Chapter 5 — Foreign Currency Hedges
Chapter 5 — Foreign Currency Hedges
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
|
|
Unrecognized firm commitment
|
Derivative or nonderivative
| |
|
Foreign currency cash flow hedge (see
Section
5.3)
|
|
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:
- The operating unit that has the foreign currency exposure is a party to the hedging instrument.
- Another member of the
consolidated group that has the same functional
currency as that operatingunit 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:
-
Enters into a derivative instrument with an unrelated third party to offset the exposure that results from that internal derivative
-
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:
-
It offsets the aggregate or net exposure to that currency.
-
It matures within the same 31-day period.
-
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:
-
It tracks the exposure that it acquires from each hedging affiliate.
-
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:
-
The change in fair value of the actual derivative instrument designated as the hedging instrument
-
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
1
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.
5.2 Foreign Currency Fair Value Hedges
|
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
|
Recognized asset or liability (including AFS securities)
|
Derivative
|
|
Unrecognized firm commitment
|
Derivative or nonderivative
|
As indicated in the ASC master glossary and discussed in Chapter 3, a fair value hedge is “[a] hedge of the exposure to
changes in the fair value of a recognized asset or liability, or of an unrecognized
firm commitment, that are attributable to a particular risk.” The changes in that
fair value must have the potential to affect reported earnings. When an entity
elects to hedge a foreign-currency-denominated asset or liability for changes in
fair value that are attributable to changes in foreign currency exchange rates,
additional guidance is needed because the hedged item in many cases is already
subject to remeasurement under ASC 830-20.
5.2.1 Hedged Items in a Foreign Currency Fair Value Hedge
A hedged item would only have exposure to changes in fair value that are
attributable to changes in foreign currency exchange rates if it is an existing
foreign-currency-denominated asset or liability or an unrecognized firm
commitment to purchase or sell an asset with a price that is a fixed amount of a
foreign currency.
ASC 815-20
25-37 This paragraph
identifies possible hedged items in fair value hedges of
foreign exchange risk. If every applicable criterion is
met, all of the following are eligible for designation
as a hedged item in a fair value hedge of foreign
exchange risk:
-
Recognized asset or liability. A derivative instrument can be designated as hedging the changes in the fair value of a recognized asset or liability (or a specific portion thereof) for which a foreign currency transaction gain or loss is recognized in earnings under the provisions of paragraph 830-20-35-1. All recognized foreign-currency-denominated assets or liabilities for which a foreign currency transaction gain or loss is recorded in earnings shall qualify for the accounting specified in Subtopic 815-25 if all the fair value hedge criteria in this Section (including the conditions in paragraph 815-20-25-30(a) through (b)) are met.
-
Available-for-sale debt security. A derivative instrument can be designated as hedging the changes in the fair value of an available-for-sale debt security (or a specific portion thereof) attributable to changes in foreign currency exchange rates. The designated hedging relationship qualifies for the accounting specified in Subtopic 815-25 if all the fair value hedge criteria in this Section (including the conditions in paragraph 815-20-25-30(a) through (b)) are met.
-
Subparagraph superseded by Accounting Standards Update No. 2016-01.
-
Unrecognized firm commitment. Paragraph 815-20-25-58 states that a derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss under Topic 830 can be designated as hedging changes in the fair value of an unrecognized firm commitment, or a specific portion thereof, attributable to foreign currency exchange rates.
In a manner consistent with ASC 815-20-25-37, if the relevant hedge accounting
requirements are met, foreign currency exposures associated with (1) a
recognized asset or liability, (2) an AFS security (subject to some
restrictions), and (3) an unrecognized firm commitment may qualify as the hedged
item in a fair value hedge of foreign currency risk.
5.2.1.1 Recognized Foreign-Currency-Denominated Asset or Liability
A foreign currency exposure on a recognized asset or liability may qualify as
the hedged item in a fair value hedging relationship provided that the asset
or liability is subject to the measurement provisions of ASC 830-20-35-1.
The application of the foreign currency measurement requirements of ASC
830-20 is not viewed as measurement of the exposure at fair value, with
changes in fair value recognized in earnings, because the remeasurement of
the foreign-currency-denominated asset or liability is only based on changes
in the foreign currency spot exchange rate, as noted in ASC 815-20-25-29. In
that way, foreign currency exposures associated with recognized assets and
liabilities are not precluded from qualifying as the hedged item. However,
an asset or liability that is carried at fair value, with changes in fair
value recognized in earnings (e.g., an equity security subject to ASC 321),
would not qualify as the hedged item even if it is a
foreign-currency-denominated asset or liability that is subject to ASC
830-20.
Also, as noted in Section 2.3.2.2, a
recognized asset or liability must be denominated in a foreign currency for
it to have exposure to changes in foreign currency exchange rates.
Therefore, recognized nonfinancial assets do not qualify to be the hedged
item in a foreign currency fair value hedge.
5.2.1.1.1 Recognized Foreign-Currency-Denominated Asset or Liability — Fair Value Hedge or Cash Flow Hedge?
Under ASC 815-20-25-28, an entity may enter into the following types of
foreign currency hedges for a recognized asset or liability: (1) a fair
value hedge of the recognized asset or liability, or a specific portion
thereof (including an AFS debt security), and (2) a cash flow hedge of
the forecasted functional currency cash flows associated with the
recognized asset or liability. For such hedges, ASC 815-20-25-71(b) and
(c) state that a nonderivative financial instrument cannot be designated
as the hedging instrument.
Foreign-currency-denominated assets and liabilities have exposure to
changes in both fair value and functional-currency cash flows when
foreign currency exchange rates change. Consequently, entities have the
choice of applying either fair value hedges (see ASC 815-20-25-37(a)) or
cash flow hedges (see ASC 815-20-25-38(b)) to offset the foreign
currency risk of recognized foreign-currency-denominated assets and
liabilities. In some cases, if the entity wants to hedge more than one
risk, the type of hedging relationship applied will be determined by the
nonforeign currency risk. For example, if an entity wants to hedge
fixed-rate foreign-currency denominated debt for both interest rate risk
and foreign currency risk, it would designate a fair value hedging
relationship because changes in interest rates affect the debt’s fair
value.
In addition, the type of hedge that an entity can designate depends on
whether the hedge is intended to eliminate all the variability in the
hedged item’s functional currency cash flows, which would be a
requirement for any cash flow hedge of the entity’s exposure to foreign
currency risk under ASC 815-20-25-39(d) (see Section
5.3.3.1.1). Accordingly, risk management strategies in
which the foreign currency exposure of a recognized asset or liability
is swapped into a variable-rate exposure in an entity’s functional
currency will not qualify for cash flow hedging because the hedged
items’ functional currency cash flows would still be subject to
variability.
The table below provides examples of the type of hedge that would be
appropriate for an entity to designate to implement the listed risk
management strategies. In each scenario, the foreign currency exposure
is swapped into the entity’s functional currency, which is assumed to be
USD. Depending on the nature of the strategy, the entity could designate
an instrument such as a currency swap, forward contract, or combined
interest rate and currency swap (CIRCUS) as the hedging derivative.
|
Issued by Entity With USD Functional Currency
|
Risk Management Strategy
|
Type of Hedge Under ASC 815
|
|---|---|---|
|
Fixed-rate foreign-currency-denominated debt
|
Swap into fixed-rate USD debt
|
Fair value or cash flow hedge of foreign currency
risk
|
|
Fixed-rate foreign-currency-denominated debt
|
Swap into variable-rate USD debt
|
Fair value hedge of foreign currency and interest
rate risk
|
|
Floating-rate foreign-currency-denominated
debt
|
Swap into fixed-rate USD debt
|
Cash flow hedge of foreign currency and interest
rate risk
|
|
Floating-rate foreign-currency-denominated
debt
|
Swap into floating-rate USD debt
|
Fair value hedge of foreign currency risk
|
An entity that enters into a cross-currency interest rate swap to hedge
foreign-currency-denominated debt for changes in its fair value
attributable to foreign currency risk may exclude the cross-currency
basis spread in the swap from the hedge effectiveness assessment in
accordance with ASC 815-20-25-82(e). In doing so, the recognition of the
accrual of the periodic interest settlements on the swap in earnings is
considered a systematic and rational method of recognizing the initial
value of the excluded component.
In addition, we believe that if all the following conditions are met, an
entity may apply the critical-terms-match method (see Section 2.5.2.2) to a hedge of
foreign-currency-denominated debt for changes in its fair value
attributable to changes in the foreign currency spot exchange rate:
-
The debt is fixed-rate foreign-currency-denominated debt.
-
The hedging instrument is a fixed-for-fixed cross-currency interest rate swap.
-
The notional amount of the foreign currency leg of the swap matches the principal amount of the debt that is designated as the hedged item throughout the term of the hedging relationship.
-
The two currencies underlying the exchange rate of the swaps match the functional currency of the entity and the currency in which the debt is denominated.
-
Either of the following:
-
The cross-currency basis spread is excluded from the assessment of hedge effectiveness.
-
The interest payments on the foreign currency leg of the swap match the designated portion of the hedged interest payments (both timing and amount).
-
-
The swap has standard terms (see Section 5.4.2.1.1.1) and its fair value at hedge inception is zero.
See Example 5-7 for a detailed example of an entity
using a fixed-for-fixed cross-currency interest rate swap to hedge
fixed-rate foreign-currency-denominated debt.
5.2.1.1.2 AFS Securities
Foreign currency exposures on AFS debt securities may be identified as a
hedged item in a fair value hedging relationship. While an AFS debt
security is measured at fair value, changes in fair value (including
those changes resulting from changes in foreign currency exchange rates)
are recognized in OCI, not in earnings. Accordingly, an AFS debt
security is not prohibited from being a hedged item.
An entity may choose to simply hedge the foreign currency risk related to
the principal amount of an AFS debt security by entering into a forward
contract.
Example 5-3
Weekapaug Regional Bank, an entity with a USD
functional currency, acquires a EUR-denominated
AFS debt security with a principal amount of EUR
10 million that matures in two years. It enters
into a forward contract to sell EUR 10 million in
exchange for USD 12.5 million in two years.
Weekapaug could elect to designate the forward
contract as a fair value hedge of the AFS debt
security for changes in its fair value
attributable to changes in the EUR/USD exchange
rate.
An entity may also use a compound derivative, such as a CIRCUS, to hedge
the foreign currency and interest exposures on a fixed-rate AFS debt
security that is denominated in a foreign currency. ASC 320-10-35-36
requires an entity to record the entire change in the fair value of a
foreign-currency-denominated AFS security in OCI (unless there is an
impairment loss, which is recognized in earnings) rather than record the
foreign currency component of that change in fair value through
earnings, as would be required under ASC 830.
Example 5-4
Weekapaug Regional Bank, an entity with USD
functional currency, has a five-year fixed-rate
100 million EUR-denominated debt security and
classifies the investment as an AFS security.
Weekapaug wants to enter into a derivative to
“convert” the security to the equivalent of a
USD-denominated variable-interest-rate investment.
To do so, it enters into a CIRCUS in which (1) at
maturity, it exchanges EUR 100 million for a fixed
number of USD and (2) each quarter, it pays a
fixed rate of interest in EUR and receives a
variable rate of interest in USD. This strategy
eliminates the risk of changes in the security’s
fair value that are attributable to foreign
currency and interest rate exposures (see
Section
5.2.1.1.1). The CIRCUS should be
accounted for as a fair value hedge of the AFS
debt security as long as it is highly effective
and all other conditions of ASC 815-20-25-37 are
satisfied.
