Bookkeeping is not only about entering accounting cases, generating countless reports and analyses, but also about properly documenting accounting cases in order to know over time what was entered and why, and also as a means of evidence for the tax authorities in the context of a possible tax audit.

In addition to the usual tax documents, contracts, calculations of estimates and other documents used as a basis for accounting, one of the important documents is hedging documentation used to support the correctness of accounting for financial derivatives negotiated in the context of financial risk management.

As already indicated, firstly, the creation of hedging documentation relates exclusively to companies using financial derivatives that the company has arranged to hedge financial risks. If a company has arranged financial derivatives for the purpose of trading them, the creation of hedging documentation is irrelevant. 

And what exactly is a financial risk management derivative?

Of the different types of derivatives, currency forwards and swaps are mainly used as hedging instruments, which are negotiated to hedge a specific exchange rate to convert one currency into another at a specific point in time in the future and thereby minimise the effects of fluctuations in exchange rates over time. It may also involve repeated purchases and sales of funds in a particular currency at predetermined points in time. In addition, interest rate swaps are often used in practice and banks often impose their conclusion as one of the conditions for granting a loan.

The specific type of derivative a company uses depends on the risk the accounting entity is trying to manage.

If the company has a derivative, it is required to remeasure the derivative to fair value no later than the balance sheet date, the date of interim and extraordinary financial statements or the date of reporting under specific legislation. In other words, we can say that a revaluation is carried out by a company whenever it prepares its financial statements. 

If the derivative is held for trading, the remeasurement to fair value is accounted for in profit or loss and may significantly affect the entity’s profit or loss for the current accounting (taxable) period. However, the revaluation of a derivative used to hedge cash flows will, in certain cases, be accounted for on the balance sheet and the current period profit or loss will not be affected by the revaluation. There is one big hitch to it, though. In order for a company to apply equity accounting (balance sheet approach), it need to have hedging documentation in place to demonstrate the effectiveness of the hedge. Without this documentation, the company must account for all derivatives as derivatives intended for trading (i.e. on a performance basis), even if they are held to hedge risk. It follows from the above that the preparation of hedging documentation is not an obligation, but only an option that can bring benefits to the company.

Hedging instruments are not that easy...

In the event that an entity decides to manage its financial risks, whether currency, interest rate or otherwise, it is necessary to consider whether the financial instrument negotiated will meet the prescribed conditions defined in Decree No. 501/2002 Coll., implementing certain provisions of Act No. 563/1991 Coll. on Accounting, for accounting entities that are banks and other financial institutions (to which Czech Accounting Standard for Business Enterprises No. 009 – Derivatives refers).

These are the following conditions:

• The hedging relationship shall be documented at the inception of the hedge,
• Assurance must be effective,
• Effectiveness is reliably measurable and continuously assessed.

These conditions imply that the entity needs to be aware of these conditions and be prepared to meet them when the derivative is designated as a hedging instrument.

Now that I have a hedging tool, how do I properly document it?

Hedging documentation should generally have 2 parts:

1.    Part – Identification of the hedging instrument

This part is the introductory one and must be prepared at the beginning of the hedging relationship. It shall include an identification of the hedged transactions and hedging instruments, a definition of the risk the entity is hedging and the method of calculating effectiveness.
Efficiency can be calculated using different methods depending on the nature of the hedging relationship (the hedging instrument used). The appropriate method chosen must be stated and described in the securing documentation.

2.    Part – calculating the effectiveness of a hedging instrument

As discussed in the terms and conditions for hedging instruments, effectiveness is calculated at the inception of the hedging relationship by prospective testing to demonstrate that the entity correctly assumes that the hedge is highly effective, and then always at the date of the financial statements by retrospective testing to assess the actual effectiveness of the hedge. Therefore, the hedging documentation will include both the calculation of the expected effectiveness at the beginning of the hedging relationship and the calculation of the actual effectiveness at the end of the accounting period (at the balance sheet date). The expected values of the effectiveness of the hedge (which is effectively a mutual offset of changes) over the life of the hedging relationship must reach between 80 % and 125 % of the changes in the fair values of the hedging instruments corresponding to the hedged risk.

Can financial risk be managed in other ways?

In some cases, for example, currency risk can also be hedged in a natural way or with a natural hedging instrument. An example is a situation where a company receives rental payments in EUR and, on the other hand, repays a loan on a rental property also in EUR. In this case, there is no need to negotiate a currency derivative because this flow of funds covers any fluctuations in currency exchange rates. However, for this system to work properly, it is necessary to coordinate incoming and outgoing payments, to determine whether such natural hedging is effective (indeed, the amount of incoming and outgoing payments is similar and takes place over a relatively short period of time) and can be relied upon in the future.

In conclusion...

In times of changing exchange rates and interest rates, many companies consider hedging their risks through derivatives. If you are considering this option, please do not hesitate to contact us for consultation or advice.
 
Author: Karolina Vernerová, Jan Vácha