5.4 Net Investment Hedging
Hedging Relationship Type
|
Possible Types of Foreign-Currency-Denominated Hedged Items
(See ASC 815-20-25-28)
|
Permitted Hedging Instruments
|
---|---|---|
Net investment hedge
|
Net investment in a foreign operation
|
Derivative or nonderivative
|
A net investment hedge is a hedge of the foreign currency exposure of a net
investment in a foreign operation. Such an exposure is a result of the translation
of the investment into the parent’s functional currency in accordance with ASC 830.
The resulting gains and losses from translation are recognized in OCI as CTAs. The
application of net investment hedging allows entities to defer recognizing the gains
and losses on the hedging instrument that are included in the effectiveness
assessment as a CTA in OCI in a manner consistent with the classification of the CTA
that arises from the hedged item. As in cash flow hedging relationships, the gains
and losses recognized in the CTA are reclassified into earnings when the hedged item
(i.e., the net investment in foreign operations) affects earnings (see
Section 5.4.3 for further discussion).
The concept of hedging a net investment in foreign operations, which is made up of
assets and liabilities, is unique to this type of hedging relationship. Unlike fair
value and cash flow hedging relationships, a net investment hedge permits hedge
accounting to be applied to a group of items (the net investment) that typically
includes both assets and liabilities that in many cases would not be considered
similar items. Because of the unique nature of this hedging relationship, distinct
qualification criteria must be met to qualify for this type of hedging.
5.4.1 Hedging Instruments in a Net Investment Hedge
ASC 815-20
25-66 A derivative
instrument or a nonderivative financial instrument that
may give rise to a foreign currency transaction gain or
loss under Subtopic 830-20 can be designated as hedging
the foreign currency exposure of a net investment in a
foreign operation provided the conditions in paragraph
815-20-25-30 are met. A nonderivative financial
instrument that is reported at fair value does not give
rise to a foreign currency transaction gain or loss
under Subtopic 830-20 and, thus, cannot be designated as
hedging the foreign currency exposure of a net
investment in a foreign operation.
25-67 Hedging instruments
that are eligible for designation in a net investment
hedge include, among others, both of the following:
- A receive-variable-rate, pay-variable-rate
cross-currency interest rate swap, provided both
of the following conditions are met:
-
The interest rates are based on the same currencies contained in the swap.
-
Both legs of the swap have the same repricing intervals and dates.
-
- A receive-fixed-rate, pay-fixed-rate cross-currency interest rate swap. A cross-currency interest rate swap that has two fixed legs is not a compound derivative instrument and, therefore, is not subject to the criteria in (a).
25-68 A cross-currency
interest rate swap that has either two variable legs or
two fixed legs has a fair value that is primarily driven
by changes in foreign exchange rates rather than changes
in interest rates. Therefore, foreign exchange risk,
rather than interest rate risk, is the dominant risk
exposure in such a swap.
25-68A Under the guidance in
paragraph 815-20-25-71(d)(1), a cross-currency interest
rate swap with one fixed-rate leg and one floating-rate
leg cannot be designated as the hedging instrument in a
net investment hedge.
An entity may use either a derivative or certain nonderivative instruments as
hedging instruments in a net investment hedge. To qualify as a hedging
instrument, a nonderivative instrument must be subject to the measurement
requirements of ASC 830-20. ASC 815-20-25-66 notes that any nonderivative
instrument that is reported at fair value does not qualify as a hedging
instrument in a net investment hedging relationship because it “does not give
rise to a foreign currency transaction gain or loss under Subtopic 830-20.”
Since the translation of net investments in foreign operations is based on
changes in foreign currency exchange rates in accordance with ASC 830, ASC 815
requires the remeasurement of the hedging instrument to be predominantly based
on changes in foreign currency exchange rates. That requirement limits the types
of derivatives that can be used as hedging instruments in net investment hedges
to those whose fair value is predominantly based on changes in foreign currency
exchange rates. Accordingly, many compound derivatives and all synthetic
instruments are precluded from qualifying as hedging instruments within net
investment hedging relationships.
Generally, ASC 815 does not permit the use of a compound derivative that has
multiple underlyings as the hedging instrument in a net investment hedge. As
discussed in Section 2.4.1.3.4, the only
compound derivatives that an entity may use as the hedging instrument in a net
investment hedging relationship are:
-
Receive-variable-rate, pay-variable-rate cross-currency interest rate swaps in which (1) the interest rates are based on the same currencies contained in the swap and (2) both legs of the swap have the same repricing intervals and dates.
