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How COVID-19 can impact your FX cash flow hedge program

At Hedge Trackers we see three sources that will be affected: 

  1. Supply chain disruption failing to deliver the product 
  2. The weakening of sales demand for products that are delivered
  3. Financiers withholding cash due to uncertainty

As a result, companies that hedge anticipated transactions might find their forecasts related to foreign sales, costs, and even operating expenses at risk. At the same time, economic stresses have historically impacted currency volatility.  Your cash flow hedge program sits at the intersection of this increasing currency volatility and increasing exposure uncertainty.

Use caution entering into new hedges

If your hedge strategy execution has been on autopilot, it’s time to take back the wheel this quarter. Companies with forecasts influx should be cautious about adding new FX cash flow hedges. 

Your FP&A organization is likely trying to assess the impact (positive or negative) of the Coronavirus crisis for the C-Suite. If their updated insights aren’t available as new global forecasts, you should chase down key planning contacts for anticipated direction and magnitude (range of possible effects) currently under consideration. This is an excellent time to gather the FX Risk Committee to collect insights, expectations, and direction.

For non-contracted commitments, it is always better to explain a currency headwind impacting business operations, rather than a derivative loss from being over-hedged. Therefore, it may be appropriate to adjust hedge target levels in light of the current high degree of economic uncertainty combined with the FASB’s admonition that“the probability of a forecasted transaction increases as the period within which the hedged item is expected to occur grows nearer.” 

Tactically, it might be appropriate to postpone incremental hedging, reduce hedge targets, shorten hedge horizons, document expanded hedge periods (the time frame within which the hedged item is expected to occur) on any new hedges, and, perhaps, be prepared to take advantage of generational rate opportunities (like the current 10 year Treasury yield drop below 1%). 

Carefully evaluate exposure probability 

Managing existing FX cash flow hedges under current market conditions is, unfortunately, more difficult than adjusting new hedge activity. When a cash flow hedge is designated, the requirement is that the hedged item must be “probable” to occur within a specified period (hedge period). As forecasted transaction volumes are reduced, the accounting guidance requires a re-evaluation and stratification of the hedged item’s probability. The guidance applies different accounting for hedges of anticipated transactions that are probable of occurring, that are possible to occur, and those that were hedged but are now probable not to occur (remote). 

Management should be informed that changes in exposure status may generate surprise earnings impacts. 

A review is required at the end of each external reporting period to affirm the continued expectation that hedged anticipated transactions remain probable of occurring. If there is a reduction in hedged forecasted activity (or an expectation that the forecasted activity may be reduced), a documented review at the quarter-end will be required to determine if the defined hedged transactions are:

  1.  Still probable of occurring in the originally specified hedge period
  2. Still probable of occurring, not within the originally specified hedge period but within the following two months
  3. Reasonably possible of occurring in the originally specified period or the following two months
  4. Probable not to occur in the originally specified period or the following two months (remote)

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See below for industry-standard interpretation of probable, reasonably possible and remote:

  • Probability Definitions: ASC 450 Contingencies
  • The different levels of probability are based on a range of the likelihood that a future event or events will occur, as follows:  
  • Probable:  The future event or events are likely to occur (80% or more certainty) in the originally specified period.
  • Probable:  The future event or events are likely to occur, but not in the specified period.
  • Reasonably Possible:  The chance of future events or events occurring is more than remote but less than likely (20-80% certainty)
  • Remote:  The chance of the future event or events occurring is slight. (20% or less certainty) The FASB further defines remote transactions as probable not to occur.
  • Knowing how and when to change the status of cash flow hedge relationships can be difficult because the bar is set relatively high by the FASB on both the probable and remote hurdles. This means as forecasts change, companies need to very carefully identify the items landing in each of the three categories. Having miss forecasted a probable transaction is just as critical as having a remote transaction actually occur. Under normal conditions, both of these circumstances could jeopardize your hedge program. 
  • Please refer to 815-30-40-4 within ASU 2017-12 for precise guidance. 

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When a hedged transaction’s probability changes from probable of occurring to reasonably possible or remote, the accounting treatment for cash flow hedges also changes. 

Hedges of items that are considered “still probable, but not within the originally specified period“ or “reasonably possible” must be de-designated, and all future changes in the value of the hedge contract must be recorded in income (these contracts can be re-designated or closed to stop ongoing impacts to earnings). Any amount previously collected in accumulated other comprehensive income (AOCI) will remain there until the hedged item occurs (and reclassified at the end of the two months if it has not occurred). The impact on earnings is limited to the current period gain/loss.  

For derivatives identified as hedging transactions that are remote or probable not to occur, all amounts in AOCI and current period changes in value (the full fair value of the derivative) are required to be reclassified into income in the P&L line item where the defined hedged item would have been recorded. This value must also be disclosed in Derivative notes in the financial statements as associated with forecasted transactions that failed to occur.

Extenuating circumstances

The FASB generally expects the hedged item to occur within the originally documented hedge period or an additional two months. But they have acknowledged that, occasionally, there are circumstances outside of a company’s control that could impact the timing of a hedged item. The Coronavirus fallout may provide such an event for your hedged items. 

If the hedged item is probable of occurring but, due to extenuating circumstances, is probable to occur on a date past the hedge period plus two months, then your company should de-designate the current hedge relationship and re-designate the derivative (late designation) in a new hedge relationship with a new expected hedge period (be generous). Hold amounts in AOCI associated with the original designation until the hedged item is recognized in earnings. This treatment is only available under very rare circumstances. 

For help with these de- or re-designations, late designation effectiveness testing, and other nuanced accounting treatments, please reach out to our team. 

Extenuating circumstances will not be considered a missed forecast. This is critical because missed forecasts are frequently considered “a strike” against a company’s hedge program, and, often, auditors apply a “three-strikes, and you’re out” rule — “out” meaning your hedge program may no longer be able to take advantage of special hedge accounting for anticipated transactions. It is important to recognize that if the exposure goes away rather than delayed, the extenuating circumstances will not apply.

In the event of greater success

Like many disasters, the threat of global pandemic negatively impacts many — but not all — companies and industries. Companies that source or sell anti-viral or related drugs, hand sanitizer, masks, etc. will likely experience windfalls. Just as hedge programs with falling forecasts need attention, so too do hedge programs that see relatively large increases in exposure. Increased exposures may require increased hedge coverage to protect exposed margins. Again, this is a critical time to engage your FX Risk Committee to collect critical information from key finance and operations functions around your company.  

Are you audit ready?

Hedge Trackers is prompting clients to be prepared for a forecast “probability” conversation with their auditors this quarter-end. 

Auditors are likely to address: 

  1.  The documentation of your hedge probability assessment 
  2. The documentation that you have contemplated current market uncertainty (Coronavirus impact)
  3. Stratification of hedged item probability
  4. That your company can justify its current hedge levels and future hedge layer planning, considering changing market conditions. They will want to know what has changed in the forecast and how your company arrived at its conclusions.

If you do have a decline in probability, be prepared to walk the auditors through your journal entries. Whether you use software or manually calculate your hedge accounting, the results may look very different from the past.

Conclusion

As the marketplace reacts to the increasing threat of a global pandemic, we think it is prudent to review all existing hedge relationships and planned hedge activity. New hedge layers may need to be reduced or delayed. Existing hedge relationships may begin to falter as forecasts weaken. 

FASB guidance does provide some relief for unusual market conditions like these, but that relief may not be enough. Treasury needs to prepare for an audit conversation around the impact of changing business conditions on their hedge portfolio.

(This article was first published on Hedge Trackers website on March 6th, here.)

 

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