A group will often carry out activities through foreign operations. Foreign operations are those entities in a group's financial statements incorporated by consolidation, or the equity method, for which their functional currency is different from the currency in which the group's financial statements are reported (the presentation currency). A foreign operation's results and financial position are translated into the group's presentation currency, creating a foreign exchange exposure called translation exposure. For example, the revaluation differences resulting from the translation of net assets of a foreign operation into a group's presentation currency are included in the translation differences (or exchange differences) account, a component of consolidated shareholders' equity.
Many companies consider that the foreign exchange risk arising from foreign operations is only a translation risk – merely an accounting issue – with no impact on cash flows, and as a consequence there is no need to hedge it. This stance is flawed, especially in today's dynamic and competitive environment, as companies frequently buy and sell foreign operations. Disregarding translation exposures as “accounting exposures” and focusing solely on cash flows or transaction exposures could be risky. For example, adverse translation movements may result in a significant decrease of total consolidated equity and, in turn, a higher debt-to-equity ratio that could trigger covenants included in financing agreements (with severe implications for liquidity if debt needs to be repaid). Moreover, a large deficit in the translation differences account may distort future disposal decisions.
In this chapter, I explore the challenges faced by a consolidated group when hedging subsidiaries whose functional currency is different from the presentation currency of the consolidated group. Hedging a foreign subsidiary is often challenging (see Figure 6.1):
This chapter deals with the measurement and hedging of foreign currency exposure caused by foreign operations. Through the cases provided in this chapter, five topics will be analysed in detail:
These five topics are interdependent, and therefore their joint hedge needs to take into account the overall exposure.
For simplicity, most cases in this chapter assume a group formed by two entities: (i) a parent company with the EUR as its functional and presentation currency and (ii) a controlled foreign operation (i.e., a subsidiary). When a subsidiary is not fully owned by the parent entity, adjustments related to minority interests are needed. The effect of minority interests is covered in Section 6.5 below. In this section, the three levels of financial statements – at the subsidiary, at the parent-only and at the consolidated level – are covered.
The purpose of a subsidiary's stand-alone financial statements is to present the financial position of the subsidiary as if it were a single business enterprise. The parent company is considered merely as an outside investor. Normally, a subsidiary's financial statements are prepared according to the accounting principles of the country in which it operates. When local accounting principles are different from those of IFRS standards, the subsidiary's statements need to be restated to IFRS upon consolidation. In the cases provided, it is assumed that the subsidiary financial statements are prepared according to IFRS.
The purpose of a parent's stand-alone financial statements is to present the financial position of the parent as if it were a single business enterprise. Its subsidiaries are treated purely as equity investments, ignoring the subsidiaries assets and liabilities.
Similarly to a subsidiary, a parent's stand-alone financial statements are prepared according to the local accounting standards prevailing in the parent's jurisdiction. The parent-only financial statements commonly use the cost method to account for their equity investments in subsidiaries. The general underlying concepts behind the cost method are the following (see Figure 6.2):
Because consolidated financial statements are prepared using IFRS guidelines, any subsidiary's financial statements not prepared according to IFRS rules need to be restated to IFRS. The purpose of the consolidated financial statements is to present, primarily for the benefit of the group's shareholders and creditors, the financial position of the parent company and all its subsidiaries as if the group were a single economic entity. All the assets and liabilities of each foreign subsidiary are taken into account as assets and liabilities of the group after being translated into the group's presentation currency. Similarly, each foreign subsidiary's profit or loss statement is also integrated in the group's profit and loss, after being translated into the group's presentation currency.
In consolidation, the parent's “investment in subsidiary” account is eliminated and the value of the translation differences is calculated as well. The carrying value of this account is a “plug” figure that balances all the translated assets and liabilities of each foreign subsidiary. Figure 6.3 summarises the consolidated balance sheet and profit or loss statements, assuming that there are no intragroup transactions.
The rationale behind the translation of a foreign operation's financial statements is to preserve the item-to-item relationships (e.g., profitability ratios, liquidity ratios, specific asset to total assets percentages) that exist in the operation's foreign currency statements. The only way to maintain these relationships is to translate all the operation's assets and liabilities using a single exchange rate.
Certain fundamental procedures must be performed before the financial statements of foreign operations may be translated into EUR (i.e., the group's presentation currency).
The individual accounts of a foreign operation are translated using the following procedures:
The financial statements of a foreign operation in the currency of a hyperinflationary economy are first restated in accordance with IAS 29 Financial Reporting in Hyperinflationary Economies. All components are then translated into the presentation currency at the closing rate at the end of the reporting period. This prior adjustment is made to maintain the comparability of prior period information.
The reclassification of an economy as hyperinflationary may have substantial impact on the consolidated financial statements. Suppose that a group has a foreign subsidiary, and that due to the high level of inflation reached during the last year and the cumulative inflation rate over the last few years, the subsidiary's country is now considered a hyperinflationary economy. The main implications of this are as follows:
Adjustment of the income statement to reflect the financial loss caused by the
impact of inflation in the reporting period on net monetary assets (loss of purchasing power).
Investments in foreign operations are exposed to exchange rate fluctuations. The “translation differences” account reports the accumulated translation gains and losses related to the translation of a foreign subsidiary's net asset position. This account is reported as a separate component of shareholders' equity. The “translation differences adjustment” for the accounting period is the difference between the “translation differences account” carrying values at the beginning and end of the period. The amount at the end of the period is calculated in such a way that the sum of all debits matches the sum of all credits in a foreign subsidiary's translated statement of financial position (i.e., balance sheet).
