By Geri Westphal
Embedded derivatives are coming back to haunt many treasurers due to the strength of the US dollar and general FX market volatility.
Embedded derivatives are not new, but historically, the P&L impact of embedded derivatives has not been something treasurers have had to worry much about. But now things have changed. With the continued stre ngth of the US dollar, this issue has gone from a source of irritation to one of major concern, as many organizations are being forced to take a closer look at how they identify embedded derivatives included in their sales contracts. Treasury teams are reviewing their business practices to ensure that they are involved in the review and approval of embedded derivative language prior to the signing of the sales contract instead of the usual notification at the tail-end of the order-to-cash process.
What is an embedded derivative?
An embedded derivative is part of a financial instrument that also includes a non-derivative host contract. The embedded derivative requires that some portion of the contract’scash flows be modified in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate.
For example, a USD company might enter into a sales contract with an EUR company, creating a host contract. If the contract is denominated in a foreign currency, such as GBP, an embedded foreign currency derivative is created. According to the US GAAP and International Financial Reporting Standards (IFRS), the embedded derivative has to be separated from the host contract and accounted for separately unless the economic and risk characteristics of both the embedded derivative and host contract are closely related.
So what’s the big deal?
The big deal is that according to accounting guidelines, these embedded derivatives must be separately identified and accounted for independently from the host (sales) contract. The company has to mark-to-market the value of the embedded derivative, and based on the continued strength of the USD along with the increased volatility in the FX markets, the mark-to-market value flowing to the P&L can have a material impact on earnings.
From Irritant to major pain
According to statistics presented at the Summer 2015 meeting of the FXMPG, the USD has rallied by 21% for the Fed’s “major currencies’ index and 18% for the ‘broad’” index since 2014. Using previous cycle peaks and other long-term fair value models, it is estimated that the USD could strengthen by an additional 10-15%, over the next 2-3 years. This means that the value of the embedded derivatives could be significant (either as a gain or as a loss) when marked-to-market from period A to period B and the difference is directly reflected in the overall earnings of the organization. This adds volatility to earnings, which is why this issue has escalated in priority.
What Can be Done?
For most organizations, gaining real-time visibility into their receivables is a critical step to properly identifying embedded derivatives. Gaining this kind of front-end visibility means that organizations need to put systems in place that allow for centralized aggregation and administration of all AR activity as described in a 2015 white paper by Fundtech (now part of D+H Financial Technologies), titled “Tackling the Challenge of Embedded Derivatives: How Receivables Automation Enables Earlier Identification and Reduces the Risk of Improper Accounting Treatment.”
As proposed in the white paper, by moving to a centralized hub-based structure for AR and implementing a variety of work-flow approval processes, organizations can capture the embedded derivative information on the front-end of the order-to-cash cycle and allow treasurers to more proactively manage these exposures.
This type of centralization and automation can reduce audit scrutiny and give treasurers greater peace of mind that all embedded derivatives are being properly managed through the risk management and accounting processes.