Investments are generally made in assets in foreign currency areas and for a certain period of time these serve the company's purpose in that area.
Investments in foreign operations are undertaken for a variety of reasons. Investments are generally made in assets in foreign currency areas and for a certain period of time these serve the company's purpose in that area.
From the economic perspective of Treasury, these transactions normally constitute an investment in a foreign currency area. Put simply, an initial net investment (possibly in foreign currency) is followed by either a steady inflow of funds in foreign currency (e.g. directly in the form of payments from investment income) or an increase in value, which will lead in future to a one-off inflow of funds as part of a sale (purchase price payment). The resulting currency risks are frequently described as translation risks, which are also accorded a transactional character from a certain point in time onwards (e.g. the dividend resolution or in another case when setting a sale price).
Starting from the incurrence of the contractual claim for the funds in another currency (dividend resolution or recognition of the purchase price receivable), these transactions then lead to a currency risk on the balance sheet, which subsequently ends when the payment is made and the foreign currency converted into the base currency. However, seen from a risk management perspective, these are already considered risks when it becomes clear that the funds are intended to be withdrawn from the currency area again. This point in time can occur substantially earlier, i.e. even at the inception of the investment or during the planning of the dividend strategy.
Therefore, even at this early stage Treasury often wants to hedge the resulting currency risks using derivatives. In doing so groups are often faced with the challenge of implementing the same economic risk management strategy for both the separate financial statements prepared in accordance with the German Commercial Code [HGB] and the consolidated financial statements according to IFRS in such a way that P&L is not subject to any uncontrollable fluctuations. In this respect differing principles have been developed under IFRS and HGB to present these circumstances either as hedge accounting or a hedge (valuation unit). Sometimes these regulations can be somewhat at odds with each other, as the following points demonstrate.
According to IFRS, dividends are not permissible hedged items (underlying transactions) whilst investments in foreign operations using a "hedge of a net investment/HoNI" can be very easily converted into hedge accounting. Furthermore, in future (IFRS 9) the designated hedging purpose must correspond to the economic hedging purpose. On the other hand, according to HGB dividends are potentially permitted hedged items whilst the hedging of investment book values is generally barred. At the same time the expected hedged items for both accounting methods need to be highly probable. For dividends, this evidence should be provided over a certain period of time in the future and for some sales considerations this is difficult to produce.
Therefore, from an economic perspective it is often easy to hedge these risks using derivatives; however, reporting these in the financial statements is generally not so straightforward. Be that as it may, over recent years we have developed many practical solutions for many tasks of this kind.
An enterprise value in foreign currency, which is to be withdrawn over the coming three years through dividends, can be hedged using a HoNI under IFRS, e.g. by using three derivatives. Although this may not reach the goal whereby the dividends can be recognised at the hedging rate, the valuation effects of the derivative can be recognised directly in equity. Due to the fact that an alternative interpretation of the risk can generally be designated in the financial statements according to HGB, three hedges can be used as hedged items for the planned dividend payment in this instance.
Treasury generally presents the entire business process in the opposite direction as a payment flow. The same also applies to a company's strategic decisions. Therefore, it is important that such payment flows are incorporated into the risk management strategy and that these are presented in a source-based manner on the balance sheet. Although the regulations in this regard vary significantly according to which accounting standard is applied, in general there will be a solution available which will at least achieve the most important goals.
Source: KPMG Corporate Treasury News, Edition 68, June 2017
Author: Felix Wacker-Kijewski, Manager, Finance Advisory, firstname.lastname@example.org
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