The balance of the translation differences account is removed from that account and reported in consolidated profit or loss on complete (or substantially complete) sale or liquidation of the foreign operation. On partial divestment of the foreign operation, the proportional part of the translation differences account relating to that foreign operation is recognised in profit or loss as part of the gain or loss on the partial divestment.
The translation differences account balance at the end of the accounting period is calculated as follows:
Calculation of the accounting period translation differences | |
translated assets (including goodwill and fair value adjustments) | |
less | translated liabilities (including fair value adjustments) |
equals | shareholders' equity |
less | translated shared capital |
less | translated share premium |
less | translated other comprehensive income |
equals | total retained earnings and translation differences |
less | beginning of accounting period retained earnings |
less | translated net income |
plus | translated dividends |
equals | end of accounting period translation differences |
less | beginning of accounting period translation differences |
equals | translation differences adjustment |
Not only is the equity investment in a foreign operation's assets and liabilities considered part of a net investment. Other items, such acquisition goodwill, fair value adjustments and some monetary items, may also be part of the net investment in a foreign subsidiary.
When one company invests in another (either a subsidiary, associate or joint operation), all the assets and liabilities of the acquiree are fair valued. The fair value adjustments are the difference, at the time of acquisition, between the fair value and the book value of the acquiree's assets and liabilities. Goodwill is the difference between what the acquirer paid and the fair value of the acquiree's assets and liabilities. Under IAS 21, goodwill and fair value adjustments arising from the acquisition of a foreign operation are treated as assets and liabilities of the foreign operation and translated at the closing rate.
Certain monetary items of the parent may be part of its net investment in a foreign operation. This situation occurs when, in addition to providing equity capital to a foreign operation, a parent company provides funds through, commonly, a loan that is similar to an equity investment. A loan is part of a parent's investment in a foreign operation when repayment is neither planned nor likely to occur in the foreseeable future. A history of repayments is likely to be indicative that a loan does not form part of the investment in a foreign operation. The impacts on the individual financial statements are as follows:
An entity may have other monetary items, such as a receivable from or payable to a foreign operation, for which settlement is neither planned nor likely to occur in the foreseeable future. These items are, in substance, part of the entity's net investment in that foreign operation. They do not include trade receivables or trade payables.
Suppose that SubCo issues to ParentCo perpetual debt (i.e., debt without a legal maturity) denominated in USD with an annual interest rate of 4%. The perpetual debt has no issuer call option or holder put option. Thus, contractually it is just an infinite stream of interest payments in USD.
In the group's consolidated financial statements, the perpetual debt is considered a monetary item “for which settlement is neither planned nor likely to occur in the foreseeable future”, and therefore, the perpetual debt can be considered part of ParentCo's net investment in SubCo. The interest payments are treated as interest receivable by ParentCo and interest payable by SubCo, not as repayment of the debt principal.
IAS 21 does not specify a time period that might qualify as “foreseeable future”. Therefore, the term “foreseeable future” is not meant to imply a specific time period, but is an intent-based indicator. An intragroup monetary item may qualify as part of the net investment in a foreign operation when:
On disposal of a foreign operation, the cumulative amount of the exchange differences relating to that operation, recognised in other comprehensive income and accumulated in a separate component of equity, is reclassified from equity to profit or loss (as a reclassification adjustment) when the gain or loss on disposal is recognised.
In addition to the disposal of an entity's entire interest in a foreign operation, the following events, transactions or changes in circumstances are accounted for as disposals, even if the entity retains an interest in the former subsidiary, associate or joint operation:
Therefore, the loss of control, significant influence or joint control of an entity is accounted for as a disposal (not as a partial disposal) under IAS 21. Therefore, all of the exchange differences previously accumulated in equity are reclassified to profit or loss – none are attributed to the interest retained by the entity.
When minority interests relating to foreign entities exist, their share of the translation gains and losses should be added to the “minority interests” in the consolidated balance sheet, as described in the following example.
Suppose that ABC, a EUR based entity, had an 80% investment in a US subsidiary. The net assets of the foreign subsidiary were USD 1 billion. No activity took place during the period. The EUR–USD exchange rates were 1.0000 on 1 January and 1.2500 on 31 December. Thus, the translation adjustments loss was EUR 200 million (= 1 billion × (1/1.0000 – 1/1.2500)).
As ABC owned 80% of the subsidiary, a negative EUR 160 million was recorded in the translation differences account and the remaining EUR 40 million was subtracted from minority interests in the consolidated balance sheet.
Under IFRS 9, for hedge accounting purposes the net investment is viewed as a single asset, as opposed to several individual assets and liabilities that comprise the balance sheet of a foreign operation. The accounting for hedges of net investments in foreign operations follows rules similar to those of cash flow hedges. That is, the effective portion of the change in fair value of the hedging instrument is temporarily recognised in equity, in the translation differences account.
The hedging of net investments in foreign operations is usually implemented by one of the group holding companies through the following instruments:
IFRS 9 allows the use of non-derivative financial instruments, such as foreign currency debt, to hedge a net investment. This is a common hedging alternative when an acquisition is financed with new debt. All the hedge accounting requirements of IFRS 9 must be met, including that an economic relationship must exist between gains and losses on the net investment and gains and losses on the debt.
Sometimes the foreign operation's functional currency is non-convertible, making it impossible for a non-resident holding company to issue debt denominated in such foreign currency. It may also be that the debt market in the currency concerned is too illiquid to accommodate the placement of new debt. In these cases the group is basically left with derivatives to hedge the net investment.
