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Derivative toolkit: Deciphering foreign currency hedging · PwC's accounting podcast

• 0:00
  SPEAKER_03: Thought Leadership from PWC.
• 0:07
  SPEAKER_00: Welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_00: I'm Heather Horn.
• 0:12
  SPEAKER_00: Thanks for tuning in to another episode in our Toolkit series, where we're taking a deep dive each month into a single topic, recapping the basics, but also focusing in on frequently asked questions and judgmental areas.
• 0:26
  SPEAKER_00: This month is all about derivatives.
• 0:38
  SPEAKER_01: It's mostly understanding kind of where all of your risks are in the organization when it comes to foreign currency.
• 0:44
  SPEAKER_00: That was Brett Dooley and Chris Judeau, both from PWC's national office, who will be continuing the series with a discussion today of applying the hedge accounting model for foreign currency hedges.
• 0:56
  SPEAKER_00: We have a lot to cover, so let's get started.
• 1:02
  SPEAKER_00: So, Brett, Chris, welcome back to the podcast.
• 1:05
  SPEAKER_00: Nice to have you back together again for the third episode in our series.
• 1:09
  SPEAKER_00: And today's topic is one that I know a lot of companies deal with and can, again, have complexity, like I think everything else in this derivatives area.
• 1:18
  SPEAKER_00: And that's talking about when you have foreign operations, what you need to know about foreign currency hedges.
• 1:24
  SPEAKER_00: So, Chris, I thought I'd start things with you and ask you to just explain at a high level at least foreign currency accounting in general before we get into hedges.
• 1:34
  SPEAKER_00: So at least people have sort of, we're all starting from the same point.
• 1:37
  SPEAKER_01: Sure.
• 1:38
  SPEAKER_01: So explain foreign currency in 25 words or less.
• 1:40
  SPEAKER_00: Exactly.
• 1:41
  SPEAKER_00: Exactly.
• 1:42
  SPEAKER_00: Okay.
• 1:44
  SPEAKER_01: Well, yeah, so I think as you know you would imagine, there are many companies that conduct transactions in multiple currencies, not just one currency, right?
• 1:52
  SPEAKER_01: And so definitionally, a currency other than your own currency is going to be a foreign currency.
• 1:58
  SPEAKER_01: Um when those companies need to prepare their financial statements.
• 2:02
  SPEAKER_01: You can't have a set of financial statements with a whole bunch of different currencies within your balances.
• 2:07
  SPEAKER_01: So you need to do something to measure or remeasure all those other currencies into the currency that you're using when you're reporting your financial statements.
• 2:17
  SPEAKER_01: So that ultimately your financial statements will be measured in just one currency.
• 2:23
  SPEAKER_01: Um and that's typically uh referred to as you know your functional currency.
• 2:28
  SPEAKER_01: Um and so maybe what is a functional currency?
• 2:31
  SPEAKER_01: Well, that's going to be the currency of the primary economic environment of the distinct and separable operations of the particular company or part of the company you're talking about.
• 2:45
  SPEAKER_01: So you know, if it's a consolidated parent company, its functional currency is going to be where it conducts the um, you know, its operations or what its primary economic environment is.
• 2:56
  SPEAKER_01: Um, it may have a subsidiary in a foreign location that conducts transactions in a different currency.
• 3:05
  SPEAKER_01: And so that and that subsidiary's functional currency may be different.
• 3:09
  SPEAKER_01: Um we'll get into what that means in a second, right?
• 3:12
  SPEAKER_01: Um, but it's just kind of important that you know you understand um that you know the the there's a functional currency, and that will be the basis of which other currencies will be re-measured into.
• 3:24
  SPEAKER_01: There's two basic processes for remeasuring other currencies into your currency, and that's going to be transaction measurements um and translation.
• 3:37
  SPEAKER_01: Why don't we take the transmac the transaction measurements first?
• 3:41
  SPEAKER_01: I mean, that's going to be simply any transaction that a company does or a particular operation does that is in a currency other than its functional currency.
• 3:53
  SPEAKER_01: So if I'm a US company, I issue euro debt, um, that's going to be a transaction I'm doing in a different currency.
• 4:02
  SPEAKER_01: And I would need to remeasure that euro debt into my US functional currency.
• 4:09
  SPEAKER_01: Um the changes that result from that remeasurement, when you're talking about remeasuring transactions, um, that's going to be profit or loss.
• 4:18
  SPEAKER_01: Those are going to be gains or losses that actually go to your income statement as transaction gains or losses.
• 4:26
  SPEAKER_01: Um they're basically two types when you when you think about um what do I need to remeasure from a transaction uh perspective.
• 4:36
  SPEAKER_01: Um it's basically broken down into monetary transactions versus non-monetary transactions.
