5.1 Overview

The requirements for applying hedge accounting to foreign currency exposures are consistent with the general concepts outlined in ASC 815. However, because of the unique nature of a foreign currency exposure and its interaction with the measurement and translation guidance in ASC 830, there are a number of special considerations related to foreign currency hedges that affect the eligible hedged items and hedging instruments as well as the mechanics and application of hedge accounting.

This chapter focuses on the key foreign currency exposures that are affected by the functional currency concepts of ASC 830, which include the following, as outlined in ASC 815-20-25-26:

An unrecognized foreign-currency-denominated firm commitment
A recognized foreign-currency-denominated asset or liability
A foreign-currency-denominated forecasted transaction
The forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability
A net investment in a foreign operation.

5.1.1 Types of Foreign Currency Hedging Relationships

The type of hedging relationship that an entity applies to a foreign currency exposure has a substantial impact on the hedge accounting mechanics. Other features of a hedging relationship that affect the mechanics of the accounting include:

The effectiveness assessment method selected (see Section 2.5.2.1.1).
The components of the hedging instrument that are excluded from the hedge effectiveness assessment (see Section 2.5.2.1.2.1).
Changes in qualifying events or the discontinuation of hedge accounting.

ASC 815 allows three types of foreign currency hedging relationships provided that all qualifying criteria are met. The type of relationship that an entity applies is largely driven by the risk exposure that it wants to hedge (i.e., the hedged item). The permissible combinations of hedged items and hedging instruments by foreign currency hedging relationship type are as follows:

Hedging Relationship Type	Possible Types of Foreign-Currency-Denominated Hedged Items (See ASC 815-20-25-28)	Permitted Hedging Instruments
Foreign currency fair value hedge (see Section 5.2)	Recognized asset or liability (including AFS securities)	Derivative
Foreign currency fair value hedge (see Section 5.2)	Unrecognized firm commitment	Derivative or nonderivative
Foreign currency cash flow hedge (see Section 5.3)	Forecasted transaction Unrecognized firm commitment Forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability Forecasted intra-entity transaction	Derivative
Net investment hedge (see Section 5.4)	Net investment in a foreign operation	Derivative or nonderivative

While each of the relationship types has separate qualification requirements, an entity must first identify the source of the foreign currency exposure and the reporting level at which a hedging relationship may exist.

5.1.2 Understanding Foreign Currency Exposures and Hedge Accounting Eligibility

ASC 815-20

25-30 Both of the following conditions shall be met for foreign currency cash flow hedges, foreign currency fair value hedges, and hedges of the net investment in a foreign operation:

For consolidated financial statements, either of the following conditions is met:
1. The operating unit that has the foreign currency exposure is a party to the hedging instrument.
2. Another member of the consolidated group that has the same functional currency as that operating
  unit is a party to the hedging instrument and there is no intervening subsidiary with a different functional currency. See guidance beginning in paragraph 815-20-25-52 for conditions under which an intra-entity foreign currency derivative can be the hedging instrument in a cash flow hedge of foreign exchange risk.
The hedged transaction is denominated in a currency other than the hedging unit’s functional currency.

Irrespective of the type of hedging relationship being designated, when determining eligibility for hedge accounting, an entity should identify (1) the exposure to foreign currencies and (2) where the exposure arises within the consolidated entity. As discussed in the next subsection, with some exceptions, the operating unit with the foreign currency exposure must be a party to the hedging instrument. Therefore, the source of a foreign currency exposure must be identified to determine whether the entity with the hedging instrument can pursue hedge accounting for that exposure.

5.1.2.1 Identifying the Source of Exposure

ASC 815-20

Hedged Items and Transactions Involving Foreign Exchange Risk

25-23 Under the functional currency concept of Topic 830, exposure to a foreign currency exists only in relation to a specific operating unit’s designated functional currency cash flows. Therefore, exposure to foreign currency risk shall be assessed at the unit level.

25-24 A unit has exposure to foreign currency risk only if it enters into a transaction (or has an exposure) denominated in a currency other than the unit’s functional currency.

25-25 Due to the requirement in Topic 830 for remeasurement of assets and liabilities denominated in a foreign currency into the unit’s functional currency, changes in exchange rates for those currencies will give rise to exchange gains or losses, which results in direct foreign currency exposure for the unit but not for the parent entity if its functional currency differs from its unit’s functional currency.

