Take a deep breath and strap yourself in, because we're going to look at an important and often overlooked feature of accounting which can impact your P&L 😳
👉 This article is intended as an introduction, it is not advice, and we recommend that you speak to your accountant, your auditor, and your tax advisor for help. We would also be very happy to refer you to a specialist advisor!
So what's all this about?
When you enter into a currency contract to protect your business – a hedging trade – and you hold this position over your financial year-end, you'll need to record its valuation in your accounts. Here's a really simple example to get started:
- You've made a purchase from a German supplier totalling EUR 1million
- The payment is due after your current financial year end
- You booked a forward contract at GBP/EUR 1.15 to hedge the euro purchase
- In your accounts you need to record the mark-to-market valuation
- The revaluation rate is GBP/EUR 1.20
- This contract has a negative MTM value of (£36.2K) – going straight to your P&L
All unrealised gains and losses from the fair value measurement of derivatives are recognised in the P&L unless hedge accounting is applied!Harry Mills, Founder & CEO Oku Markets
Isn't this just an accounting loss?
Yes and no. These are unrealised gains and losses and, of course the idea behind the hedge was to offset something else (for protection).
Using the example above, the €1million will cost £869.5K at 1.15. It won't cost £36.2k more because the exchange rate has moved to 1.20, but there's an unrealised loss on the contract that is held.
💡A derivative is a financial contract that derives its value from an underlying asset. A currency Forward Contract is a derivative of the cash price (spot rate).
The process of valuing derivatives can therefore bring about P&L volatility which can have real consequences on your business, for example:
- Derivatives valuations can mean the difference between making a profit or a loss
- Lower reported profit could impact your ability to pay dividends
- Credit worthiness could be impacted, possibly increasing your funding costs
- Higher reported profit could impact your tax liability
If you value performance metrics such as EBITDA or earnings per share, or if you have reason to care about your reported earnings (see above), then you should look at the impact of derivatives valuations on your numbers.
OK now you're interested... How do you fix this?
This is where you will need to seek advice, probably starting with your accountant and/or auditor. There are qualifying conditions and the rules can be complex depending on the accounting standards used.
Hedge accounting allows for the recognition of gains and losses on hedging instruments and the hedged item to occur in the same accounting period. Through this matching process, volatility of the income statement due to derivatives valuations can be reduced, better reflecting the performance of the business.Harry Mills, Founder & CEO Oku Markets
You'll need to be able to evidence hedge effectiveness, which PWC define as "the extent to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item."
You should be able to document the following for each hedge:
- Risk management objective and strategy
- Type of hedging relationship
- Nature of the risk being hedged
- Identification of the hedged item
For the type of hedging relationship, there are specified eligible hedging instruments and you must identify the type of hedge e.g. cash flow hedge or fair value hedge.
It can be a fairly arduous process, but if you must engage in significant hedging activities to manage currency risk, then the reduction in P&L volatility caused by derivatives valuations might be a no-brainer for you.
Should you look at hedge accounting?
You need to balance the costs and benefits of hedge accounting. It ain't easy but for some businesses it's mandatory in order to avoid the varios pitfalls described above.
Contact Oku Markets on [email protected] or by calling 0203 838 0250 and we'll steer you in the right direction.