Section 5.2.1.1.1 notes that an
entity may designate a recognized foreign-currency-denominated asset,
including an AFS debt security, as the hedged item in a fair value or
cash flow hedging relationship. The type of relationship that an entity
applies is likely to be determined by the terms of the AFS debt security
(e.g., fixed- or floating-rate) and the type of derivative used (e.g., a
forward contract or CIRCUS). See Section 5.2.3.2.1
for further discussion of the accounting for foreign currency fair value
hedges of AFS debt securities.
5.2.1.2 Firm Commitments
Firm commitments generally qualify as a hedged item in a fair value hedging
relationship. However, foreign currency exposures on firm commitments may
affect both the firm commitment’s fair value (in a fair value hedge) as well
as the forecasted cash flows related to the firm commitment (in a cash flow
hedge).
Even though firm commitments are required to have a fixed price, a cash flow
exposure may arise because that price is not required to be denominated in
the entity’s functional currency. As a result, foreign currency exposures on
firm commitments may be eligible as a hedged item in either a fair value or
a cash flow hedging relationship, depending on the manner in which it is
designated.
The following firm commitments are precluded from qualifying as the hedged
item in a foreign-currency-related fair value hedge:
- Intercompany commitments — Such commitments would not meet the definition of a firm commitment because they are not with a third party (see Section 3.1.1). However, an entity may hedge forecasted transactions related to certain intercompany commitments that have foreign currency exposure in a cash flow hedging relationship (see Section 5.3.1.1.1).
- Firm commitments to enter into a business combination — ASC 815-20-25-43(c)(5) specifically prohibits such commitments from qualifying as the hedged item in a fair value hedge.
5.2.2 Hedging Instruments in a Foreign Currency Fair Value Hedge
Generally, only derivative instruments are permissible hedging instruments in a
fair value hedging relationship. However, as noted in Section 2.4.2, certain nonderivative instruments may qualify as
the hedging instruments in a fair value hedge of the foreign currency risk of an
unrecognized firm commitment. For a nonderivative to qualify, it must be subject
to the measurement criteria of ASC 830-20, as required by ASC 815-20-25-58.
Therefore, a nonderivative instrument that is measured at fair value, with
changes in fair value recognized in earnings, would not qualify.
5.2.3 Accounting for Foreign Currency Fair Value Hedges
ASC 815-25
Changes Involving Foreign Exchange Risk
35-15 Gains and losses on a
qualifying foreign currency fair value hedge shall be
accounted for as specified in Section 815-25-40 and
paragraphs 815-25-35-1 through 35-10.
35-16 If a nonderivative
instrument qualifies as a hedging instrument under
paragraph 815-20-25-58, the gain or loss on the
nonderivative hedging instrument attributable to foreign
currency risk shall be the foreign currency transaction
gain or loss as determined under Subtopic 830-20. The
foreign currency transaction gain or loss on a hedging
instrument shall be determined, consistent with
paragraph 830-20-35-1, as the increase or decrease in
functional currency cash flows attributable to the
change in spot exchange rates between the functional
currency and the currency in which the hedging
instrument is denominated. That foreign currency
transaction gain or loss shall be recognized currently
in earnings along with the change in the carrying amount
of the hedged firm commitment.
35-17 Paragraph not
used.
35-18 Remeasurement of
hedged foreign-currency-denominated assets and
liabilities is based on the guidance in Subtopic 830-20,
which requires remeasurement based on spot exchange
rates, regardless of whether a fair value hedging
relationship exists.
As noted in Chapter 3, in a typical
qualifying fair value hedging relationship, an entity would record the change in
the hedging instrument’s fair value in current-period earnings, except for
amounts that are excluded from the hedge effectiveness assessment (see Section 3.4). It would also adjust the carrying
amount of the hedged item for the change in its fair value attributable to the
risk being hedged. The adjustment to the carrying amount for the change in the
hedged item’s fair value would also be recognized in current-period earnings.
For qualifying fair value hedges, all amounts recognized in earnings related to
both the hedging instrument and the hedged item are presented in the same income
statement line item and should be related to the risk being hedged (see
Section 5.2.3.3 for further discussion of income
statement classification).
The accounting for a qualifying foreign currency fair value hedge requires some
slight modifications to the typical fair value hedging model because of a couple
of factors:
-
The hedging instrument is not always a derivative instrument that is remeasured at fair value in accordance with ASC 815. Nonderivative instruments may be used to hedge unrecognized firm commitments for foreign currency risk.
-
The hedged item may already be subject to the measurement requirements of ASC 830-20 (i.e., foreign-currency-denominated assets and liabilities).
The measurement of the hedging instrument and the hedged item are discussed
separately in the next sections.
5.2.3.1 Accounting for the Hedging Instrument in a Foreign Currency Fair Value Hedge
The subsequent measurement and timing of the recognition of a hedging
instrument are not affected or altered upon its designation in a hedging
relationship. Instead, the hedging instrument will continue to be measured
in a consistent manner as if no hedge designation had been made, with the
resulting gains and losses recognized through earnings, as follows:
|
Hedging Instrument
|
Subsequent Measurement
|
Basis for Valuing the Instrument
|
|---|---|---|
|
Derivative
|
Fair value in accordance with ASC 815, with changes
in fair value recognized in earnings
|
Fair value (forward rate) — The fair value
measurement principle focuses on changes in the
market rates (e.g., often the forward exchange rates
when the instrument matures at future dates) between
the functional currency and the currency of the
derivative.
|
|
Nonderivative
|
In accordance with ASC 830-20, with changes in
measurement recognized in earnings
|
Spot rate — The measurement principle in
accordance with ASC 830-20 focuses on changes in the
spot exchange rates between the functional currency
and the currency of the hedging instrument, which is
not affected by hedge accounting, as noted in ASC
815-25-35-16.
|
In a manner consistent with the above discussion, a key feature that
distinguishes a derivative from a nonderivative hedging instrument is the
basis of subsequent measurement. Accordingly, an entity should consider the
manner in which a hedging instrument is measured when determining its
hedging strategy and how to designate the hedging relationship. For example,
when using a nonderivative instrument as the hedging instrument in a foreign
currency fair value hedging relationship, an entity cannot exclude any
components of the nonderivative instrument from the assessment of
effectiveness. In addition, an entity would be likely to choose to assess
hedge effectiveness on the basis of changes in the hedged item’s fair value
that are attributable to changes in the spot exchange rate because the
hedging instrument is remeasured on the basis of changes in the spot
exchange rate. All amounts recognized in earnings related to the change in
the measurement of the hedging instrument and the hedged item are presented
in the same income statement line item and should be related to the risk
being hedged.
5.2.3.2 Accounting for the Hedged Item in a Foreign Currency Fair Value Hedge
As discussed in Chapter 3, in a
qualifying fair value hedging relationship, the hedged item is remeasured
for changes in its fair value that are attributable to the hedged risk.
However, ASC 815-25-35-18 notes that if the hedged item is a
foreign-currency-denominated asset or liability, hedge accounting does not
override the requirement of ASC 830-20 to remeasure those assets and
liabilities on the basis of foreign currency exchange spot rates “regardless
of whether a fair value hedging relationship exists.” In other words, ASC
830-20 already provides guidance on how to translate
foreign-currency-denominated assets and liabilities (i.e., remeasure on the
basis of changes in the foreign currency spot exchange rate), so if a
foreign-currency-denominated asset or liability is the hedged item in a
foreign currency fair value hedge, no further adjustments to the carrying
amount are needed for changes attributable to foreign currency risk as a
result of hedge accounting. However, if a foreign-currency-denominated asset
or liability is the hedged item in a qualifying fair value hedging
relationship that is being hedged for changes in fair value attributable to
risks other than foreign currency risk, the hedged item should be remeasured
for changes in its fair value attributable to those other risks before being
translated in accordance with ASC 830-20.
As with all qualifying fair value hedging relationships, the changes in the
hedged item’s carrying amount that result from the application of hedge
accounting are recorded currently in earnings and presented in the same
income statement line item as the changes in the derivative’s fair value,
which should be related to the risk being hedged. In some cases, if multiple
risks are being hedged, this could result in the changes in the hedged item
being recognized in multiple income statement line items.
Example 5-5
Remeasuring Foreign-Currency-Denominated Debt
Hedged for Interest Rate Risk and Foreign Currency
Risk
SimpleBand has a functional and reporting currency in
USD. On January 1, it obtains a EUR 1 million
fixed-rate debt facility and wants to hedge the
risks arising from its foreign-currency-denominated
fixed-rate debt facility in a fair value hedge.
SimpleBand designates as the hedged risks the
changes in fair value that are attributable both to
(1) changes in the foreign currency exchange rate
and (2) changes in the benchmark interest rate.
Assume that the hedge qualifies for hedge accounting
and the hedging relationship is highly
effective.
Accordingly, when subsequently measuring the hedged
item, SimpleBand would apply the following steps to
determine the gains or losses to be recorded for
each risk being hedged:
-
Step 1a — Determine the gain or loss attributable to the interest rate risk. The change in fair value attributable to changes in the benchmark interest rate of the foreign-currency-denominated debt facility is calculated in the facility’s contractual currency (the foreign currency).
-
Step 1b — The journal entry recorded for the gain or loss associated with the change in fair value attributable to changes in the benchmark interest rate is translated into SimpleBand’s functional currency by using the beginning-of-period foreign currency exchange spot rate.
-
Step 2 — Determine the transaction gain or loss associated with the ASC 830 remeasurement (the foreign currency exposure).
The above sequence of steps ensures that the hedged
item’s fair value is first identified on the basis
of its contractual currency (foreign currency fair
value). Subsequently, the measurement principles of
ASC 830-20 would be applied to isolate the effects
of the changes in foreign currency spot exchange
rates.
Assume the following USD/EUR exchange rates and fair
values for SimpleBand’s foreign-currency-denominated
fixed-rate debt facility at the beginning and end of
the year:
SimpleBand records the following journal entries for
the hedged item in the fair value hedging
strategy:
December 31
Thus, SimpleBand recognizes the following:
By contrast, if no hedge accounting had been applied
or if the hedged risk had been designated as being
only related to changes in fair value attributable
to changes in foreign currency exchange rates, the
debt facility would have been carried at $1.1
million instead of at $1.045 million, reflecting a
change of 0.10 in the spot rates on only the initial
principal amount (EUR 1 million). The resulting gain
of $100,000 differs from the gain of $95,000
associated with changes in the foreign exchange spot
rate because the carrying amount of the debt was
adjusted for changes in fair value attributable to
changes in the benchmark interest rate before it was
translated under ASC 830-20.
Therefore, while it is noted that the subsequent
measurement principles of ASC 830-20 apply
irrespective of whether the hedged item is
designated in a hedging relationship, the recognized
gains and losses associated with a change in the
spot rate are affected by whether other risks are
being hedged in addition to the foreign currency
exposure since this will affect the balance on which
the remeasurement principles of ASC 830-20 are
applied.