-
Receive-fixed-rate, pay-fixed-rate cross-currency interest rate swaps.
ASC 815-20-25-71(d) precludes synthetic instruments that consist of a combination
of a debt instrument and derivative instrument from qualifying as hedging
instruments in a net investment hedging relationship. If such instruments were
viewed as one, the measurement principles of the individual components under ASC
830-20 and ASC 815 would be contravened. ASC 815-20-55-49 and 55-50 provide an
example of a synthetic instrument:
55-49 A debt instrument denominated in the investor’s functional
currency and a cross-currency interest rate swap cannot be accounted for
as synthetically created foreign-currency-denominated debt to be
designated as a hedge of the entity’s net investment in a foreign
operation.
55-50 For example, a parent entity that has the U.S. dollar (USD)
as its functional and reporting currency has a net investment in a
Japanese yen- (JPY-) functional-currency subsidiary. The parent borrows
in euros (EUR) on a fixed-rate basis and simultaneously enters into a
receive-EUR, pay-Japanese yen currency swap (for all interest and
principal payments) to synthetically convert the borrowing into a
yen-denominated borrowing. The parent entity cannot designate the
EUR-denominated borrowing and the currency swap in combination as a
hedging instrument for its net investment in the JPY-functional-currency
subsidiary.
5.4.2 Accounting for a Net Investment Hedge
ASC 815-35
35-1 The gain
or loss on a hedging derivative instrument (or the
foreign currency transaction gain or loss on the
nonderivative hedging instrument) that is designated as,
and is effective as, an economic hedge of the net
investment in a foreign operation shall be reported in
the same manner as a translation adjustment (that is,
reported in the cumulative translation adjustment
section of other comprehensive income).
35-2 The
hedged net investment shall be accounted for consistent
with Topic 830. The provisions of Subtopic 815-25 for
recognizing the gain or loss on assets designated as
being hedged in a fair value hedge do not apply to the
hedge of a net investment in a foreign operation.
As in a cash flow hedging relationship, the hedged item is not adjusted in a net
investment hedging relationship. The gain or loss on the hedging instrument in a
qualifying net investment hedging relationship is reported in the CTA component
of OCI in a manner consistent with the translation of the net investment under
AC 830. There are two circumstances that result in a modification to this model:
-
An entity designates a derivative as the hedging instrument in a qualifying net investment hedging relationship and assesses the effectiveness of the hedging relationship under the spot method (see Section 5.4.2.1.1.1).
-
An entity elects to hedge on an after-tax basis (see Section 5.4.2.2).
5.4.2.1 Differences in Methods of Assessing Effectiveness
ASC 815-35
35-4 If a derivative
instrument is used as the hedging instrument, an
entity may assess the effectiveness of a net
investment hedge using either a method based on
changes in spot exchange rates (as specified in
paragraphs 815-35-35-5 through 35-15) or a meth-od
based on changes in forward exchange rates (as
specified in paragraphs 815-35-35-17 through 35-26).
This guidance can also be applied to purchased
options used as hedging instruments in a net
investment hedge. However, an entity shall
consistently use the same method for all its net
investment hedges in which the hedging instrument is
a derivative instrument; use of the spot method for
some net investment hedges and the forward method
for other net investment hedges is not permitted. An
entity may change the method that it chooses to
assess the effectiveness of its net investment
hedges in accordance with paragraphs 815-20-55-55
through 55-56A.
Section 2.5.2.1.2.5 discusses the two
different methods for assessing the effectiveness of a net investment
hedging relationship. The table below summarizes the different types of
hedging instruments and the effectiveness assessment methods available for
each type of instrument.
Hedging Instrument
|
Effectiveness Assessment Methods
|
---|---|
Nonderivative instrument
|
Spot method
|
Derivative instrument
|
Spot method or forward method
|
As indicated in ASC 815-35-35-4, an entity must “consistently use the same
method for all its net investment hedges in which the hedging instrument is
a derivative instrument.” It is not permitted to “use . . . the spot method
for some net investment hedges and the forward method for other net
investment hedges.” For most entities, the selection of an assessment method
is driven by the difference in the accounting for the relationships under
each method. These differences are described in Sections
5.4.2.1.1 (the spot method) and
5.4.2.1.2 (the forward method).
