MODEC’s step to an automated FX hedging process

MODEC, the world’s largest independent operator of offshore floating production systems for the oil and gas industry, was managing its foreign exchange (FX) hedging process manually.

Since our functional currency is US dollars, we are exposed to a significant FX risk

Qiurong Chong, Financial Planning & Treasury Manager

In 2020, the company decided to automate this process, successfully reducing the time spent on it from three days to within one day.

Headquartered in Tokyo, MODEC is a general contractor for the engineering, procurement, construction and installation (EPCI) of floating systems for deep-sea oil production. These systems include FPSO (floating production storage and offloading) units, FSO (floating storage and offloading) units, floating liquefied natural gas (FLNG) facilities, tension-leg platforms (TLPs), semi-submersible platforms, mooring systems and new technologies to meet the challenges of gas production floaters.

As largest independent operator of FPSO’s in the world, MODEC specializes in units for offshore deep sea oil production. “Then we either sell it to our clients or own and operate it on client’s behalf for 20 to 25 years,” says Qiurong Chong, Financial Planning & Treasury Manager at MODEC. Her business unit is located in Singapore and handles the conversion and EPCI of the FPSOs. From there, majority of the constructed FPSOs are handed over to MODEC’s business unit in Brazil responsible for the operations and maintenance of the vessels. “Our operations are therefore substantially in Brazil. But we do have presence in Australia, Ghana and Vietnam too.”

Challenge

Need for automation

As a global company, MODEC deals with a lot of vendors and major equipment suppliers. Chong: “Our vendors are located everywhere. Some are in China, where we usually do our transactions in US dollars. The major equipment vendors are located in Europe, such as Italy, Germany and The Netherlands. Therefore, the euro is one of the main foreign currencies. And since our functional currency is US dollars, we are exposed to a significant FX risk.”

MODEC’s finance department was managing the FX hedging process manually with the use of spreadsheets. By the end of 2019, there were approximately 350 outstanding FX forwards hedging the future cash flows of the purchase orders (POs) associated with MODEC’s projects. “The POs contain the information we need from the vendors for the FX process, including the cost in dollar value, the breakdown of the payment milestones and the expected payment date,” Chong explains.

The PO information was extracted from its system to be incorporated in an Excel overview driving their hedging activities. This was a labor-intensive process and since the expected number of FX transactions increased, MODEC decided to automate this process. Chong: “With Excel you have less control over the data integrity and only a few people had access to the account data. There were quite some governance concerns on this manual spreadsheet. We wanted to improve this process. And as our company grows, with an increasing number of projects running at the same time, the effort that we spend on updating and maintaining hundreds of transactions was too much.”

SAP TRM for straight-through-processing

Previously, all FX forwards were communicated via email, letter or phone and processed through a single cash centre between two banks. Bank accounts exist within each bank for all the currencies transacted, which total around eight for each bank. Monthly valuations are provided by the banks and upon settlement the bank automatically debits and credits MODEC’s bank accounts accordingly. GL journal entries were manually created in SAP. In the coming years, the number of FX forwards is expected to grow to 500 or more.

In the summer of 2020, MODEC Finance decided to implement SAP TRM for the straight-through-processing of FX forwards. Chong: “We asked around in the market about what system they used for their FX transactions. Our accounting migrated to SAP in 2017, which is quite recent. And since our information on vendors and POs are all in SAP, we thought: why not integrate everything together? That is why we decided to choose SAP TRM.”

Solution

Meeting the requirements

Thereafter, the new system needed to be integrated and automated. “We had been working with SAP successfully for some time and they recommended Zanders to support us. We reached out and asked Zanders for a demo. During that demo the team showed us the flow and functionalities that the TRM module in SAP could offer. It met our requirements, and we felt comfortable as Zanders could explain what we did not understand. It is important to be able to communicate with consultants in very simple terms and things that our department could understand. That is why we chose Zanders to support us in this project.”

Chong then asked Zanders to customize a program that could correctly capture the exposure positions and hedge relationships with the FX forward contracts. “Once a new PO is created, it can read that information and integrate it into the treasury module. We had quite some difficulties in trying to make the program to what it should be. The way we use SAP is not very standard, at some points, things got quite complex, but Zanders was able to resolve the complexities. Now the program is running very well. This process is expected to provide hedge accounting documentation under IFRS 9 and generate GL journal entries for monthly valuations and settlement.”