25-26 The functional currency concepts of Topic 830 are relevant if the foreign currency exposure being hedged relates to any of the following:

An unrecognized foreign-currency-denominated firm commitment
A recognized foreign-currency-denominated asset or liability
A foreign-currency-denominated forecasted transaction
The forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability
A net investment in a foreign operation.

25-27 Because a parent entity whose functional currency differs from its subsidiary’s functional currency is not directly exposed to the risk of exchange rate changes due to a subsidiary transaction that is denominated in a currency other than a subsidiary’s functional currency, the parent cannot qualify for hedge accounting for a hedge of that risk. Accordingly, a parent entity that has a different functional currency cannot qualify for hedge accounting for direct hedges of a subsidiary’s recognized asset or liability, unrecognized firm commitment or forecasted transaction denominated in a currency other than the subsidiary’s functional currency. Also, a parent that has a different functional currency cannot qualify for hedge accounting for a hedge of a net investment of a first-tier subsidiary in a second-tier subsidiary.

The identification of a foreign currency exposure is determined by the ASC 830 concept of functional currencies. In line with this concept, ASC 815-20-25-23 through 25-27 require entities to identify exposures to foreign currencies at the individual operating unit level (e.g., subsidiary) from the perspective of each operating unit’s own functional currency.

Because an exposure is assessed at an operating unit level, the functional currency of each operating unit will affect the identification of a foreign currency exposure on an individual operating unit basis as well as at the various levels of consolidation. This distinction is important for entities operating in multiple environments because a foreign currency exposure at one level of the consolidated entity may not reflect a foreign currency exposure at another level of the consolidated structure.

The focus on the functional currency is one feature that distinguishes foreign currency exposures and related hedging requirements from general hedge accounting strategies. For example, an entity that hedges the contractually specified interest rate risk of a term loan would be exposed to the contractually specified interest rate risk irrespective of the entity’s functional currency. By contrast, the determination of a foreign currency exposure is directly related to an entity’s functional currency (e.g., a forecasted euro-denominated-sale may represent a foreign currency exposure for one entity but not another).

Further, the exposures at each level of the consolidation structure are affected by the mechanics of consolidation and the requirements of ASC 830, as contemplated in ASC 815-20-25-27. For instance, on an individual operating unit level, a transaction denominated in a foreign currency would be subject to ASC 830-20 and represent a foreign currency exposure that could directly affect earnings. Such an exposure through earnings would also be present on a consolidated basis in instances in which the subsidiaries have the same functional currency as the parent, thereby allowing the parent entity to have a direct line to the exposure.

Conversely, on a consolidated basis, a subsidiary whose functional currency differs from the parent would be subject to ASC 830-30 and translated upon consolidation, with a CTA recorded in OCI. Therefore, the parent entity would have neither a direct exposure nor a direct line to the exposures of the foreign subsidiary.

Example 5-1

Identifying the Exposure at Each Reporting Level

Parent Co. has a USD functional currency and consolidates a subsidiary, Sub Co, which has a euro (EUR) functional currency.

Scenario 1 — Sub Co. Has Forecasted EUR-Denominated Sales

On a reporting-unit basis, Sub Co. would not have a foreign currency exposure related to its forecasted EUR-denominated sales because the sales are denominated in its functional currency. Further, Parent Co. is not directly exposed to the exchange rate risk. Therefore, neither Parent Co. nor its subsidiary would be permitted to designate the foreign currency risk on the forecasted EUR-denominated sales as a hedged risk.

Scenario 2 — Sub Co. Has Forecasted USD-Denominated Sales

On a reporting-unit basis, Sub Co. has a foreign currency exposure related to its forecasted USD-denominated sales because its functional currency is the EUR. Therefore, Sub Co. could designate this exposure as its hedged item.

Conversely, Parent Co. would not have a direct exposure because upon consolidation, Sub Co.’s financial statements are subject to the translation guidance of ASC 830-30.

5.1.2.2 Identifying the Eligible Party to the Hedging Instrument

Once the source of a foreign currency exposure has been identified, it is necessary to establish which entity must hold the hedging instrument for hedge accounting to be permissible. In accordance with ASC 815-20-25-30(a), hedge accounting may be applied on a consolidated level if either (1) the entity with the foreign currency exposure holds the hedging instrument directly or (2) the parent entity holds the hedging instrument provided that it has the same functional currency as the subsidiary with the exposure and there are no intervening subsidiaries with a different functional currency. As noted in Section 2.4.1.3.1, in scenarios in which the hedging instrument is held by the parent, internal derivatives can be used to allow for hedge accounting on a stand-alone level.

