Source: KPMG Corporate Treasury News, Edition 48, October 2015
Movements in foreign exchange markets have turned 'currency management' into an ever greater focus of management boards. Even just a cursory glance at currency gain or loss raises many questions, such as: "How did this currency gain/loss come about, aren't we hedged?“ or "The US dollar has risen considerably since the beginning of the year, why is this not reflected in our currency gains and losses?"
It is difficult even for an experienced treasurer to answer such questions immediately. The reason for this frequently does not lie in flawed currency management or inappropriate hedging strategies of treasury, but rather uncertainty at the treasury department as to where − and in what form − the effects of hedged items and the related hedging instruments are evident in the financial statements. Flaws and inefficiencies in the setup of accounting systems exacerbate this problem.
Let us assume that a company uses derivative financial instruments to hedge future sales in foreign currency. There is no specific IFRS standard setting out in which profit or loss item the effects of hedging instruments are to be recognized in tandem with the effects of hedged items. Nevertheless, according to prevailing opinion, the effects of hedging instruments should be recognised under the same financial statement item as the hedged item, even though clients have the choice in principle, under IFRS, to recognise gains or losses on financial instruments used to hedge foreign currency risk under currency gains and losses. In the second scenario, the hedging effect is shown below operating profit, so that currency gain or loss is far from being offset.
Other causes for uncompensated foreign currency effects frequently are the use of several exchange rates in the system. If, for example, a loan in foreign currency is entered into the accounting system on the transaction date, this usually occurs at the current rate available in the system, which often reflects the rate fixed for the day by the ECB. If the loan in foreign currency is hedged on the same day with an FX forward, the hedging instrument is highly likely to show a different spot basis due to fluctuations in the day's exchange rate. Incomplete offsetting of foreign currency effects is pre-programmed, even though this inefficiency could easily be avoided by manual entry of the same spot basis for the hedged item and the hedging instrument.
But sources of error could also be technical in nature. They arise, for example, when account structures or systems are expanded. It is essential, in connection with setting up new accounts, to include the accounts concerned properly in the foreign currency valuation run as at the closing date. If the new account is not properly mapped for the valuation run or not properly integrated into exposure calculation, treasury is not able to include the ensuing currency risks in their impact analysis or hedge them. This results in undesirable or inexplicable foreign currency effects.
The reasons for undesired foreign currency effects can be found not least in the underlying methodology, assuming that currencies are actively managed at the same time. Foreign currency exposure is usually hedged on the basis of planned figures; a target/actual comparison with respect to actual cash flows and the associated back-testing of the quality of cash flow planning are frequently omitted. But the quality of cash flow planning is decisive also for the effectiveness of each hedging decision.
Another favorite is the hedging of net positions or omitting hedging transactions with reference to a 'natural hedge position', whereby it is not taken into account that the actual gross transactions for the hedged items could find their way into the accounts at differing exchange rates. This leads to currency effects in the company's financial statements.
Efficient foreign currency management goes hand in hand with a clear understanding of the financial statement items that reflect the relevant changes in value and which offsetting effects affect not only cash flows but also the balance sheet. This understanding is rounded off by customized FX reporting, providing the necessary details with sufficient transparency and clarity for those in charge.
Author: Ralph Schilling, Senior Manager, firstname.lastname@example.org
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