IT IS A BOLD corporate treasurer who seeks to predict foreign exchange markets, but it is an even bolder one who reports that unmitigated effects of currency volatility have adversely affected annual profits.
The first quarterly Deloitte CFO survey of 2012 revealed a marked increase in risk appetite among UK corporates – in fact, it rose at its fastest rate since 2007. However, the report also revealed that less than one quarter (24%) of UK businesses trading in overseas markets – and therefore most at risk by ongoing market uncertainty – have taken adequate steps to manage the potential threat to their business.
Unhedged foreign exchange losses can compress profit margins, render companies uncompetitive and put pressure on covenant compliance. A robust foreign exchange risk management framework should be a priority for all UK companies currently trading, or looking to start trading, in international markets and take into account a minimum of four points:
1) Define your risk appetite and strategic goals
Senior management and the board must have an informed understanding of the foreign exchange risks in the business – controllable and uncontrollable – in order to design specific hedging policies consistent with risk appetite.
Assess whether the foreign exchange exposures need to be hedged at all, the extent and nature of hedging required and what hedging options are best suited to the company. Businesses often employ a mix of commercial actions such as: electing to invoice in the same currency as the cost base, natural hedging where receivables and payables are offset and derivative contracts such as forwards or options.
Using derivative contracts for hedging introduces more risk than natural hedging, therefore it’s also important to be aware that cash flow and associated profit or loss implications are often complex and require a distinct understanding of transaction types.
2) Implement policy, processes, systems and metrics
Once management has clearly articulated how it intends to manage its foreign currency risks, operating policies and procedures should be designed and implemented.
Effective risk management of foreign exchange transactions is contingent on the successful measurement of exposures. It’s important to prepare accurate and timely analyses of the company’s exposures and have a clear view of all current and future transactions, as well as the extent to which various exposures offset.
Accurate and complete position reporting is dependent on full exposure visibility, reliable forecasts and timely reporting from all areas of the business. Hedges taken out in error due to inaccurately forecasted transactions will leave the company under-hedged or over-hedged, creating additional risk rather than mitigating it. At best this will increase the company’s transaction costs as it adjusts its hedging activities; at worst, it will expose the company to the risk of significant financial loss.
Derivative transactions can present particular risk. There should be effective segregation of duties across transaction approval, counterparty liaison, confirmation and cash settlement. Internal financial control also benefits from clear restrictions on transaction limits and permissible hedging instruments. Most importantly, senior management and the board must receive regular and accurate information regarding live derivative positions.
3) Report internally against your defined policy
Understanding and reporting the impact of foreign exchange is fundamental to the interpretation of financial results.
Analysis of budget variances, difficult even in the absence of currency volatility, is dependent on accurate and comprehensive cash flow forecasts and the extent of hedging activity. Critically, it’s also linked to the recording of foreign currency transactions in the general ledger. Considering some straightforward questions is important: how often are system currency rates updated; are transactions recorded in local currency; are transactions recorded on the appropriate day?
There’s often residual foreign exchange volatility in the income statement therefore it’s also important there’s sufficient appreciation of foreign exchange accounting and the selected hedging strategy to articulate the causes of the fluctuations.
It’s essential senior management is accountable for the agreed risk management policy. Board oversight will ensure segregation of duties is firmly in place, transaction limits are adhered to and the credit risk implications of exposures to certain derivative counterparties are monitored.
4) Determine your accounting policies and report externally
Finally, the accounting for foreign exchange and related hedging activities under existing UK GAAP standards is complex and will only get more challenging as the standards evolve. In the next few years many companies will be required to adopt full International Financial Reporting Standards (IFRS) or IFRS for SMEs.
IFRS accounting for derivatives is significantly more complex than the UK GAAP approach with onerous requirements to achieve an accounting treatment properly reflecting hedging activities. If hedge accounting is not applied then gains and losses on derivative transactions go directly through the profit or loss account, even where they effectively hedge a future transaction. There are also tax implications from certain foreign exchange risk management activities – particularly important where the twin objective of economic hedging and tax efficiency diverge.
Craig Cosham, partner at Deloitte