• 4:43
  SPEAKER_01: And it's somewhat simple in the definition and sounds exactly as it is, right?
• 4:47
  SPEAKER_01: A monetary transaction is going to be something like cash or investments or receivables, but it's going to be something that you kind of expect to settle in the future.
• 4:58
  SPEAKER_01: Right?
• 4:58
  SPEAKER_01: The cash flow is going to kind of happen in the future.
• 5:01
  SPEAKER_01: There's going to be some settlement in the future that'll result in a settlement in the foreign currency.
• 5:07
  SPEAKER_01: Those types of assets or liabilities will need to be remeasured at the rate that's in effect at the end of the reporting period.
• 5:15
  SPEAKER_01: So that's something that'll constantly be remeasured until the actual asset reliability is settled.
• 5:23
  SPEAKER_01: Contrast that with a with a non-monetary um asset reliability.
• 5:28
  SPEAKER_01: And those are going to be things like inventory or PPE.
• 5:32
  SPEAKER_01: Um those are things that are initially measured at the currency in effect at say the time you bought the inventory, at the time you bought the property, plant, and equipment.
• 5:43
  SPEAKER_01: But you don't remeasure that going forward.
• 5:47
  SPEAKER_01: You use that rate and that measurement at the time of purchase, and then say through a cost of goods sold or through depreciation, that'll wind up um you know impacting your income statement at the original rate, not re-measured as you keep going through through time.
• 6:09
  SPEAKER_02: I think when you think of that concept, it it can be that one can be sort of intuitive.
• 6:14
  SPEAKER_02: If I bought a building, it doesn't matter to my subsequent accounting whether I bought the building in US dollars or I paid, I said euro for the building.
• 6:23
  SPEAKER_02: The building's going to be on my balance sheet at its acquisition price.
• 6:26
  SPEAKER_02: And subsequently, it doesn't matter that I what I paid for it to the accounting.
• 6:32
  SPEAKER_01: Right.
• 6:33
  SPEAKER_01: Because the cash flow itself from that asset doesn't change, right?
• 6:38
  SPEAKER_01: Um, so the the other process is translation, right?
• 6:43
  SPEAKER_01: And so that's where I was talking before, where you may have you may have a parent company that's say domiciled in the US and has the US dollar as its functional currency, but then it has operations in you know wherever.
• 6:58
  SPEAKER_01: And it's going to be conducting businesses through a subsidiary in another jurisdiction that has a different currency as its primary um economic environment and a different functional currency.
• 7:12
  SPEAKER_01: So what you really need to do with that is take that subsidiary's financial statements, and as you're consolidating that subsidiary subsidiary into your consolidated financials, you need to translate from their functional currency into what your functional currency is.
• 7:32
  SPEAKER_01: And that's not an easy process.
• 7:34
  SPEAKER_01: You know, that that could be very time-consuming, very careful.
• 7:38
  SPEAKER_01: You need to think about multiple layers of subsidiaries.
• 7:40
  SPEAKER_01: So if I had, you know, let's say a European subsidiary that in turn has a South American subsidiary, I first need to translate from the South American subsidiary into the European subsidiary's functional currency, and then take those results and translate that into my parent company, Domacild, in the US.
• 8:01
  SPEAKER_01: So you can see where this can get pretty complex as you're doing that.
• 8:06
  SPEAKER_01: Um, anyway, there's different rates, again, that you would use when you're making that translation.
• 8:13
  SPEAKER_01: Um from a balance sheet perspective, from an assets and liabilities, you generally use the rate that's in effect at the end of the period.
• 8:21
  SPEAKER_01: However, for the income statement, you try to use the rate that's in effect at the time that the income or the expense is incurred.
• 8:31
  SPEAKER_01: However, what a lot of places do is they use a weighted average rate, which can be appropriate, um, you know, if the kind of it's earned evenly through the year, say.
• 8:40
  SPEAKER_01: Like it would sort of like a practical way of having to not think about each individual transaction.
• 8:47
  SPEAKER_01: And then for equity, that's going to be slightly different too.
• 8:51
  SPEAKER_01: So with equity, you're going to use the historical rate that was in effect at the time the equity transaction occurred, except for retained earnings.
• 9:01
  SPEAKER_01: Which, because retained earnings is basically an accumulation of your income, right?
• 9:06
  SPEAKER_01: You kind of use whatever the rates were that you use for the income for each period as you're recording it to retained earnings.
• 9:12
  SPEAKER_01: So clear as mud.
• 9:14
  SPEAKER_01: And um, so you know, that's the that's foreign currency in 25 words or less, which I probably used about 100.
• 9:20
  SPEAKER_02: So I was gonna say one thing we'll talk about is um this cumulative translation adjustment because um Chris just went through the different rates used on your balance sheet in your income statement.
