The UK left the EU on 31 January 2020 and entered a transition period until the end of 2020, while the UK and EU negotiate additional arrangements. The current rules on trade, travel, and business for the UK and EU will continue to apply during the transition period, however, there is still uncertainty surrounding how the UK and EU will operate in the future and how businesses with ties to the UK will be impacted. Decisions made throughout the transition period could have an impact on the application of hedge accounting from a U.S. GAAP perspective.
Changes to Derivative Transactions
From an accounting perspective, a company’s derivative positions could be impacted both directly and indirectly. Most notably, some banks may begin to reach out proactively to make certain amendments to their ISDA Master Agreements. These amendments could take the form of migration of trades through new derivatives contracts with banks’ EU affiliates or subsidiaries (“novations”) as well as the incorporation of regulatory provisions into ISDA Master Agreements to address Brexit.
To the extent that your bank reaches out to you to incorporate certain provisions into your trading agreements, please review carefully to ensure those changes meet your expectations or contact your Chatham Relationship Manager regarding our capabilities to assist with the evaluation.
Probability of Forecasted Transactions in Cash Flow Hedges
Brexit may cause a disruption in the flow of goods and services that are currently in place for entities within the UK. For entities that are hedging future revenues or expenses, a change in the supply chain could disrupt the originally expected timing, the originally expected currency, or even the likelihood of those transactions to occur at all. Companies should review expected future transactions to determine what, if any, changes in timing could occur due to Brexit. If a timing change has occurred, companies will need to assess whether the hedged transactions are still probable of occurring and if their current derivatives still qualify as effective hedges.
Impact on Net Investment Hedges
For entities hedging the net investment in a foreign-denominated operation, volatility stemming from Brexit could reduce the value of the hedged operation’s net assets, therefore reducing the capacity for net investment hedge accounting. Entities should review the impact of Brexit on the value of any hedged operation’s net assets and determine if a de-designation, in whole or in part, of the hedging relationship is necessary.
Furthermore, entities that have intercompany transactions in Britain or the EU that are long-term in nature may need to determine if this assertion still applies post-Brexit. Foreign denominated assets and liabilities which fall under this category are required to record all associated FX gains and losses in a cumulative translation adjustment (CTA) account. This accounting treatment generates a net investment exposure from a hedge accounting perspective. Brexit may lead to changes in market dynamics such that companies should appropriately question the nature of these transactions and determine if they still meet the long-term in nature criteria. If such criteria is no longer met then FX gains and losses associated with the foreign asset or liability would no longer be recorded to CTA. Hedge accounting on any associated net investment hedges would thus require dedesignation due to lack of net investment exposure.
Lastly, current accounting standards permit the application of net investment hedge accounting on an after-tax basis. These designations require the hedged item to appropriately reflect the impact of potential changes in tax rates on the hedged net investment balance. Thus, companies should be considering material changes in their tax environment resulting from Brexit as those changes may have an impact on the after-tax net investment capacity.
Impact on the Spot Rate used for Foreign Currency Transactions
Under the guidelines of ASC 830, entities are permitted to record foreign denominated revenues, expenses, gains, and losses using a weighted average or other method as an approximation. This guidance allows entities to avoid the administratively burdensome task of recording individual income statement items at the daily spot rate on the date in which they occurred. Entities should monitor whether or not their use of a weighted average or other approximation remains appropriate as a result of Brexit.
Impact on Functional Currency
Entities may view Brexit as a trigger to review the environment in which they primarily generate and expend cash, which could lead to a change in their functional currency post-Brexit (e.g. going from EUR-functional to GBP-functional). For example, a UK entity with a EUR functional currency has historically hedged GBP inventory purchases and designated the derivatives under cash flow hedge accounting. Due to Brexit, the Company reviewed the overall economic environment and identified that its functional currency changed to GBP. Such a change eliminates the foreign currency exposure required to maintain cash flow hedge accounting and thus could cause a de-designation of the hedging relationship.
Impact on Disclosures
The possible effects of Brexit on derivative instruments such as a change in an entity’s credit risk, currency risk, fair value measurement, liquidity risk, change in hedged transaction probability, and any other identifiable risks should be included in an entity’s disclosures to the financial statements. Additional risks derived from Brexit that may impact an entity’s financials, such as newly applicable laws and regulations, should also be contemplated for disclosures.
For companies with business ties to the UK, measuring the financial and accounting impact of Brexit will be a challenging endeavor. With a team of over 50 accountants dedicated to helping our clients navigate the complexities of hedge accounting for U.S. GAAP, Chatham Financial is fully prepared to assist companies with contemplating the accounting impact of Brexit on their hedging programs. As these conversations come up within your organization, please do not hesitate to reach out to your Chatham Relationship or Accounting Manager.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0051