Applying hedge accounting to forecasted inter company transactions

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Applying hedge accounting to forecasted inter
company transactions
January - IASB Meeting Observer note- Agenda
Paper 9

• IASB, London
• 19th January, 2005
• Mark Kirkland

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• Philips Organisation
• 2. Risk Management in Philips
• 3. Collection Process of Cash in Philips
• 4. Issues of moving to a 3rd party Cash flow
  hedge

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Philips Organisation.

• Five main Product Divisions Lighting
• Domestic Appliances
• Consumer Electronics
• Semi Conductors
• Medical
• Run as independent businesses.
• Lighting is relatively de-centralized, DAP and
  Semi Conductors are very centralized.
• KPENV is the holding company
• Approx.1200 reporting entities (funlocs/ business
  organisations)

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Financial Risk Management

• The objective of Financial Risk Management is
  to increase shareholder value by reducing the
  fluctuations in earnings and in cash flow as a
  result of movements in the financial markets.

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Foreign Exchange Risk Management
Exposures versus non functional currency in
1. Transactions 2. Loans and Deposits 3.
Equity Holdings 4. Translation of
Profits 5. Translation of Equity 6.
Competitive Risk

• Business Organisations
• Corporate Treasury
• Corporate Treasury
• Corporate Treasury

• Hedged
• Hedged
• Currently Not Hedged
• Not Hedged
• Partially Hedged
• Not Hedged

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Management of Transaction Exposures

• Define functional currency (SFAS 52)
• Identify and measure all committed transactions
  in currencies other than functional currency.
  Hedge these transactions using forwards. (There
  is no distinction between inter company and 3rd
  party transactions.) Document these hedges and
  the relationship to the underlying exposure.
• Identify and measure all anticipated transactions
  in currencies other than the functional currency.
  Hedge up to 50 using forwards. Greater
  percentages require approval by PD CFO and Group
  Treasurer. (There is no distinction between inter
  company and 3rd party transactions.) Document
  these hedges and the relationship to the
  underlying exposure.
• The PD CFO and Group Treasurer may suspend the
  hedging of hard currency receipts or soft
  currency payments in certain countries.

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Where, When and How?

• The business organisations hedge so that the
  results of the hedges occur and are recorded
  where the underlying exposure affects the PL of
  Philips.
• The business organisations apply hedge accounting
  so that the results of the hedges are recorded
  when the underlying exposure affects the PL of
  Philips.
• All external hedges are executed in the financial
  market centrally via Corporate Treasury to ensure
  professional execution.

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Collection of Cash in Philips

• Philips runs an In-House Bank (IHB)
• All cash received on the business bank accounts
  is pooled through an overlay structure to the
  holding company.
• The business is then credited on their IHB
  account.

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100 from customer
? ? ? KPENV
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Intra Day
? ? ? KPENV
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End of Day
? ? ? KPENV
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• The actual cash has been divorced from the
• information flow.
• KPENV is able to use the cash but the cash is
  still
• owned by Philips Business Lighting in US.
• Even though Philips has received US it has not
• been converted to Euro since the beneficial owner
  
• has a US functional currency.

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Customer pays 100
? ? ? KPENV
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Intra Day
? ? ? KPENV
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End of Day
Bank
? ? ? KPENV
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• The receipt of Euro has lead to an external FX
  transaction with a bank despite being the
  presentational currency of Philips because the
  funds belong to a US functional currency company

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• If a Philips entity with Euro functional currency
  makes a US payment to a Philips entity with US
  functional currency, then the IHB will credit the
  US entity in US and debit the European entity
  the equivalent Euro.
• In order to ensure the assets and liabilities of
  KPENV are matched, KPENV will sell the Euro to a
  bank to buy the US for this intercompany
  transaction.

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• Conclusions
• Receipts of US to Philips from 3rd parties do
• not necessarily lead to external FX deals with a
• bank.
• Receipts of Euro to Philips from 3rd Parties may
  lead to external FX deals with a bank.
• Inter company payments in Philips can lead to
• external FX deals with a bank.
• We are actually hedging the external FX spot
  deals which result from the cash flow processes

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Example 1
(1) GBP 65 Sales in the UK
Philips CE (UK) GBP
TSMC (unconsolidated)
(3) GBP 50
(5) US 70
(2) GBP 5 Labour cost
(9) US 5
A
Philips CE (France) EUR
Philips Semi Conductors (US) US
Philips Components (US) US
B
(6) US 70
(8) US 50
(4) Eur 90
(7) US 10
(10) US 40
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Under Current Way of Working Sell GBP 50 vs
Eur (3) Buy US 70 vs Eur (5) Buy US 70 vs
Eur (6)
Under 3rd Party Cash flow Method Sell GBP 65 vs
EUR (1) Combined Buy GBP 5 vs EUR
(2) Buy US 70 vs EUR (5) Sell GBP 60 vs EUR
(1)(2) Buy US 10 vs EUR (7) Buy US 70 vs
EUR (5) Buy US 5 vs EUR (9) Buy US 55 vs
EUR (7)(9)(10) Buy US 40 vs EUR (10) The
result is not significantly different!
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Issues of Changing to a 3rd Party Cash Flow Hedge

• Timing
• may not match
• actual conversion

In most corporates the actual external conversion
of foreign currency with a bank is at point A or
B and not when the Sterling is received by the
UK sub or when the US are paid by the US subs.
The hedges should be timed to mature when the
conversions take place.
2. Complexity of hedging increased for units
Showing that the inter company flows match
eventual external flows and trying to link them
add undue burden which does not add value. It
may logistically be barely possible as the chain
could be much longer.
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Issues of Changing to a 3rd Party Cash Flow Hedge

• Complexity
• of hedging increased
• for units

Under the 3rd Party Cash Flow hedge model,
Philips CE France would be required to do
something different for purchases from TSMC and
purchases from Philips Semi Conductors in the
US, despite the fact that in Philips both
customers are treated by Philips CE France as
arms length customers.
4. Complexity of Management Reporting increased
Currently, management can clearly evaluate the
value added of each point of the chain. Judging
Philips CE in France is easy, despite the
foreign exchange flows as results of the hedges
are taken by Philips CE France
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Issues of Changing to a 3rd Party Cash Flow Hedge

• Increased
• Operational risk

Under the current way of working, we can focus
the hedging and identification of exposures on a
small number of businesses. This ensures
qualified professionals can assess exposures.
The 3rd Party Cash Flow hedging method forces a
large number of entities to hedge or trace
relevant flows and hence increases operational
risk.

• Hedging of
• IFO through the
• back-door

When comparing the two methods we hedged
slightly less GBP and slightly more US under
the current way of working. This represents the
profit margin in the model. Since most companies
are net sellers in foreign currency the 3rd
Party Cash Flow hedging method allows hedging of
IFO through the back-door.
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Issues of Changing to a 3rd Party Cash Flow Hedge

• Inconsistency

A change in the Groups presentation currency to
US would significantly alter the hedges
undertaken by each entity under the 3rd Party
Cash Flow hedging method. In the example the
hedges would be Sell GBP 65 vs US (1) Buy GBP
5 vs US (2) Sell EUR 90 vs US (4) Which are
significantly different from when presentation
currency is Euro.
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Example 2
(1) TWD 2500
Philips Semi Conductors Taiwan (TWD)
(4) R350
Philips CE Brazil (Real)
USD 100
(2) TWD 500
8. Clarity It is unclear under the 3rd Party cash
flow hedging method, who should hedge and
what should be hedged, which is of paramount
importance for internal control and risk
management.