It seems that not a day passes in 2015 without a new concern of crisis in the foreign exchange markets. As I write, the Greek public has recently voted “no,” and the ECB’s hope to avoid further degradation of confidence appears slim at best.
With the likely first sovereign exit of the European Monetary Union (will it be the last?) it has become painfully obvious that the very real possibility of a rapidly spreading currency war exists - a “war” that must be met with urgent consideration and proper war-ready equipment by every Treasurer AND Controller.
In this volatile rate environment the finance suite faces little choice but to hedge FX and account for it properly. Hedging foreign exchange properly, efficiently and effectively presents significant challenges for both treasury and accounting:
- Minimise FX volatility’s impact on P&L
- Explain quickly any unusual or sizable FX gain/loss impact
- Protect the Company’s margins (revenues and expenses) from the seemingly ever strengthening USD
- Create repeatable performance reporting packages which drives credibility
- Communicate effectively with FP&A, Accounting, Tax & management so that the effect of the hedges are used in planning and accounting properly
- Take Treasury’s hedge strategies and document them for special hedge accounting when applicable
- Account and report on all of the Company’s derivatives both designated and non-designated with limited resources and often limited experience in this most difficult accounting area
- Communicate effectively with management
Many Treasurers and Controllers remain unaware that derivative management systems can easily codify foreign exchange strategies, prepare trades for execution, and produce accounting results. In fact, such systems ensure the functional and effective coordination of Treasury, Accounting, Tax and SEC reporting.
Corporate treasuries typically choose to battle foreign exchange volatility with balance sheet and/or cash flow hedge programs. The popular belief is that the equipment (or technology) that supports these hedge programs is difficult to deploy and understanding is often limited to the Treasury side of the equation, while ignoring the Accounting side implications. This belief is simply not true in today’s environment, where companies can advise on and deploy a robust derivative management system in a matter of weeks or months, rather than years. Journal entries, disclosures and hedge documentation take significant time to create and accounting models built by hand on spreadsheets are typically at risk for errors over time or when responsibilities change. This can leave companies open for audit issues either immediately or down the road.
The real challenge that Treasurers and Controllers face is the absence of a viable derivative management system that addresses and ensures the vital functional coordination of Treasury, Accounting and the rest of the business. The coordination of these teams provides a responsive, nimble, prepared foundation upon which corporate currency risk can be minimised during this “war.”
Unexpected or unexplained gains/losses happen when a company hedges the wrong amount, in the wrong direction or not at all. Employing a treasury system coordinated with their accounting processes minimises the risks significantly and adds an analytical tool to hone in on the sources of FX gain/loss. Beyond the obvious benefits of automating the treasury and accounting processes for FX; the right technology enables a strong understanding of impact through consolidations and prepares treasury and accounting to work together to handle the risk ahead.
In today’s environment, technology (coupled with domain experts specialising in the space) ensures best practices around strategy, data integrity, execution of trades per policy, accounting compliance and analytics/performance reporting.
Identifying operational strategies to mitigate foreign currency exposures on the balance sheet starts in Treasury. With technology in their toolkit, the department can:
- Allow for remote data capture of exposures to establish a global exposure position
- Enable back-to-back trades to trade on behalf of subsidiaries (removing some Dodd-Frank hurdles)
- Outline key controls for derivative trading and establishes trading protocols to ensure best pricing
- Manage all derivatives providing an audit trail and less chance of errors associated with a manual process.
- Easily links to trading portals removing the risk of having to key in trades more than once
- Systematise the process to analyse the FX gain/loss line, summarising worldwide foreign exchange gains and losses by currency and by entity as a SOX control and for hedge program performance reporting
And continues in accounting as technology can:
- Ensure proper set-up and coordination of the accounting rules in the derivative management system
- Fair value derivatives, prepare journal entries and prepare quantitative tables for external reporting for derivatives used in currency hedge programs.
- Provide role based controls around confirmations, trading, accounting and reporting
In the current risk-rich environment, Treasurers should urgently review their existing foreign exchange policy or create a new one that outlines the purpose of derivative activity, limitations on trading, details of authority and responsibility, analytics, performance reporting, and an outline for an appropriate control structure.
The Controller must recognise the policy and prepare accounting guidelines to serve as internal documentation of the key elections and approaches the company has chosen in the application of derivative accounting. Codification of hedging strategies and documentation is invaluable in guiding auditors through a company’s application of hedging programs. It includes discussions of derivative strategies, effectiveness tests, sources of inputs, modeling of hypotheticals, income statement geography decisions, credit approaches, accounting details and disclosures requirements.
Technology deployed rapidly and effectively by domain experts connects the details behind the company’s application of hedge accounting guidance in treasury to the trade ticket to provide comprehensive documentation on the accounting side. By combining exposure and trade management with derivative accounting in the same system a company increases their ability to understand their exposures, hedge effectively, account for them painlessly, explain gains and losses, and protect EPS. Technology in your bunker will allow your treasury and accounting teams to collaborate and thrive while the currency war rages outside.
By Kevin LaBranche, Director of Sales, Hedge Trackers