• 9:36
  SPEAKER_02: You need this cumulative translation adjustment to get your balance sheet to balance in the US dollars in his example.
• 9:43
  SPEAKER_02: So we're gonna be talking about that that CTA as as kind of the the uh the net holding tank for all of these adjustments in rates.
• 9:51
  SPEAKER_00: I think that's a good reminder.
• 9:53
  SPEAKER_00: It kind of does bring together everything Chris was talking about.
• 9:56
  SPEAKER_00: I do want to remind our listeners that if you want more on foreign currency, more than 25 words, then we definitely have some other podcasts to listen to.
• 10:06
  SPEAKER_00: I think, though, for purposes of our hedged conversation, foreign currency hedges, definitely, you know, the key, the key points are here, and we'll revisit some of them too.
• 10:15
  SPEAKER_00: So stick with us because there's definitely some important foreign currency hedging to discuss, in particular, because I think this is an area where a lot of companies, even if they say, oh no, no, no, we don't hedge, but they actually do hedge because they enter into foreign currency hedges.
• 10:30
  SPEAKER_00: They just don't necessarily think of them, I guess, that way.
• 10:33
  SPEAKER_00: So with all of that background, Chris, let me go back to you.
• 10:37
  SPEAKER_00: And in particular, if we're talking about foreign currency hedges, I think one of the places we often see this is with uh forecasted sales that will be denominated in a foreign currency.
• 10:49
  SPEAKER_00: So, how do you kind of think about those?
• 10:51
  SPEAKER_01: That's right.
• 10:51
  SPEAKER_01: That's probably the most basic of a foreign currency hedge is forecasted um sales and hedging those forecasted sales in a foreign currency.
• 11:00
  SPEAKER_01: And as you said, sometimes companies may be hedging and not even realizing it, right?
• 11:05
  SPEAKER_01: And so maybe an example of that is there are oftentimes sort of a natural hedge where I have sales, I also have expenses, and so the sales in the foreign currency, which is my cash inflow, kind of naturally offset or are offset by some of my expenses in in that same currency, and especially if they kind of are happening in a similar time frame, that kind of provides a natural hedge for the company.
• 11:31
  SPEAKER_01: But that's not always going to work out perfectly, right?
• 11:34
  SPEAKER_01: You know, I mean, that's life, right?
• 11:36
  SPEAKER_01: And so some companies will then either specifically hedge the forecasted sales or separately the forecasted expenses.
• 11:46
  SPEAKER_01: Um, but let's focus on the forecasted sales.
• 11:49
  SPEAKER_01: Um at its core, a hedge of a forecasted sale is no different than just simply saying it's a cash flow hedge.
• 11:59
  SPEAKER_01: Right?
• 11:59
  SPEAKER_01: I'm going to um I'm going to forecast what the sales are going to be.
• 12:06
  SPEAKER_01: I don't know exactly what that number is going to be, um, for two reasons, right?
• 12:12
  SPEAKER_01: I need to forecast.
• 12:14
  SPEAKER_01: And I also need to then think about what the foreign currency differences are going to be at the time the the um sales are actually occurring or or settled, right?
• 12:22
  SPEAKER_01: So I have that variability that I'm trying to hedge against, right?
• 12:26
  SPEAKER_01: That's what I'm trying to shoot for, right?
• 12:28
  SPEAKER_01: That's the risk that I'm really trying to hedge there.
• 12:31
  SPEAKER_01: Um, so the item, the hedged item, would be then a percentage of what my forecasted sales are going to be in a specific currency and over a certain time frame, say 12 to 18 months out, right?
• 12:46
  SPEAKER_01: Um companies will often under hedge.
• 12:51
  SPEAKER_01: You know, they they don't they don't know exactly what it's going to be, but maybe to play it safe a little bit, they'll say, let's hedge you know, 50% of what I expect it to be, or 70%, you know, whatever you're more comfortable with.
• 13:03
  SPEAKER_01: Um, but generally you're not trying to shoot for exactly 100% because you're not quite sure what it's actually going to be.
• 13:11
  SPEAKER_01: But I think it's very important here, too, is that the standard does not allow for kind of a net hedge.
• 13:17
  SPEAKER_01: Right?
• 13:17
  SPEAKER_01: I can't kind of think about what my net effects going to be, what my income and my expenses.
• 13:23
  SPEAKER_01: I have to separately think about my cash inflows of my sales.
• 13:27
  SPEAKER_01: And if I want to hedge that, and if I wanted to hedge kind of a net position, either do a lower percentage or I could hedge the expenses themselves, but I can't combine the two and say shoot for the net.
• 13:39
  SPEAKER_01: During the hedge period, then, you know, and I'll enter into a derivative, a FX swap or or a future or whatever derivative I choose to use to hedge.