ASC 815-35-35-4 also notes that an “entity may change the method that it
chooses to assess the effectiveness of its net investment hedges in
accordance with paragraphs 815-20-55-55 through 55-56A.” However, in a
manner consistent with the overall guidance for changing assessment methods
(see Section 2.5.4), a change in methods:
-
May only be done if the entity can demonstrate that the new method of assessing effectiveness is an “improved method,” in accordance with ASC 815-20-35-19 and ASC 815-20-55-56.
-
Would apply to all net investment hedging relationships in which the hedging instrument is a derivative.
-
Would be accomplished for any outstanding hedging relationship by dedesignating the original hedging relationship and then designating a new hedging relationship.
ASC 815-20-55-56 notes that the requirement to demonstrate that the new
method of assessing effectiveness is an “improved method” does not mean that
the new method must be deemed “preferable” under ASC 250; however, once an
entity switches from one method to the other and asserts that the new method
is “improved,” it would most likely be unable to switch back to its original
method of assessing hedge effectiveness at a later date because it would be
difficult to support an argument that the original method has reverted to
being an “improved” method.
5.4.2.1.1 The Spot Method
5.4.2.1.1.1 Hedging Instrument Is a Derivative
ASC 815-35
Hedging Instrument Is a Derivative
Instrument
35-5A An entity shall
recognize in earnings the initial value of the
component excluded from the assessment of
effectiveness using a systematic and rational
method over the life of the hedging instrument.
Any difference between the change in fair value of
the excluded component and amounts recognized in
earnings under that systematic and rational method
shall be recognized in the same manner as a
translation adjustment (that is, reported in the
cumulative translation adjustment section of other
comprehensive income).
35-5B An entity
alternatively may elect to record changes in the
fair value of the excluded component currently in
earnings. This election shall be applied
consistently to similar hedges in accordance with
paragraph 815-20-25-81.
35-6 The interest accrual
(periodic cash settlement) components of
qualifying receive-variable-rate,
pay-variable-rate and receive-fixed rate,
pay-fixed-rate cross-currency interest rate swaps
shall also be reported directly in earnings.
35-7 The change in fair
value of the derivative instrument attributable to
changes in the spot rate shall be reported in the
same manner as a translation adjustment (that is,
reported in the cumulative translation adjustment
section of other comprehensive income).
If an entity designates a derivative instrument in a hedge of a net
investment in foreign operations and elects to assess hedge
effectiveness under the spot method, it must recognize the excluded
component’s initial value in earnings over the life of the hedging
relationship in a manner similar to any other relationship in which
components are excluded from the effectiveness assessment. The
default treatment under ASC 815 is to recognize the initial value of
the excluded component in earnings by using a systematic and
rational method. Alternatively, as noted in ASC 815-35-35-5B, an
entity may elect to record the changes in the excluded component’s
fair value currently in earnings.
ASC 815-35-35-6 notes that the “interest accrual (periodic cash
settlement) components of qualifying receive-variable-rate,
pay-variable-rate and receive-fixed rate, pay-fixed-rate
cross-currency interest rate swaps shall also be reported directly
in earnings.”
If an entity designates an at-market cross-currency interest rate
swap (i.e., its fair value is zero) with standard terms as the
hedging instrument and recognizes the periodic interest accruals in
earnings, there are no other excludable components to recognize in
earnings. A standard cross-currency interest rate swap has the
following terms:
-
The exchange of currencies at inception and the return of those same amounts upon final settlement of the swap are based on the spot exchange rate at the inception of the derivative.
-
The periodic interest accruals are calculated in the same manner for each settlement:
-
For a fixed-for-fixed swap, each leg has the same fixed rate for the life of the swap.
-
For a variable-for-variable swap:
-
Each leg has the same contractually specified rate over the life of the swap.
-
Any fixed spread added to a leg of the swap is the same fixed spread over the life of the swap.
-
The contractually specified interest rates for both legs are based on comparable interest rate curves (e.g., three-month LIBOR and three-month commercial paper rates are not considered comparable under ASC 815-35-35-18(b)).
-
-
5.4.2.1.1.1.1 Hedging With Derivatives That Are Off-Market or Have Nonstandard Terms
The designation of a derivative that is off-market (i.e., its
fair value is other than zero at hedge inception) or has other
than standard terms (see Section
5.4.2.1.1.1) as a hedging instrument in a net
investment hedge raises other accounting issues. Such a
situation may arise when an entity designates (1) a preexisting
cross-currency interest rate swap instead of a new at-market
cross-currency interest rate swap or (2) a cross-currency
interest rate swap that is highly structured. If a net
investment hedging relationship includes an off-market
derivative, an entity must consider the derivative’s initial
fair value as representing an in-substance financing that must
be factored into the accounting for the new hedging
relationship.