Thus, while the application of hedge accounting generally requires the operating unit with the foreign currency exposure to be a party to the hedging instrument (either via an external or qualifying internal derivative), as an exception to this requirement, ASC 815-20-25-32 establishes that a parent entity may look through to the foreign currency exposure if no intervening subsidiaries with different functional currencies exist. By focusing on the intervening subsidiaries, the guidance recognizes and contemplates the step-by-step consolidation mechanics, as affected by ASC 830-30.

To be eligible for hedge accounting, the entity with the hedging instrument is required to have either direct exposure or a direct line to the exposure, or both.

Example 5-2

Identifying the Eligible Party to the Hedge

Assume the following organizational structure, with the noted functional currency for each entity:

In this scenario, SimpleBand may qualify to use its hedging instruments to directly hedge foreign currency exposures arising from subsidiaries Cymbal Co. and Saxophone Co. on a consolidated basis. However, SimpleBand would not be permitted to hedge the foreign currency exposures of Skyscraper Co. because that subsidiary has a different functional currency (EUR) than SimpleBand (USD). In addition, SimpleBand would not be permitted to hedge the foreign currency exposures of BeBop Co., even though they share the same functional currency, because the intervening Skyscraper Co. has a different functional currency. Therefore, all exposures at the BeBop Co. level would first be translated into the functional currency of Skyscraper Co. (EUR), which would then be translated into the functional currency of SimpleBand (USD). In this way, SimpleBand would not be exposed to the foreign currency exposure of BeBop Co.

If either Skyscraper Co. or BeBop Co. wants to hedge its foreign currency exposures, the reporting unit would need to enter into a hedging instrument and designate the hedging relationship at its stand-alone level. The impacts of hedge accounting would survive consolidation.

Further, while SimpleBand would be permitted to hedge Cymbal Co.’s and Saxophone Co.’s exposure at the consolidated level with its own hedging instruments, neither Cymbal Co. nor Saxophone Co. would be permitted to apply hedge accounting on its stand-alone statements unless it (1) transacts in an intercompany hedging instrument with the parent entity or (2) holds its own hedging instrument, as noted in the next section.

5.1.2.3 Central Risk Management

ASC 815-20

Internal Derivatives as Hedging Instruments in Cash Flow Hedges of Foreign Exchange Risk

25-61 An internal derivative can be a hedging instrument in a foreign currency cash flow hedge of a forecasted borrowing, purchase, or sale or an unrecognized firm commitment in the consolidated financial statements only if both of the following conditions are satisfied:

From the perspective of the member of the consolidated group using the derivative instrument as a hedging instrument (the hedging affiliate), the criteria for foreign currency cash flow hedge accounting otherwise specified in this Section are satisfied.
The member of the consolidated group not using the derivative instrument as a hedging instrument (the issuing affiliate) either:
1. Enters into a derivative instrument with an unrelated third party to offset the exposure that results from that internal derivative
2. If the conditions in paragraphs 815-20-25-62 through 25-63 are met, enters into derivative instruments with unrelated third parties that would offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivative instruments. In complying with this guidance the issuing affiliate could enter into a third-party position with neither leg of the third-party position being the issuing affiliate’s functional currency to offset its exposure if the amount of the respective currencies of each leg are equivalent with respect to each other based on forward exchange rates.

25-62 If an issuing affiliate chooses to offset exposure arising from multiple internal derivatives on an aggregate or net basis, the derivative instruments issued to hedging affiliates shall qualify as cash flow hedges in the consolidated financial statements only if all of the following conditions are satisfied:

The issuing affiliate enters into a derivative instrument with an unrelated third party to offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivatives.
The derivative instrument with the unrelated third party generates equal or closely approximating gains and losses when compared with the aggregate or net losses and gains generated by the derivative instruments issued to affiliates.
Internal derivatives that are not designated as hedging instruments are excluded from the determination of the foreign currency exposure on a net basis that is offset by the third-party derivative instrument. Nonderivative contracts shall not be used as hedging instruments to offset exposures arising from internal derivatives.
Foreign currency exposure that is offset by a single net third-party contract arises from internal derivatives that mature within the same 31-day period and that involve the same currency exposure as the net third-party derivative instrument. The offsetting net third-party derivative instrument related to that group of contracts shall meet all of the following criteria:
1. It offsets the aggregate or net exposure to that currency.
2. It matures within the same 31-day period.
3. It is entered into within three business days after the designation of the internal derivatives as hedging instruments.
The issuing affiliate meets both of the following conditions:
1. It tracks the exposure that it acquires from each hedging affiliate.
2. It maintains documentation supporting linkage of each internal derivative and the offsetting aggregate or net derivative instrument with an unrelated third party.
The issuing affiliate does not alter or terminate the offsetting derivative instrument with an unrelated third party unless the hedging affiliate initiates that action.

25-63 If the issuing affiliate alters or terminates any offsetting third-party derivative (which should be rare), the hedging affiliate shall prospectively cease hedge accounting for the internal derivatives that are offset by that third-party derivative instrument.

Many consolidated entities use a central risk management or central treasury function to transact risk management instruments and enter into hedging relationships with their subsidiaries. Because a central treasury function manages the risks of the entire entity, such an arrangement (1) promotes improved efficiency and economies of scale and (2) allows an entity to hedge net risk exposures (e.g., if subsidiary A is “long” an exposure and subsidiary B is “short” the same exposure, the central treasury function might choose to hedge the net risk exposure of the consolidated entity).

Although ASC 815 generally does not permit hedge accounting for net exposures (see Section 2.2.2.2), the FASB created an exception for situations in which a subsidiary within a consolidated entity uses an internal derivative to hedge the foreign currency exposure arising from an unrecognized firm commitment or a forecasted borrowing,1 purchase, or sale. Such hedges can be accounted for as cash flow hedges in the consolidated financial statements if the conditions in ASC 815-20-25-61 are satisfied. First, the hedge must meet all the criteria for foreign currency cash flow hedge accounting (from the perspective of the hedging entity within the consolidated group). Second, the other party to the hedging derivative within the consolidated group (i.e., the nonhedging entity) must either (1) enter into another derivative with a third party outside the consolidated group that offsets the risk exposure of the internal derivative or (2) if certain additional criteria (described below) are satisfied, enter into a derivative with an unrelated third party that offsets, for each foreign currency, the net foreign currency exposure arising from multiple internal derivatives (this type of activity typically would be carried out by a central treasury function).

If an entity chooses to offset exposures arising from multiple internal derivatives on an aggregate or net basis (e.g., through a central treasury function or “issuing affiliate”), those internal derivatives issued to the hedging members of the consolidated group would qualify for cash flow hedge accounting in the consolidated financial statements only if all the conditions in ASC 815-20-25-62 are met.

ASC 815 includes a detailed example of offsetting exposures arising from multiple internal derivatives on an aggregate or net basis. See the example below.

ASC 815-30

Example 19: Hedge Accounting in the Consolidated Financial Statements Applied to Internal Derivatives That Are Offset on a Net Basis by Third-Party Contracts

55-113 This Example illustrates the application of paragraphs 815-20-25-61 through 25-63, specifically, the mechanism for offsetting risks assumed by a Treasury Center using internal derivatives on a net basis with third-party contracts. This Example does not demonstrate the computation of fair values and as such makes certain simplifying assumptions.

55-114 Entity XYZ is a U.S. entity with the U.S. dollar (USD) as both its functional currency and its reporting currency. Entity XYZ has three subsidiaries: Subsidiary A is located in Germany and has the Euro (EUR) as its functional currency, Subsidiary B is located in Japan and has the Japanese yen (JPY) as its functional currency, and Subsidiary C is located in the United Kingdom and has the pound sterling (GBP) as its functional currency. Entity XYZ uses its Treasury Center to manage foreign exchange risk on a centralized basis. Foreign exchange risk assumed by Subsidiaries A, B, and C through transactions with external third parties is transferred to the Treasury Center via internal contracts. The Treasury Center then offsets that exposure to foreign currency risk via third-party contracts. To the extent possible, the Treasury Center offsets exposure to each individual currency on a net basis with third-party contracts.

55-115 On January 1, Subsidiaries A, B, and C decide that various foreign-currency-denominated forecasted transactions with external third parties for purchases and sales of various goods are probable. Also on January 1, Subsidiaries A, B, and C enter into internal foreign currency forward contracts with the Treasury Center to hedge the foreign exchange risk of those transactions with respect to their individual functional currencies. The Treasury Center has the same functional currency as the parent entity (USD).

