Author Archive for Richard Eaddy

As a guest speaker at a recent, global accounting network event I was very interested to hear a robust discussion focused on the subjective area of “materiality”. The unsurprising, and somewhat unsatisfactory, conclusion from the room was that determining materiality depended on a number of different factors, and that there was no “golden rule”. Not the preferred answer for a room full of accountants. What is clear, though, is that to determine materiality one must first of all calculate the numbers before judging what is material or not.

From a financial instrument valuation perspective, my take on materiality is slightly different.

The complex nature of financial instruments means that auditors cannot simply rely on the client provided valuations and use these to judge materiality. It is a big assumption that the valuations are, indeed, correct. Valuations need to be cross-checked to ensure the starting point of deciding whether they are material is valid.

There are two important points to remember with this. Firstly, banks are often the source of clients’ valuations and they can, and do, get it wrong. The disclaimer at the bottom of any counterparty provided valuation is testament to this. The message that valuations should not be relied upon comes through loud and clear. There is plenty of scope for human error in the process of calculating financial instrument valuations. We see it regularly, when we are asked to check valuations. Despite the disclaimers it is understandable that companies do actually rely on the valuations for financial reporting purposes, particularly small and mid-size companies as they often don’t have access to the systems to value these instruments themselves.

So, as an auditor, you need to check the valuation. If not, what might at face value be regarded as immaterial might in fact be quite the opposite. The correct valuation may well be material. Again, we have seen plenty examples of this. Auditors need to look at the underlying transaction. If the notional amounts are large, or maturing a long way out into the future, then you need to check the valuation. The correct valuation is unlikely to be small due to financial market volatility.

Interest rate swaps are a good example of this. They tend to be large notional amounts and maturing in more than twelve months’ time, sometimes out 10 or 15 years. Equally, with foreign exchange contracts you need to look at the maturity date and the notional amounts being bought and sold to be able to make an informed decision on whether the results are likely to be material or not.

If there is found to be a material difference in the financial instrument valuation, it is better to find it before the audit is complete, rather than after. No one wants to have that discussion with the CFO or Finance Director about having to restate the accounts.

So next time you get involved in that riveting conversation about materiality don’t forget to look behind the numbers.

 

KathmanduKathmandu is an iconic New Zealand company, having been established in 1987 and grown to be a global success. Kathmandu is a leading specialist in quality clothing and equipment for travel and adventure in New Zealand, Australia and the United Kingdom. It has more than 160 stores around the world and is listed on both the NZX and the ASX.

With its global reach comes exposure to fluctuations in exchange rates. Kathmandu’s key currency risks lie in the USD, AUD and GBP. Being publicly listed means Kathmandu needs access to accurate information in a timely manner for its financial reporting. Kathmandu also uses Hedgebook for its hedge accounting.

Kathmandu has recently chosen HedgebookPro as the treasury system to manage its foreign exchange hedging and exposures. As Chris Kinraid, Group Financial Controller, noted “Hedgebook’s functionality satisfies our treasury needs and at a compelling price point.”

Hedgebook welcomes Kathmandu as its newest client in 2016.

Not easyWhile I am sure when Coldplay sang “Nobody said it was easy” they weren’t talking about FX hedging (unless they were thinking of repatriating some of their royalties), it doesn’t have to be as uncertain and difficult as many business owners perceive.

Here at Hedgebook our ethos is very much “keep it simple” because often we find importers and exporters are scared to hedge. That’s because they don’t understand the implications of the hedges they are putting in place, whether they are simply using FX forwards or being a bit more edgy and using options, normally zero-cost.

The basics of FX hedging haven’t changed since currencies were first freely floated. At a basic level you need to have visibility over your position. This means:

  1. forecasting your current and future foreign denominated cashflows
  2. knowing what FX hedges you have in place versus your foreign cashflows
  3. overlaying all of this with real time foreign exchange rates.

This is commonly known as the “three pillars of currency risk management”.

By pooling this information together you get total visibility over your position to make informed hedging decisions. What happens if the currency goes up or down two cents? Do I care? Does it affect me achieving my budget rate?

As with anything, the more information, the better the decision. Everyone has a view on where the exchange rate is going but that matters little if you don’t know what the impact on your business is.

Nobody said it was easy but equally there is no reason for A Rush of Blood to the Head (to quote another Coldplay song). Have total visibility over your foreign exchange exposures and start making better decisions.

For a closer look at the building blocks required to simplifying foreign exchange hedging download our Dollars & Sense eBook.

Foreign-Exchange-Market-257x300When it comes to business risks for manufacturers and exporters, time and again fx volatility comes out as the number one concern. FX risk management is seen as a murky world but it doesn’t have to be if you are disciplined about following these six steps.

Step 1 – Identify the FX exposure

It is an important first step to identify and measure the foreign exchange exposures that need to be managed. You will need to think about the timing of the receipt or payment. What date do you need to hedge to? As an exporter, how confident are you funds will be received on a certain day, week or month? For an importer, often it will be an invoice that will need to be paid on a certain day, based on the agreed payment terms with the supplier.