• 13:50
  SPEAKER_01: That derivative, you know, as we learned before, is marked to market each period.
• 13:56
  SPEAKER_01: Um and so the derivative itself, instead of going directly into the PL, into the income statement, that sort of gets parked into AOCI, accumulated other comprehensive income, which is a component uh of your equity.
• 14:11
  SPEAKER_01: And then when the item that I was hedging, the sale in our example occurs, I then take a piece of that AOCI that relates to that transaction that I was hedging, and I move it from there to the PL, so that at the same time the hedge result and the actual item are affecting income at the same time and providing that offset, if you will, within the income statement.
• 14:36
  SPEAKER_01: These hedges could be executed by different folks within the organization.
• 14:42
  SPEAKER_01: So the entity that has a direct exposure may wind up doing the hedge, but a parent company could also hedge the transactions that its subsidiary is doing.
• 14:52
  SPEAKER_01: And then some companies will use sort of a central treasury function that'll hedge kind of across the entity.
• 14:58
  SPEAKER_00: So, Chris, let me ask like take a step back and ask a question.
• 15:02
  SPEAKER_00: So, very simplistically, if I just think I have I'm selling, maybe I'm even the I am the parent, but I'm selling, let's say, into Europe and I have a contract and I'm selling in Euros and I know how much I'm selling.
• 15:16
  SPEAKER_00: In theory, if I put a hedge on sort of on day one, I'm effectively trying to lock in those sales in US dollars.
• 15:25
  SPEAKER_00: So I don't want to be exposed to foreign currency risk.
• 15:27
  SPEAKER_00: Instead, I'm saying, okay, I maybe foreign currency would help me in the future, depending on what happens with the dollar, but I'd rather just know I'm going to make a certain amount in US dollars from that contract.
• 15:39
  SPEAKER_00: Is that a fair way to think about it?
• 15:41
  SPEAKER_01: That's right, right.
• 15:42
  SPEAKER_01: You're you're you're trying to say, here is the dollars that I will earn.
• 15:47
  SPEAKER_01: Again, if you're a dollar functional.
• 15:49
  SPEAKER_01: Right.
• 15:49
  SPEAKER_01: But you kind of want to lock into a more of a fixed dollar number for the sale that's going to happen and take away the potential of changes in the dollars I'm going to make that are impacted by the foreign currency fluctuations over that period.
• 16:06
  SPEAKER_00: Okay.
• 16:06
  SPEAKER_00: So then that I think, like I said, it's very simple because I have one contract and fixed amount, fixed quantity.
• 16:12
  SPEAKER_00: But you gave the example of that, you know, let's say I did this a year in advance.
• 16:16
  SPEAKER_00: And then as it starts to get closer, I may realize that, hey, I'm actually going to sell more, maybe hopefully not, but I'm going to sell less.
• 16:25
  SPEAKER_00: And so I might get better visibility into my actual sales.
• 16:29
  SPEAKER_00: So then at that point in time, I almost layer in more hedges.
• 16:32
  SPEAKER_00: And is that the way of the right way to think about it and sort of a common strategy?
• 16:36
  SPEAKER_01: Yeah.
• 16:37
  SPEAKER_01: Well, I mean, first of all, I would say simple and hedging usually don't go together.
• 16:40
  SPEAKER_00: Okay, fair enough.
• 16:41
  SPEAKER_00: Fair enough.
• 16:42
  SPEAKER_00: Relatively simple is what it's like.
• 16:44
  SPEAKER_01: Okay, that's much better.
• 16:45
  SPEAKER_01: Um, but yeah, so so you know, we kind of talked before about how maybe you'd be a little conservative initially, and you know, you don't want to kind of go over, you want to kind of stay under for various reasons.
• 16:58
  SPEAKER_01: But yes, as you either get more comfortable in what your forecasts are going to be, or as you kind of get closer to the period, you can add on and layer on and you know, just kind of be a new hedge in place then, and you just keep layering um to the extent that you want to lock in more and you're more comfortable in kind of where your forecast is going to wind up.
• 17:20
  unknown: All right.
• 17:20
  SPEAKER_00: And then I'm gonna ask one question that's probably more for people who do other types of cash flow hedging.
• 17:27
  SPEAKER_00: Other than the fact you're dealing with the foreign currency here, are there many other subtleties you need to think about in terms of looking at like my forecast of quantity, making sure things are probable or otherwise?
• 17:40
  SPEAKER_00: Or is this just the same as any other cash flow hedge, but it's dealing with currency?
• 17:45
  SPEAKER_01: Well, I would think for the most part, it's pretty similar.
• 17:49
  SPEAKER_01: I mean, forecasts are the rules around cash flow hedging and forecasted are basically the the same.
• 17:54
  SPEAKER_01: Like I said, you can't hedge a net position when you're talking about foreign currency hedges.