A hedge of a net investment in a foreign subsidiary using derivatives is accounted for as follows (see Figure 6.4):
Before addressing the hedge on net investments in foreign operations, it is important to understand the interaction of the different components behind the translation differences (or exchange differences or cumulative translation) account. A net investment in a foreign operation is the amount of a reporting entity's interest in the net assets of the operation. Any change in the translated value of the net assets of an operation into the group's presentation currency is included in the translation differences reserve of equity. The aim of a net investment hedge is therefore to minimise the variability of amounts in the translation differences account with respect to changes in foreign exchange rates. This case study describes the process of deriving translation differences.
Suppose that on 1 January 20X0 ParentCo (the parent company of a group whose presentation currency is the EUR) acquired 80% of SubCo (whose functional currency is the USD) for a USD 1.43 billion consideration (see Figure 6.5). The fair value of SubCo's identifiable net assets was USD 1.5 billion (USD 3.5 billion of assets and USD 2 billion of liabilities). The closing EUR–USD spot rate on 1 January 20X0 was 1.3000.
It is important to note that the hedged item in a net investment hedge is a collection of the foreign operation's assets and liabilities. The net assets of a foreign operation change during the reporting period (see Figure 6.6). The change can be analysed by looking at the variation of the shareholders' equity of the foreign subsidiary during the accounting period:
Goodwill and statement of financial position items are remeasured to fair value when a stake is acquired in a foreign operation (so it is consolidated by the group either as a subsidiary, joint operation or associate) are recognised as assets and liabilities of the investee and therefore translated at the closing exchange rate.
On 1 January 20X0, ParentCo acquired SubCo. Because SubCo's functional currency (USD) was not the currency of a hyperinflationary economy, SubCo's financial position was translated from its functional currency into the consolidated group's presentation currency (EUR) using the closing spot rate at the acquisition date, 1.3000.
SubCo's item | Fair value | EUR–USD rate | Translated EUR amount |
Assets | USD 3,500 mn | 1.3000 | EUR 2,692 mn |
Liabilities | USD 2,000 mn | 1.3000 | EUR 1,538 mn |
Shareholders' equity | USD 1,500 mn | 1.3000 | EUR 1,154 mn |
Each component of SubCo's shareholders' equity was also translated using the 1.3000 closing spot rate:
SubCo's equity item | Fair value | EUR–USD rate | Translated EUR amount |
Share capital | USD 500 mn | 1.3000 | EUR 385 mn |
Retained earnings | USD 800 mn | 1.3000 | EUR 615 mn |
Other comprehensive income | USD 200 mn | 1.3000 | EUR 154 mn |
Shareholders' equity | USD 1,500 mn | 1.3000 | EUR 1,154 mn |
The group's consolidated statements included a goodwill item arising on the acquisition of SubCo. Goodwill was calculated as the difference between the consideration paid and the sum of the fair values of the underlying net assets. Goodwill was treated as an asset of SubCo, and therefore expressed in SubCo's functional currency (USD). The initial USD value of the goodwill was calculated as follows:
The EUR value of the goodwill on acquisition date was EUR 177 million (= USD 230 mn/1.3000).
The 20% of SubCo not owned by ParentCo was recognised as a non-controlling interest (i.e., a minority interest). The non-controlling interest was measured initially as a proportionate share of SubCo's net identifiable assets, as follows:
The EUR value of the non-controlling interest on acquisition date was EUR 231 mn (= USD 300 mn/1.3000).
On consolidation, the EUR 1.1 billion (= USD 1,430 mn/1.3000) carrying amount of the parent's investment in the subsidiary was replaced with the subsidiary's assets and liabilities and the non-controlling interest. Any goodwill arising on the acquisition of SubCo and any fair value adjustments to the carrying amounts of SubCo's assets and liabilities arising from the acquisition were treated as assets and liabilities of the foreign operation, and therefore expressed in the functional currency of the foreign operation.
Figures 6.7 and 6.8 show the stand-alone balance sheets of ParentCo's and SubCo, and Figure 6.9 shows the consolidated balance sheet, as of 1 January 20X0, the acquisition date (rounded to the nearest EUR million), and for simplicity assuming no intragroup transactions and no other entities in the group.
Let us examine the translation process carried out on the first reporting date following acquisition. To simplify our analysis, let us assume that the group reported its financial statements on an annual basis at year's end. Thus, the first reporting date following acquisition was 31 December 20X0. Figure 6.10 summarises SubCo's stand-alone balance sheet on that date.
The calculation of the exchange differences can be split into the following steps (see Figure 6.11):
The first step on 31 December 20X0 was to translate the subsidiary's balance sheet (excluding goodwill). Because SubCo's functional currency (USD) was not the currency of a hyperinflationary economy, SubCo's results and financial position were translated from its functional currency (USD) into the group's presentation currency (EUR) using the following procedures:
Suppose that the EUR–USD closing spot rate on 31 December 20X0 and the 20X0 average EUR–USD rate were 1.2000 and 1.1500, respectively. Suppose also that the EUR–USD closing spot rate on the day the dividend was approved by SubCo's shareholders was 1.2500. The following table summarises the translation of SubCo's statement of financial position on 31 December 20X0.