For example, if a fixed-for-fixed cross-currency interest rate
swap has a fair value of $1 million (an asset) at the time of
designation, that initial fair value indicates that the entity
will either receive $1 million more or pay $1 million less (on a
present value basis) than it would have if it had designated an
at-market swap as the hedging instrument at hedge inception. As
a result of this implicit financing element, there is an
additional excluded component (other than the forward points and
the cross-currency basis spread) that the entity must amortize
into earnings, which is essentially the “interest” on the
financing element of the swap.
In a public FASB meeting on February 14,
2018, the staff indicated that when the hedging instrument in a
net investment hedge (in which effectiveness is assessed by
using the spot method) is a cross-currency interest rate swap
that is off-market at hedge inception, an entity should amortize
the excluded component in a manner that would not violate the
guidance in ASC 815-35-35-6 and 35-7. The FASB staff clarified
that “at the end of the hedging relationship, only amounts of
the swap related to spot changes on the notional amount of the
net investment [that occurred during the life of the hedge]
should remain in” the CTA. Such amounts would be computed as the
product of (1) the notional amount and (2) the difference
between the market-based foreign currency spot exchange rates at
hedge maturity and hedge inception. Therefore, an entity can
apply any systematic and rational amortization approach in which
the off-market amount of the swap would equal zero at the end of
the hedging relationship. The staff cautioned, however, that any
structuring of the designated hedging cross-currency swap
designed to “achieve a specific accounting result [would not be]
considered rational in the context of a systematic and rational
approach.” The Board agreed with the staff’s conclusions.
To ensure that the off-market amount of a swap is amortized to
zero by the end of the hedging relationship, an entity may be
able to use one the following amortization methods (not all-inclusive):
-
At hedge inception, compute the time value or basis spread component of the fair value of the swap as the difference between its full fair value and its intrinsic value (the intrinsic value would be computed as the notional amount multiplied by the difference between the foreign currency spot exchange rates at (1) hedge inception and (2) the inception of the actual swap contract). Over the life of the hedging swap, amortize that time value component into earnings on a straight-line basis and recognize the interest settlements on the actual off-market swap in income each period.
-
Determine what the interest settlements would be for a hypothetical swap that has a fair value of zero at hedge inception2 and use those amounts as the basis for amortizing the initial value of the excluded component (attributable to the forward points and the cross-currency basis spread) out of CTA and into earnings in each period. In addition, the entity would separately determine the amount of “interest” on the implicit financing component3 and amortize that amount into earnings over the life of the hedging instrument on either a straight-line basis or by using an effective interest method.
As indicated above, the FASB staff noted that when an entity
chooses its amortization method for the excluded component of a
hedging instrument that is off-market at hedge inception, it
must be mindful that any structuring of the designated
cross-currency swap designed to achieve a specific accounting
result would not be considered a rational method of amortization
in the context of the systematic and rational amortization
approach required under ASC 815-35-35-5A. The amortization
method described in the first bullet above is more likely to be
susceptible to inappropriate structuring than the method
described in the second bullet; therefore, entities using the
method in the first bullet should closely review the terms of
the hedging swap to ensure that those terms would result in a
rational amortization pattern.
For example, a cross-currency interest rate swap could be
structured so that the rates earlier in the swap are
below-market and the rates later in the swap are above-market,
which would also represent an in-substance financing
arrangement.
5.4.2.1.1.1.2 Income Statement Classification
ASC 815-35 is silent on the income statement classification of amounts related to excluded components of the derivative that are recognized in earnings in connection with a hedging relationship in which the spot method is used. We believe that the FASB intended to allow entities to continue the practice they had used before the issuance of FASB Statement 133. In many cases, entities had viewed
the “cost or income” of derivatives related to foreign currency
hedging as a financing cost, so they had recognized such amounts,
whether positive or negative, in interest expense. For many
entities, the decision to recognize such costs in interest expense
was also driven by the fact that they may also have issued
foreign-currency-denominated debt to finance the foreign operations.
We believe that an entity should establish a reasonable,
consistently applied income statement classification policy and
disclose that policy in its financial statements.
