6.1.1 Subsidiary Financial Statements

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.

6.1.2 Parent-Only Financial Statements

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):

• The original cost of the investment is recognised in the parent-only financial statements in the “investment in subsidiary” account.
• No adjustments are made to reflect subsequent changes in the fair value of the investment unless there is serious doubt as to the realisation of the investment, in which case a permanent write-down is made.
• Undistributed earnings have no effect on the parent financial statements.
• When dividends are declared, dividend income is recognised. Neither the dividend declaration nor the actual dividend payments impact the carrying value of the investment in the parent-only financials.

6.1.3 Consolidated Financial Statements

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.

6.2.1 Basic Procedures prior to Translation

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).

• Restatement to IFRS. Operations conducted in a foreign entity must be accounted for using the accounting principles prevailing in its jurisdiction. When foreign currency financial statements use accounting principles that differ from IFRS, appropriate restatement adjustments must be made to those statements before translation so that they conform to IFRS. When a parent company has significant influence over a subsidiary, commonly a 20–50% interest, which must be accounted for under the equity method, the investee's foreign statements must also be adjusted to conform to IFRS principles before translation into EUR.
• Adjustments to the foreign operation's monetary items (e.g., receivables and payables). A foreign operation's monetary items in a currency other than the foreign operation's functional currency must be converted into the foreign operation's functional currency.
• Reconciliation of intragroup monetary items. For example, intragroup loans are commonly transferred between group entities with different functional currencies. Such transactions are usually recorded in separate intragroup accounts by each accounting entity. Such accounts must be reconciled with each other before translation to ensure that these accounts offset each other after translation.
• Elimination of the parent's investment in the foreign operation and the foreign operation's equity. In other words, the carrying amount of the parent investment in the foreign operation and the equity of the foreign operation corresponding to the parent ownership are eliminated.
• The accounting period translation gain or loss is computed and recognised in the “translation differences” account of equity. On disposal (or partial disposal or liquidation) of the foreign operation, the portion of the “translation differences” reserve that relates to the disposal (or liquidation) must be transferred to profit or loss in the reporting period in which the disposal is recognised.

6.2.2 Specific Translation Procedures

The individual accounts of a foreign operation are translated using the following procedures:

• All assets and liabilities are translated at the closing exchange rate. Assets and liabilities to be translated include any goodwill and fair value adjustments that arose on the acquisition of the foreign entity.
• Share capital and share premium are translated at historical exchange rates.
• Dividend payments, if any, are translated using the exchange rate in effect at the time of its declaration.
• Profit or loss accounts are translated at the average exchange rate for the accounting period. The exchange rate existing when each item was recognised in earnings can also be used, but in practice this alternative is rarely applied.
• The accounting period translation gain or loss resulting from the previous procedures is included in the “translation differences” account of equity.

6.2.3 Hyperinflationary Economies

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 historical cost of non-monetary assets and liabilities and the various items of equity of the subsidiary from their date of acquisition or inclusion in the consolidated statement of financial position to the end of the accounting period for the changes in purchasing power of the currency caused by inflation. The cumulative impact of the accounting restatement to adjust for the effects of hyperinflation for years prior to the reclassification is shown in translation differences at the beginning of the reporting period.

• 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).

• The various components in the profit or loss statement and statement of cash flows are adjusted for the inflation index since their generation, with a balancing entry in financial results and offsetting reconciling item in the statement of cash flows, respectively.
• All components of the financial statements of the foreign operation are translated at the closing exchange rate.

6.4.1 Goodwill and Fair Value Adjustments

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.

6.4.2 Long-Term Investments in a Foreign Subsidiary

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:

• When the loan is denominated in the functional currency of the foreign operation, exchange differences arising from the loan are recognised in profit or loss in the parent-only financial statements.
• When the loan is denominated in the functional currency of the parent, exchange differences arising from the loan are recognised in profit or loss in the foreign operation-only financial statements.
• When the loan is denominated in a currency that is not the functional currency of either the parent or the foreign operation, exchange differences are recognised in profit or loss in both the parent-only and foreign operation-only financial statements.

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.

6.4.3 Disposal of a Foreign Operation

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:

• the loss of control over a subsidiary that includes a foreign operation;
• the loss of significant influence over an associate that includes a foreign operation; or
• the loss of joint control over a jointly controlled entity that includes a foreign 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.

6.6.1 Net Investment Hedge Issuing Foreign Currency Debt

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.

6.6.2 Net Investment Hedge Using Derivatives

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):

• The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in OCI of equity, in the translation differences reserve. Gains and losses previously recognised in this reserve are reclassified to profit or loss upon the disposal, or part disposal, of the foreign operation.
• The ineffective portion is reported in profit or loss.