5.2.3.2.1 AFS Debt Securities
As discussed in Section 3.2.6, if the hedged item in a qualifying fair
value hedge is already measured at fair value, with changes in fair
value reported in OCI, no additional remeasurement of the hedged item is
required. However, once the item is designated in a qualifying hedge,
the portion of the change in fair value that is attributable to changes
in the designated risk is recognized in earnings instead of OCI. The
change in the fair value of a foreign-currency-denominated AFS debt
security, excluding the amount recorded in the allowance for credit
losses under ASC 326-30, is reported in OCI in accordance with ASC
320-10-35-36. If an entity is hedging an AFS debt security for changes
in its fair value attributable to changes in foreign currency exchange
rates, the transaction gain or loss that otherwise would have been
reported in OCI should be recognized in earnings for a qualifying
hedging relationship. As noted in Section 5.2.2, an entity may only use a derivative
instrument as the hedging instrument in a hedge of an AFS debt
security.
5.2.3.2.2 Unrecognized Firm Commitments
As discussed in Section 5.2.2, an entity may use either a derivative
instrument or a foreign-currency-denominated asset or liability as the
hedging instrument in a foreign currency fair value hedge of an
unrecognized firm commitment. Because firm commitments are not
foreign-currency-denominated assets or liabilities that are subject to
ASC 830-20, the guidance in ASC 815-20-35-18 that limits the
remeasurement of the hedged item to being based only on changes in spot
exchange rates is not applicable. Therefore, an entity may choose to
determine the change in a firm commitment’s fair value attributable to
changes in foreign currency exchange rates on the basis of either
forward rates or spot rates, which will in turn affect how the entity
(1) performs its hedge effectiveness assessments and (2) remeasures the
firm commitment in periods in which the relationship qualifies for hedge
accounting.
If an entity is using a nonderivative as the hedging instrument, it would
be likely to hedge the firm commitment for changes in fair value that
are attributable to changes in foreign currency exchange spot rates
since that would be consistent with how the hedging instrument is
remeasured under ASC 830-20. Such a hedge would produce the highest
level of effectiveness and reduce potential income statement volatility
because both the hedging instrument and the hedged item would be
remeasured by using spot rates.
By contrast, if an entity is using a derivative as the hedging
instrument, the remeasurement of the derivative will be based on forward
rates. However, a savvy hedger would choose between the following two
options, each of which could lead to a perfectly effective hedge if the
critical terms of the derivative match the critical terms of the firm commitment:
-
Hedge the firm commitment for changes in fair value attributable to changes in the foreign currency forward exchange rate. Under this option, the entity would remeasure the firm commitment for changes in fair value attributable to changes in the forward rates, which would be consistent with how the derivative is remeasured. The basis adjustments to the firm commitment would offset the remeasurement of the derivative and be incorporated into the basis of the item being purchased or sold under the firm commitment.
-
Hedge the firm commitment for changes in fair value attributable to changes in the foreign currency spot exchange rate and exclude components of the derivative from the effectiveness assessment. Under this option, the entity would remeasure the firm commitment for changes in fair value that are attributable to changes in the spot rate. The initial fair value of the excluded component would be recognized in earnings over the life of the hedging relationship (either by using a systematic and rational method or as the fair value of the excluded component changes), while the change in the derivative’s fair value attributable to changes in spot rates would be recognized in earnings each period. In this case, the basis adjustments to the firm commitment that only reflect changes in the spot rate would be incorporated into the basis of the item being purchased or sold under the firm commitment.
See Example 5-6 for an illustration of a foreign
currency fair value hedge of a firm commitment under both scenarios.
5.2.3.3 Income Statement Classification
As discussed in Section 3.1, all amounts recognized in earnings related to
both the hedging instrument and the hedged item in a qualifying fair value
hedging relationship are presented in the same income statement line item
and should be related to the risk being hedged. This requirement can be more
complicated for foreign currency fair value hedging relationships because
the hedged item may be hedged for multiple risks (e.g., foreign currency
risk and interest rate risk) and also because some entities use an after-tax
hedging strategy (see Section 5.1.3).
ASC 815-20
Income Statement Presentation of Hedging
Instruments
Scenario C
55-79AB Entity C
designates a fair value hedge of interest rate risk
and foreign currency risk in which the hedged item
is a foreign-currency-denominated fixed-rate
available-for-sale debt security. The derivative
designated as the hedging instrument is a
pay-fixed-rate (in foreign currency),
receive-floating-rate (in functional currency)
cross-currency interest rate swap. In this scenario,
Entity C’s objective is to convert the interest cash
flows of the fixed-rate security to floating-rate
and also to convert the cash flows of the security
(both interest cash flows and the principal cash
flow) from a foreign currency to Entity C’s
functional currency.
55-79AC The cross-currency
interest rate swap is a highly effective hedge of
both the interest rate risk and foreign currency
risk of the available-for-sale debt security.
Therefore, the change in fair value of the
cross-currency interest rate swap should be
presented in the same income statement line item or
items used to present the earnings effect of the
hedged item. Before applying hedge accounting,
Entity C recognizes the earnings effect of the
hedged item (that is, interest accruals on the
available-for-sale debt security) in an interest
income line item in the income statement and
recognizes all other changes in fair value in other
comprehensive income in accordance with paragraph
320-10-35-1(b). Entity C should present changes in
fair value of the hedging instrument (that is, the
interest accruals and all other changes in fair
value) in the same income statement line item used
to present the earnings effect of the hedged item.
However, if Entity C’s policy is to present the
effect of foreign exchange rate changes on the fair
value of the security that are recognized in
earnings after applying hedge accounting in
accordance with paragraph 815-25-35-6 in a different
income statement line item (consistent with its
presentation policies when reflecting other foreign
exchange rate changes), then the related changes in
fair value of the hedging instrument also should be
presented in that income statement line item.
55-79AD This scenario
illustrates that a single hedging instrument (a
cross-currency interest rate swap) may be highly
effective at offsetting changes in fair values or
cash flows associated with the hedged item in which
the earnings effect of the hedged item is presented
in more than one income statement line item. If a
hedging instrument is highly effective at offsetting
changes in fair values or cash flows of the hedged
item and the earnings effect of the hedged item is
presented in more than one income statement line
item, then the earnings effects of the hedging
instrument also should be presented in those
corresponding income statement line item(s).
If an entity is hedging multiple risks, the earnings effects of the hedging
instrument and the adjustments of the hedged item will need to be allocated
on the basis of how much each of the hedged risks affect the changes in the
measurement of the hedging instrument and hedged item. As noted in ASC
815-20-55-79AB through 55-79AD, an entity that is hedging a
foreign-currency-denominated fixed-rate debt security for changes in its
fair value attributable to both foreign currency risk and interest rate risk
would need to report (1) the changes in measurement attributable to changes
in the benchmark interest rate in interest income and (2) the changes in
measurement attributable to changes in the foreign currency exchange rates
in a separate line item. For example, if an entity reports gains or losses
resulting from changes in the foreign exchange rates of its investments as
investment gains or losses, the related changes in the measurement of the
hedging instrument and hedged item attributable to changes in foreign
currency risk should also be reported as investment gains or losses.
Similarly, if an entity is hedging foreign-currency-denominated fixed-rate
debt for changes in its fair value that are attributable to both foreign
currency risk and interest rate risk, the changes in the measurement of the
hedging instrument and hedged item should be allocated to interest expense
and transaction gains or losses.
In addition, as noted in ASC 815-25-35-7 and Section 5.1.3, if an entity is using an after-tax hedging
strategy, “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.”
5.2.4 Illustrative Examples
Example 5-6
Foreign Currency Fair Value Hedge of Firm
Commitment
Golden Age is a premium gold watch manufacturer with a
USD functional currency. On July 1, 20X1, Golden Age
enters into a firm commitment to purchase 1,000 ounces
of gold from a European gold supplier on December 30,
20X1, for EUR 1,151 per ounce. Golden Age separately
enters into a forward contract to purchase EUR 1,151,000
for USD 1,407,213 on December 30, 20X1, as a hedge of
the changes in the fair value of its firm commitment to
purchase gold that are attributable to changes in the
EUR/USD exchange rate. The table below shows (1) the
EUR/USD exchange rates (spot and forward) and (2) the
fair values of the forward contract as of July 1,
September 30, and December 30, 20X1.
The examples below illustrate the difference between (1)
designating the hedged risk as changes in the forward
exchange rate (Method 1) and (2) designating the hedged
risk as changes in the spot exchange rate, with the
excluded component recognized in earnings, by using a
systematic and rational amortization method (Method
2).
Method 1 — Forward Rate
Golden Age designates the forward contract as a hedge of
the changes in the firm commitment’s fair value that are
attributable to changes in the EUR/USD forward exchange
rate. The journal entries are as follows:
July 1, 20X1
No entry is required. The forward contract was entered
into at market (i.e., a fair value of zero), and the
firm commitment was entered into for no
consideration.
September 30, 20X1
December 30, 20X1
Method 2 — Spot Rate With Forward Points Excluded
From Assessment
Golden Age designates the forward contract as a hedge of
the changes in the firm commitment’s fair value that are
attributable to changes in the EUR/USD spot exchange
rate. It excludes the forward points in the forward
contract from the hedge effectiveness assessment and
will recognize the forward points’ initial fair value in
earnings by using a systematic and rational amortization
method.
The initial fair value of the excluded component is
calculated below.
The forward contract has a term of six months. As a
result of using the systematic and rational amortization
method, Golden Age will recognize $3,223 of the initial
fair value in earnings each quarter (as an expense).
The journal entries are as follows:
July 1, 20X1
No entry is required. The forward contract was entered
into at market (i.e., a fair value of zero) and the firm
commitment was entered into for no consideration.
September 30, 20X1
December 30, 20X1
Example 5-7
Fixed-for-Fixed Cross-Currency Interest Rate Swap
Hedging Fixed-Rate Debt Denominated in Foreign
Currency
Orcas Worldwide, an entity with a USD functional
currency, wishes to hedge its exposure to changes in its
SEK 50 million foreign-currency-denominated fixed-rate
debt attributable to changes in the USD/SEK foreign
currency exchange rate. The debt was issued on March 5,
20X6, with interest payable quarterly (on the last day
of each calendar quarter) at a rate of 1.75 percent per
year. Principal is payable at maturity (September 30,
20X7), and the debt is not prepayable. On March 5, 20X6,
Orcas 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 — USD 55,025,000 notional at a rate of 3.4 percent per annum.
-
Receive leg — SEK 50 million notional at a rate of 1.75 percent per annum.
-
Quarterly periodic settlements beginning March 31, 20X6.
-
Initial exchange — Orcas pays SEK 50 million and receives USD 55,025,000.
-
Final exchange — Orcas pays USD 55,025,000 and receives SEK 50 million.
-
Maturity date — September 30, 20X7.
Orcas designates the cross-currency interest rate swap as
a hedge of SEK 50 million of changes in the fair value
of the fixed-rate foreign-currency-denominated debt
attributable to changes in the USD/SEK foreign currency
exchange rate and designates the cross-currency interest
rate swap as hedging changes in the swap’s fair value
attributable to changes in the USD/SEK spot exchange
rate. Orcas assesses the effectiveness of the hedging
relationship by comparing (1) the changes in the swap’s
fair value (excluding the changes in fair value
attributable to changes in the cross-currency basis
spread) with (2) the changes in debt’s fair value that
are attributable to changes in the spot USD/SEK exchange
rate. 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. Orcas may assume that the hedge is
perfectly effective under ASC 815-20-25-84 and 25-85 because:
-
The two currencies underlying the exchange rate of the swap match the functional currency of Orcas (USD) and the currency in which the debt is denominated (SEK).
