Risk Management

You Make Me Feel Like a Natural Hedge

Companies are reporting an array of natural hedges for currency risk under the fair-value standard, according to a new study.
David KatzJuly 5, 2011

The costs, compliance burdens, and restatement risks of hedge accounting are spurring many companies to report naturally occurring foreign-currency hedges under a less-onerous standard, a forthcoming research report suggests.

Such “natural hedges” are gaining in significance in the financial management of many companies, according to an author of the report.

To be sure, many companies have gained favorable accounting treatment for their derivatives use under the Financial Accounting Standards Board’s Statement 133, “Accounting for Derivative Instruments and Hedging Activities.” The statement, now codified as FASB Topic 815, enables companies to record an earnings gain or loss on a hedged item and a matching loss or gain on an associated derivative either right away or in a deferred manner.

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The use of hedge accounting has helped companies curb earnings volatility by allowing them to wait until the derivative fully offsets the liability before they must report the effects of the transaction on their income statement. But that flexibility has come at a high price. “All you need to do is mention Statement 133 and hedge accounting to a CFO, and he’ll likely roll his eyes and tell a horror story,” says Charles Mulford, director of the Georgia Tech Financial Analysis Lab, who wrote the report, “Natural Hedges and the Management of Foreign Currency Risk,” with Eugene Comiskey.

Under Statement 133, when a company enters into a derivative arrangement that is being used as a hedge, it must at that time designate that derivative as the hedge of a specific item. It must also show quantitatively that the derivative is “highly effective” in offsetting the earnings effects of the underlying asset or liability — and monitor the effectiveness of the hedge in an ongoing way.

Such processes are costly and time consuming. But perhaps the direst downside of using hedge accounting is the risk that a company will have to restate its financials if its compliance goes awry. Says Mulford, “The problem was that if you messed up in any way — if, for example, the [Securities and Exchange Commission] came in and afterwards showed the hedge wasn’t sufficiently effective, or that you didn’t monitor it closely enough — then all of the hedge accounting you had applied would be disallowed.”

That threat apparently caused many companies to shy away from hedge accounting altogether. In a 2008 research report, “The Non-designation of Derivatives as Hedges for Accounting Purposes,” Mulford and Comiskey noted that companies were frequently choosing not to designate derivatives as hedges for accounting purposes.

How then to account for them? As it happened, FASB had issued a standard the year before that has proved a no-fuss, low-cost answer for many companies. Under the standard, “The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159, codified as ASC825-10-25), companies can mark both the hedge and the financial asset or liability to market and include those market-value changes in earnings.

If the hedge actually offsets the earnings effects of changes in the fair value of the company’s assets and liabilities, “no net earnings effect would be experienced,” according to the new report from Georgia Tech.

Thus, without having to comply with hedge accounting’s arduous rules, companies can still use hedging to reduce earnings volatility. The one hitch? Companies can’t defer reporting the effects of the hedging on their financial statements, as they can under hedge accounting.

That hasn’t deterred companies from reporting a rich array of hedging activities under the fair-value standard rather than under Statement 133, according to the new report, which is based on the annual reports of 70 companies with fiscal years that ended in 2009 or early 2010.

Under the fair-value standard, companies have been able to broaden the use of “natural hedges” to flatten the effects of currency fluctuation on their balance sheets and income statements.

The researchers were looking for 10-Ks that referred to foreign-currency-related “natural hedges” or “natural offsets.” In its purest form, a natural hedge is simply a preexisting byproduct of a company’s operations that requires no action to cover a risk.

For instance, a U.S. airline doing business in Japan could naturally hedge the risk of currency fluctuation against the dollar in its future yen-denominated sales by paying in yen for future operating costs of its Japanese operations. A decline in the dollar value of its yen-denominated expenses could thus serve as an effective hedge against the same decline in the dollar value of its yen-denominated revenues.

Similarly, a U.S. company that buys from Canadian suppliers may also be selling into the Canadian market, spawning receivables denominated in Canadian dollars. In that case, a gain in the currency price of the receivable could provide a hedge against an identical loss on the Canadian-dollar payable.

Such situations are by far the most frequently cited form of natural hedge used to manage currency risk, with 46% of the companies in the Georgia Tech study reporting “[o]ffsetting of revenues and expenses” and 10% mentioning offsets of receivables and payables.

In another form of pure natural hedging, 9% of the companies say they manufacture or source goods using the currency of the country where they sell them.

At the same time, companies are reporting heavy use of what the authors call “quasi-natural hedges.” In such situations, companies take action to shore up assets against the possibility that a rise or dip in a foreign currency will add to their liabilities. For example, 17% report they either engage in transactions to offset their foreign-currency assets and liabilities or borrow in local currencies to manage risk.

Not that the purchase of currency swaps or futures is going out of fashion. Six percent of the companies report they use derivatives “without a hedge accounting designation.” Regardless of how companies account for them, it appears the use of derivatives in managing currency risk is here to stay.