SubCo's balance sheet item | Fair value | EUR–USD rate | Translated EUR amount |
Assets (A) | USD 3,800 mn | 1.2000 (closing) | EUR 3,167 mn |
Liabilities (B) | USD 2,100 mn | 1.2000 (closing) | EUR 1,750 mn |
Share capital (C) | USD 500 mn | 1.3000 (historical) | EUR 385 mn |
Opening retained earnings (D) | USD 800 mn | 1.3000 (historical) | EUR 615 mn |
Profit or loss (E) | USD 100 mn | 1.1500 (average) | EUR 87 mn |
Dividends (F) | USD 40 mn | 1.2500 (approval date) | EUR 32 mn |
Opening OCI (G) | USD 200 mn | 1.3000 (historical) | EUR 154 mn |
Change in OCI during period (H) | USD 140 mn | 1.2000 (closing) | EUR 117 mn |
Exchange rate differences (A) – (B) – (C) – (D) – (E) + (F) – (G) – (H) | EUR 91 mn |
The change in OCI was translated using the closing EUR–USD spot rate (1.3000). This translation assumes that all the change in OCI took place on the closing date. An alternative, probably more realistic, would be to use the average EUR–USD rate during the accounting period (i.e., 1.1500), similar to the conversion treatment of the profit or loss statement, assuming that the change in OCI took place gradually during that period.
In the second step, exchange differences, excluding goodwill, were calculated such that the translated assets equalled the sum of (i) the translated liabilities and (ii) the translated shareholders' equity. Figure 6.12 shows the translated balance sheet of SubCo and the carrying value of the exchange differences.
In the third step, the EUR 91 mn exchange differences (excluding goodwill retranslation) were allocated to the group and to the non-controlling interests, based on their proportionate share of SubCo's net assets. In our case, ParentCo's share of SubCo's net assets was 80%. Therefore:
Exchange differences attributable to the non-controlling interests were EUR 18 mn
(= EUR 91 mn × 20%).
Next, the exchange differences related to the goodwill were calculated as follows:
Finally, the exchange differences were calculated as follows:
The aim of this case study is to illustrate the hedge accounting mechanics when hedging a net investment in a foreign operation with an FX forward.
Suppose that ABC, a group whose presentation currency is the EUR, had a net investment in a US subsidiary (SubCo) whose functional currency was the USD. Suppose that ABC's net investment in the subsidiary was USD 500 million as of 1 January 20X1. On that date, ABC entered into an FX forward to hedge its net investment in the subsidiary, with the following terms:
FX forward terms | |
Start date | 1 January 20X1 |
Counterparties | ABC and XYZ Bank |
Maturity | 31 January 20X2 |
ABC buys | EUR 400 million |
ABC sells | USD 500 million |
Forward rate | 1.2500 |
Settlement | Cash settlement |
ABC designated the FX forward as the hedging instrument in a net investment hedge. The effectiveness of the hedge was assessed on a forward basis (i.e., the forward points of the FX forward were included in the assessment of hedge effectiveness).
At its inception, ABC documented the hedging relationship as follows:
Hedging relationship documentation | |
Risk management objective and strategy for undertaking the hedge | The objective of the hedge is to protect, in the group's consolidated financial statements, the value of the USD 500 million investment in the US subsidiary SubCo against unfavourable movements in the EUR–USD exchange rate. This hedging objective is consistent with ABC's overall FX risk management strategy of reducing the variability of its shareholders' equity as stated in the group's hedging policy using FX forwards, FX options and foreign currency debt. The risk being hedged is the risk of changes in the EUR–USD exchange rate that will result in changes in the value of the group's net investment in SubCo when translated into EUR. The risk is hedged from 1 January 20X0 to 31 January 20X2 |
Type of hedge | Net investment hedge |
Hedged item | The first USD 500 million of the net assets of SubCo |
Hedging instrument | The FX forward contract with reference number 012345 entered into by the parent company ParentCo. The main terms of the contract are a USD 500 million notional, a 1.25000 forward rate and a maturity on 31 January 20X2. The counterparty to the forward is XYZ Bank and the credit risk associated with this counterparty is considered to be very low |
Hedge effectiveness assessment | See below |
Hedge effectiveness will be assessed by comparing cumulative changes in the fair value of the hedging instrument to cumulative changes in the forward value of the net investment. For the avoidance of doubt, the forward element of the forward contract will be part of the hedging instrument.
Hedge effectiveness will be assessed prospectively at hedging relationship inception and on an ongoing basis at least upon each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.
The hedging relationship will qualify for hedge accounting only if all the following criteria are met:
The hedging relationship will be considered effective if the following three requirements are met:
Whether there is an economic relationship between the hedged item and the hedging instrument would be assessed on a qualitative basis by comparing the critical terms of the hedging instrument and the hedged item. The critical terms considered would be the notional amount, the term and the underlying. The assessment will be complemented by a quantitative assessment using the scenario analysis method for one scenario in which the EUR–USD FX rate at the end of the hedging relationship (31 January 20X2) will be calculated by shifting the EUR–USD spot rate prevailing on the assessment date by +10%, and the change in fair value of both the hypothetical derivative and the hedging instrument compared.
The effective and ineffective amounts of the change in fair value of the hedging instrument will be computed by comparing the cumulative change in fair value of the hedging instrument with that of the hedged item. The effective amount will be recognised in the “translation differences” reserve in OCI. Any part of the cumulative change in fair value of the hedging instrument that does not offset a corresponding cumulative change in the fair value of the hedged item will be treated as ineffectiveness and recorded in profit or loss.
An effectiveness assessment was performed at inception and at each reporting date. The assessment also included the relationship hedge ratio and an identification of the sources of potential ineffectiveness, as follows.