-
The notional amount of the foreign currency leg of the swap (SEK) matches the principal amount of the debt through the term of the hedge (maturity of the debt).
-
The maturity date of the swap matches the maturity date of the debt (i.e., the date the last hedged cash flow is due and payable).
-
The fair value of the swap at hedge inception is zero and the swap has standard terms.
-
The cross-currency basis spread is excluded from the assessment of hedge effectiveness.
For this example, assume that the critical terms of the
debt and the cross-currency swap match for the duration
of both instruments.
Below is a table of key
assumptions.
Orcas would record the
following journal entries for each reporting period to
account for the hedge and the translation of its
foreign-currency-denominated fixed-rate debt:
March 31,
20X6
Translation of the foreign-currency-denominated debt 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
5.3 Foreign Currency Cash Flow Hedges
|
Hedging Relationship Type
|
Possible Types of Foreign-Currency Denominated Hedged Items
(See ASC 815-20-25-28)
|
Permitted Hedging Instruments
|
|---|---|---|
|
Foreign currency cash flow hedge
|
|
Derivative
|
As discussed in the ASC master glossary and Chapter
4, a cash flow hedge is “a hedge of the exposure to variability in
the cash flows of a recognized asset or liability, or of a forecasted transaction,
that is attributable to a particular risk.” The variability in that risk must have
the potential to affect reported earnings. When an entity elects to hedge a
recognized asset or liability for changes in cash flows attributable to changes in
foreign currency exchange rates, additional guidance is needed because the hedged
item in many cases is already subject to measurement under ASC 830-20.
5.3.1 Hedged Items in a Foreign Currency Cash Flow Hedge
To have exposure to changes in cash flows that are attributable to changes in
foreign currency exchange rates, the hedged item must be either (1) an existing
foreign-currency-denominated asset or liability or (2) a forecasted transaction
that will be settled in a foreign currency, including certain intra-entity
transactions.
ASC 815-20
25-38 The conditions in the
following paragraph relate to a derivative instrument
designated as hedging the foreign currency exposure to
variability in the functional-currency-equivalent cash
flows associated with any of the following:
- A forecasted transaction (for example, a forecasted export sale to an unaffiliated entity with the price to be denominated in a foreign currency)
- A recognized asset or liability
- An unrecognized firm commitment
- A forecasted intra-entity transaction (for example, a forecasted sale to a foreign subsidiary or a forecasted royalty from a foreign subsidiary).
In a manner consistent with ASC 815-20-25-38, if the relevant cash flow hedge
accounting requirements are met, foreign currency exposures associated with any
of the following may qualify as the hedged item in a cash flow hedge of foreign
currency risk: (1) a forecasted transaction, including intra-entity
transactions, (2) a recognized foreign-currency-denominated asset or liability,
and (3) an unrecognized firm commitment.
5.3.1.1 Forecasted Transactions
Foreign currency exposures related to a forecasted transaction may qualify as
the hedged item in a cash flow hedging relationship. Note that entities are
permitted to hedge forecasted intra-entity foreign-currency-denominated
transactions on a consolidated basis, which is unique to foreign currency
cash flow hedging (see Section
5.3.1.1.1 for further discussion of hedging intra-entity
transactions).
Forecasted transactions that will be denominated in a foreign currency may
qualify as the hedged item in a cash flow hedging relationship if the
hedging relationship meets the conditions to qualify for cash flow hedge
accounting, as discussed in Chapter 4.
However, there are some considerations that are unique to foreign currency
cash flow hedges, which will be discussed in the remainder of this
section.
5.3.1.1.1 Forecasted Intra-Entity Transactions
Generally, intra-entity transactions cannot be designated hedged items on
a consolidated basis since such transactions would be eliminated upon
consolidation and would therefore not expose the group to a risk that
affects profit or loss. However, intra-entity
foreign-currency-denominated transactions represent an exception to this
rule in that foreign currency exposure from an intra-entity transaction
may not be fully eliminated upon consolidation as a result of the
application of ASC 830. In that way, the foreign currency exposure of a
probable forecasted intra-entity transaction may qualify for cash flow
hedge accounting provided that it gives rise to transaction gains or
losses through earnings in accordance with ASC 830-20, resulting in an
exposure that affects earnings on the reporting entity’s consolidated
basis.
Example 5-8
Intercompany Sales
SimpleBand, a U.S. company, manufactures a
product in a factory in the United States and
sells the product to its affiliates in Europe
under an intercompany sales agreement. The
functional currency of each affiliate is the local
currency, and all intercompany sales are
denominated in the local currency of the
affiliate.
SimpleBand enters into three foreign exchange
forward contracts, each with a notional amount of
EUR 50 million at the beginning of its fiscal
year. Provided that all relevant criteria are met,
SimpleBand may designate a hedge of the first EUR
150 million of its forecasted intercompany sales.
As long as the hedge is highly effective, the fair
value of the forward contracts will be recorded in
OCI and reclassified into earnings when the sales
are realized in the consolidated income statement
(i.e., when the affiliate recognizes revenue from
the sale to an unrelated third party).
The foreign currency risk of an intercompany dividend does not affect
earnings until it is declared, at which time it becomes an intercompany
receivable or payable. Thus, until it is declared, a forecasted dividend
has no earnings impact and does not qualify as a forecasted exposure
under ASC 815. In essence, a hedge of a forecasted intercompany dividend
usually represents a hedge of expected future earnings. Forecasted net
income is not a transaction; it results from many net transactions,
which under ASC 815 cannot be hedged in aggregate.
Once the dividend is declared, the parent will remeasure the dividend
receivable at prevailing spot rates until it is collected. However, the
parent could designate a derivative contract as the hedging instrument
to hedge the foreign currency risk of the foreign-currency-denominated
receivable.
5.3.1.1.2 Hedging Forecasted Transaction Through Settlement Date
ASC 815-20
25-34 The provisions of
this Section (including paragraph 815-20-25-28)
that permit a recognized
foreign-currency-denominated asset or liability to
be the hedged item in a fair value or cash flow
hedge of foreign currency exposure also pertain to
a recognized foreign-currency-denominated
receivable or payable that results from a hedged
forecasted foreign-currency-denominated sale or
purchase on credit. Specifically, an entity may
choose to designate either of the following:
-
A single cash flow hedge that encompasses the variability of functional currency cash flows attributable to foreign exchange risk related to the settlement of the foreign-currency-denominated receivable or payable resulting from a forecasted sale or purchase on credit
-
Both of the following separate hedges:
-
A cash flow hedge of the variability of functional currency cash flows attributable to foreign exchange risk related to a forecasted foreign-currency-denominated sale or purchase on credit
-
A foreign currency fair value hedge of the resulting recognized foreign-currency-denominated receivable or payable.
-
25-35 If two separate
hedges are designated, the cash flow hedge would
terminate (that is, be dedesignated) when the
hedged sale or purchase occurs and the
foreign-currency-denominated receivable or payable
is recognized.
25-36 The use of the same
foreign currency derivative instrument for both
the cash flow hedge and the fair value hedge is
not prohibited.
In many cases, a forecasted transaction exposes an entity to changes in
foreign currency exchange rates beyond the date the actual forecasted
transaction occurs because that transaction may give rise to a
foreign-currency-denominated receivable or payable that settles at a
future date. ASC 815 provides a couple of alternatives for entities that
want to hedge those forecasted transactions for foreign currency
exposure all the way to the settlement date of the resulting receivable
or payable. A hedge of the variability in cash flows related to a
forecasted transaction is a cash flow hedging relationship; however, an
entity hedging a recognized foreign-currency-denominated asset or
liability for foreign currency risk may hedge that risk as either a fair
value hedge (see Section 5.2.1.1)
or a cash flow hedge (see Section 5.3.1.2).
Therefore, if an entity wants to hedge both the forecasted transaction
and the foreign-currency-denominated asset or liability resulting from
that transaction, it may choose to designate that hedging relationship
as either of the following:
-
A single hedging relationship of the variability in both (1) the cash flows related to the forecasted transaction and (2) the cash flows related to the recognized foreign-currency-denominated receivable or payable.
-
First, a cash flow hedge of the variability in the cash flows related to the forecasted transaction, and then a separate fair value hedge of the foreign-currency-denominated receivable or payable.
Example 5-9
Hedge of Forecasted
Foreign-Currency-Denominated Sale Through
Receivable Settlement Date
GoldenAge (a USD functional entity) expects to
sell watches to a large customer on March 17,
20X1, in a sale denominated in EUR, with 90-day
payment terms (due June 15, 20X1). To hedge its
exposure to the foreign currency, GoldenAge enters
into a forward contract to exchange EUR for USD
that settles on June 15, 20X1. GoldenAge has two
alternatives for hedging the exposure up to the
expected collection date of the receivable (i.e.,
when it expects to receive the foreign
currency).
Alternative 1 — Combined Cash Flow
Hedge
GoldenAge designates the forward contract as a
cash flow hedge of the variability in the USD cash
flows attributable to changes in the EUR/USD
exchange rate related to the settlement of the
EUR-denominated receivable resulting from the
forecasted sale of watches on March 17, 20X1.
Thus, it is a combined hedge of both (1) the
changes in the USD cash flows from a sale that
will occur in a fixed amount of EUR and (2) the
transaction gains and losses GoldenAge will incur
on the receivable, once it is recognized. The
hedge does not need to be dedesignated when the
forecasted sale occurs.
Alternative 2 — Cash Flow Hedge of
Forecasted Sale and Fair Value Hedge of
EUR-Denominated Receivable
GoldenAge designates the derivative as a cash
flow hedge of the variability in the USD cash
flows attributable to changes in the EUR/USD
exchange rate related to the forecasted
EUR-denominated sale on credit. When the
forecasted sale occurs, GoldenAge must discontinue
the cash flow hedging relationship and could then
redesignate the forward as the hedging instrument
in a foreign currency fair value hedge of the
EUR-denominated receivable.
See Example 5-15 for
a detailed illustration of a hedge of the foreign
currency risk related to a forecasted transaction
through the settlement date of the receivable.
Connecting the Dots
If an entity uses a purchased option to hedge
the foreign currency risk related to a forecasted purchase or
sale through the settlement date of the payable or receivable
and would like to assess the effectiveness of the hedge by
evaluating the option’s terminal value (see Sections
2.5.2.1.2.2 and 4.1.3), it should consider
that the terminal value method may only be applied to a cash
flow hedging relationship. Accordingly, an entity that uses a
purchased option that settles on the same date as the forecasted
settlement of the payable or receivable resulting from a
forecasted purchase or sale would be likely to prefer to
document the hedging relationship as a single combined cash flow
hedging relationship of the variability in the cash flows
related to the forecasted settlement of the payable or
receivable resulting from the forecasted purchase or sale
(Alternative 1 in Example 5-9). In this
case, as long as the four criteria noted in ASC 815-20-25-129
are met, the hedging relationship may be considered perfectly
effective. See Example 5-16 for an illustration of the use of
the terminal value method for a purchased option hedging the
foreign currency risk related to the forecasted settlement of a
payable resulting from a forecasted purchase of inventory.
