is based on how well these two amounts offset each other.
Accounting Standards
To ensure the greatest efficiency, companies need to adopt uniform foreign exchange accounting policies and procedures across all business units/subsidiaries. Multiple general ledger systems and integration issues have the potential to create additional risks associated with foreign currency revaluations. Even if some general ledgers are on a different system, uniform exchange rates must still be applied across all systems.
In some cases, revaluation of general ledger accounts might not be consistently applied across all subsidiaries (for example, in the case of accrued liabilities), or certain accounts might be excluded from the revaluation process. This oversight can happen for any number of reasons—for example, because the missing revalued general accounts weren’t identified during the setup process, or because the general ledger accounts were identified but the revaluation process was not set up properly to accommodate them. In any case, companies need to be keenly aware of these issues, especially those organizations that have grown through acquisitions.
In general, the accounting profession and corresponding accounting treatment have moved to recording the fair market value of foreign currency hedges, often called the "mark-to-market position" (the value of the forex hedge as at the financial reporting date). With forex carry spot hedges, the mark-to-market value is readily available and accurate. The more challenging component of recording the mark-to-market value is deciding how to record the other side of the journal entry.
US GAAP and IFRS
Hedges are recorded on the balance sheet at their fair value. Accounting standards enable special hedge accounting for three distinct types of designated forex hedges:
- A cash flow hedge may be designated for a highly probable forecasted transaction, a firm commitment (not recorded), foreign currency cash flows of a recognized asset or liability, or a forecasted intercompany transaction.
- A fair value hedge may be designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability.
- A net investment hedge may be designated for the net investment in a foreign operation.
Note that a forex hedge may also be employed to manage foreign currency risk, but not designated for accounting purposes.
In order for a company to designate a forex hedge as one that qualifies for the special hedge accounting, specific criteria must be met, documented, maintained and tested. While each type of forex accounting hedge (cash flow, fair value or investment) has unique accounting treatment, the guiding principle in each case is the recognition of the gain/loss of the hedged items and the gain/loss of the forex hedge into earnings at the same time.
Upfront proper documentation is critical to achieving hedge accounting treatment and to how the hedge accounting treatment is applied. Further, prospective and retrospective assessment of forex hedges must take place during the life of the hedge to ensure the hedge is effective. Any ineffective portion of a forex hedge is recorded directly to the income statement. Hedge accounting is not an automatic right; it must be earned.
If the cash flow hedge is not documented or not effective (that is, outside of the GAAP effective range of 80% to 125%) then changes in the forex hedge's value will flow through earnings. Consult your auditor on acceptable hedging effectiveness ranges and methods for proving hedging effectiveness.
See the GAAP Accounting PDF for a more detailed description.
Adequate Internal Controls - Segregation of Duties
Strong internal controls, including segregation of duties and authorization limits, have always been an important aspect of sound risk management. A company must segregate its trading, confirmation, and accounting processes. Additionally, the appropriate personnel must prepare a risk report on exposures for review by senior management that compares hedge positions to the balance sheet exposure and future transactions. Ideally, based on the organization's size and accounting systems, an increase in automation to allow for tracking outside of Microsoft Excel spreadsheets is also a prudent control measure.