The hedge qualified for hedge accounting as it met the three effectiveness requirements:
Scenario analysis assessment (1) | |||
Hedging instrument | Hedged item | ||
Nominal USD | 500,000,000 | 500,000,000 | – |
Forward rate | 1.2500 (1) | 1.2520 (1) | – |
Nominal EUR | 400,000,000 | 399,361,000 | – |
Nominal USD | 500,000,000 | 500,000,000 | – |
Final rate | 1.3530 | 1.3530 | – |
Value in EUR | 369,549,000 | 369,549,000 | – |
Difference | 30,451,000 | <29,812,000> | – |
Discount factor | 1.00 | 1.00 | – |
Fair value | 30,451,000 | <29,812,000> | – |
Degree of offset | 102.1% |
Notes:
(1) See Section 5.5.5 for an explanation of the formulas
(2) The forward rate of the hedging instrument and the hedged item differed due to the absence of CVA in the hedged item
There were two main sources of potential ineffectiveness: firstly, a significant credit deterioration of the counterparty to the hedging instrument (XYZ Bank); and secondly, a reduction of the net assets of the hedged foreign operation below the notional of the hedging instrument.
In order to calculate the hedge's effective and ineffective amounts, ABC computed the fair value of the forward and the hypothetical derivative.
The spot and forward FX rates, and the fair values of the forward contract (i.e., the hedging instrument) on the relevant dates were as follows:
Date | EUR–USD spot | Credit risk-free forward EUR–USD | Discount factor | Forward fair value (1) |
1-Jan-20X1 | 1.2300 | 1.2520 | — | -0- |
31-Dec-20X1 | 1.2850 | 1.2900 | 0.997 | 12,366,000 |
31-Jan-20X2 | 1.3300 | 1.3300 | 1.000 | 24,060,000 |
Note:
(1) Forward fair value = [(500 mn/1.25 – 500 mn/(Forward rate)] × Discount factor – CVA.
The CVA was considered to be immaterial on 31 December 20X1 due to the forward's short remaining life, and it was zero on 31 January 20X2. The immateriality conclusion on 31 December 20X1 was arrived at as follows. According to the above table, on 31 December 20X1 the fair value of the FX forward, prior to any CVAs/DVAs, was EUR 12,366,000. On 31 December 20X1 ABC assessed whether the adjustment for counterparty credit risk had a material impact on the forward's fair valuation. The EUR 12,366,000 fair value was the present value of the FX forward's expected payoff discounted at Euribor. The forward had 1 month to expiry (i.e., 31 days) and Euribor for such maturity was trading at 2.70%. Therefore, the expected payoff of the option was calculated as the future value of EUR 12,366,000:
One-month EUR-denominated CDs issued by XYZ Bank were trading at 10 basis points (i.e., 0.10%) over 1-month Euribor. The credit adjusted fair value of the forward was calculated as the present value of the expected payoff using XYZ Bank's credit spread:
The difference between the credit adjusted and the unadjusted fair values was only EUR <1,000> (= 12,365,000 – 12,366,000), deemed to be immaterial.
The fair values of the hedged item on a forward basis at each relevant date were as follows:
Date | EUR–USD credit risk-free forward | Discount factor | Cumulative change in hedge item valuation (*) |
1-Jan-20X1 | 1.2520 | — | |
31-Dec-20X1 | 1.2900 | 0.9970 | <11,729,000> |
31-Jan-20X2 | 1.3300 | 1.0000 | <23,421,000> |
(*) [500 mn/(Forward rate) – (500 mn/1.2520)] × Discount factor
The calculation of the effective and ineffective parts of the change in fair value of the hedging instrument was as follows (see Section 5.5.6 for an explanation of the calculations):
31-Dec-20X1 | 31-Jan-20X2 | |
Cumulative change in fair value of hedging instrument | 12,366,000 | 24,060,000 |
Cumulative change in fair value of hypothetical derivative | 11,729,000 | 23,421,000 |
Lower amount | 11,729,000 | 23,421,000 |
Previous cumulative effective amount | Nil | 11,729,000 |
Available amount | 11,729,000 | 11,692,000 |
Period change in fair value of hedging instrument | 12,366,000 | 11,694,000 |
Effective part | 11,729,000 | 11,692,000 |
Ineffective part | 637,000 | 2,000 |
The net investment translation into EUR at each relevant date was as follows:
Date | Spot EUR–USD | Net investment (USD) | Net investment (EUR) (*) | Period retranslation difference (EUR) |
1-Jan-20X1 | 1.2300 | 500,000,000 | 406,504,000 | — |
31-Dec-20X1 | 1.2850 | 500,000,000 | 389,105,000 | <17,399,000> |
31-Jan-20X2 | 1.3300 | 500,000,000 | 375,940,000 | <13,165,000> |
(*) Net investment in EUR = 500 million/Spot rate
Assuming that ABC reported annually at year's end, the accounting entries related to the hedge were as follows:
No entries in the financial statements were required as the fair value of the forward contract was nil.
The net investment lost EUR 17,399,000 in value over the period when translated into EUR.
The net investment lost EUR 13,165,000 in value over the period when translated into EUR.