Alternatively, an entity may choose to designate
a cash flow hedge of the variability in functional currency cash
flows attributable to foreign exchange risk related to a
forecasted foreign-currency-denominated sale or purchase on
credit and then separately designate a foreign currency fair
value hedge of the resulting recognized
foreign-currency-denominated receivable or payable (Alternative
2 in Example
5-9). In that case, the entity would terminate
(dedesignate) the cash flow hedge when the hedged sale or
purchase occurs and the foreign-currency-denominated receivable
or payable is recognized. Such a strategy would not be
considered perfectly effective because cash flow hedging is only
applied until the date the forecasted purchase or sale occurs,
which does not match the option’s settlement date. In this
scenario, the “perfect” hypothetical option would have a
maturity date matching the date of the forecasted purchase or
sale, and hedge effectiveness would be assessed by comparing the
change in fair value of (1) the actual option with (2) the
hypothetical option. Under this hedging designation, once a
foreign-currency-denominated receivable or payable exists, only
fair value hedging may be applied. Even though this strategy
cannot be considered perfectly effective, hedge accounting is
not precluded.
5.3.1.1.3 Portfolio Hedging — Net Cash Flows
As discussed in Section 2.2.2.2,
ASC 815-20-25-15(a)(2) allows an entity to hedge a group of individual
transactions that have the same risk exposure. However, “[a] forecasted
purchase and a forecasted sale shall not both be included in the same
group of individual transactions that constitute the hedged
transaction.” ASC 815-20-25-39(c) provides consistent guidance on
foreign currency cash flow hedging relationships; it states, in part,
that “[i]f the hedged transaction is a group of individual forecasted
foreign-currency-denominated transactions, a forecasted inflow of a
foreign currency and a forecasted outflow of the foreign currency cannot
both be included in the same group.”
It is common for entities with significant operating activities in
foreign environments to both generate sales and incur expenses in those
environments. An entity is prohibited from designating the forecasted
sales and expenditures as the hedged item in the same hedging
relationship. However, it can determine its net forecasted cash inflows
or outflows and designate a portfolio of either forecasted sales or
forecasted expenses as the hedged item. For example, if an entity with a
USD functional currency expects to have sales of EUR 100 million and
expenses of EUR 80 million in the following month (i.e., a forecasted
net cash inflow of EUR 20 million), it could not designate as the hedged
item the forecasted net purchases and sales for the following month.
However, it may designate as the hedged item the first EUR 20 million of
sales in the following month.
Section 5.1.2.3 discusses the
exception for the use of a central treasury function to offset the
exposures arising from multiple internal derivatives on an aggregate or
net basis. An entity’s ability to use the function to enter into
derivatives with third parties that are related to the net exposure from
multiple hedging relationships does not override the prohibition on
hedging a portfolio of cash inflows and outflows in a single hedging
relationship.
5.3.1.1.4 Foreign-Currency-Denominated Debt Acquisition or Issuance
An entity may expect to issue debt that will be denominated in a foreign
currency. While this often occurs because the entity will be funding a
significant purchase in that currency, in some cases the entity may
simply want to take advantage of beneficial interest rates in a
particular economic environment. In either case, 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 because there is no earnings exposure from the potential changes
in cash flows attributable to changes in foreign currency exchange
rates. 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.
Foreign currency risk exposure related to the forecasted acquisition of a
foreign-currency-denominated debt instrument does not qualify for hedge
accounting for the same reason that the forecasted issuance of debt does
not qualify (i.e., there is no earnings exposure). However, hedges of
the interest receipts related to a forecasted acquisition of a debt
instrument for changes in cash flows attributable to changes in foreign
currency exchange rates may qualify for hedge accounting.
5.3.1.1.5 Hedges of Foreign Currency Exposure on Forecasted Business Acquisitions Prohibited
As noted in Section
2.2.1.3, ASC 815-20-25-15(g) prohibits the hedge of a
forecasted transaction involving a business combination. In addition,
even if an entity has entered into a firm commitment to acquire a
business in which the purchase price is denominated in a foreign
currency, it is prohibited from hedging the foreign currency exposure
related to that firm commitment, as noted in Section 5.2.1.2.
Example 5-10
Forecasted
Acquisition of a Foreign Business
On January 1, 20X0, Forbin, a
company with a USD functional currency, announces
a tender offer to acquire all of the common stock
of Rutherford, a British company. Forbin offers
GBP 6.90 for each share of Rutherford, GBP 3.5
billion in total. The transaction is expected to
close sometime in the third quarter of 20X0.
Forbin is exposed to foreign currency risk during
the tender period because a strengthening of the
pound will result in a higher cost to Forbin.
Fluff, an investment banker, provides Forbin with
a hedging proposal in which the currency exposure
would be mitigated by using at-the-money call
options on pounds. However, the forecasted
business combination does not meet the criteria to
qualify as the hedged item in a foreign currency
cash flow hedge since ASC 815-20-25-15(g)
prohibits hedges of forecasted transactions
involving business combinations; in addition, ASC
815-20-25-43(c) states that a firm commitment to
enter into a business combination cannot be the
hedged item in a fair value hedge.
Connecting the Dots
In a June 19, 2018, agenda request, the ISDA’s Accounting
Committee asked the FASB to consider an agenda topic that
“extends the ability to designate a fair value or cash flow
hedge of foreign currency exposure” related to either a firmly
committed or forecasted acquisition of a business. As of the
date of the publication of this Roadmap, the FASB has not added
this topic to its agenda.
5.3.1.2 Recognized Foreign-Currency-Denominated Asset or Liability
An entity may hedge a foreign-currency-denominated asset
or liability for changes in its cash flows that are attributable to
changes in foreign currency exchange rates under ASC 815-20-25-38(b). As
discussed in Section 5.2.1.1,
entities have the choice of applying either fair value hedging (see ASC
815-20-25-37(a)) or cash flow hedging (see ASC 815-20-25-38(b)) to
protect themselves from foreign currency risk for recognized
foreign-currency-denominated assets and liabilities.
ASC 815-20
25-39 A
hedging relationship of the type described in the
preceding paragraph qualifies for hedge accounting
if all the following criteria are met:
-
The criteria in paragraph 815-20-25-30(a) through (b) are met.
-
All of the cash flow hedge criteria in this Section otherwise are met, except for the criterion in paragraph 815-20-25-15(c) that requires that the forecasted transaction be with a party external to the reporting entity.
-
If the hedged transaction is a group of individual forecasted foreign-currency-denominated transactions, a forecasted inflow of a foreign currency and a forecasted outflow of the foreign currency cannot both be included in the same group.
-
If the hedged item is a recognized foreign-currency-denominated asset or liability, all the variability in the hedged item’s functional-currency-equivalent cash flows shall be eliminated by the effect of the hedge.
25-40 For
purposes of item (d) in the preceding paragraph,
an entity shall not specifically exclude a risk
from the hedge that will affect the variability in
cash flows. For example, a cash flow hedge cannot
be used with a variable-rate
foreign-currency-denominated asset or liability
and a derivative instrument based solely on
changes in exchange rates because the derivative
instrument does not eliminate all the variability
in the functional currency cash flows. As long as
no element of risk that affects the variability in
foreign-currency-equivalent cash flows has been
specifically excluded from a foreign currency cash
flow hedge and the hedging instrument is highly
effective at providing the necessary offset in the
variability of all cash flows, a less-than-perfect
hedge would meet the requirement in (d) in the
preceding paragraph. That criterion does not
require that the derivative instrument used to
hedge the foreign currency exposure of the
forecasted foreign-currency-equivalent cash flows
associated with a recognized asset or liability be
perfectly effective, rather it is intended to
ensure that the hedging relationship is highly
effective at offsetting all risks that impact the
variability of cash flows.
25-41 If
all of the variability of the
functional-currency-equivalent cash flows is
eliminated as a result of the hedge (as required
by paragraph 815-20-25-39(d)), an entity can use
cash flow hedge accounting to hedge the
variability in the functional-currency-equivalent
cash flows associated with any of the
following:
-
All of the payments of both principal and interest of a foreign-currency-denominated asset or liability
-
All of the payments of principal of a foreign-currency-denominated asset or liability
-
All or a fixed portion of selected payments of either principal or interest of a foreign-currency-denominated asset or liability
-
Selected payments of both principal and interest of a foreign-currency-denominated asset or liability (for example, principal and interest payments on December 31, 20X1, and December 31, 20X3).
Example 13: Eliminating All Variability in
Cash Flows
55-132
The following Cases illustrate the application of
paragraph 815-20-25-39(d) regarding whether all
the variability in a hedged item’s
functional-currency-equivalent cash flows are
eliminated by the effect of the hedge:
-
Difference in optionality (Case A)
-
b. Difference in reset dates (Case B)
-
Difference in notional amounts (Case C).
Case A: Difference in Optionality
55-133 An
entity has issued a fixed-rate
foreign-currency-denominated debt obligation that
is callable (that is, by that entity) and desires
to hedge its foreign currency exposure related to
that obligation with a fixed-to-fixed
cross-currency swap. A fixed-to-fixed currency
swap could be used to hedge the fixed-rate
foreign-currency-denominated debt instrument that
is callable even though the swap does not contain
a mirror-image call option as long as the terms of
the swap and the debt instrument are such that
they would be highly effective at providing
offsetting cash flows and as long as it was
probable that the debt instrument would not be
called and would remain outstanding.
Case B: Difference in Reset Dates
55-134 An entity has
issued a variable-rate
foreign-currency-denominated debt obligation and
desires to hedge its foreign currency exposure
related to that obligation. The entity uses a
variable-to-fixed cross-currency interest rate
swap in which it receives the same foreign
currency based on the variable rate index
contained in the debt obligation and pays a fixed
amount in its functional currency. If the swap
would otherwise meet this Subtopic’s definition of
providing high effectiveness in hedging the
foreign currency exposure of the debt instrument,
but there is a one day difference between the
reset dates in the debt obligation and the swap
(that is, the one day difference in reset dates
results in the hedge being highly effective, but
not perfectly effective), the variable-to-fixed
cross-currency interest rate swap could be used to
hedge the variable-rate
foreign-currency-denominated debt instrument even
though there is a one-day difference between the
reset dates or a slight difference in the notional
amounts in the debt instrument and the swap. This
would be true as long as the difference in reset
dates or notional amounts is not significant
enough to cause the hedge to fail to be highly
effective at providing offsetting cash flows.
Case C: Difference in Notional Amounts
55-135
This Case involves the same facts as in Case B,
except that there is no difference in the reset
dates. However, there is a slight difference in
the notional amount of the swap and the hedged
item. If the swap would otherwise meet this
Subtopic’s definition of providing high
effectiveness in hedging the foreign currency
exposure of the debt instrument, paragraph
815-20-25-39(d) does not preclude the swap from
qualifying for hedge accounting simply because the
notional amounts do not exactly match. The
mismatch attributable to the slight difference in
the notional amount of the swap and the hedged
item could be eliminated by designating only a
portion of the contract with the larger notional
amount as either the hedging instrument or hedged
item, as appropriate.
Under ASC 815-20-25-39(d), “[i]f the hedged item is a recognized
foreign-currency-denominated asset or liability, all the variability in
the hedged item’s functional-currency-equivalent cash flows shall be
eliminated by the effect of the hedge.” If viewed in isolation, ASC
815-20-25-39(d) appears to require the hedging instrument to perfectly
fix all variability in cash flows of the entire hedged
foreign-currency-denominated asset or liability. However, ASC
815-20-25-40 and the examples in ASC 815-20-55-132 through 55-135 help
illustrate that an entity must hedge all the different risks that result
in variability in the cash flows of the designated hedged item. For
example, to qualify for foreign currency cash flow hedge accounting, an
entity that issues variable-rate foreign-currency-denominated debt needs
to hedge the changes in cash flows that are attributable to both
interest rate risk and foreign currency risk. Such a hedge could
typically be achieved with a pay-fixed, receive-variable cross-currency
interest rate swap. Note that the interest rate index and the stated
currency for the variable leg of that cross currency interest rate swap
do not need to match the interest rate and currency of the hedged debt;
however, the cross-currency interest rate swap needs to be highly
effective at offsetting the changes in cash flows of the hedged debt
that are attributable to changes in interest rates and foreign currency
exchange rates.