55-116 Subsidiaries A, B, and C have the following foreign currency exposures and enter into the following internal contracts with the Treasury Center.

55-117 Subsidiaries A, B, and C designate the internal contracts with the Treasury Center as cash flow hedges of their foreign currency forecasted purchases and sales. Those internal contracts may be designated as hedging instruments in the consolidated financial statements if the requirements of this Subtopic are met. From the subsidiaries’ perspectives, the requirements of paragraph 815-20-25-61 for foreign currency cash flow hedge accounting are satisfied as follows:

From the perspective of the hedging affiliate, the hedging relationship must meet the requirements of paragraphs 815-20-25-30 and 815-20-25-39 through 25-41 for cash flow hedge accounting. Subsidiaries A, B, and C meet those requirements. In each hedging relationship, the forecasted transaction being hedged is denominated in a currency other than the subsidiary’s functional currency, and the individual subsidiary that has the foreign currency exposure relative to its functional currency is a party to the hedging instrument. In addition, the criteria in Section 815-20-25 are met. Specifically, each subsidiary prepares formal documentation of the hedging relationships, including the date on which the forecasted transactions are expected to occur and the amount of foreign currency being hedged. The forecasted transactions being hedged are specifically identified, are probable of occurring, and are transactions with external third parties that create cash flow exposure that would affect reported earnings. Each subsidiary also documents its expectation of high effectiveness based on the internal derivatives designated as hedging instruments.
The affiliate that issues the hedge must offset the internal derivative either individually or on a net basis. The Treasury Center determines that it will offset the exposure arising from the internal derivatives with Subsidiaries A, B, and C on a net basis with third-party contracts. Each currency for which a net exposure exists at the Treasury Center is offset by a third-party contract based on that currency.

55-118 To determine the net currency exposure arising from the internal contracts with Subsidiaries A, B, and C, the Treasury Center performs the following analysis.

55-119 For Subsidiaries A, B, and C to designate the internal contracts as hedging instruments in the consolidated financial statements, the Treasury Center must meet certain required criteria outlined in paragraphs 815-20-25-62 through 25-63 in determining how it will offset exposure arising from multiple internal derivatives that it has issued. Based on a determination that those requirements are satisfied (see the following paragraph, the Treasury Center determines the net exposure in each currency with respect to USD (its functional currency). The Treasury Center determines that it will enter into the following three third-party foreign currency forward contracts. The Treasury Center enters into the contracts on January 1. The contracts mature on June 30.

55-120 From the Treasury Center’s perspective, the required criteria in paragraphs 815-20-25-62 through 25-63 are satisfied as follows:

The issuing affiliate enters into a derivative instrument with an unrelated third party to offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivatives, and the derivative instrument with the unrelated third party generates equal or closely approximating gains and losses when compared with the aggregate or net losses and gains generated by the derivative instruments issued to affiliates. The Treasury Center enters into third-party derivative instruments to offset the exposure of each foreign currency on a net basis. The Treasury Center offsets 100 percent of the net exposure to each currency; that is, the Treasury Center does not selectively keep any portion of that exposure. In this Example, the Treasury Center’s third-party contracts generate losses that are equal to the losses on internal contracts designated as hedging instruments by Subsidiaries A, B, and C (see analysis beginning in the following paragraph).
Internal derivatives that are not designated as hedging instruments and all nonderivative instruments are excluded from the determination of the foreign currency exposure on a net basis that is offset by the third-party derivative instrument. The Treasury Center does not include in the determination of net exposure any internal derivatives not designated as hedging instruments or any nonderivative instruments.
Foreign currency exposure that is offset by a single net third-party contract arises from internal derivatives that involve the same currency and that mature within the same 31-day period. The offsetting net third-party derivative instrument related to that group of contracts must offset the aggregate or net exposure to that currency, must mature within the same 31-day period, and must be entered into within 3 business days after the designation of the internal derivatives as hedging instruments. The Treasury Center’s third-party net contracts involve the same currency (that is, not a tandem currency) as the net exposure arising from the internal derivatives issued to Subsidiaries A, B, and C. The Treasury Center’s third-party derivative instruments mature within the same 31-day period as the internal contracts that involve currencies that are offset on a net basis. In this Example, for simplicity, all internal contracts and third-party derivative instruments are entered into on the same date.
The issuing affiliate tracks the exposure that it acquires from each hedging affiliate and maintains documentation supporting linkage of each derivative instrument and the offsetting aggregate or net derivative instrument with an unrelated third party. The Treasury Center maintains documentation supporting linkage of third-party contracts and internal contracts throughout the hedge period.
The issuing affiliate does not alter or terminate the offsetting derivative instrument with an unrelated third party unless the hedging affiliate initiates that action. If the issuing affiliate does alter or terminate the offsetting third-party derivative (which should be rare), the hedging affiliate must prospectively cease hedge accounting for the internal derivatives that are offset by that third-party derivative. Based on Entity XYZ’s policy, the Treasury Center may not alter or terminate the offsetting derivative instrument with an unrelated third party unless the hedging affiliate initiates that action.
If an internal derivative that is included in determining the foreign currency exposure on a net basis is modified or dedesignated as a hedging instrument, compliance must be reassessed. For simplicity, this Example does not involve a modification or dedesignation of an internal derivative.