Let us analyse the hedge's accounting implications:
Translation differences: | |||
Due to net investment translation | < 30,564,000 > | ||
Due to effective part of hedge | 23,421,000 | ||
Total | < 7,143,000> | ||
Profit or loss: | |||
Due to ineffective part of hedge | 639,000 | ||
Total | <6,504,000> |
Several conclusions can be inferred from the table above:
IFRS 9 allows the forward points of a forward contract to be excluded from a hedging relationship. Forward points derive from the interest rate differential between the currencies specified in the FX forward. Let us see what the accounting treatment would have been had the forward points of the FX forward been excluded from the hedging relationship. The change in the FX forward fair value would have had two components: one component due to changes in the spot rate and a second component due to changes in the forward points. The following table shows the changes in fair value of the FX forward at each relevant date:
1-Jan-20X1 | 31-Dec-20X1 | 31-Jan-20X2 | |
Spot EUR–USD | 1.2300 | 1.2850 | 1.3300 |
Discount factor | — | 0.997 | 1.000 |
Forward total fair value (1) | -0- | 12,366,000 | 24,060,000 |
Change in total fair value (period) | — | 12,366,000 | 11,694,000 |
Change in fair value due to spot (period) (1) | — | 17,399,000 | 13,165,000 |
Change in fair value due to spot (cumulative) | — | 17,399,000 | 30,564,000 |
Change in fair value due to forward (period) (1) | — | <5,033,000> | <1,471,000> |
Notes:
(1) Calculated in Section 6.8.4
(2) Change in fair value due to spot = [(500 million/1.23 – 500 million/(Spot rate)] × Discount factor, assuming no CVA on this component
(3) Change in fair value due to forward points = Change in total fair value – Change in fair value due to spot
The calculation of the effective and ineffective parts of the change in fair value of the hedging instrument was as follows (see Section 5.5.6 for an explanation of the calculations):
31-Dec-20X1 | 31-Jan-20X2 | |
Cumulative change in fair value of hedging instrument | 17,399,000 | 30,564,000 |
Cumulative change in translation value of hedged item (opposite sign) | 17,399,000 | 30,564,000 |
Lower amount | 17,399,000 | 30,564,000 |
Previous cumulative effective amount | Nil | 17,399,000 |
Available amount | 17,399,000 | 13,165,000 |
Period change in fair value of hedging instrument | 17,399,000 | 13,165,000 |
Effective part | 17,399,000 | 13,165,000 |
Ineffective part | -0- | -0- |
The net investment translation into EUR at each relevant date was as follows:
Date | Spot EUR–USD | Net investment (USD) | Net investment (EUR) (*) | Period retranslation difference (EUR) |
1-Jan-20X1 | 1.2300 | 500,000,000 | 406,504,000 | — |
31-Dec-20X1 | 1.2850 | 500,000,000 | 389,105,000 | <17,399,000> |
31-Jan-20X2 | 1.3300 | 500,000,000 | 375,940,000 | <13,165,000> |
(*) Net investment in EUR = 500 million/Spot rate
The accounting entries were as follows, assuming that ABC closed its books annually at year's end:
No entries in the financial statements were required as the fair value of the forward contract was zero.
The net investment lost 17,399,000 in value over the period when translated into EUR. In practice all the net assets of SubCo would have been translated. In our case, the retranslation of just USD 500 million of net assets was assumed and summarised in a “net investment in subsidiary” figurative account for illustrative purposes.
The net investment lost EUR 13,165,000 in value over the period when translated into EUR.
Let us analyse the hedge's accounting implications:
Translation differences: | |||
Due to net investment translation | < 30,564,000 > | ||
Due to effective part of hedge | 30,564,000 | ||
Total | Nil | ||
Profit or loss: | |||
Due to ineffective part of hedge | -0- | ||
Due to change in forward points | <6,504,000> | ||
Total | <6,504,000> |
As we can see, the net investment translation loss was fully offset by the hedge. This perfect offset was due to the assumed absence of CVA in the spot component of the forward (i.e., all CVA charges were assigned to the forward points component). All the change in fair value of the forward contract due to changes in the instrument's forward points was recorded in profit or loss.
A decision on whether or not to include the forward points of the FX forward in the hedging relationship may have a strong effect in the financial statements.
In our case, on 1 January 20X1 the market expected a depreciation of the USD relative to the EUR because USD interest rates were higher than EUR interest rates. The expected depreciation was EUR 6,504,000 (= 500 mn/1.25 – 500 mn/1.23). In other words, at inception of the hedge the FX market expected the value of the investment to deteriorate by that amount during the period from 1 January 20X1 to 31 January 20X2. By entering into the FX forward, ABC locked in this EUR 6,504,000 deterioration. The effects of the decision on whether or not to include the forward points in the hedging relationship were the following:
In a situation like this case, in which the functional currency of the subsidiary is expected to depreciate relative to the presentation currency of the group, the inclusion of the forward points in a hedging relationship at first sight looks better because the deterioration in the value of the investment implied in the forward points will not show up in profit or loss. This, however, is a flawed conclusion. Remember that the amount deferred in the translation differences account will be recycled to profit or loss on disposal or liquidation of the subsidiary.
Let us imagine that ABC rolled the hedge over several years. Then the inclusion of the forward points in a hedging relationship could result in a large loss being deferred in equity. If one day ABC decided to sell the subsidiary, then the huge deficit would show up in profit or loss immediately. This reclassification could jeopardise an otherwise sound strategic decision to sell a subsidiary due to its negative accounting effects in profit or loss. Therefore, when the forward points imply a depreciation of the net investment value, the exclusion of the forward points from the hedging relationship is more conservative as there will be no significant deficit in the translation differences account. By excluding the forward points, the expected depreciation would be gradually recognised in profit or loss, as shown in Figure 6.15.
On a consolidated basis the hedge worked notably well. Let us not forget that it was the parent company, ParentCo, that entered into the forward. In its stand-alone financial statements, unless ParentCo could apply hedge accounting, the forward would be fair valued with changes recognised through profit or loss, potentially causing volatility in ParentCo's profit or loss statement. An alternative for ParentCo was to designate its equity investment in SubCo as the hedged item in a fair value hedge of the exchange rate risk associated with the shares, provided that all of the conditions for hedge accounting were met.
The aim of this case study is to illustrate the hedge of a foreign operation with a non-derivative financial instrument denominated in the functional currency of the foreign operation. This strategy is commonly used when the hedging horizon is long-term.
