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Hedge accounting doesn't need to be complicated kyriba 11.17.16 wbn slides ss

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With upcoming changes to derivative accounting rules in the US, there is a greater opportunity for treasury teams to benefit from pursuing hedge accounting. Yet, there remains much confusion about the nuances of hedge designation, mark-to-market, and effectiveness testing. In this presentation, we demystify derivative and hedge accounting and show how simple it can be to comply.

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Hedge accounting doesn't need to be complicated kyriba 11.17.16 wbn slides ss

  1. 1. Bob Stark | Vice President, Strategy | Kyriba Gerry Daly | Director, Product Management | Kyriba
  2. 2. 2© 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 2 Gerry Daly Product Management Kyriba Corporation gdaly@kyriba.com Bob Stark Product Strategy Kyriba Corporation bob@kyriba.com @treasurybob Today’s speakers
  3. 3. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 3 Today’s Agenda Topics of Discussion  Why don’t more companies hedge?  Derivative and Hedge Accounting – Mark-to-Market – Derivative accounting – Hedge accounting  Simplifying compliance with treasury technology  Questions (and Answers)
  4. 4. Why don’t more companies hedge?
  5. 5. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 5 Objective of hedging is simple: Predictability!  Knowing the value of future cash flows -> Confidence  Confidence -> more certain projections – Cash Flow guidance – Earnings guidance – Leverage to make acquisitions – Profitability in new markets Why hedge? Investors do not have sympathy for ↓ EPS due to poor hedging programs
  6. 6. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 6 Top reasons why organizations don’t hedge (enough): Why not hedge? Reason Description Cost • Derivatives are complicated and may require budget • Having right people may be an expensive luxury • Technology is expensive too (can’t do on spreadsheets) Confidence • Many treasuries lack the in-house expertise to make confident decisions Compliance • FAS133 -> ASC815 -> IFRS 7/9/13 • Cost of compliance (i.e. people, technology, expertise)
  7. 7. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 7 Derivative Accounting adds complexity  Need to know what you’re doing  Must have technology  Extra work for treasury and accounting Our goal: make each of these points easier for you Why not hedge?
  8. 8. Derivative and Hedge Accounting: Explained
  9. 9. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 9 Key Topics 1) Valuations / Mark-to-Market 2) Accounting for Derivatives 3) Hedge Accounting Derivative and hedge accounting
  10. 10. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 10 Objective  Provide a fair value of the financial instrument via a mark- to-market process  FAS157 provides guidance on what fair value means – Level 1: Quoted market value (e.g. the price of a bond on a Reuters terminal) – Level 2: Observable market inputs (e.g. use market data from a Reuters terminal and use a fancy formula that you learned in college) – Level 3: Getting creative with artificial market instruments Valuations
  11. 11. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 11 What we need to do  Either find the value that already exists in the market OR create a value based on market rates  For derivatives (e.g. forwards, swaps, options) we need to create a value using fancy formulas and market rates  Unless you just finished college or your CFA, you will likely want technology to do the work for you (tip: your auditors prefer this approach too) Valuations
  12. 12. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 12  FAS133 (and revisions since then) changed the way derivatives were accounted for: – Derivatives must be fair valued on the balance sheet – Unrealized gains/losses from derivatives must be reflected in Income Statement in current period o Previously waited until gains were realized, after derivative matured – Accounting for unrealized gains/losses => P&L impact from derivatives occurs earlier than exposure they are meant to hedge  Mismatch of gains/losses and earnings volatility Derivative Accounting
  13. 13. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 13 Derivative Accounting Mismatch of P&L Impacts • Assume Forward contract used to hedge future cash flow Event Date Today January 1st EUR Cash flow received July 1st Buy derivative to hedge EUR Cash Flow January 1st Unrealized gain/loss from derivative booked to earnings Between January 1st and July 1st Bad
  14. 14. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 14 Hedge Accounting • If a corporate can prove they meet the requirements to apply hedge accounting – Unrealized gains/losses deferred to the Balance Sheet – Deferral is temporary; until Hedge “ends” • Derivative matures • Hedge is de-designated (no longer meets hedge accounting rules) – When hedge ends, derivative gains/losses and exposure gains/losses booked to income statement at the same time Hedge Accounting
  15. 15. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 15 Hedge Accounting Hedge Accounting • Why corporates try for hedge accounting Event Date Today January 1st EUR Cash flow received July 1st Buy derivative to hedge EUR Cash Flow January 1st Without hedge accounting, unrealized gain/loss from derivative booked to earnings Between January 1st and July 1st With hedge accounting, realized gain from derivative affects earnings July 1st Good Bad
  16. 16. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 16 Document Assess Measure Document • Risk Management objective • Hedged item & hedged risk • Hedging Instrument • Which assessment test? Assess • Prove hedge is “highly effective” • What type of test should be run • Frequency of tests? • What if the test fails? Measurement is on a cumulative dollar offset basis Hedge Accounting
  17. 17. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 17 Hedge Accounting decision tree Yes No Hedge Accounting Designate Relationship Prospective Test Highly effective Low P&L volatility Retrospective Test Fair Value P&L Volatility Hedge Accounting
  18. 18. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 18 Hedged Item Derivative Nominal values $10,000 $10,000 Currency USD USD Date 30 June 2017 30 June 2017 Dollar offset ratio Regression analysis < 125 % ∆ Derivative Fair Value ∆ Hedged item Present Value (risk) 80 % < Critical terms match Hedge Accounting – Effectiveness Testing
