This article is a follow-up to "Currency gains and losses – an unknown quantity for many companies", which was published in October 2015.
Many companies use cash flow hedge accounting to hedge against exchange rate risks affecting the cash flows from the planned procurement of goods from abroad. Despite this, exchange rate fluctuations often remain in their profit or loss for the period or their gross margin. However, unexpected fluctuations can be prevented by ensuring that hedges are geared towards the value chain. IFRS 9 provides a specific springboard for reviewing existing structures in hedging for foreign-currency procurement and coordinating the procedure between Treasury, Procurement and Accounting.
As discussed in our article in October 2015, there may be many reasons for exchange rate fluctuations in a company's profit or loss for the period. As a first step, an examination of the entire process chain, and particularly the underlying transactions, can be a useful way of identifying the origin of the undesirable effects. In the case of foreign-currency procurement, i.e. non-financial underlyings, currency gains and losses generally occur only when inventories or intermediate products are consumed or written down, for example, and hence are primarily reported in the cost of goods sold, the cost of materials or write-downs. This means that they directly affect the gross margin, a key performance indicator for controlling at many companies.
The established hedging process for foreign-currency procurement can be summarised as follows: The planned foreign-currency volumes are hedged on the basis of budget or liquidity planning, with the hedging decision by Treasury initially based on the timing of the foreign-currency cash flow. Thanks to the use of cash flow hedge accounting, the effective exchange rate changes affecting the hedging transactions are subsequently reported in other comprehensive income (OCI) rather than profit or loss during the term of the hedge, thus preventing fluctuations in the income statement. The cumulative exchange rate effects then – theoretically – remain in OCI until the underlyings affect profit or loss for the period.
In terms of Treasury processes, the hedging relationship is terminated when the derivative matures and the supplier payments are settled. Assuming matching maturities, for many companies this is the point in the process at which Accounting recycles OCI to profit or loss. This often occurs "automatically" as a result of the derecognition of the derivative. It is precisely this approach that leads to undesirable exchange rate effects, however, as in many cases the underlyings are still a long way from affecting profit or loss at this point. Accordingly, it is important to identify this timing and integrate it into the hedging process.
It is worth starting by analysing the operational value chain. The inventories or intermediate products delivered and the corresponding supplier liability are initially posted at the current exchange rate on the respective day. Depending on the agreed payment terms, the time between the delivery of the ordered goods to the warehouse and the secured payment process is usually just a few days or weeks. If a closing date falls between these two dates, the supplier liability must be measured at the closing rate, while the non-financial assets continue to be recognised in the balance sheet at the historical exchange rate. Depending on the agreed payment terms, however, the periods involved are often relatively short.
Things get interesting when it comes to the storage period of the inventories and products purchased. This determines the date on which the exchange rate effects are recognised in profit or loss, as (taking inventories as an example) these effects only materialise via the cost of goods sold or the cost of materials when the inventories are consumed. Depending on the company and the product type, assets may be held in storage for a considerable amount of time before being removed for processing at another group company or for external sale. A storage period of several months or quarters is far from a rarity. Accordingly, write-downs become increasingly important in the context of longer storage periods, as the initial exchange rate effects are recognised in profit or loss only over time.
For companies that wish to incorporate these findings into their existing posting logic, an additional difficulty is presented by the fact that the new IFRS 9 limits the available options for implementation, and a variant that was previously popular in practice will be prohibited from 2018 onwards. IAS 39 provided an option for either recycling OCI directly to profit or loss – the option applied by many companies – or adjusting the carrying amount of the underlying. Only the basis adjustment option is permissible under IFRS 9. This means companies are faced with the dual challenge of adjusting their existing "simplified" posting logic while also obtaining information on how and when the underlyings will be recognised in profit or loss.
The basis adjustment to the inventory item theoretically means that the "parked" exchange rate effects are automatically reclassified to profit or loss when the underlyings are derecognised. This is conceivable for micro-hedges, e.g. in plant engineering or project business. In the case of portfolio hedges or macro-hedges with no direct relation to an individual underlying, however, most systems are unable to allocate directly to the individual underlyings, so the automated derecognition of the basis adjustment is largely impossible. This gives rise to the problem of finding a practicable solution for reversing the basis adjustment at the right point and in the correct amount. Depending on the specific situation, for example, general assumptions on the consumption of inventories or write-downs may be made, and the basis adjustment can then be reversed on a pro rata basis over a defined period or at a later date.
In addition to the challenges described, however, the elimination of the option for directly recycling OCI also offers companies the opportunity to examine existing assumptions in the hedging process and integrate the Procurement department or Controlling into the process to a greater extent. In conclusion, the clean implementation of exchange rate management across the entire value chain is an important step towards reducing exchange rate fluctuations in a company's profit or loss and margins.
Source: KPMG Corporate Treasury News, Edition 57, July 2016
Author: Christian Pfeiffer, Manager, Finance Advisory, firstname.lastname@example.org
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