55-121 At the end of the quarter, each subsidiary determines the functional currency gains and losses for each contract with the Treasury Center.

55-122 At the end of the quarter, the Treasury Center determines its gains or losses on third-party contracts.

55-123 Journal Entries at March 31 (Note: All journal entries are in USD.)

Subsidiaries’ Journal Entries

German Subsidiary A

There is no entry for Contract 1 because the USD gain or loss is zero.

Japanese Subsidiary B

There is no entry for Internal Contract 4 because the USD gain or loss is zero.

UK Subsidiary C

Treasury Center’s Journal Entries

Journal Entries for Internal Contracts With Subsidiaries

There is no entry for Internal Contract 1 because the USD gain or loss is zero.

Journal Entries for Third-Party Contracts

Results in Consolidation

55-124 In consolidation, the amounts in the balance sheets of Subsidiaries A, B, and C reflecting derivative instrument assets and derivative instrument liabilities arising from internal derivatives acquired from the Treasury Center eliminate against the Treasury Center’s derivative instrument liabilities and derivative instrument assets arising from internal derivatives issued to the subsidiaries. The amount reflected in consolidated other comprehensive income reflects the net entry to other comprehensive income of Subsidiaries A, B, and C. The Treasury Center’s gross derivative instrument asset and gross derivative instrument liability arising from third-party contracts are also reflected in the consolidated balance sheet. Based on the assumptions in this Example, the Treasury Center’s net loss on third-party derivative instruments used to offset the exposure, on a net basis, of internal contracts with Subsidiaries A, B, and C equals the net loss on internal contracts with the subsidiaries. Therefore, within the Treasury Center, the gains on internal contracts issued to Subsidiaries A, B, and C, and the losses on third-party contracts are equal and offsetting. If the Treasury Center’s net gain or loss on third-party contracts does not equal the net gain or loss on internal derivatives designated as hedging instruments by affiliates, the difference must be recognized in consolidated other comprehensive income.

55-125 The reclassification of amounts out of consolidated other comprehensive income is based on Subsidiaries A, B, and C’s internal contracts with the Treasury Center. That is, the reclassification of amounts out of consolidated other comprehensive income into earnings is based on the timing and amounts of the individual subsidiaries’ forecasted transactions. In this Example, at June 30, the forecasted transactions at Subsidiaries A, B, and C have been consummated and the net debit amount in consolidated other comprehensive income of 3 has been reversed.

The conditions in ASC 815-20-25-62 only apply when an entity wants to use a central treasury function that offsets exposures arising from multiple internal derivatives on an aggregate or net basis. Those conditions do not apply to entities that use intra-entity derivatives in hedging relationships if each of those derivatives is also offset with a derivative entered into with a third party, as discussed in Section 2.4.1.3.1.

The exception that permits an entity to hedge foreign currency risk for net cash flow exposures by currency type may not be applied to (1) foreign currency fair value hedges, (2) hedges of net investments in foreign operations, or (3) hedges of cash flow exposures related to recognized foreign-currency-denominated assets or liabilities, even if such assets or liabilities resulted from a specifically identified forecasted transaction that was initially designated as a cash flow hedge.