We thought: why not integrate everything together?

Qiurong Chong, Financial Planning & Treasury Manager

Meeting the requirements

Performance

Connected

“We kicked off the project in August 2020 with a key user training, which was very useful – it prepared us well for the whole process. After that we had four weeks of requirements gathering, which was quite intensive but very productive. We had a few challenging areas that required additional effort by Zanders to do some research. Eventually all challenges were resolved, and we went live in February this year, so the project took about a half year.”

The systems are now connected. “So far, the systems are running well. There have been some small issues here and there – then we reached out to Zanders to resolve it. Zanders consultants Michiel and Mart were really very helpful throughout the whole process. Even our hedge accounting entries are done by the system. The automation reduces the processing time from an average of three days to within one day. The main beneficial part for us is that the business has the hedge documentation available from the system. In the past, we spent hours on computing effectiveness for the hundreds of transactions. When we were using Excel, we were only doing this on a quarterly basis. Now we can do it every month.”

Next steps

Are there still any challenges to be met for MODEC Finance? Chong: “We are still trying to stabilize the work process and get the hang of the new system. Once everything is more stable, there are some things we may explore. Automating this FX transaction was a first step for us in the treasury department. We are still doing many other reports manually for our headquarters in Japan. By bringing our HQ onboard this TRM module, we can have a seamless flow of information between us and them, which reduces any lag time and the need for us to extract the reports for them.”

Contact

Would like to know more about our treasury system support in Asia? Then please contact Michiel Putman Cramer via +81 3 6892 3047.

An overview of Hedge Accounting

November 2011

4 min read

Author: Pierre Wernert

Derivatives are often used to mitigate or offset risks (such as interest or currency risk) that arise from corporate activities. The standard accounting treatment for hedge instruments is that changes in fair value will have to be recorded in Profit and Loss (P&L). As opposed to the hedge instruments, the hedged assets or liabilities are often measured at (amortized) cost or fair value through equity, or are forecasted items which are not recognized in the Balance Sheet.

This results in a (temporary) valuation and or timing; mismatch between the hedged item and the hedge instrument. The objective of hedge accounting is to avoid temporary undesired volatility in P&L as a result of these valuation and timing differences. However, entities can practice hedge accounting only if they meet the numerous and complex requirements set out in IAS 39. What are these requirements and how Zanders can help you in the different steps?

What is hedging?

The aim of hedging is to mitigate the impact of non-controllable risks on the performance of an entity. Common risks are foreign exchange risk, interest rate risk, equity price risk, commodity price risk and credit risk.

The hedge can be executed through financial transactions. Examples in which hedging is used include:

an entity that has a liability in a foreign currency and wants to protect itself against the change in the foreign exchange rate
a company entering into an interest rate swap so that the floating rate of a loan becomes a fixed rate

Types of hedge accounting

There are three types of hedge accounting: fair value hedges, cash flow hedges and hedges of the net investment in a foreign operation.

Fair Value Hedge
The risk being hedged in a fair value hedge is a change in the fair value of an asset or a liability. For examples, changes in fair value may arise through changes in interest rates (for fixed-rate loans), foreign exchange rates, equity prices or commodity prices.
Cash Flows Hedges
The risk being hedged in a cash flow hedge is the exposure to variability in cash flows that is attributable to a particular risk and could affect the income statement. Volatility in future cash flows will result from changes in interest rates, exchange rates, equity prices or commodity prices.
Hedges of net investment in a foreign operation
An entity may have overseas subsidiaries, associates, joint ventures or branches (‘foreign operations’). It may hedge the currency risk associated with the translation of the net assets of these foreign operations into the group’s currency. IAS 39 permits hedge accounting for such a hedge of a net investment in a foreign operation.