• 17:59
  SPEAKER_01: So that is one of the rules.
• 18:02
  SPEAKER_01: Um, there may be certain allowances actually when you're forecasting.
• 18:06
  SPEAKER_01: So oftentimes with a forecasted transaction, it kind of has to be a third party.
• 18:10
  SPEAKER_01: You could do some intercompany transactions and hedge some intercompany.
• 18:14
  SPEAKER_01: So it doesn't always have to be kind of a third unrelated party.
• 18:19
  SPEAKER_00: Okay.
• 18:19
  SPEAKER_00: So and again, I think that's just helpful context for people who maybe deal with these hedges in like again, commodities or or otherwise.
• 18:27
  SPEAKER_00: So then, Brett, let me ask about a different strategy.
• 18:30
  SPEAKER_00: And this one almost makes me laugh at the title, considering that Chris just told us you can't do a net hedge, but there is a type of hedge called a net investment hedge.
• 18:40
  SPEAKER_00: So maybe what's the difference from what Chris was describing and how do you think about that?
• 18:46
  SPEAKER_02: Right.
• 18:46
  SPEAKER_02: So Chris was talking about um hedging sales, like hedging a foreign currency transaction.
• 18:54
  SPEAKER_02: Uh, here we're going to be talking about hedging uh an investment in a foreign subsidiary.
• 19:01
  SPEAKER_02: So I'm doing business in another country, I've determined that the functional currency of that legal entity of my subsidiary is a different functional currency.
• 19:12
  SPEAKER_02: And so we talked about that translation process of bringing, let's talk about a Euro functional subsidiary, bringing the Euro functional financial statements and financial uh results uh into the US dollars for the parent.
• 19:27
  SPEAKER_02: And we talked about that the net assets are gonna be remeasured at the period end spot rate.
• 19:34
  SPEAKER_02: Um, and and Chris walked through how we're gonna remeasure equity and retained earnings, right?
• 19:41
  SPEAKER_02: So, and the result of that is a CTA balance.
• 19:44
  SPEAKER_02: And so that CTA balance is gonna fluctuate up and down as the rates used to translate um these different items differ over time.
• 19:55
  SPEAKER_02: And so some companies will want to hedge the value and fix the value of that net investment as it relates to the currency translation.
• 20:06
  SPEAKER_02: So interestingly, this is a one area where you can use multiple different um multiple different types of hedging instruments.
• 20:13
  SPEAKER_02: So you can use derivatives like we often use in hedges, but you can also use foreign currency denominated debt as a hedge of that of that instrument.
• 20:22
  SPEAKER_02: So let's let's talk through that for a minute.
• 20:24
  SPEAKER_02: So let's say that I've I've got my Eurofunctional uh subsidiary, I've decided I want to hedge it.
• 20:31
  SPEAKER_02: I'm gonna hedge it um with foreign currency debt on my balance sheet.
• 20:37
  SPEAKER_02: So when I have foreign currency debt on the parent company balance sheet, we said normally I would remeasure that debt for changes in FX rates, changes in the spot rates through earnings.
• 20:48
  SPEAKER_02: Through the hedge process, I can designate that debt as a hedge of my of my foreign net investment.
• 20:56
  SPEAKER_02: And rather than marking that to spot through earnings, I will take that spot, those changes in spot on the derivative or on the debt instrument and record them in CTA.
• 21:08
  SPEAKER_02: So think of it as the foreign currency gets more valuable, I'm economically gaining on those net assets I have in my subsidiary because they're becoming more valuable.
• 21:21
  SPEAKER_02: And I will have an economic loss on the debt that I've issued because the amount of US dollars I'll need to use to repay that debt is going up.
• 21:31
  SPEAKER_02: And so I'm I'm getting that offset between my foreign currency debt and my uh investment in my foreign operations.
• 21:41
  SPEAKER_02: And through hedge accounting, I'm recognizing both amounts in CTA as an offset.
• 21:47
  SPEAKER_02: Likewise, if I don't want to use debt, um, I can use a derivative to get the same impact.
• 21:54
  SPEAKER_02: Uh, and I'll provide, I'll get the economic offset in a similar manner to the debt.
• 22:00
  SPEAKER_02: The way treasurers think about this is often interesting and different than some of the accounting because they can often look at these situations as very simply.
• 22:12
  SPEAKER_02: I've got net assets in a foreign subsidiary.
• 22:15
  SPEAKER_02: I've got um offsetting foreign currency exposures on my debt that's funding those, and I'm just getting the offset.
• 22:22
  SPEAKER_02: And they think of the derivative, some cases, as synthetically creating foreign currency debt.
• 22:27
  SPEAKER_02: But however you think of it, you can think of the these hedges once you qualify for net investment hedging as the offset is going into CTA to offset that um that mark you're taking in the CTA.
