Global Finance 389There is some hedging of translation, but the hedging of translation expo-
sure is clearly less common than the hedging of transaction exposure. Hedging
practice, based upon cited surveys and our own study of hundreds of company
reports, suggests the following order ing of management demand for hedging,
from high to low:
- To protect cash f low and earnings, both level and stability.
- To protect earnings, both level and stability.
- To protect shareholders’ equity, both level and stability.
In continuing to observe hedging motivated by both two and three above,
it is important to consider the significance of earnings and equity amounts
without regard to the issue of cash f lows. For example, there is a tremendous
current focus on whether or not earnings meet the consensus forecasts of Wall
Street. The penalty for missing the forecast, sometimes by pennies, can be dra-
matic reductions in share value. Of the two translation methods, only the tem-
poral (remeasurement) method includes the remeasurement gains or losses in
the computation of net income. There is no evidence that a failure to meet the
Wall Street consensus will be forgiven if it results from unhedged remeasure-
ment exposure.
Management compensation is often based, directly or indirectly, upon re-
ported earnings. This provides an incentive for management to hedge in order
to avoid earnings reductions from remeasurement losses.
Finally, it is common for debt and credit agreements to include financial
covenants that require the maintenance of minimum amounts of shareholders’
equity or minimum ratios of debt to equity. Unhedged translation exposure,
under either the all-current or temporal (remeasurement) methods, may re-
duce shareholders’ equity and cause these covenants to be violated.
Differences in hedging practices are explained in part by different atti-
tudes towards bearing currency risk as well as the cost and capacity to hedge
exposures in different countries. In addition, firms will differ in their capacity
to minimize currency exposure through various operational, organizational and
business arrangements.
As a final topic in this coverage of currency risk and hedging, an over-
view of the current requirements in the accounting for currency derivatives
is provided.
ACCOUNTING FOR HEDGES:
CURRENT GAAP REQUIREMENTS
Important changes in the accounting for currency derivatives were introduced
with the issuance of SFAS No. 133, Accounting for Derivative Instruments and
Hedging.^37 Initial required application of the standard begins with the first fis-
cal quarter of the first fiscal year beginning after June 15, 2000.
One of the most important requirements of the new standard is that all
derivative instruments must be recognized on the balance sheet and carried