In addition, ASC 815-20-25-41 clarifies that an entity may still hedge
selected contractual payments related to an existing
foreign-currency-denominated asset or liability. Specifically, an entity
may “hedge the variability in the functional-currency-equivalent cash
flows associated with any of the following:
-
All of the payments of both principal and interest of a foreign-currency-denominated asset or liability
-
All of the payments of principal of a foreign-currency-denominated asset or liability
-
All or a fixed portion of selected payments of either principal or interest of a foreign-currency-denominated asset or liability
-
Selected payments of both principal and interest of a foreign-currency-denominated asset or liability.”
In other words, if an entity wants to hedge the variability in the cash
flows of an existing foreign-currency-denominated asset or liability, it
first needs to identify the selected cash flows from the asset or
liability that it wishes to hedge. Those cash flows can be any or all
the cash flows (interest or principal, or both). An entity may hedge a
proportion of the cash flows selected, but if so, it must pick the same
proportion of the asset’s cash flows for each of the contractual cash
flows identified as the hedged item. Once the entity has identified the
contractual cash flows (or portions thereof) to be hedged, it must hedge
all of the risks that create variability in the
functional-currency-equivalent cash flows related to those contractual
cash flows.
Example 5-11
Hedging Foreign-Currency-Denominated
Variable-Rate Debt
PiperPiper has a USD functional currency. On
January 1, 20X1, it issues EUR 100 million of
EURIBOR-based debt, with interest payable annually
on December 31. The principal is due only at
maturity on December 31, 20X5. Below are some
examples of the different hedging instruments and
designated hedged items that PiperPiper is
considering.
|
Derivative
|
Hedged Item
|
Qualifies for Cash Flow Hedging?
|
|---|---|---|
|
Five-year pay-USD-fixed, receive-EUR EURIBOR
swap with notional of EUR 100 million
|
All principal and interest cash flows of the
debt
|
Yes. PiperPiper may identify all of the
contractual cash flows of the debt as the hedged
item. The derivative eliminates all of the
variability in cash flows since it converts both
the variable interest rate and the foreign
currency into a fixed amount of functional
currency.
|
|
Five-year pay-USD-fixed USD, receive-EUR-LIBOR
swap with notional of EUR 100 million
|
All principal and interest cash flows of the
debt
|
Maybe. PiperPiper may identify all of the
contractual cash flows of the debt as the hedged
item. However, the interest rate underlying the
variable leg of the swap (LIBOR) is not the same
as the interest rate index for the variable-rate
debt (EURIBOR), so the swap would only qualify for
hedge accounting if it is highly effective at
offsetting the variability in
functional-currency-equivalent cash flows.
PiperPiper would not be prohibited from applying
hedge accounting because the swap hedges the
variability related to all risks that result in
variability in cash flows (i.e., interest rate
risk and foreign currency risk).
|
|
Pay USD, receive EUR forward with 70 million
EUR notional; matures on December 31, 20X5
|
70 percent of the principal payment of the debt
due on December 31, 20X5
|
Yes. PiperPiper may identify any individual
contractual cash flow of the debt, or a portion
thereof. In addition, the only source of
variability in functional-currency-equivalent cash
flows related to that principal payment due on
December 31, 20X5, is changes in EUR/USD exchange
rates (i.e., the changes in interest rates do not
affect the amount of principal due on December 31,
20X5). The forward contract eliminates the
variability attributable to that risk.
|
|
Five different pay USD, receive EUR forwards,
each with a EUR 4 million notional (based on the
EURIBOR rate at inception of the hedge multiplied
by the principal amount of the debt); maturity
dates are December 31 of 20X1, 20X2, 20X3, 20X4,
and 20X5
|
The forecasted interest payments for each of
the five years of the debt
|
No. While PiperPiper may identify the hedged
item as only the interest payments associated with
the debt (or a portion thereof) and not the
principal, it must eliminate the variability in
the functional-currency-equivalent cash flows. The
forward contracts do not eliminate such
variability because changes in EURIBOR will alter
the amount of interest due on each of those dates.
The forward contracts only hedge foreign currency
risk, not interest rate risk.
|
Example 5-12
Hedging
Foreign-Currency-Denominated Fixed-Rate
Debt
PiperPiper has a USD functional
currency. On January 1, 20X1, it issues EUR 100
million of fixed-rate debt, with interest of 5
percent payable annually on December 31. The
principal is due only at maturity on December 31,
20X5. Below are some examples of the different
hedging instruments and designated hedged items
that PiperPiper is considering.
|
Derivative
|
Hedged Item
|
Qualifies for Cash Flow
Hedging?
|
|---|---|---|
|
Five-year pay-USD-fixed,
receive-EUR-fixed swap with notional of EUR 100
million
|
All principal and interest
cash flows of the debt
|
Yes. PiperPiper may identify
all the contractual cash flows of the debt as the
hedged item. The derivative eliminates all the
variability in cash flows since it converts all of
the payments into a fixed amount of functional
currency.
|
|
Pay USD, receive EUR forward
with 70 million EUR notional; matures on December
31, 20X5
|
70 percent of the principal
payment of the debt due on December 31, 20X5
|
Yes. PiperPiper may identify
any individual contractual cash flow of the debt,
or a portion thereof. In addition, the only source
of variability in functional-currency-equivalent
cash flows related to that principal payment due
on December 31, 20X5, is changes in EUR/USD
exchange rates (i.e., the changes in interest
rates do not affect the amount of principal due on
December 31, 20X5). The forward contract
eliminates the variability attributable to that
risk.
|
|
Five different pay-USD,
receive-EUR forwards, each with a notional of EUR
5 million; maturity dates are on December 31 of
20X1, 20X2, 20X3, 20X4, and 20X5
|
The forecasted interest
payments for each of the five years of the
debt
|
Yes. PiperPiper may identify
the hedged item as only the interest payments
associated with the debt (or a portion thereof)
and not the principal. In addition, because it is
fixed-rate debt, the only source of variability in
functional-currency-equivalent cash flows for
those interest payments is the changes in the
EUR/USD exchange rate. The forward contracts
eliminate the variability attributable to that
risk.
|
|
A pay-USD, receive-EUR forward
with a notional of EUR 5 million; matures on
December 31, 20X1
|
The forecasted interest
payment due on December 31, 20X1
|
Yes. PiperPiper may identify
the hedged item as any individual interest or
principal payment associated with the debt (or a
portion thereof). In addition, because it is
fixed-rate debt, the only source of variability in
functional-currency-equivalent cash flows related
to that interest payment is changes in the EUR/USD
exchange rate. The forward contract eliminates the
variability attributable to that risk.
|
5.3.1.3 Firm Commitments
ASC 815-20
Foreign Exchange Risk of a Firm Commitment as
Hedged Transaction in a Cash Flow Hedge
25-42
The reference in the definition of a forecasted
transaction indicating that a forecasted transaction
is not a firm commitment focuses on firm commitments
that have no variability. The reference does not
preclude a cash flow hedge of the variability in
functional-currency-equivalent cash flows if the
commitment’s fixed price is denominated in a foreign
currency. Although that definition of a firm
commitment requires a fixed price, it permits the
fixed price to be denominated in a foreign currency.
A firm commitment can expose the parties to
variability in their functional-currency-equivalent
cash flows. The definition of a forecasted
transaction also indicates that the transaction or
event will occur at the prevailing market price.
From the perspective of the hedged risk (foreign
exchange risk), the translation of the foreign
currency proceeds from the sale of the nonfinancial
assets will occur at the prevailing market price
(that is, current exchange rate). Example 14 (see
paragraph 815-20-55-136) illustrates the application
of this guidance.
It may seem counterintuitive that there is exposure to changes in cash flows
related to a firm commitment since the definition of a firm commitment
requires the price of the item being bought or sold to be fixed. However, as
noted in ASC 815-20-25-42, if that price is expressed as a fixed amount of a
foreign currency, there is exposure to changes in
functional-currency-equivalent cash flows attributable to changes in foreign
currency exchange rates.
The following firm commitments are precluded from qualifying as the hedged
item in a foreign-currency-related cash flow hedge:
-
Intercompany commitments — Such commitments do not meet the definition of a firm commitment because they are not with a third party (see Section 3.1.1). However, an entity may hedge forecasted transactions related to intercompany commitments that have foreign currency exposure in a cash flow hedging relationship (see Section 5.3.1.1.1).
-
Firm commitments to enter in a business combination — ASC 815-20-25-43(c) specifically prohibits such commitments from qualifying as the hedged item in a fair value hedge. ASC 815 is silent regarding whether such commitments are permissible as foreign currency cash flow hedges. We believe that it would be inappropriate to hedge a firm commitment to enter into a business combination for foreign currency risk under a cash flow hedging model for many of the same reasons that an entity is prohibited from hedging a forecasted transaction involving a business combination (see Section 2.2.1.3).
5.3.2 Hedging Instruments in a Foreign Currency Cash Flow Hedge
Derivative instruments are the only permissible hedging instruments in a foreign
currency cash flow hedging relationship. Certain nonderivative instruments may
qualify as the hedging instruments in some foreign currency fair value hedges
and net investment hedges, but nonderivative instruments are not permitted as
the hedging instrument in a foreign currency cash flow hedge.
5.3.3 Accounting for Foreign Currency Cash Flow Hedges
As noted in Chapter 4, in a typical
qualifying cash flow hedging relationship, an entity records the change in the
hedging instrument’s fair value in OCI, except for any changes in the fair value
of components that are excluded from the effectiveness assessment if the entity
elects to recognize such changes in current-period earnings (see Section 4.1.6). Amounts in AOCI are reclassified
into earnings when the hedged item affects earnings or when it becomes probable
that the forecasted transaction will not occur.
5.3.3.1 Unique Considerations for Foreign Currency Cash Flow Hedges
The accounting for a qualifying foreign currency cash flow hedge requires
some slight modifications to the typical cash flow hedging model in a few circumstances:
-
If an entity is hedging the variability in the functional-currency-equivalent cash flows of a recognized foreign-currency-denominated asset or liability that is remeasured at spot exchange rates in accordance with ASC 830, the initial time value of the hedging instrument should be recognized in earnings over the life of the hedging instrument, even if the entity does not exclude any components of the hedging instrument from the effectiveness assessment. See Section 5.3.3.1.1 for further discussion.
-
If an entity is hedging a forecasted intra-entity transaction, amounts recognized in OCI should be reclassified out of AOCI when the forecasted transaction affects earnings, which depends on when the related transaction with an external third-party affects earnings. See Section 5.3.3.1.2 for further discussion.
-
If an entity has designated and documented that it will assess effectiveness on an after-tax basis (see Section 5.1.3), 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. See Section 5.3.3.1.3 for further discussion.