See Examples 5-18 and
5-19 for detailed illustrations of the application
of the spot method to a net investment hedge involving a forward
contract and Example 5-21 for an illustration of the application
of the spot method to a net investment hedge involving a
cross-currency interest rate swap.
5.4.2.1.1.2 Hedging Instrument Is a Nonderivative Instrument
ASC 815-35
Hedging Instrument Is Not a Derivative
Instrument
35-12 The
translation gain or loss determined under Subtopic
830-30 by reference to the spot exchange rate
between the transaction currency of the debt and
the functional currency of the investor (after tax
effects, if appropriate) shall be reported in the
same manner as the translation adjustment
associated with the hedged net investment (that
is, reported in the cumulative translation
adjustment section of other comprehensive income)
if both of the following conditions are met:
-
The notional amount of the nonderivative instrument matches the portion of the net investment designated as being hedged.
-
The nonderivative instrument is denominated in the functional currency of the hedged net investment.
In that circumstance, the hedging relationship
would be considered perfectly effective, and no
prospective quantitative effectiveness assessment
is required at hedge inception (see paragraph
815-20-25-3(b)(2)(iv)(01)).
If an entity designates a nonderivative instrument as the hedging
instrument in a qualifying net investment hedge, it must apply the spot
method because the hedging instrument is remeasured at spot rates in
accordance with ASC 830-20. ASC 815-35-35-12 states, in part, that if
the “notional amount of the nonderivative instrument matches the portion
of the net investment . . . being hedged” and “is denominated in the
[same] functional currency” as the net investment, the translation gain
or loss on the nonderivative instrument is recognized in a CTA along
with the translation adjustment associated with the net investment. We
believe that even in situations in which one of the two conditions in
ASC 815-35-35-12 is not met, as long as the hedging relationship
qualifies for hedge accounting, the entire translation gain or loss on
the nonderivative instrument is recognized in a CTA in a manner
consistent with the guidance in ASC 815-35-35-1.
In some cases, a nonderivative instrument is both the hedging instrument
in a net investment hedge and the hedged item in a fair value hedge. For
example, an entity may designate a pay-variable, receive-fixed interest
rate swap as a fair value hedge of foreign-currency-denominated
fixed-rate debt for changes in its fair value that are attributable to
changes in the benchmark interest rate. As a result of the fair value
hedge, the carrying amount of the debt will be adjusted for changes in
its fair value that are attributable to changes in the designated
benchmark interest rate. This debt may also be the hedging instrument in
a hedge of a net investment in foreign operations.
Changing Lanes
In its November 2019 proposed
ASU of Codification improvements to hedge
accounting, the FASB proposed to eliminate the recognition and
presentation mismatch related to these “dual hedges” (described
above) that results from adjusting the carrying amount of the
debt in a fair value hedge.
At the October 11, 2023, FASB meeting, the Board decided to
affirm the proposed amendments to eliminate the recognition and
presentation mismatch related to dual hedges. Under the proposed
amendments, an entity would eliminate that mismatch by excluding
the foreign-currency-denominated debt instrument’s fair value
hedge basis adjustment from the net investment hedge
effectiveness assessment. As a result, an entity would
immediately recognize the gains and losses from the
remeasurement of the debt instrument’s fair value hedge basis
adjustment at the spot exchange rate in earnings. Entities would
be prohibited from applying this guidance by analogy to other
circumstances.
5.4.2.1.2 The Forward Method
ASC 815-35
35-17 Under a method based
on changes in forward exchange rates, an entity
shall report all changes in fair value of the
derivative instrument in the same manner as a
translation adjustment (that is, reported in the
cumulative translation adjustment section of other
comprehensive income), including the following
amounts:
-
The time value component of purchased options
-
The interest accrual/periodic cash settlement components of qualifying receive-variable-rate, pay-variable-rate and receive-fixed-rate, pay-fixed-rate cross-currency interest rate swaps.
Under the forward method, an entity would report all
changes in the derivative instrument’s fair value in the CTA portion of
OCI for a qualifying net investment hedging relationship. See Example 5-17 for
a detailed illustration of a forward contract hedging a net investment
in foreign operations under the forward method and Example 5-20 for
a detailed illustration of a fixed-for-fixed cross-currency interest
rate swap hedging a net investment in foreign operations under the
forward method.
5.4.2.2 Hedging on an After-Tax Basis
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.