  19. 19. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 19 125% 100% 80% No hedge accounting Ineffectiveness to P&L Ineffectiveness to P&L No hedge accounting Hedge Effectiveness Testing What results of effectiveness testing mean Hedge Accounting – Effectiveness Testing 100% is perfectly effective Anything more or less means P&L impact
  20. 20. Simplifying Compliance with Technology
  21. 21. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 21 Derivative and hedge accounting Key Topic Can Technology Help? Valuations / Mark-to-Market  Accounting for Derivatives  Hedge Accounting 
  22. 22. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 22 Ways to value FX derivatives 1) Take value from other system (e.g. Bloomberg or bank) 2) Generate valuations in TRM system • Calculate forward points from differential between interest rate curves + spot rate • Interpolate forward rate from FX Forward Curve • (Options only) Use a fancy formula to calculate Valuations
  23. 23. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 23 TRMS supports mark-to-market of derivative transactions to generate a fair value for each position  Automated calculations  Integrated market data  Documented industry pricing models  Scenario and ‘what if’ testing Valuations
  24. 24. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 24 Derivative Accounting Requirement How Technology Simplifies Calculate change in value of derivative for current period  Embedded mark-to-market process  Integrated Market Data  Scheduled Reporting  Stored history of valuations Post change in value of derivative to P&L account in the general ledger  Accounting engine to create journal entries from valuations  GL Interface for straight through processing  Sub-ledger to store posting history When not pursuing hedge accounting, requirements are:
  25. 25. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 25 Hedge Accounting Requirement How Technology Simplifies Calculate change in value of derivative for current period  Embedded mark-to-market process  Integrated Market Data  Scheduled Reporting  Stored history of valuations Document hedging relationship  Designate derivative with hedged item  Template for documentation  Document attachment  Define effectiveness testing and other details When pursuing hedge accounting, more requirements:
  26. 26. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 26 Hedge Accounting Requirement How Technology Simplifies Perform effectiveness testing  Prospective and retrospective testing  Flexibility in testing methods (Critical Terms, Dollar Offset, Regression)  Report on measurement – based upon tolerances for your organization/auditors When pursuing hedge accounting, more requirements:
  27. 27. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 27 Hedge Accounting Requirement How Technology Simplifies Create accounting entries  Accounting engine to create journal entries from valuations and effectiveness testing  Effective amounts – posted to balance sheet accounts (e.g. OCI)  Ineffective amounts – posted to P&L accounts  Reclassification of OCI balances back to income statement (after hedge is done)  GL Interface for straight through processing  Sub-ledger to store posting history When pursuing hedge accounting, more requirements:
  28. 28. “Best Practice Risk Management is to hedge” – Successful CFOs Goal of hedging is to mitigate risk • Effective hedging is expected by management and stakeholders • Cost of not hedging = EPS impact Hedge Accounting isn’t so bad • Valuations • Documenting and measuring hedges • Creating the appropriate journal entries Technology makes compliance easier • Affordable technology is the difference between wanting to hedge and actually doing it • Not as expensive as you think; ROI is significant In Summary…
  29. 29. Questions? Bob Stark bob@kyriba.com @treasurybob Gerry Daly gdaly@kyriba.com
  30. 30. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 30 Further Reading Blog posts: http://www.kyriba.com/blog • Simplifying FX program lifecycles without losing auditable valuation processes • FX: To hedge or not to hedge, that is the question • Who hedged my cheese? • FX: Managing uncertainty
  31. 31. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 31 Valuations Terminology: Term Description Valuation The output Mark to Market The process to create the valuation Yield Curve Set of rates going forward in the future Usually refers to interest rates from today to 30 years out FX (Forward) Curve Set of future FX rates going forward in the future Volatility Market indicator used in Mark-to-Market of Options Spot Rate Today’s FX rate Forward Rate Future FX rate Forward Points Different between Forward Rate and Spot Rate
  32. 32. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 32 Valuations Terminology: Term Description Interpolation Calculating a forward rate from the FX or Yield Curve FASB Federal Accounting Standards Board IFRS International Financial Reporting Standards; the replacement globally for FASB IAS 39 IFRS version of FAS133 (requires fair value of financial instruments to be placed on balance sheet) Credit Value Adjustment (CVA) Interpretation with IFRS 13 / FAS157 that requires discounting value of derivative based on risk of default by your counterparty
  33. 33. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 33 Hedge Accounting Terminology Term Description FASB Federal Accounting Standards Board IAS International Accounting Standards IFRS International Financial Reporting Standards; the replacement globally for FASB and IAS IFRS 7 IFRS version of FAS157 (requires fair value of financial instruments to be placed on balance sheet) IFRS 9 IFRS version of FAS133 Credit Value Adjustment (CVA) Interpretation with IFRS 7 / FAS157 that requires discounting value of derivative based on risk of default by your counterparty Hedge Accounting
  34. 34. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 34 Hedge Accounting Terminology Term Description OCI (Other Comprehensive Income) Balance Sheet Account where derivative gains/losses are temporarily deferred (Cash Flow Hedges) CTA (Cumulative Translation Adjustment) Balance Sheet Account where derivative gains/losses are temporarily deferred (Net Investment Hedge) OCI Reclassification When gains/losses are moved from balance sheet to income statement accounts at end of the hedge Critical Terms Match/Shortcut Method Effectiveness testing is skipped if derivative and exposure can be proven to identically match Hedge Accounting
  35. 35. © 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 35 Stay in touch with us facebook.com/kyribacorp twitter.com/kyribacorp linkedin.com/company/kyriba-corporation youtube.com/kyribacorp slideshare.com/kyriba kyriba.com/blog

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