Source: KPMG Corporate Treasury News, Edition 45, July 2015
Different companies see their currency (FX) risks in different ways. Some hedge currency translation risks in addition to transaction risks. Different philosophies also prevail in the way foreign exchange risks are measured and controlled. Although planned cash flows are hedged in many cases, for example, some companies only do this on the basis of fixed contractual terms within defined budget periods.It is right to focus on these economic considerations. But it is also important not to forget a number of accounting aspects. The hedge philosophy and its implementation are usually clarified in advance in order to achieve a certain measure of economic security. By contrast, the resultant accounting issues often only become apparent once hedges have been put in place and entries have to be made in the books.
In practice, hedging strategies become problematic if the market value of hedging derivatives turns negative and the corresponding effect appears in profit and loss. As a rule, a hedging strategy that is deemed to make good economic sense should therefore also appear as such in the accounts – a practice referred to as hedge accounting. Hedge accounting naturally always records the cost of hedging, but this cost is only recognized in the period in which the hedged transaction is recognized in profit and loss. This being the case, the success of the hedging strategy can normally be shown very clearly in FX hedge accounting. Literature on the topic already provides good descriptions of this modeling practice for a large number of standard cases (see, for example, KPMG Insights into IFRS 11th, section 7.7).
One issue that crops up again and again in practice nevertheless attracts too little attention – and is the subject of heated debate at various corporate groups. Problems arise whenever various companies within the same group have different functional currencies, and where products are first invoiced internally between these companies and then sold to third parties. In cases where hedge accounting is to be applied for external derivatives not only at group level but also at the level of the individual company, the accounting becomes very complex.
As a rule, both the hedging strategy and the settlement currency for internal invoices will already have been defined. It is unusual for the accounting department to prompt changes in either the one or the other.
At the level of individual company accounts (HGB, IFRS), hedge accounting is normally relatively easy to document and apply. At group level, however, the elimination of intragroup profits and the need to define the hedged risk in the hedge documentation add an extra dimension. For example, answers are needed to the questions when OCI is to be reclassified and to what item in the profit and loss account. Reading on, we will see that hedging gains appear at different times in the individual and consolidated accounts. Moreover, the definition of the hedged risk leads to reclassification either in sales revenue or in the cost of sales.
Example: Within the framework of management's strategy, consumer goods (inventories) are produced at German companies (whose functional currency is the euro) and sold in euros to group-owned foreign sales companies. These foreign sales companies work with a different functional currency (let us say US dollars) and sell the products to external customers in the local currency (USD). This production and future sale constellation exposes the group to a EUR-/FX+ risk (in this case, a EUR-/USD+ risk), so the corporate treasury function uses forward exchange contracts (EUR+/USD-) to hedge the risk. The hedged portion of the planned risk is selected such that the cash flow is highly probable. The hedged transaction is permissible in accordance with IAS 39.80 in conjunction with AG99A, because the products are resold to third parties.
Where hedge accounting is applied, other comprehensive income (OCI) is formed for the effective portion in the course of the transaction. This OCI must then be reclassified at the time when the hedged risk is recognized in profit and loss (IAS 39.97/98). In individual IFRS or HGB financial statements, this is the time when intragroup invoices are sent out. However, profit or loss accrued within the group must be eliminated within the framework of consolidation and therefore cannot serve as the trigger for reclassification. Foreign subsidiaries' inventories are consolidated to group inventories at the exchange rate valid on the closing date (IAS 21.39(a)), but must then be recognized in OCI (IAS 21.39 (c) in conjunction with IAS 21.4), so they too fail to trigger reclassification. It follows that the time of reclassification is the time of the external sale, as sales revenue is realized and the cost of sales is recognized in profit and loss at this point.
Although reclassification to consolidated sales is often cited as an example in literature on the subject, this approach would – in the above example – result in a discrepancy: Hedging gains (i.e. OCI) would be reclassified to the cost of sales in the individual financial statements, but would be reclassified to sales revenue at group level if standard practice were adopted. The advantage of reclassification to the cost of sales is that, at the level of the individual financial statements, the external derivative can, using internal derivatives, be included in an identical hedge accounting system at the subsidiary. The subsidiary whose functional currency is USD would then have a (group-internal) derivative in respect of the corporate (i.e. parent) treasury function (EUR+/USD-) and a (group-internal) risk arising from the sourcing of goods in euros. The reclassification of OCI to the cost of sales in the individual IFRS financial statements, which takes place at the time of external resale, can then be transferred as is to the consolidated financial statements. Only the OCI for intragroup invoices that do not lead to external sales would now need to be eliminated at group level.
The crucial factor for the presentation of reclassification is determining whether it is the intragroup sourcing of goods (EUR-/USD+) or the external sale of goods (EUR-/USD+) that is hedged. If it is the intragroup sourcing of goods, the cost of sales (IAS 39.98) constitutes the hedged risk. In this case, the planned transaction must be posited on the interim acquisition of euro-denominated inventories by a subsidiary that uses a foreign currency (USD). If it is the external sale of goods (IAS 39.97), external sales revenue constitutes the hedged risk. Reclassification can then be shown both in the external sales revenue and in the group's cost of sales.
The above example shows that a variety of aspects must be heeded even when modeling predefined business transactions in the accounts. At least implicitly, it also shows that different options can be chosen. Income and expenses arising from hedging instruments can thus also be assigned to their genuine causes both in consolidated profit and loss and in segment reporting.
Author: Felix Wacker-Kijewski, Manager, email@example.com
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