As indicated in ASC 815-35-35-3, if an entity has designated and documented
that it will be hedging on an after-tax basis, as permitted by ASC
815-20-25-3(b)(2)(vi), “the portion of the gain or loss on the hedging
instrument that [exceeds] the loss or gain” from translating the net
investment is recognized as an offset to the related tax effects in the
period in which those tax effects are recognized. See Section 5.1.3 for further discussion of
hedging on an after-tax basis.
5.4.3 Discontinuing a Net Investment Hedge
Gains and losses on the hedging instrument that are recorded in the CTA portion
of OCI are treated consistently with all other amounts in the CTA related to a
net investment in foreign operations. ASC 830-30 includes guidance on the
circumstances under which a CTA may be released, including scenarios involving
(1) full and substantially complete liquidations and (2) partial sales and
liquidations. See Section 5.4 of
Deloitte’s Roadmap Foreign Currency
Matters.
ASC 815-35
40-1 When applying the
guidance in paragraph 815-35-35-5A and a hedge is
discontinued, any amounts that have not yet been
recognized in earnings shall remain in the cumulative
translation adjustment section of accumulated other
comprehensive income until the hedged net investment is
sold or liquidated in accordance with paragraphs
830-30-40-1 through 40-1A.
In accordance with ASC 815-35-40-1, if an entity discontinues a hedging
relationship in which a derivative was the hedging instrument and the spot
method was applied, any amounts that were recognized in the CTA related to
excluded components that have not yet been recognized in earnings should remain
in the CTA.
We do not believe that it would be appropriate for an entity to effectively
“freeze” amounts in CTA that are related to excluded components by dedesignating
a hedging relationship and immediately redesignating it in exactly the same
manner with the same hedging instrument and hedged net investment in foreign
operations.
As discussed in Section 2.5.2.2.4, because
of the nature of the hedged item, the process for periodically monitoring a net
investment hedging relationship is a bit unique. The balance of an entity’s net
investment in foreign operations is subject to change in each reporting period
on the basis of (1) the operating results of the investee and (2) capital
transactions between the entity and the investee (dividends, etc.). Accordingly,
the entity should continually assess the balance of the net investment to ensure
that it is not overhedged before the start of a reporting period (i.e., when it
would be performing the prospective assessment for the upcoming period). If the
balance of the net investment drops below the amounts designated as the hedged
item, the entity would need to consider the one of following alternatives:
-
Dedesignate the proportion of the hedging relationship related to the “shortfall” of the net investment.4 Any portion of the hedging instrument that is no longer in the net investment hedge could potentially be (1) designated in a new hedging relationship or (2) simply reported at fair value in subsequent periods, with changes in fair value recognized in earnings.
-
Dedesignate the entire hedging relationship and redesignate a new one. The entity would need to identify a different notional amount for the hedged net investment because the amount of the hedged item cannot exceed the balance of the net investment. As discussed in Section 2.5.2.2.4, an entity could purposely overhedge the net investment, but the new hedging relationship would need to be highly effective and the entity could not assume perfect effectiveness.
-
Dedesignate the entire hedging relationship and consider whether to either designate the hedging instrument in a new hedging relationship or simply report it at fair value in subsequent periods, with changes in fair value recognized in earnings.
5.4.4 Illustrative Examples
Example 5-17
Forward Contract Hedging a Net Investment in Foreign
Operations (Forward Method)
SimpleBand, a U.S. multinational company, has a wholly
owned German subsidiary, Skyscraper Co., with a euro
functional currency. SimpleBand’s investment in
Skyscraper Co. is EUR 10 million. In accordance with ASC
830, SimpleBand records the translation adjustments
related to its German subsidiary in the CTA component of
OCI.
On June 30, 20X0, SimpleBand enters into a six-month
forward contract to sell EUR 10 million for USD
11,772,000 (a EUR/USD forward rate of 1.1772). The
EUR/USD spot exchange rate on June 30, 20X0, is 1.1667.
SimpleBand designates the forward contract as a hedge of
the foreign currency exposure of its net investment in
Skyscraper Co.
SimpleBand elects to apply the forward method to assess
the effectiveness of the hedge. The hedging relationship
is considered to be perfectly effective under ASC
815-35-35-17A because:
-
The notional amount of the forward matches the portion of the net investment designated as being hedged.