5.3.3.1.1 Hedging Variability in Functional-Currency-Equivalent Cash Flows of Recognized Foreign-Currency-Denominated Asset or Liability
ASC 815-30
35-3 When the relationship
between the hedged item and hedging instrument is
highly effective at achieving offsetting changes
in cash flows attributable to the hedged risk, an
entity shall record in other comprehensive income
the entire change in the fair value of the
designated hedging instrument that is included in
the assessment of hedge effectiveness. More
specifically, a qualifying cash flow hedge shall
be accounted for as follows: . . .
d. If a non-option-based contract is the
hedging instrument in a cash flow hedge of the
variability of the functional-currency-equivalent
cash flows for a recognized
foreign-currency-denominated asset or liability
that is remeasured at spot exchange rates under
paragraph 830-20-35-1, an amount that will both
offset the related transaction gain or loss
arising from that remeasurement and adjust
earnings for that period’s allocable portion of
the initial spot-forward difference associated
with the hedging instrument (cost to the purchaser
or income to the seller of the hedging instrument)
shall be reclassified each period from other
comprehensive income to earnings if the assessment
of effectiveness is based on total changes in the
non-option-based instrument’s cash flows. If an
option contract is used as the hedging instrument
in a cash flow hedge of the variability of the
functional-currency-equivalent cash flows for a
recognized foreign-currency-denominated asset or
liability that is remeasured at spot exchange
rates under paragraph 830-20-35-1 to provide only
one-sided offset against the hedged foreign
exchange risk, an amount shall be reclassified
each period to or from other comprehensive income
with respect to the changes in the underlying that
result in a change in the hedging option’s
intrinsic value. In addition, if the assessment of
effectiveness is based on total changes in the
option’s cash flows (that is, the assessment will
include the hedging instrument’s entire change in
fair value — its entire gain or loss), an amount
that adjusts earnings for the amortization of the
cost of the option on a rational basis shall be
reclassified each period from other comprehensive
income to earnings. This guidance is limited to
foreign currency hedging relationships because of
their unique attributes and is an exception for
foreign currency hedging relationships. . .
.
35-6 Remeasurement of the
hedged foreign-currency-denominated assets and
liabilities is based on the guidance in Topic 830,
which requires remeasurement based on spot
exchange rates, regardless of whether a cash flow
hedging relationship exists.
Under the cash flow hedging model, if a qualifying hedging relationship
is highly effective, all changes in the derivative’s fair value that are
included in the effectiveness assessment are recognized in OCI. However,
in a foreign currency cash flow hedging relationship involving a
foreign-currency-denominated asset or liability, the remeasurement of
that asset or liability under ASC 830 is based only on changes in the
spot exchange rate. ASC 815-30-35-3(d) requires an entity to reclassify
amounts out of AOCI and into earnings if they are related to and offset
the transaction gain or loss on the hedged asset or liability. If the
entity includes the total changes in the hedging instrument’s fair value
in the effectiveness assessment, there will be a mismatch between (1)
the gains and losses on the derivative that are recognized in OCI and
(2) the amounts that would be reclassified out of AOCI to offset the
transaction gains and losses on the hedged asset or liability. As a
result, ASC 815-30-35-3(d) also requires an entity to recognize the
difference (referred to as the “cost or income” from the hedging
instrument) in earnings over the life of the hedging relationship. The
calculation of the “cost or income” and the method for recognizing that
amount in earnings over the life of the hedging relationship depends on
the nature of both the derivative and the hedged item. The table below
summarizes the alternatives.
|
Derivative Type
|
Cost or Income
|
Hedged Item — Method of Recognition in
Earnings
|
|---|---|---|
|
Forward
|
The initial difference between the spot and
forward rates
|
Interest-bearing asset or liability — interest
method
Non-interest-bearing asset or liability — either
interest method or pro rata method
Combined hedge of forecasted transaction through
settlement date — based on either initial forward
rates or pro rata method
|
|
Option
|
Time value of option
|
All assets and liabilities — rational method of
amortization
|
ASC 815-30-35-9 describes how to apply the guidance in ASC 815-30-35-3(d)
to a single combined hedging relationship involving a forward contract
hedging the change in cash flows attributable to foreign currency risk
related to the settlement of a foreign-currency-denominated receivable
or payable resulting from a forecasted sale or purchase on credit (see
Section 5.3.1.1.2). However,
ASC 815-30-35-9(b) provides broader guidance on how to recognize the
initial spot-forward difference in earnings, depending on the nature of
the hedged item. ASC 815-30-35-9(b) states:
The functional currency interest rate implicit in the hedging
relationship as a result of entering into the forward contract
is used to determine the amount of cost or income to be ascribed
to each period of the hedging relationship. The cash flow
hedging model for recognized foreign-currency-denominated assets
and liabilities requires use of the interest method at the
inception of the hedging relationship to determine the amount of
cost or income to be ascribed to each relevant period of the
hedging relationship. However, for simplicity, in hedging
relationships in which the hedged item is a short-term
non-interest-bearing account receivable or account payable, the
amount of cost or income to be ascribed each period can also be
determined using a pro rata method based on the number of days
or months of the hedging relationship. In addition, in a
short-term single cash flow hedging relationship that
encompasses the variability of functional-currency-equivalent
cash flows attributable to foreign exchange risk related to the
settlement of a foreign-currency-denominated receivable or
payable resulting from a forecasted sale or purchase on credit,
the amount of cost or income to be ascribed each period can also
be determined using a pro rata method or a method that uses two
foreign currency forward exchange rates. The first foreign
currency forward exchange rate would be based on the maturity
date of the forecasted purchase or sale transaction. The second
foreign currency forward exchange rate would be based on the
settlement date of the resulting account receivable or account
payable.
Example 18 in ASC 815-30-55-106 through 55-112 shows a
detailed illustration of an entity hedging a forecasted purchase of
inventory on credit through the settlement date of the payable. The
example includes an illustration of how to allocate the “cost or income”
under both the pro rata method and the method that uses two foreign
currency forward rates. In our experience, most entities apply the pro
rata method. See Examples 5-13 and 5-15 for detailed illustrations of
entities applying a single hedging relationship to a forecasted
transaction through the settlement date of the related receivable or
payable under the pro rata method.
The guidance in ASC 815-30-35-3(a) does not apply to the
components of the derivative that are excluded from the effectiveness
assessment (see Section 4.1.6) or to any hedging relationship in which
an entity is applying the terminal value method (see Section 4.1.3).
See Example
5-14 for an illustration of an entity that hedges a
forecasted purchase of inventory through the settlement date of the
related payable and excludes the forward points of the derivative from
the effectiveness assessment. See Example 5-16 for an illustration
of an entity using the terminal value method for a hedge of a forecasted
purchase of inventory with a purchased option.
5.3.3.1.2 Hedging Forecasted Intra-Entity Transactions
ASC 815-30
Example 14: Reclassifying Amounts From a
Cash Flow Hedge of a Forecasted
Foreign-Currency-Denominated Intra-Entity
Sale
55-86 This Example
illustrates the application of paragraphs
815-20-25-30 and 815-20-25-39 through 25-41. This
Example has the following assumptions:
- Parent A is a multinational corporation that has the U.S. dollar (USD) as its functional currency.
- Parent A has the following two
subsidiaries:
- Subsidiary B, which has the Euro (EUR) as its functional currency
- Subsidiary C, which has the Japanese yen (JPY) as its functional currency.
-
Subsidiary B manufactures a product and has a forecasted sale of the product to Subsidiary C that will be transacted in JPY.
55-87 Eventually,
Subsidiary C will sell the product to an unrelated
third party in JPY. Subsidiary B enters into a
forward contract with an unrelated third party to
hedge the cash flow exposure of its forecasted
intra-entity sale in JPY to changes in the EUR-JPY
exchange rate.
55-88 The transaction in this
Example meets the hedge criteria of paragraphs
815-20-25-30 and 815-20-25-39 through 25-41, which
permits a derivative instrument to be designated
as a hedge of the foreign currency exposure of
variability in the functional-currency-equivalent
cash flows associated with a forecasted
intra-entity foreign-currency-denominated
transaction if certain criteria are met.
Specifically, the operating unit having the
foreign currency exposure (Subsidiary B) is a
party to the hedging instrument; the hedged
transaction is denominated in JPY, which is a
currency other than Subsidiary B’s functional
currency; and all other applicable criteria in
Section 815-20-25 are satisfied.
55-89 Subsidiary B
measures the derivative instrument at fair value
and records the gain or loss on the derivative
instrument in accumulated other comprehensive
income. In the consolidated financial statements,
the amount in other comprehensive income
representing the gain or loss on a derivative
instrument designated in a cash flow hedge of a
forecasted foreign-currency-denominated
intra-entity sale should be reclassified into
earnings in the period that the revenue from the
sale of the manufactured product to an unrelated
third party is recognized and presented in
earnings in the same income statement line item as
the earnings effect of the hedged item. The
reclassification into earnings in the consolidated
financial statements should occur when the
forecasted sale affects the earnings of Parent A.
Because the consolidated earnings of Parent A will
not be affected until the sale of the product by
Subsidiary C to the unrelated third party occurs,
the reclassification of the amount of derivative
gain or loss from other comprehensive income into
earnings in the consolidated financial statements
should occur upon the sale by Subsidiary C to an
unrelated third party.
55-90 This guidance is
relevant only with respect to the consolidated
financial statements. In Subsidiary B’s separate
entity financial statements, the reclassification
of the amount of the derivative instrument gain or
loss from other comprehensive income into earnings
should occur in the period the forecasted
intra-entity sale is recorded because Subsidiary
B’s earnings are affected by the change in the
EUR-JPY exchange rate when the sale to Subsidiary
C occurs.
As discussed in Section 5.3.1.1, an
entity may hedge foreign-currency-denominated forecasted intra-entity
transactions in a foreign currency cash flow hedge for changes in cash
flows attributable to foreign currency risk as long as those
transactions ultimately result in a transaction with an external third
party. Example 14 in ASC 815-30-55-86 through 55-90 illustrates a few
important concepts for hedging forecasted intra-entity transactions:
-
The forecasted transaction is the intra-entity transaction, so hedge accounting related to that transaction ceases when the intra-entity transaction occurs.
-
Amounts recognized in OCI related to that intra-entity transaction are reclassified out of AOCI when the transaction with the unrelated third party occurs (i.e., when the transaction affects earnings for the consolidated financial statements).
-
The timing of reclassification from AOCI in the stand-alone financial statements of individual subsidiaries may differ from the timing in the consolidated financial statements.
5.3.3.1.3 Hedging on an After-Tax 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.
If an entity is hedging on an after-tax basis, as discussed in Section 5.1.3, 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.
Only the amount necessary to offset the loss or gain on the hedged item
is recognized in OCI as part of the hedging relationship.
5.3.3.2 Income Statement Classification
As discussed in Section 4.1, all
amounts in AOCI for a qualifying cash flow hedging relationship (1) should
be reclassified into earnings when the forecasted transaction affects
earnings and (2) are presented in the same line item as the earnings effect
of the hedged item. If the hedged item is a forecasted transaction and it
becomes probable that the transaction will not occur within two months of
the originally specified time period, amounts are generally immediately
reclassified from AOCI (see Section
4.1.5.2 for further discussion of the accounting for
discontinued cash flow hedges).