You may have some offsetting risks. From a risk management point of view it reduces your risk if you can offset any incoming amounts against any outgoings that are in the same foreign currency, so that you only hedge the net amount. Again this will depend on the timing of the receipt and the payment.

Step 2 – Develop your FX risk management policy

Once you have identified your FX exposure it is then important to formulate a Risk Management Policy that is followed in a disciplined way. This policy can be developed by yourself or you can use your bank or an independent treasury adviser/consultant to help you.

The policy will include the amount of hedging that can be transacted (likely a minimum and maximum percentage of the exposure) and the instruments that can be used.

Depending on the size of your organisation, often the Board of Directors will approve the policy and give senior management the authority to act within it. The only time senior management would go back to the Board would be if they wanted to do something that was outside of the agreed Risk Management Policy.

Step 3 – Ascertain and measure your budget and/or costing rates

For most companies it is important to protect the budget rates that have been agreed prior to the start of the financial year. For manufacturers it may be a costing rate for a particular job or event that is important.

The protection of such rates may well be the underlying reasons to hedge. It is important that these rates are identified and measured.

Step 4 – Formulate your hedging strategy

Formulating a hedging strategy that works within your policy and bests position you to achieve the outcomes you desire is an important step.

It is important that you have access to accurate information when looking at your strategy. You need to have good visibility over your expected cashflows, the hedging you may already have in place and where exchange rates currently are.

You may require some outside help to formulate your strategy. Your bank or an independent treasury adviser/consultant can assist with this in terms of the instruments you should use, the exposures you are hedging and the amount of risk you are prepared to take.

Step 5 – Execute your hedging strategy

Once the hedging strategy has been formulated the next step is to execute. It is important that you understand the impact of the hedging you are putting in place. For those using FX forwards this is simpler than if you are also using options as a hedging instrument.

If you can’t explain to your board the instruments you are entering into and the impact on your FX position then you shouldn’t be entering into them.

Step 6 – Evaluate the results and adjust if necessary

The final step in the hedging process is to evaluate and measure the results, and, if necessary, adjust the strategy.

The basis of the evaluation will depend on the overriding reason to hedge. Was it to protect a budget rate, a costing rate or merely to give some certainty of cashflow?

To measure these results you need to be able to accurately track the hedges you have put in place and compare to the budget rate or the spot rate on the day. This will require the ability to measure the weighted average exchange rate achieved and to compare against the yardstick you have chosen. This is possible within a spreadsheet but easier with a treasury system.

Dive deeper into how to better manage FX risk with our handy guide Dollars & Sense. Download to better understand what constitutes FX risk, whether you should be hedging against it, the common financial instruments involved and the technology tools available to make the process easier.

We are only a week or so past 30 June (a common balance date for many Hedgebook clients) and already we are fielding questions/comments regarding the big movements in the mark-to-market valuations of our clients’ portfolios. The questions have nothing to do with the accuracy of the valuations but mostly around, “why has this happened?” Many of the big movements relate to our clients that hedge their interest rate risk via interest rate swaps.

It is no surprise given the sharp downward movements we have seen in the New Zealand and Australian yield curves over the last few months (see charts). A 1% move on a 5 year $5 million swap will result in a $250,000 move in the mark-to-market. Depending on the size of your swap portfolio, and the tenor of the swaps, the moves can be material.

NZD swap movements

AUD swap movements

An interest rate swap is a valuable hedging tool which helps companies manage their interest rate risk. Many companies have treasury policies which force them to have a proportion of fixed and floating interest rate risk which helps with certainty of interest cost as well as smoothing sharp interest rate movements, both up and down. However, there is also a requirement to mark-to-market swaps, and for many to post these changes to their profit and loss account. Some companies negate this profit and loss volatility by hedge accounting, but many don’t which often requires some explanation to senior management, directors and investors.

For publicly listed companies the impact, both real and perceived, of large movements in financial instrument valuations is even more critical. The requirement for continuous disclosure means that a large move in these valuations may require the issue of a profit warning, as we have recently seen from Team Talk, the telecommunications company. Team Talk’s shares dropped 6.3% on the back of the hit taken by a revaluation of interest rate swaps. The company noted that the change in the value of the interest rate swap portfolio was due to “wholesale interest rates falling significantly in the period”.

Equally we have a number of private companies and local governments who have been concerned at the change in their valuations and how they are going to be explained further up the tree. Having constant visibility over these changes will at least forearm any difficult conversations, as opposed to relying on the bank’s month end valuations.

Whilst Hedgebook won’t help improve mark-to-market valuations, it does assist with companies keeping abreast of changes in the value of swap portfolios on any given day. This is pretty much a “must have” for publicly listed companies that have the responsibility of continuous disclosure but forewarned is forearmed and many others are also seeing the benefit of having access to mark-to-market valuations at any time.

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