-
The underlying of the forward (EUR/USD) is related solely to the foreign exchange rate between the functional currency of Skyscraper Co. (EUR) and the functional currency of SimpleBand (USD).
For this example, assume that the net investment in
Skyscraper Co. does not decline below EUR 10 million.
Skyscraper Co. records the following journal
entries:
June 30, 20X1
No entry is required. The forward contract is
at-the-money.
September 30, 20X1
The table below shows (1) the three-month EUR/USD forward
rate as of September 30, 20X1, (2) the forward
contract’s fair values at the beginning and end of the
period, and (3) the change in the forward contract’s
fair value.
The table below shows (1) the EUR/USD spot exchange rates
at beginning and end of the period and (2) the related
CTA for Skyscraper Co. in accordance with ASC 830.
The journal entries are as follows:
December 31, 20X1
The table below shows (1) the EUR/USD
spot exchange rate as of December 31, 20X1, (2) the
forward contract’s fair values at the beginning and end
of the period, and (3) the change in the forward
contract’s fair value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
Example 5-18
Forward Contract Hedging a Net Investment in Foreign
Operations (Spot Method — Systematic and Rational
Amortization)
Assume the same facts as in Example
5-17, except that SimpleBand elects to
assess the effectiveness of the hedging relationship by
using the spot method. The hedging relationship is
considered to be perfectly effective under ASC
815-35-35-5 because:
-
The notional amount of the forward matches the portion of the net investment designated that is being hedged.
-
The underlying of the forward (EUR/USD) is related solely to the foreign exchange rate between the functional currency of Skyscraper Co. (EUR) and the functional currency of SimpleBand (USD).
SimpleBand elects to recognize the initial value of the
excluded component (the forward/spot difference) in
earnings over the life of the hedging relationship in a
systematic and rational basis. It has a consistently
applied policy of recognizing the earnings effect of the
excluded components of derivatives related to net
investment hedges in interest expense because it views
those components as a financing cost of the derivatives.
The calculation of the excluded component’s initial value
(i.e., the difference between the forward and spot
rates) is as follows:
For this example, assume that the net investment in
Skyscraper Co. does not decline below EUR 10 million.
Skyscraper Co. records the following journal
entries:
June 30, 20X1
No entry is required. The forward contract is
at-the-money.
September 30, 20X1
The table below shows (1) the three-month EUR/USD forward
rate as of September 30, 20X1, (2) the forward
contract’s fair values at the beginning and end of the
period, and (3) the change in the forward’s fair
value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
December 31, 20X1
The table below shows (1) the EUR/USD spot exchange rate
as of December 31, 20X1, (2) the forward contract’s fair
values at the beginning and end of the period, and (3)
the change in the forward’s fair value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
Example 5-19
Forward Contract Hedging a Net Investment in Foreign
Operations (Spot Method — Change in the Fair Value
of Excluded Components in Earnings)
Assume the same facts as in Example 5-18, except
that SimpleBand elects to assess the effectiveness of
the hedging relationship by using the spot method and
recognizes the changes in the excluded component’s fair
value (the forward/spot difference) in current earnings,
as allowed by ASC 815-35-35-5B. SimpleBand has a
consistently applied policy of recognizing the earnings
effect of the excluded components of derivatives related
to net investment hedges in interest expense because it
views those components as a financing cost of the
derivatives.
For this example, assume that the net investment in
Skyscraper Co. does not decline below EUR 10 million.
Skyscraper Co. records the following journal
entries:
June 30, 20X1
No entry is required. The forward contract is
at-the-money.
September 30, 20X1
The table below shows (1) the three-month EUR/USD forward
rate as of September 30, 20X1, (2) the forward
contract’s fair values at the beginning and end of the
period, and (3) the change in the forward contract’s
fair value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
December 31, 20X1
The table below shows (1) the EUR/USD spot exchange rate
as of December 31, 20X1, (2) the forward contract’s fair
values at the beginning and end of the period, and (3)
the change in the forward contract’s fair value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
Example 5-20
Fixed-for-Fixed Cross-Currency Interest Rate Swap
Hedging Net Investment in Foreign Operations
(Forward Method)
TreyCo wishes to hedge its exposure to
changes in its SEK 50 million net investment in its
foreign subsidiary (Kasvot) that are attributable to
changes in the USD/SEK foreign currency exchange rate.
On March 5, 20X6, TreyCo enters into a fixed-for-fixed
cross-currency interest rate swap to hedge that risk.