Suppose that ABC, a group whose presentation currency was the EUR, had a US subsidiary (SubCo) whose functional currency was the USD. Suppose further that ABC was looking to hedge a USD 500 million net investment in the US subsidiary for the next 3 years through the issuance of USD-denominated debt. Thus, on 1 January 20X0, ABC issued a 3-year fixed rate USD-denominated bond with the following terms:
USD-denominated bond terms | |
Start date | 1 January 20X0 |
Issuer | ABC |
Maturity | 31 December 20X2 |
Currency | USD |
Notional | USD 500 million |
Interest | 5.20% annually, 30/360 basis |
ABC designated the USD bond as the hedging instrument in a net investment hedge of its US subsidiary.
At its inception, ABC documented the hedging relationship as follows:
Hedging relationship documentation | |
Risk management objective and strategy for undertaking the hedge | The objective of the hedge is to protect, in the group's consolidated financial statements, the value of the USD 500 million investment in the US subsidiary SubCo against unfavourable movements in the EUR–USD exchange rate. This hedging objective is consistent with ABC's overall FX risk management strategy of reducing the variability of its shareholders' equity as stated in the group's hedging policy using FX forwards, FX options and foreign currency debt. The risk being hedged is the risk of changes in the EUR–USD exchange rate that will result in changes in the value of the group's net investment in SubCo when translated into EUR. The risk is hedged from 1 January 20X0 to 31 December 20X2 |
Type of hedge | Net investment hedge |
Hedged item | The first USD 500 million of the net assets of SubCo |
Hedging instrument | The USD-denominated 3-year bond with reference number 016135. The bond has a USD 500 million notional and pays an annual 5.20% coupon |
Hedge effectiveness assessment | See next |
Hedge effectiveness will be assessed by comparing the foreign currency gains and losses of the hedging instrument to the gains and losses on the translation amount of the net investment that are attributable to the hedged risk (i.e., changes in spot exchange rates). For the avoidance of doubt, hedge effectiveness assessment will be performed on a spot-spot basis. Accrued interest on the hedged item will be excluded from the hedging relationship.
Hedge effectiveness will be assessed prospectively at hedging relationship inception and on an ongoing basis at least upon each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.
The hedging relationship will qualify for hedge accounting only if all the following criteria are met:
The hedging relationship will be considered effective if the following three requirements are met:
Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis by comparing the critical terms of the hedging instrument and the hedged item. The critical terms considered will be the notional amount, the term and the underlying. The qualitative assessment will be supplemented with a quantitative assessment using the scenario analysis method for one scenario in which a final spot rate will be calculated by shifting the EUR–USD spot rate prevailing on the assessment by +10%, and the variation in fair values of both the hedging instrument and the hedged item compared.
The effective and ineffective amounts of the change in fair value of the hedging instrument will be computed by comparing the cumulative change in fair value of the hedging instrument with that of the hedged item. The effective amount will be recognised in the “translation differences” reserve in OCI. Any part of the cumulative change in fair value of the hedging instrument that does not offset a corresponding cumulative change in the translation amount of the hedged item will be treated as ineffectiveness and recorded in profit or loss.
An effectiveness assessment was performed at inception and at each reporting date. The assessment also included the relationship hedge ratio and an identification of the sources of potential ineffectiveness, as follows:
The hedge qualified for hedge accounting as it met the three effectiveness requirements:
A test EUR–USD spot rate (1.3750) was simulated by shifting the EUR–USD spot rate prevailing on the assessment date (1.2500) by +10%. As shown in the table below, the change in fair value of the hedged item was expected to be largely offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
Scenario Analysis Assessment | ||
Hedging Instrument | Hedged Item | |
Nominal USD | 500,000,000 | 500,000,000 |
Initial spot rate | 1.2500 | 1.2500 |
Initial EUR value | 400,000,000 | 400,000,000 |
Nominal USD | 500,000,000 | 500,000,000 |
Shifted spot rate | 1.3750 | 1.3750 |
Final EUR value | 363,636,000 | 363,636,000 |
Difference | 36,364,000 | <36,364,000> |
Fair value change | 36,364,000 | <36,364,000> |
Degree of offset | 100.0% |
There were two are the main sources of potential ineffectiveness: firstly, a significant credit deterioration of the counterparty to the hedging instrument (XYZ Bank); and secondly, a reduction of the net assets of the hedged foreign operation below the hedging instrument notional.
The net investment translation into EUR was calculated using the EUR–USD spot rate at each relevant date:
Date | Spot EUR–USD | Net Investment (USD) | Net Investment (EUR) (*) | Period Retranslation Difference (EUR) |
1-Jan-20X0 | 1.2500 | 500,000,000 | 400,000,000 | — |
31-Dec-20X0 | 1.2700 | 500,000,000 | 393,701,000 | <6,299,000> |
31-Dec-20X1 | 1.3100 | 500,000,000 | 381,679,000 | <12,022,000> |
31-Dec-20X2 | 1.2900 | 500,000,000 | 387,597,000 | 5,918,000 |
(*) Net investment in EUR = 500 million/Spot rate
The fair value change of the foreign debt due to movements in the EUR–USD FX rate at each relevant date was as follows:
Date | EUR–USD spot rate | Bond carrying amount (USD) | Bond carrying amount (EUR) (*) | Period fair value change (EUR) |
1-Jan-20X0 | 1.2500 | 500,000,000 | 400,000,000 | — |
31-Dec-20X0 | 1.2700 | 500,000,000 | 393,701,000 | 6,299,000 |
31-Dec-20X1 | 1.3100 | 500,000,000 | 381,679,000 | 12,022,000 |
31-Dec-20X2 | 1.2900 | 500,000,000 | 387,597,000 | <5,918,000> |
(*) Bond carrying amount (EUR) = Bond carrying amount (USD)/EUR–USD spot rate
The annual coupon flows that ABC paid during the life of the bond were USD 26 million (= USD 500 mn × 5.20%). The interest expense was translated at the average rate for the annual interest period as interest accrued over time. At each reporting date there was no accrued interest. The coupon payment was translated at the EUR–USD spot rate prevailing on payment date. Any difference between the translated amounts of interest expense and coupon payments were recognised in the “other financial income/expenses” line of profit or loss.
