Tackling the Challenge of Embedded Derivatives
by Danne Buchanan, Executive Vice President, Head of North America Operations, D+H
For multinational corporations selling in multiple currencies, the recent strengthening of the US dollar has turned embedded derivatives from a minor consideration into a material issue. To account for and report on embedded derivatives, most corporations have to date applied a ‘rear view’ perspective, identifying and classifying them at the back end of the receivables process rather than up-front. But by automating receivables and capturing them in a centralised hub, organisations can gain 100% real-time visibility into embedded derivatives – thus dramatically reducing the associated risks, while simultaneously realising wider benefits ranging from a higher rate of straight-through processing (STP) to improved working capital.
Surge in US dollar value
In March 2015, it was reported that the US dollar was undergoing its “fastest rise in four decades”  – a climb accelerated by the US economy’s increasingly robust recovery and a weakening of the euro. For multinational corporations conducting transactions across different currency zones, the strengthening of the dollar’s international value – as illustrated in Figure 1 – represents a significant shift in the business environment.
As a result, many corporations have taken swift action in response. Their moves include convening boards and senior executive teams to review their pricing in overseas markets, as well as broadly re-examining their foreign currency and commodity hedging strategies – particularly in cases where the US dollar is involved.
Accounting for embedded derivatives
The stronger dollar has also led many companies and audit firms to renew their focus on a topic that had slipped down the corporate agenda in recent years: the accounting standards that apply to embedded derivatives – namely ASC 815 in the US, and IAS 39 in Europe and other territories.
To explain why embedded derivatives are once again on the radar, here’s a brief primer on why and how they arise. Imagine a scenario in which Company ABC, whose base accounting currency is UK sterling (making it ‘GBP functional’), is selling goods or services to Company DEF, which accounts in euros (‘EUR functional’), and the denomination currency of the transaction is US dollars (USD). Since the denomination currency is not the functional currency of either party to the transaction, the sale creates embedded derivative GBP-USD on Company ABC’s books and EUR-USD on Company DEF’s books. For the purposes of this example, we’ll look at the derivative only from the perspective of Company ABC.