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Discover the Details of FX Hedge Documentation

When accounting for FX derivatives, firms have a choice between the “default” and “elective” accounting treatment. Elective accounting treatment is not required and involves extra preparation and utilization of resources, but for forecasted transactions and hedges of net investments in foreign operations, the benefits can outweigh the costs particularly for publicly traded firms most concerned with mitigating periodic earnings volatility.

The “elective” accounting treatment permits special accounting for items designated as being hedged and offers 2 main financial reporting benefits; Timing & Geography: (1) timing refers to reducing periodic earnings volatility by deferring derivative mark-to-market gains and losses in equity and (2) geography refers to accounting for the derivative gain or loss in the same geographic area of the financial statements as the hedged exposure.

It is important to emphasize that elective hedge accounting never changes the economics of a hedge, only the financial reporting. The choice of whether or not to use “elective” accounting treatment will depend on the foreign exchange risk management objectives of each organization, and part of the strategic decision making process involves determining if the financial reporting benefits outweigh the administrative and compliance costs.

To satisfy the requirement for elective accounting treatment, companies must prepare formal contemporaneous hedge documentation at the inception of the hedge. The hedge documentation outlines the hedging relationship, and the entity's risk management objective and strategy for undertaking the hedge, including identification of following 5 components:

  1. The hedging instrument
  2. The hedged item or transaction
  3. The nature of the risk being hedged
  4. The method that will be used to retrospectively and prospectively assess the hedging instrument's effectiveness
  5. The method that will be used to measure ineffectiveness

Effectiveness is an assessment of the degree by which the derivative offsets the hedged transactions changes in cash flows that are attributable to foreign exchange risk. While hedge documentation and effectiveness testing can range significantly in detail and complexity, two simplified examples of hedge documentation are addressed in FX Initiative’s currency risk management training.

Our Hedging FX Transactions and Hedging Foreign Subsidiaries courses walk you through real world scenarios using Apple, Inc. as an example, and show you the required documentation as well as the timing and geography benefits using our FX Transaction Simulator and Foreign Subsidiary Consolidator. Hedging documentation can be daunting, but our training makes preparation practical so you can achieve for your foreign exchange risk management goals.

Are you interested in discovering the details of FX hedge documentation? Take the FX Initiative by subscribing today!

Cheers,

The FX Initiative Team
support@fxinitiative.com



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