• 22:41
  SPEAKER_00: So, Brett, then it sounds like this idea of a net investment hedge would only be used in the circumstance where I'm trying to hedge foreign currency changes associated with a subsidiary that has a functional currency other than US dollar or the my functional currency.
• 22:58
  SPEAKER_00: Is that fair summary?
• 22:59
  SPEAKER_02: I think that's right.
• 23:00
  SPEAKER_02: Because remember, you're you're you're it's all starting with this translation process.
• 23:04
  SPEAKER_02: And you don't have the translation process in the first place if you're dealing with uh a subsidiary with the same functional currency as the parent.
• 23:12
  SPEAKER_00: All right.
• 23:12
  SPEAKER_00: I think that's a helpful reminder.
• 23:14
  SPEAKER_00: So then let's get into a little bit about fair value.
• 23:16
  SPEAKER_00: And I think this is an important point that people should listen carefully because we're gonna use some terminology here.
• 23:22
  SPEAKER_00: We'll try to go slow.
• 23:24
  SPEAKER_00: But uh I understand that we have a choice here on when we're considering our hedge, whether we use the entire fair value of the derivative or only changes in the spot foreign currency rates.
• 23:37
  SPEAKER_00: So can can you explain a little what we mean by that and and how you should think about that?
• 23:41
  SPEAKER_02: Sure, sure.
• 23:42
  SPEAKER_02: Um, so let's start, let's anchor ourselves with my debt hedge example.
• 23:47
  SPEAKER_02: So when I've issued foreign currency debt, I said I would normally re-measure that debt at spot rates.
• 23:54
  SPEAKER_02: And when I've designated as a hedge and qualified as a hedge, I can take those changes in spot rates and record them in CTA rather than in earnings.
• 24:04
  SPEAKER_02: And so the changes in spot are what's gonna be reflected in CTA.
• 24:10
  SPEAKER_02: Likewise, when I think of the value of a derivative, value of a foreign currency derivative is not gonna be based solely on spot rates, but is going to be change, be changes in the forward rates for that currency.
• 24:25
  SPEAKER_02: And uh there's a policy choice that you can elect for for these uh for these instruments.
• 24:31
  SPEAKER_02: You can choose to um record in CTA the full fair value changes in the derivative based on the forward rates.
• 24:39
  SPEAKER_02: So take all changes of derivative and and put them in CTA.
• 24:44
  SPEAKER_02: What that means is you know, CTA itself is created using spot rates, but when you take all changes in fair value of the derivative based on forward rates and put it in CTA, you'll have a mismatch going on in CTA.
• 24:56
  SPEAKER_02: Or you can choose to um put only the spot rate changes in the derivative.
• 25:03
  SPEAKER_02: So I I take my full um change in fair value of the derivative and I separate it into what is due to based in what is due to changes in spot rates versus other changes in value of the derivative.
• 25:15
  SPEAKER_02: And if I choose this, I just put the spot rate changes in in CTA.
• 25:21
  SPEAKER_02: So it's in CTA, it will look just like I just like I talked through with the debt.
• 25:25
  SPEAKER_02: And then I've got to decide what to do with the with the difference between the what we call spot forward points.
• 25:32
  SPEAKER_02: Um I can either recognize that difference currently in earnings, or I can take those amounts and record them in OCI and amortize them over the life of the derivative.
• 25:42
  SPEAKER_02: So I've I've got a policy choice and and and we see companies use use different methods.
• 25:48
  SPEAKER_00: And uh Brett, is that a policy choice you make sort of on a case by case, or is this one of our ones that you know that we normally see where it's you have to apply the same policy choice to similar items?
• 25:59
  SPEAKER_02: Great question.
• 25:59
  SPEAKER_02: It's a policy choice for similar items, not on a hedge-by-hedge basis.
• 26:03
  SPEAKER_00: All right, so not a policy choice to make lightly.
• 26:06
  SPEAKER_00: So then let me ask another follow-up question because I know that there was some changes to the standard, I guess five.
• 26:12
  SPEAKER_00: Wow, it's crazy.
• 26:13
  SPEAKER_00: Five years ago, 2017, seems like it just happened, uh, where it, because of some changes to the standard, it became uh more popular to exclude the fair value and to amortize that forward price difference or forward points to earnings.
• 26:31
  SPEAKER_00: So, what about the changes to the hedge itself?
• 26:35
  SPEAKER_00: When do those come into earnings?
• 26:37
  SPEAKER_02: Right.
• 26:37
  SPEAKER_02: So we put those amounts into in CTA and they're gonna remain in CTA until that CTA is is comes into earnings.
• 26:47
  SPEAKER_02: So some which often is very, very much delayed.