The terms of the cross-currency interest rate swap are
as follows:
-
Pay leg — SEK 50 million notional at a rate of 1.75 percent per annum.
-
Receive leg — USD 55,025,000 notional at a rate of 3.4 percent per annum.
-
Quarterly periodic settlements beginning March 31, 20X6.
-
Initial exchange — TreyCo receives SEK 50 million and pays USD 55,025,000.
-
Final exchange — TreyCo receives USD 55,025,000 and pays SEK 50 million.
-
Maturity date — September 30, 20X7.
TreyCo designates the cross-currency interest rate swap
as a hedge of SEK 50 million of the beginning balance of
its net investment in Kasvot and elects to assess the
effectiveness of the hedging relationship by using the
forward method. TreyCo may assume that the hedge is
perfectly effective under ASC 815-35-35-17A because:
-
The swap’s notional amount matches the amount of the net investment being hedged.
-
The swap’s underlying is related solely to the foreign currency exchange rate between the functional currency of the parent (USD) and the functional currency of the hedged subsidiary (SEK).
For this example, assume that the net investment in
Kasvot does not decline below SEK 50 million.
Below is a table of key assumptions.
TreyCo would record the following journal entries for
each reporting period to account for the hedge and the
translation of its net investment in Kasvot:
March 31, 20X6
Translation of the foreign subsidiary is not required
because the spot rate has not changed.
June 30, 20X6
September 30, 20X6
December 31, 20X6
March 31, 20X7
June 30,
20X7
September 30,
20X7
Example 5-21
Fixed-for-Fixed Cross-Currency Interest Rate Swap
Hedging Net Investment in Foreign Operations (Spot
Method)
Assume the same facts as in Example 5-20, except
that TreyCo elects to assess the effectiveness of the
hedging relationship by using the spot method. Because
the swap is an at-market swap with standard terms, there
are no excluded components to recognize in earnings
separately from the periodic settlements. TreyCo has a
consistently applied policy of recognizing the earnings
effect of the excluded components of derivatives related
to net investment hedges in interest expense because it
views those components as a financing cost of the
derivatives.
TreyCo may assume that the hedge is perfectly effective
under ASC 815-35-35-5 because:
-
The swap’s notional amount matches the amount of the net investment being hedged.
-
The swap’s underlying is related solely to the foreign currency exchange rate between the functional currency of the parent (USD) and the functional currency of the hedged subsidiary (SEK).
For this example, assume that the net investment in
Kasvot does not decline below SEK 50 million.
Below is a table of key assumptions.
TreyCo would record the following journal entries for
each reporting period to account for the hedge and the
translation of its net investment in Kasvot:
March 31, 20X6
Translation of the foreign subsidiary is not required
because the spot rate has not changed.
June 30, 20X6
September 30, 20X6
December 31, 20X6
March 31, 20X7
June 30, 20X7
September 30, 20X7
Footnotes
2
The terms of the hypothetical derivative should
reflect those of a receive-fixed-rate,
pay-fixed-rate cross-currency interest rate swap
that has (1) a fair value of zero at hedge
inception and (2) terms (other than the notional
amount and fixed interest rate on the leg whose
interest payments are not denominated in the
functional currency of the designated hedged net
investment) that match those of the actual hedging
derivative (e.g., maturity date, repricing, and
payment frequencies of any interim settlements).
Furthermore, the notional amount of the leg of the
hypothetical swap denominated in the functional
currency of the net investment being hedged should
match the amount of that hedged net investment.
The notional amount of the leg that matches the
hedging entity’s functional currency would be set
by converting the foreign-currency-denominated leg
on the basis of the current foreign exchange rate
(i.e., the spot foreign currency exchange rate at
hedge inception). The interest rate on the
functional currency leg would then be set at
whatever rate results in the swap’s having a fair
value of zero at inception of the hypothetical
derivative.
3
This element can be determined by looking at
the difference between the payments on the
off-market (actual) swap and the payments on the
at-market (hypothetical) swap. The difference
between the fair value of the swap and the
undiscounted “extra” payments is the interest
element that would be amortized out of CTA on a
systematic and rational basis in a manner
consistent with the treatment of other excluded
components under the amortization approach.
4
See Sections 3.5.1.3.1 and
4.1.5.1.3.1 for a discussion of partial
dedesignations for fair value hedges and cash flow hedges.
The concepts are similar for a net investment hedge, as
supported by ASC 815-35-55-1.