The mismatch in the income statement recognition

Under the accounting standard IAS 39, all derivatives are recorded at fair value in the income statement. However these derivatives are often used to hedge recognized assets and liabilities, which are recorded at amortized cost or forecasted transactions that are not yet recognized on the Balance Sheet yet. The difference between the fair value measurement for the derivative and the amortized cost for the asset/liability leads to a mismatch in the timing of income statement recognition.

Hedge accounting seeks to correct this mismatch by changing the timing recognition in the income statement. Fair value hedge accounting treatment will accelerate the recognition of gains or losses on the hedged item into the P&L, whereas cash flow hedge accounting and net investment hedge accounting will defer the gains or losses on the hedge instrument.

The hedge relation

The hedge relation consists of a hedged item and a hedge instrument. A hedged item exposes the entity to the risk of changes in fair value or future cash flows that could affect the income statement currently or in the future. For example, a hedged item could be a loan in which the entity is paying a floating rate (e.g., Euribor 6 month + spread) to a counterparty.

If the hedge instrument is a derivative, it can be designated entirely or as a proportion as a hedging instrument. Even a portfolio of derivatives can be jointly designated as a hedge instrument. The hedge instrument can be a swap in which the entity is receiving a floating rate and paying a fixed rate. With this relation the entity is offsetting the floating rate payments and will only pay the fixed rate.

Criteria to qualify for hedge accounting

Hedge accounting is an exception to the usual accounting principles, thus it has to meet several criteria:

At the start of the hedge, the hedged item and the hedging instrument has to be identified and designated.
At the start of the hedge, the hedge relationship must be formally documented.
At the start of the hedge, the hedge relationship must be highly effective.
The effectiveness of the hedge relationship must be tested periodically. Ineffectiveness is allowed, provided that the hedge relationship achieves an effectiveness ratio between 80% and 125%.

Hedge effectiveness

Complying with IAS 39 requires two types of effectiveness tests:

A prospective (forward-looking) test to see whether the hedging relationship is expected to be highly effective in future periods
A retrospective (backward-looking) test to assess whether the hedging relationship has actually been highly effective in past periods

Both tests need to be highly effective at the start of the hedge. A prospective test is highly effective if, at the inception of the hedge relation and during the period for which the hedge relation is designated, the expected changes in fair value of cash flows are offset. Meaning that during the life of the hedge relation, the change in fair value (due to change in the market conditions) of the hedged item should be offset by the change in fair value of the hedged instrument.

A retrospective test is highly effective if the actual results of the hedge are within the range 80%-125%.

Calculation methods

IAS 39 does not specify a single method for the calculation of the effectiveness of the hedge. The method used depends on the risk management strategy. The most common methods are:

Critical terms comparison – this method consists of comparing the critical terms (notional, term, timing, currency, and rate) of the hedging instrument with those from the hedged item. This method does not require any calculation.
Dollar offset method – this is a quantitative method that consists of comparing the change in fair value between the hedging instrument and the hedged item. Depending on the entity risk policies, this method can be performed on a cumulative basis (from inception) or on a period-by-period basis (between two specific dates). A hedge is considered highly effective if the results are within the range 80%-125%.
Regression analysis – this statistical method investigates the strength of the statistical relationship between the hedged item and the hedge instrument. From an accounting perspective this method proves whether or not the relationship is sufficiently effective to qualify for hedge accounting. It does not calculate the amount of ineffectiveness.

Termination of the hedge relation

A hedge relation has to be terminated going forward when any of the following occur:

A hedge fails an effectiveness test
The hedged item is sold or settled
The hedging instruments are sold, terminated or exercised
Management decides to terminate the relation
For a hedge of a forecast transaction; the forecast transaction is no longer highly probable.

Please note that these requirements described previously may change as the IASB is currently working to replace IAS39 by IFRS9 (new qualification of hedging instruments, hedged items, hedge effectiveness…)

Conclusion

Hedge accounting is a complex process involving numerous and technical requirements with the objective to avoid temporary undesired volatility in P&L. This volatility is the result of valuation and or timing mismatch between the hedged item and the hedge instrument. If you are considering hedge accounting, we have a dedicated team on the valuation desk. We can offer advices on the calculation of the market values of the underlying risks and the hedge instruments, as well as setting up the hedge relation, preparing documentation and helping on the accounting treatment of the results.