GAAP Hedging

Foreign currency hedging is a prudent strategy to manage your foreign currency transactions. When hedging is successfully implemented, not only will you have cost and revenue certainty, but you will also receive the desired accounting treatment under Generally Accepted Accounting Principles (GAAP).

Requirements

International Accounting Standards (IAS 39) require that all hedging relationships be documented before a hedge is started. Such documentation must cover, among other things, the following items:

• How the hedge forms part of the entity's overall risk management policy.
• Details of the hedged item, hedging instrument, and the specific amount of risk being hedged.
• How the effectiveness of the hedge will be demonstrated, both prospectively and retrospectively.

In the United States, FAS 133 requires that all hedge relationships be documented in advance and cover the following areas:

• Identification of the forex hedge and the hedged item (for example, details on the forex carry spot trade—sell or buy—and the related sales contract).
• The risk you are hedging (for example, changes in the foreign currency value).
• The accounting treatment you are applying (cash flow or fair value).
• The objective of the hedge (for example, to remove the volatility of future earnings related to changes in foreign currency exchange rates).
• Methods for evaluating whether or not you have effectively hedged risk (for example, using the dollar offset method comparing the change in the forex hedge vs. the change in the value of the future financial asset or liability).
• An assessment of the counterparty risk for the hedge provider.

If a cash flow hedge is not documented properly or is ineffective, all changes to the fair value of the forex hedge will be recorded directly on the income statement for each reporting period, as opposed to being recorded in the equity section under Other Comprehensive Income.

Types of GAAP Hedges

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.

A forex hedge may also be employed to manage foreign currency risk, but not designated for accounting purposes.

For more information on the types of GAAP hedging, consult the GAAP Accounting PDF.

Next Steps

For a detailed overview of how to accomplish GAAP hedging,

• Review the Best Forex Practices
• Review the GAAP Accounting PDF
• Contact the FXConsulting team, who can help you understand your own particular requirements for achieving the accounting treatment you need.