FX Forward Contracts: Minimising Volatility with Hedge Accounting
Why do FX forward contracts create unwanted P&L volatility if hedge accounting is not correctly applied? The fair value of forward FX contracts can change dramatically from month to month, especially with economic uncertainty post-pandemic.
An FX forward contract is a financial derivative, making it essential to understand the applicable accounting standards, recognise the risks of foregoing hedge accounting, and analyse the benefits of outsourcing your hedge accounting program.
Understanding the Accounting Standards for FX Forward Contracts
Correctly accounting for FX forward contracts isn’t just suggested; it’s required under IFRS 9. This accounting standard requires derivatives to be measured at fair value with subsequent changes in value recognised each month.
Whether you are creating internal financials for management review or external financials for third parties, following the applicable legislation is vital. In addition, tax authorities require businesses to abide by the standards laid out by the IFRS setters.
Recognising the Risks of Foregoing Hedge Accounting
Despite what many business owners may believe, there are risks in foregoing hedge accounting. First, unlike foreign currency AR and AP that is already booked in the general ledger and adjusted every month, a foreign currency forecast will not produce mirroring journal entries to offset the amounts from the foreign FX contract. This creates detrimental fluctuations in reporting.
Business owners and members of management want to be sure they are making the most informed decisions, which relies on minimising the fluctuations in the P&L. Furthermore, without the application of hedge accounting, market movements must be reported on the P&L. However, with hedge accounting, unrealised gains in FX foreign contracts can be sent to a cash flow hedge reserve, significantly altering your financial statements, and reducing P&L volatility.
Analysing the Benefits of Outsourcing Your Hedge Accounting Program
Applying hedge accounting is not always straightforward, meaning enlisting the help of an expert might be the right decision for your business. Certain conditions must be adopted before application, such as determining eligibility, preparing hedge documentation, and completing effectiveness testing.
Do you have the time, energy or will to allocate to implementing an effective hedge accounting program? Or you may need more appropriate infrastructure (systems and in-house skill set), there are other options. Working with the experts at Hedge Effective Advisory can help you overcome the challenges associated with hedge accounting, allowing your business to maximise efficiency and accurate reporting.
Hedge accounting can help your business minimise volatility in the P&L from market-to-market movements in your FX forward contracts. Fully understanding what hedge accounting means for your business can seem overwhelming.
Luckily, the experts at Hedge Effective Advisory are here to help. We can have the unwanted noise in your P&L from forward FX contracts taken care of in a matter of days adding reliability and predictability to your gross margins and reported earnings.
For more information on Hedge Accounting or advice on a specific hedge accounting challenge, contact our team at info@hedgeeffective.com