Date | Spot EUR–USD | Annual Average Spot EUR–USD | Coupon Payment (USD) | Coupon Payment (EUR) | Interest Expense (EUR) |
31-Dec-20X0 | 1.2700 | 1.2650 | 26,000,000 (1) | 20,472,000 (2) | 20,553,000 (3) |
31-Dec-20X1 | 1.3100 | 1.2840 | 26,000,000 | 19,847,000 | 20,249,000 |
31-Dec-20X2 | 1.2900 | 1.3020 | 26,000,000 | 20,155,000 | 19,969,000 |
Notes:
(1) Coupon payment USD = USD 500 mn × 5.20% = 26 mn
(2) Coupon payment EUR = USD coupon payment/Spot EUR–USD = 26 mn/1.2700
(3) Interest expense = Coupon payment/Annual Average spot = 26 mn/1.2650
In the case of a net investment hedge accounting using a bond (or a loan), only the changes in the bond's amortised cost and accrued interest arising from movements in the FX spot rate are reported in the same manner as the translation adjustment associated with the net investment. In this case, as the functional currency of the subsidiary and the currency denomination of the debt matched, and as the notional amount of the debt did not exceeded the net investment hedged amount, no hedge ineffectiveness was recognised in profit or loss.
Assuming that ABC closed its books annually at year's end, the accounting entries related to the hedge were as follows:
No transaction costs were incurred relating to the USD bond issuance. As a result, ABC proceeds from the bond issuance were USD 500 million. The debt was recognised as a financial liability at amortised costs. Assuming that ABC immediately converted the raised USD into EUR at the then prevailing EUR–USD spot rate (1.2500), the EUR proceeds from the bond were EUR 400 million (=500 million/1.25).
The net investment lost EUR 6,299,000 in value over the period when translated into EUR. In practice all the net assets of SubCo would have been translated. In our case, the retranslation of USD 500 million of net assets is assumed and summarised in a “net investment in subsidiary” figurative account for illustrative purposes.
Following a similar approach to the accounting entries made on 31 December 20X0:
On 31 December 20X2, ABC repaid the USD 500 million bond principal. ABC exchanged the USD 500 million at the then prevailing EUR–USD spot rate (1.2900) for EUR 387,597,000 (=500 mn/1.29). Following a similar approach to the accounting entries made on 31 December 20X1, and adding the bond repayment:
In our case the hedge performed very well, as the decline in value of the net investment due to the depreciation of the USD relative to the EUR was completely offset by the change in the carrying value of the USD debt (see Figure 6.16). However, two comments are worth noting:
I now turn to the accounting treatment of net investment hedges using cross-currency swaps. CCSs are frequently used when the hedging horizon is long-term, as an alternative to issuing foreign debt.
Suppose that ABC, a group whose presentation currency was the EUR, had a net investment in a US subsidiary whose functional currency was the USD. Suppose further that ABC was looking to hedge its net investment in the US subsidiary for the next 3 years through a EUR–USD CCS. ABC had four choices (see Chapter 2 for a more detailed description of CCSs):
At maturity there would be a EUR cash payment or receipt calculated as the difference between the EUR nominal and the EUR value of the USD nominal. The fair value of a EUR–USD CCS is exposed to four different market risks: the movement in the EUR–USD spot rate, the movement of the USD interest rate curve, the movement of the EUR interest rate curve and the movement of the basis.
In a pay USD floating/receive EUR floating CCS, the fair value change due to interest rate movements is usually small relative to the fair value change due to the FX rate movement. As a consequence, the change in fair value of the CCS would primarily arise from changes in the EUR–USD spot rate. Because the value of the net investment being hedged is determined by translating the amount of the net investment into the group's presentation currency using the spot exchange rate, this hedge would be highly effective if well constructed.
In a pay USD fixed/receive EUR fixed CCS, the changes in its fair value due to movements in both interest rate curves can be substantial. This type of CCS equates to a string of FX forwards. Because effectiveness can be calculated using forward rates, this hedge would be highly effective if well constructed.
In a pay USD fixed/receive EUR floating CCS, the exposure to the USD interest rate curve can be important. Similarly, in a pay USD floating/receive EUR fixed CCS, the exposure to the EUR interest rate curve can be large. Because there could be significant differences between the change in fair value of these CCSs and the change in the net investment based in either spot rates or forward rates, substantial ineffectiveness may arise.
As a result, net investment hedges using floating-to-floating CCSs or fixed-to-fixed CCSs are expected to be highly effective. Substantial ineffectiveness may arise if either fixed-to-floating CCSs or floating-to-fixed CCSs are used as hedging instruments.
CCS | Expected ineffectiveness |
Pay USD fixed/receive EUR fixed | Minimal (excluding basis) |
Pay USD floating/receive EUR floating | Minimal (excluding basis) |
Pay USD floating/receive EUR fixed | Potentially significant |
Pay USD fixed/receive EUR floating | Potentially significant |
Regarding the basis, IFRS 9 allows an entity to recognise changes in the basis element of a CCS temporarily in equity to the extent that these changes relate to the hedged item. This treatment is similar to the forward element of a forward contract.