In a manner similar to the accounting for fair value hedging relationships
(see discussion in Section 5.2.3.3),
if an entity is hedging multiple risks, the earnings effect of the amounts
reclassified out of AOCI will need to be allocated on the basis of how much
each of the hedged risks affected the changes in the hedging instrument’s
fair value that were recorded in OCI. For example, an entity hedging
foreign-currency-denominated variable-rate debt for changes in cash flows
that are attributable to both foreign currency risk and interest rate risk
would need to allocate amounts reclassified out of AOCI to interest expense
and transaction gains or losses.
In addition, if the entity is using an after-tax hedging strategy, as
discussed in Section 5.1.3, the
portion of the gain or loss on the hedging instrument that exceeded 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.
5.3.4 Illustrative Examples
Example 5-13
Hedging Forecasted Foreign-Currency-Denominated
Purchase of Inventory Through Payable Settlement
Date
On January 1, 20X1, BeBop Co., an entity with a USD
functional currency, forecasts the purchase of EUR 1
million of inventory on April 30, 20X1. The resulting
EUR-denominated payable is expected to be settled on
June 30, 20X1. BeBop Co. enters into a forward contract
on January 1, 20X1, to sell USD 980,873 and buy EUR 1
million on June 30, 20X1, and designates it as a
combined hedge of the variability in cash flows
attributable to changes in the USD/EUR exchange rate
from the forecasted settlement of a
foreign-currency-denominated payable resulting from its
forecasted purchase of inventory. BeBop Co. will assess
the effectiveness of the hedge on the basis of the total
changes in the forward contract’s fair value (i.e., it
will not exclude any components of the forward contract
from the effectiveness assessment). BeBop Co. elects to
ascribe the initial difference between the forward rate
and spot rate to each period by using the pro rata
method, as allowed by ASC 815-30-35-9(b). The USD/EUR
spot exchange rate on January 1, 20X1, was 1.0064. In
other words, BeBop Co. could buy EUR 1 million for USD
993,641 on January 1, 20X1.
The allocation of the initial difference between the
forward rate and spot rate under the pro rata method is
as follows:
Assume that (1) the forecasted transactions remain
probable throughout the entire hedging relationship and
will occur when expected and (2) the inventory is sold
on July 31, 20X1, for $1.3 million.
Note that for simplicity, it is assumed that the forward
contract’s fair value is equal to the forward rate as of
the date of valuation less the contractual exchange rate
multiplied by the notional; discounting is ignored. The
reclassification of amounts from AOCI into earnings is
reported in the same income statement line item in which
the hedged transaction is reported. In this example,
since this strategy effectively combines two
transactions (the purchase of inventory and the
settlement of a payable) into one hedging relationship,
(1) amounts related to hedging the changes in foreign
currency risk associated with the inventory will be
recognized in cost of goods sold and (2) amounts related
to the recognized payable will be recognized in
transaction gains and losses.
BeBop Co. records the following journal entries:
January 1, 20X1
No entry is required. The forward contract was entered
into at-the-money.
March 31, 20X1
The rate for a USD/EUR forward settling on June 30, 20X1,
is 0.9308. Therefore, the forward contract has a
positive fair value of $93,472.
April 30, 20X1
The table below shows (1) the relevant spot and forward
rates on April 30, 20X1, (2) the forward contract’s fair
values on March 31, 20X1, and April 30, 20X1, and (3)
the change in the forward contract’s fair value.
The journal entries are as follows:
June 30, 20X1
The table below shows (1) the spot rate on June 30, 20X1,
(2) the forward contract’s fair values on April 30,
20X1, and June 30, 20X1, and (3) the change in the
forward contract’s fair value.
The journal entries are as follows:
July 31, 20X1
BeBop Co. sells the inventory for $1.3 million. The
journal entries are as follows:
Example 5-14
Hedging Forecasted
Foreign-Currency-Denominated Purchase of Inventory
Through Payable Settlement Date — Excluded
Component
On January 1, 20X1, BeBop Co., an entity
with a USD functional currency, forecasts the purchase
of EUR 1 million of inventory on April 30, 20X1. The
resulting EUR-denominated-payable is expected to be
settled on June 30, 20X1. BeBop Co. enters into a
forward contract on January 1, 20X1, to sell USD 980,873
and buy EUR 1 million on June 30, 20X1. It designates
the contract as a combined hedge of the variability in
cash flows attributable to changes in the USD/EUR
exchange rate from the forecasted settlement of a
foreign-currency-denominated payable resulting from its
forecasted purchase of inventory. BeBop Co. will assess
the effectiveness of the hedge on the basis of the
changes in the spot exchange rate (i.e., it will exclude
the forward/spot component of the forward contract from
the effectiveness assessment). BeBop Co. elects to
amortize the initial difference between the forward rate
and spot rate evenly over the life of the hedging
relationship. The USD/EUR spot exchange rate on January
1, 20X1, is 1.0064; therefore, BeBop Co. could buy EUR 1
million for USD 993,641 on that date.
The allocation of the initial difference
between the forward rate and spot rate for amortization
over the hedging period is as follows:
Assume that (1) the forecasted
transactions remain probable throughout the entire
hedging relationship and will occur when expected and
(2) the inventory is sold on July 31, 20X1, for $1.3
million.
Note that for simplicity, it is assumed
that the forward contract’s fair value is equal to the
forward rate as of the date of valuation less the
contractual exchange rate multiplied by the notional;
discounting is ignored. The reclassification of amounts
from AOCI into earnings is reported in the same income
statement line item in which the hedged transaction is
reported. In this example, since this strategy
effectively combines two transactions (the purchase of
inventory and the settlement of a payable) into one
hedging relationship, (1) amounts related to hedging the
changes in foreign-currency risk associated with the
inventory will be recognized in cost of goods sold and
(2) amounts related to the payable will be recognized in
transaction gains and losses.
BeBop Co. records the following journal
entries:
January 1,
20X1
No journal entry is required. The
forward contract was entered into at-the-money.
March 31,
20X1
The rate for a USD/EUR forward settling
on June 30, 20X1, is 0.9308. Therefore, the forward
contract has a positive fair value of $93,472. The
journal entry as of March 31, 20X1, is as follows:
April 30,
20X1
The table below shows (1) the relevant
spot and forward rates on April 30, 20X1, and (2) the
forward contract’s fair values on March 31, 20X1, and
April 30, 20X1.
The journal entries are as follows:
June 30,
20X1
The table below shows (1) the spot rate
on June 30, 20X1, (2) the forward contract’s fair values
on April 30, 20X1, and June 30, 20X1, and (3) the change
in the forward contract’s fair value.
The journal entries are as follows:
July 31,
20X1
BeBop Co. sells the inventory for $1.3
million. The journal entries are as follows:
Example 5-15
Hedging Forecasted
Foreign-Currency-Denominated Sale of Inventory
Through Receivable Settlement Date
On January 1, 20X1, Golden Age, an
entity with a USD functional currency, forecasts the
sale of EUR 1 million of inventory on April 30, 20X0.
The resulting euro receivable is expected to be settled
on June 30, 20X1. Golden Age enters into a forward
contract on January 1, 20X1, to buy USD 980,873 and sell
EUR 1 million on June 30, 20X1. It designates the
contract as a combined hedge of the variability in cash
flows attributable to changes in the USD/EUR exchange
rate from the forecasted settlement of a
foreign-currency-denominated receivable on June 30,
20X1, resulting from its forecasted sale of inventory on
April 30, 20X0. Golden Age will assess the effectiveness
of the hedge on the basis of the total changes in the
forward contract’s fair value (i.e., it will not exclude
any components of the forward contract from the
effectiveness assessment). Golden Age elects to ascribe
the initial difference between the forward rate and spot
rate to each period by using the pro rata method, as
allowed by ASC 815-30-35-9(b). The USD/EUR spot exchange
rate on January 1, 20X1, is 1.0064; therefore, Golden
Age could sell EUR 1 million for USD 993,641 on that
date.
The allocation of the initial difference
between the forward rate and spot rate for amortization
over the hedging period is as follows:
Assume that the forecasted transactions
remain probable throughout the entire hedging
relationship and will occur when expected.
Note that for simplicity, it is assumed
that the forward contract’s fair value is equal to the
forward rate as of the date of valuation less the
contractual exchange rate multiplied by the notional;
discounting is ignored. The reclassification of amounts
from AOCI into earnings is reported in the same income
statement line item in which the hedged transaction is
reported. In this example, since this strategy
effectively combines two transactions (the sale of
inventory and the settlement of a receivable) into one
hedging relationship, (1) amounts related to hedging the
changes in foreign-currency risk associated with the
sale of inventory will be recognized in revenue and (2)
amounts related to the receivable will be recognized in
transaction gains and losses.
Golden Age records the following journal
entries:
January 1,
20X1
No entry is required. The forward
contract was entered into at-the-money.
March 31,
20X1
The rate for a USD/EUR forward settling
on June 30, 20X1, is 0.9308. Therefore, the forward
contract has a negative fair value of $93,472. The
journal entry is as follows:
April 30,
20X1
The table below shows (1) the relevant
spot and forward rates as of April 30, 20X1, (2) the
forward contract’s fair values on March 31, 20X1, and
April 30, 20X1, and (3) the change in the forward
contract’s fair value.
The journal entries are as follows:
June 30,
20X1
The table below shows (1) the spot rate
as of June 30, 20X1, (2) the fair values of the forward
contract on April 30, 20X1, and June 30, 20X1, and (3)
the change in the forward contract’s fair value:
The journal entries are as follows:
Example 5-16
Purchased Option
Hedging Forecasted Foreign-Currency-Denominated
Purchase of Inventory Through Settlement Date —
Terminal Value Method
On January 1, 20X2, Golden Age, an
entity with a USD functional currency, forecasts the
purchase of EUR 1 million of inventory on March 31,
20X1. The resulting EUR payable is expected to be
settled on June 30, 20X2. Golden Age enters into a
European option contract on January 1, 20X2, to sell USD
942,300 and buy EUR 1 million on June 30, 20X2. It
designates the contract as a combined hedge of the
variability in cash flows attributable to changes in the
USD/EUR exchange rate from the forecasted settlement of
the euro-denominated payable on June 30, 20X2, resulting
from its euro-denominated forecasted purchase on March
31, 20X2. Entering into this type of a purchased option
is in compliance with Golden Age’s overall risk
management policy. It pays a premium of $28,866 for the
option.
Golden Age formally documents the
hedging relationship at the inception of the hedge. In
accordance with its policy, Golden Age will (1) assess
effectiveness on the basis of the total changes in the
option’s cash flows and (2) compare the option’s
terminal value to the expected change in forecasted cash
flows for USD/EUR spot exchange rates above 0.9423 (see
ASC 815-20-25-126 through 25-129). Golden Age may assume
perfect effectiveness because (1) the terms of the
option perfectly match the forecasted purchase of EUR
and (2) the option cannot be exercised before maturity
(i.e., the criteria in ASC 815-20-25-129 are
satisfied).
The table below shows the spot rates and
fair values of the option as of January 1, March 31, and
June 30, 20X2.
Assume that (1) the forecasted
transactions remain probable throughout the entire
hedging relationship and will occur when expected, (2)
the payable is settled on June 30, 20X2, and (3) the
inventory is sold on July 31, 20X2, for $1.3
million.
Golden Age records the following journal
entries:
January 1,
20X2
March 31,
20X2
June 30,
20X2
No entry is necessary for the settlement
of the option because it expires unexercised
(out-of-the-money).
July 31,
20X2
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.