5.1.3 Hedging on an After-Tax Basis

ASC 815-20

25-3 Concurrent designation and documentation of a hedge is critical; without it, an entity could retroactively identify a hedged item, a hedged transaction, or a method of measuring effectiveness to achieve a desired accounting result. To qualify for hedge accounting, there shall be, at inception of the hedge, formal documentation of all of the following: . . .

b. Documentation requirement applicable to fair value hedges, cash flow hedges, and net investment hedges: . . .

2. The entity’s risk management objective and strategy for undertaking the hedge, including identification of all of the following: . . .

vi. If the entity is hedging foreign currency risk on an after-tax basis, that the assessment of effectiveness, including the calculation of ineffectiveness, will be on an after-tax basis (rather than on a pretax basis). . . .

ASC 815-30

35-5 If an entity has designated and documented that it will assess effectiveness and measure hedge results of a cash flow hedge of foreign currency risk on an after-tax basis as permitted by paragraph 815-20-25-3(b)(2)(vi), the portion of the gain or loss on the hedging instrument that exceeded the loss or gain on the hedged item shall be included as an offset to the related tax effects in the period in which those tax effects are recognized.

ASC 815-35

35-3 If an entity has designated and documented that it will assess effectiveness and measure hedge results on an after-tax basis as permitted by paragraph 815-20-25-3(b)(2)(vi), the portion of the gain or loss on the hedging instrument that exceeded the loss or gain on the hedged item shall be included as an offset to the related tax effects in the period in which those tax effects are recognized.

35-19 The assessment of hedge effectiveness due to such differences between the hedging derivative instrument and the hedged net investment considers the following:

Different notional amounts. If the notional amount of the derivative instrument designated as a hedge of the net investment does not match the portion of the net investment designated as being hedged, hedge effectiveness shall be assessed by comparing the following two values:
1. The change in fair value of the actual derivative instrument designated as the hedging instrument
2. The change in fair value of a hypothetical derivative instrument that has a notional amount that matches the portion of the net investment being hedged and a maturity that matches the maturity of the actual derivative instrument designated as the net investment hedge. See paragraph 815-35-35-26 for situations in which the hedge of a net investment in a foreign operation is hedging foreign currency risk on an after-tax basis, as permitted by paragraph 815-20-25-3(b)(2)(vi). . . .

35-26 Paragraph 815-20-25-3(b)(2)(vi) permits hedging foreign currency risk on an after-tax basis, provided that the documentation of the hedge at its inception indicated that the assessment of effectiveness and measurement of hedge results will be on an after-tax basis (rather than on a pretax basis). If an entity has elected to hedge foreign currency risk on an after-tax basis, it shall adjust the notional amount of its derivative instrument appropriately to reflect the effect of tax rates. In that case, the hypothetical derivative instrument used to assess effectiveness shall have a notional amount that has been appropriately adjusted (pursuant to the documentation at inception) to reflect the effect of the after-tax approach.

FASB Statement 52 permitted entities to apply hedge accounting for foreign currency exposures on an after-tax basis because it is common for a parent to assert that profits in a foreign subsidiary will be indefinitely reinvested for tax purposes. In such cases, the effects of a hedging instrument on the parent would be subject to the parent’s taxing jurisdiction. FASB Statement 133 carried forward those provisions of Statement 52, which are now incorporated into ASC 815-20-25-3(b)(2)(vi).

While hedging on an after-tax basis occurs most often with hedges of net investments in foreign operations, hedging on an after-tax basis is not limited to net investment hedges. Entities should consider the tax effects on both the hedging instrument and the hedged item in assessing the effectiveness of the hedging relationship. In addition, if tax rates change, an entity should consider how those changes in rates affect the effectiveness assessment. If an entity is using an after-tax hedging strategy for cash flow or net investment hedges, the portion of the gain or loss on the hedging instrument that exceeds the loss or gain, respectively, on the hedged item should be included as an offset to the related tax effects in the period in which such effects are recognized.

Footnotes

While ASC 815-20-25-61 discusses hedging forecasted borrowings for foreign currency risk, note that the forecasted issuance of foreign-currency-denominated debt does not give rise to a foreign currency risk related to the principal amount of the debt before it is issued. There is no earnings exposure from the potential changes in cash flows attributable changes in foreign currency exchange rates for the principal amount of debt in a forecasted issuance of foreign-currency-denominated debt. However, forecasted interest payments related to the forecasted issuance of foreign-currency-denominated debt may be hedged for foreign currency risk. An entity may hedge the foreign currency risk related to the principal, interest payments, or both for recognized foreign-currency-denominated debt.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.