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

Bob Stark | Vice President, Strategy | Kyriba Gerry Daly | Director, Product Management | Kyriba

2© 2016 Kyriba Corp. All rights reserved. PROPRIETARY & CONFIDENTIAL. 2

Gerry Daly

Product Management

Kyriba Corporation

[email protected]

Bob Stark

Product Strategy

Kyriba Corporation

[email protected]

@treasurybob

Today’s speakers

mailto:[email protected]


© 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)

Why don’t more companies hedge?


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


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)


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?

Derivative and Hedge Accounting: Explained


Key Topics

1) Valuations / Mark-to-Market

2) Accounting for Derivatives

3) Hedge Accounting

Derivative and hedge accounting


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


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


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



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 1stBad


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


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


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?

Measurementis on a cumulative dollar offset basis

Hedge Accounting


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


Hedged Item Derivative

Nominal values $10,000 $10,000

Currency USD USDDate 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


125%

100%

80%

No hedge accounting

Ineffectiveness to P&L

Ineffectiveness to P&L

No hedge accounting

HedgeEffectiveness

Testing

What results of effectiveness testing mean

Hedge Accounting – Effectiveness Testing

100% is perfectly effective

Anything more or less means P&L

impact

Simplifying Compliance with Technology


Derivative and hedge accounting

Key Topic Can Technology Help?

Valuations / Mark-to-Market

Accounting for Derivatives

Hedge Accounting


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


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



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:


Hedge Accounting


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:


Hedge Accounting


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



Hedge Accounting


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


“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…

Questions?

Bob [email protected]

@treasurybob

Gerry [email protected]




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

http://www.kyriba.com/blog

http://www.kyriba.com/blog/tom-gavaghan/simplifying-fx-program-lifecycles-without-losing-auditable-valuation-processes

http://www.kyriba.com/blog/tom-gavaghan/fx-hedge-or-not-hedge-question

http://www.kyriba.com/blog/robert-pierson/who-hedged-my-cheese

http://www.kyriba.com/blog/thomas-gavaghan/fx-managing-uncertainty-2016


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 futureUsually 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


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


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


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/ShortcutMethod

Effectiveness testing is skipped if derivative and exposure can be proven to identically match

Hedge Accounting


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

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