Hedge Accounting – when to start?
At Rochford, we recognise that building strong relationships is key to long-term success. We regularly meet with decision makers in the treasury industry to understand the challenges facing their business. A question that we’ve recently been asked has prompted me to write this article.
Q: We’re seeing some volatility of the earnings figure relating to the mark-to-market movements on our derivative positions. Can we hedge account to park these movements in Equity?
A: This can only be achieved if hedge accounting is applied at inception of the hedge. To meet the hedge accounting criteria, formal documentation of the hedging relationship, the entity’s risk management objective and the strategy for undertaking the hedge is required. Unfortunately it cannot be applied to these hedges retrospectively.
At what point should a business implement a hedge accounting policy? Here are some of the most common opportunities to avoid the pitfall above:
- M&A – a major deal could trigger the need for hedge accounting due to increased exposure, for example, foreign exchange risk with expansion into an overseas market
- Changes to accounting standards – this opportunity can sometimes be overlooked. AASB 139 complexity has driven some companies to avoid hedge accounting but the new standard AASB 9 has simplified the approach. Some companies have been proactive and early adopted AASB 9 to take advantage of these changes
- Business valuation – the most theoretically sound method to value a business is to use future expected cash-flows and to discount them back into today’s value. The difficulty arises with trying to estimate these future cash-flows. Hedge accounting will assist in reducing the volatility of these cash-flows and aid accurate forecasting
- Debt issues with strict covenants – hedge accounting assists businesses to achieve the financial metrics borrowers’ need to meet throughout the term of a borrowing. For example, the borrower might be required to always have a certain amount in Interest Cover. Hedge accounting can protect the EBIT number from adverse movements
- Systems and Technology – CAPEX in a new treasury management system (TMS) with powerful hedge accounting functionality could remove the pain of manual hedge effectiveness testing
- Outsourcing – With many companies going through finance transformation projects some treasury accounting functions are being outsourcing to achieve cost efficiencies. Outsourcing hedge accounting to a third party can cost a fraction of the cost of a FTE to meet cost saving targets
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Kevin Mitchell, ‘Partner – Advisory Services’ at Rochford, the leading treasury advisory house in Australia advising on in excess of AU$20 billion in financial market risk.