• 26:51
  SPEAKER_02: Um, one of my colleagues refers to this as the roach motel, because roaches go into CTA and they don't come out because that CTA balance will remain there until the subsidiary is substantially liquidated or sold.
• 27:04
  SPEAKER_02: And so it's not a model where we often see where those hedge results come into earnings based on the foreign operations or changes in net income of that of that subsidiary.
• 27:14
  SPEAKER_02: They actually remain in CTA and with that subsidiary until you liquidate it or sell it.
• 27:20
  SPEAKER_00: All right.
• 27:21
  SPEAKER_00: So then one more question, hopefully no roaches in the answer to this question.
• 27:25
  SPEAKER_00: Um, that would be on hedges of foreign denominated debt.
• 27:28
  SPEAKER_00: And again, this could be a case where you have a US company that's issuing debt in other currencies for various reasons, maybe interest rates are better or otherwise.
• 27:37
  SPEAKER_00: So, Brett, how do you think about those types of hedges?
• 27:41
  SPEAKER_02: Yeah, a few things to think about.
• 27:42
  SPEAKER_02: And let me start out with something that's off that's counterintuitive to some with related related to forecasted issuances of foreign currency-denominated debt.
• 27:53
  SPEAKER_02: So if um if I believe that I'm going to issue debt in the future, um, some companies will talk about wanting to lock in the FX rate that that will be received at the time that you actually issue the debt.
• 28:09
  SPEAKER_02: And one of the requirements for hedge accounting is that it's an item that affects earnings.
• 28:13
  SPEAKER_02: And in that case, the changes in foreign currency rates when you issue debt will impact the amount of debt, the amount of cash that you get, the amount of US dollars that you get, but it doesn't have an impact on earnings.
• 28:28
  SPEAKER_02: And so that that uh forecasted issuance of foreign currency denominated debt is actually not something uh that is uh considered to be a hedgeable item.
• 28:39
  SPEAKER_02: So we're starting with hedges once the debt is issued.
• 28:42
  SPEAKER_02: And um I may issue fixed rate foreign currency denominated debt, and I may want to swap that into US dollars.
• 28:51
  SPEAKER_02: I can do a couple things.
• 28:52
  SPEAKER_02: I can use a foreign currency swap to convert it into fixed rate, um, a fixed rate functional currency debt, in which case I'd be using a cash flow hedge because I am taking those variable cash flows uh from foreign currency debt and I'm fixing them into cash flows.
• 29:14
  SPEAKER_02: Or I can uh convert that into floating rate debt.
• 29:18
  SPEAKER_02: Um so I'm gonna leave the interest rate fluctuating, but I want to lock in the FX exchange rate, and that would be a fair value hedge.
• 29:27
  SPEAKER_02: This is one case where sometimes companies just choose to use the derivative as an economic hedge, and they they bypass all of the hedge accounting and hedging accounting requirements because the spot rate changes in the foreign currency denominated debt are gonna be flowing through earnings anyway.
• 29:45
  SPEAKER_02: So some companies will just choose to say, I'm gonna have my changes in the derivative, uh, normally mark-to-market through PL, and those are gonna be just recorded in earnings.
• 29:57
  SPEAKER_02: And I'll get a partial offset between the full changes in fair value of the derivative and the spot rate changes on the debt, and that's kind of a good enough offset.
• 30:06
  SPEAKER_02: Um, they'll have the the volatility and earnings just from the spot versus forward differences.
• 30:11
  SPEAKER_02: Um, um, you know, I just talked about taking that debt and using it as a net investment hedge itself.
• 30:21
  SPEAKER_02: And so that's another way that companies are are using debt in in in hedges, not hedging the debt itself, but hedging using the debt as a hedge of of something else.
• 30:32
  SPEAKER_00: So, Brett, definitely a lot to think about, and particularly when I reflect on our entire conversation, clearly this is an area that can get complicated very quickly.
• 30:42
  SPEAKER_00: However, I do think it's an important one because if I take a step back and think about treasures of our clients, or if you are in a company, the treasure of your company, this is often something they're very focused on, is managing these foreign currency exposures.
• 30:57
  SPEAKER_00: So I think just having a fundamental understanding, at least big picture of these different techniques, and then uh sometimes knowing where to look for the answer is is half the battle.
• 31:08
  SPEAKER_00: So on that note, Brett, where would you say people should go for more information on these types of hedges in particular?
• 31:16
  SPEAKER_02: Yeah, I would start with the foreign currency guide, because like we did on the on this uh podcast, you got to start with making sure you understand the basics of foreign currency accounting.
• 31:27
  SPEAKER_02: And then I'd layer on the derivatives and hedging guide with that has some guidance around uh these foreign currency hedges in particular.
• 31:35
  SPEAKER_00: All right.
