Foreign Currency Hedging for Projects

Global infrastructure spending is expected to top one trillion US dollars in 2010, according to CIBC World Markets. As companies begin to take on capital projects, they will want to be aware of the benefits of project hedge accounting, which allows treasury departments to recognise revenue and hedge relationships with as much fluidity as a project timeline. While purchases of foreign components are often at play in constructing bridges, roads and schools, upgrading power plants or building new facilities, multiple foreign currency exposures can be difficult to track over a project’s lifetime. Financial professionals can use hedge accounting at the project level to achieve a good hedge accounting outcome and minimise forecast errors in situations where payments or receipts are certain, but the timing is not.

What the Standards Boards Say

Both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) allow project hedge accounting. Although project accounting varies for different industries, it enables for recognition of expenses and revenue that are related to a new project to be accounted for by various methods, e.g at the time incurred, by project milestone, etc. Derivatives entered into to hedge project cash flows are also project costs/income, and so revenue recognition of hedging expenses/revenues may also be accounted for by any of the methods described in this article.

FX Cash Flow Hedging

The basic rules for foreign currency hedging of forecast foreign exchange (FX) payables and receivables are very well known:

• Designated risk is foreign currency exposure at a date or within a period.
  
• No netting of forecast sales and purchases in one hedge relationship.
  
• Time limits on slippage of exposure against a derivative and release of other comprehensive income (OCI) /equity.
  
• Assessment and measurement of ineffectiveness, i.e. change in the lesser of the cumulative change goes to OCI and balance to earnings.
  
• Choice of assessment methods; spot or forward, discounted or undiscounted.
  
• Once on the balance sheet, payables/receivables require translation gain/loss.
  

Less well known are FAS DIG G16 and IAS 11, which clarify the application of cash flow hedging applying to designated risks that occur within a time period and related to one project. This is very common in the construction, oil and gas, and engineering industries where projects are undertaken. Both standards clarify hedge accounting treatment for exposures where the date of payment/receipt is uncertain, although the amount and period of payment/receipt is certain.

To illustrate, consider a company that plans to build a factory and needs foreign-made components to do the job. The factory will take one year to build, and it is estimated that foreign components will be needed prior to a particular project milestone. The cash flow amounts and timing can be estimated, although, as estimates, they may slip. The company can choose to specify the designated risk to be all payments of foreign currency for foreign-sourced components needed to build the factory over the one-year period. It need not worry about slippage of the payments within the life of the project or within a reasonable period after the expected completion date. The key is to document that each exposure will occur during the life of the project and hedge the expected cash flow date of each exposure.

If expected cash flow dates of exposures slip, then no de-designation is needed. The only limitation under FAS 133 is that they not slip past 60 days, or under IAS 39, not past a reasonable time after the forecasted end of the project.

Assessment and Measurement

The following table shows the different assessment methods available for project hedge accounting along with the impact of each on earnings and commentary.

Table: Assessment and measurement methods

Spot undiscounted assessment is the most conservative approach. It is often adopted to cater to slippage of exposures and does not require the automatic rolling or pre-delivery of hedging derivatives to maintain effectiveness. Even though this creates timing mismatches, a spot assessment method will ensure effectiveness and qualification for hedge accounting. Earnings are limited to the time value of derivatives using cumulative dollar offset (CDO).

A forward method can be used, although there is a greater risk of a hedge being ineffective as slippage occurs and timing mismatches create differences in fair values. In this case, regression is the preferred assessment method.

Entities that consider using a forward or discounted method will often do a pre-hedge analysis to gain an understanding of how much time slippage can be tolerated while still maintaining effectiveness.

Management of Revenue Recognition

A project has multiple exposures, derivatives and hedge designations, and during its life, a changing OCI/equity balance, being the sum of the cumulative effective components of all hedges. During the project, derivatives and exposures are maturing and the project progresses toward completion. OCI/equity will be released and revenue recognised.
There are multiple ways to recognise revenue, based on:

• FIFO (first-in, first-out) method - recognise revenue for hedges maturing prior to the reporting date up to a notional amount equal to the percent complete multiplied by the total project amount, starting with the earliest dated exposure.
• Pro rata method - recognise the completed project percent multiplied by the exposure amount for exposures flagged as advances and release using the FIFO method for all other exposures.
• Specific identification - recognise revenue by specific identification when only one exposure is being hedged.
  

Data Requirements

Adopting project hedge accounting requires the following information to be kept on each project:

Project name, type and entity.

• Total project amount and currency.
  
• Start date, end date and percentage complete.
  
• Revenue recognition method.
  
• Project type (milestone, cost-to-cost, completed).
  

This at-inception information, along with a hedge designation, is enough to perform assessment and measurement of all hedges associated with the project and enough to manage recognition of revenue over the life of a project. All a hedger needs to do is update the percentage of a project’s completion over the lifetime of the project. A system can then fairly value derivatives, perform hedge assessment and measurement, re-calculate revenue recognition and generate accounting entries.

Project hedge accounting is a very useful means of applying hedge accounting to hedges of multiple exposures related to a common project. It gives users the flexibility to recognise revenue that is suited to the project’s cash flows and minimises the book-keeping and documenting of changing hedge relationships.

Article was earlier published in the reputed finance website.

Article by Peter Seward is responsible for the strategic direction of Reval web-based platform and Reval Center valuation and hedge accounting service. He has also written the modules Reval IAS 39, IFRS 7 and FAS 161 Doctors. Seward's 15 years experience in financial services software spans Asia-Pacific, Europe and North America. Prior to Reval, he was a sales engineer at Principia Partners, an implementation consultant and custom development project manager for Integrity Treasury Systems in both Sydney and Chicago, and a manager of treasury systems at Rabobank Australia in Sydney. He holds a Bachelor of Science in mathematics and economics from the University of Western Australia.