• 31:35
  SPEAKER_00: And then Chris, maybe a final question for you.
• 31:37
  SPEAKER_00: I know you have a lot of experience working with companies that are executing these types of transactions.
• 31:42
  SPEAKER_00: So I always like to end with the question of what is your best advice for if you're starting to deal with these types of instruments, particularly, you know, sort of for the first time or you're relatively new to it.
• 31:54
  SPEAKER_01: Well, I think it's it's mostly understanding kind of where all of your risks are in the organization when it comes to foreign currency.
• 32:01
  SPEAKER_01: You know, it's not necessarily going to be, you know, it with within the parent organization, right?
• 32:08
  SPEAKER_01: You're going to find a lot of things within the subsidiary.
• 32:11
  SPEAKER_01: But I think oftentimes when you think about where do companies maybe have struggles or what do they struggle with, which going back to the beginning where we talked about the functional currency, right?
• 32:22
  SPEAKER_01: That's probably the one of the hardest things to do is make sure you really have a good understanding and a good thoughtful analysis around what the functional currency is for each of your foreign operations.
• 32:36
  SPEAKER_01: Um that's probably one that causes a lot of difficulties and potential errors in organizations.
• 32:42
  SPEAKER_00: All right, definitely good advice.
• 32:44
  SPEAKER_00: Brett, anything from your perspective?
• 32:45
  SPEAKER_02: I'd say one of the confusing things is just the importance of organization, legal entity organization to some of these.
• 32:52
  SPEAKER_02: And it matters where you're doing foreign currency transactions.
• 32:55
  SPEAKER_02: Whether I issue foreign debt out of a US dollar functional entity or I issue uh foreign currency debt out of a foreign currency functional subsidiary, you'll get very different accounting answers.
• 33:06
  SPEAKER_02: And then how you hedge it and may want to approach your hedges will also be very different.
• 33:11
  SPEAKER_02: So making sure you understand the structure of your organization and which entities have which functional currencies and how they flow up to the parent company is often very important because it'll have very significant uh implications for how you do the hedging, how you execute the hedging, and even what you may want to hedge in the first place.
• 33:30
  SPEAKER_00: All right, definitely those are both great pieces of advice.
• 33:33
  SPEAKER_00: And I think anytime you're dealing with hedges, just starting with what's the risk that I'm trying to address is also a good place to start because if you don't understand your risk, the hedge accounting is never going to make sense.
• 33:45
  SPEAKER_00: I can I can say that definitively.
• 33:46
  SPEAKER_00: So that's definitely another piece I'd look look for.
• 33:49
  SPEAKER_00: So I do have one final question.
• 33:51
  SPEAKER_00: This is sticking with my summer theme since it's July, and this one should be easy.
• 33:56
  SPEAKER_00: So curious, your favorite kind of ice cream, since ice cream came up when I talked to you guys two weeks ago.
• 34:02
  SPEAKER_00: So, Brett, I'll go to you first.
• 34:05
  SPEAKER_02: That's an embarrassing question because my my family will acknowledge that I actually really like Superman ice cream, which is sort of like you know, just a vanilla flavor, but it's got all these crazy colors.
• 34:16
  SPEAKER_02: So it's very difficult to be an aged adult and eating this ice cream that is meant for a kindergartner.
• 34:23
  SPEAKER_00: Yeah, that kind of sounds like something my daughter would have liked when she was five.
• 34:26
  SPEAKER_00: So I like it.
• 34:27
  SPEAKER_00: Very good.
• 34:28
  SPEAKER_00: Good answer.
• 34:29
  SPEAKER_00: And Chris, how about from your perspective?
• 34:31
  SPEAKER_01: I would say I really don't have a favorite flavor per se, but if I have a favorite, is I like to go to those like little, I don't think it's the right way to say it, but like mom and pop ice cream places, you know, the handmade, homemade stuff, and and try all the different variations, right?
• 34:47
  SPEAKER_01: So so I think it's more of a style of ice cream than a flavor.
• 34:51
  SPEAKER_00: I do like that.
• 34:52
  SPEAKER_00: I have to say, I like a good Sunday too, from like an old-fashioned Sunday shop.
• 34:56
  SPEAKER_00: But if I had to pick a favorite, I think many people's mint chocolate chip would probably be mine.
• 35:02
  SPEAKER_00: I sometimes stray, but always come back to that.
• 35:04
  SPEAKER_00: So, gentlemen, light note to end on a complicated topic.
• 35:08
  SPEAKER_00: So I do appreciate all your insight and thanks for joining me today.
• 35:13
  SPEAKER_00: That does it for today.
• 35:15
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• 35:25
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• 35:31
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• 35:39
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• 35:48
  SPEAKER_00: From Thought Leadership at PwC, I'm Heather Horn.
• 35:52
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