6.7.1 Elements of the Net Assets of a Foreign Subsidiary

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:

• Profit or loss is generated in the foreign operation.
• Dividends are distributed to the foreign operation's shareholders.
• Capital investment is increased by the acquisition of the foreign operation's new or existing capital instruments.
• Capital investment is reduced by the sale or cancellation of the foreign operation's existing capital instruments.
• Additional other comprehensive income is generated or reduced in the foreign operation's financial position.
• Existing or new intragroup loans become part of the group's net investment as a result of it being considered that settlement is neither planned nor likely to occur in the foreseeable future.
• Existing goodwill is impaired or new goodwill is recognised as a result of an increase in ownership.

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.

6.7.2 Translation Process on Acquisition Date

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.

Each component of SubCo's shareholders' equity was also translated using the 1.3000 closing spot rate:

Goodwill

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).

Non-controlling Interest

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.

6.7.3 Translation Process on First Reporting Date

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):

1. Take SubCo's statement of financial position (i.e., balance sheet) and translate each item, excluding goodwill.
2. Calculate the exchange differences (excluding goodwill) such that the translated assets equal the sum of (i) the translated liabilities and (ii) the translated shareholders' equity;
3. Allocate the exchange differences (excluding goodwill) between the group and the non-controlling interests, based on their share of the net assets.
4. Add the exchange differences due to the retranslation of goodwill to the group's exchange differences.

Step 2: Calculation of Exchange Differences

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.

6.8.1 Hedging Relationship Documentation

At its inception, ABC documented the hedging relationship as follows:

6.8.2 Hedge Effectiveness Assessment

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:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a foreign operation that exposes the entity to currency retranslation risk and it is reliably measurable. The hedging instrument is eligible as it is a derivative and it does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the fair value changes in the hedging relationship.
3. The weightings of the hedged item and the hedging instrument (i.e., hedge ratio) are designated based on the quantities of hedged item and hedging instrument that the entity actually uses to meet the risk management objective, unless doing so would deliberately create ineffectiveness.

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.

6.8.3 Hedge Effectiveness Assessment Performed at Hedge Inception

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:

1. Because the terms of the hedging instrument and those of the expected cash flow closely matched and due to the low credit risk exposure to the counterparty of the forward contract, it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions, and hence that an economic relationship existed between the hedged item and the hedging instrument. This conclusion was supported by a quantitative assessment, which consisted of one scenario analysis performed as follows. A EUR–USD spot rate at the end of the hedging relationship (1.3530) was simulated by shifting the EUR–USD spot rate prevailing on the assessment date (1.2300) 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 (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

2. Because the credit rating of the counterparty to the hedging instrument was relatively strong (rated A+ by Standard & Poor's) the effect of credit risk did not dominate the value changes resulting from that economic relationship.
3. The hedge ratio designated (1:1) was the one actually used for risk management and it did not attempt to avoid recognising ineffectiveness. Therefore, it was determined that a hedge ratio of 1:1 was appropriate.

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.

6.8.4 Fair Values and Calculation of Effective and Ineffective Amounts

In order to calculate the hedge's effective and ineffective amounts, ABC computed the fair value of the forward and the hypothetical derivative.

Fair Valuation of the Hedging Instrument

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.

6.8.5 Accounting Entries – Forward Points Included in Hedging Relationship

Assuming that ABC reported annually at year's end, the accounting entries related to the hedge were as follows:

1. To record the forward contract trade on 1 January 20X1

   No entries in the financial statements were required as the fair value of the forward contract was nil.

2. To record the closing of the accounting period on 31 December 20X1

   The net investment lost EUR 17,399,000 in value over the period when translated into EUR.

3. The change in the fair value of the FX forward since the last valuation was a EUR 12,366,000 gain, of which a EUR 11,729,000 gain was deemed to be effective and recorded in the translation differences account, while a EUR 637,000 gain was considered to be ineffective and recorded in profit or loss.
4. Entries on 31 January 20X2

   The net investment lost EUR 13,165,000 in value over the period when translated into EUR.

5. The change in the fair value of the FX forward since the last valuation was a EUR 11,694,000 (=24,060,000 – 12,366,000) gain, of which a EUR 11,692,000 gain was deemed to be effective and recorded in the translation differences account, while a EUR 2,000 gain was considered to be ineffective and recorded in profit or loss.
6. The settlement of the FX forward resulted in the receipt of EUR 24,060,000.

Let us analyse the hedge's accounting implications:

Several conclusions can be inferred from the table above:

• Firstly, despite being fully hedged, the “translation differences” account showed a deficit. In other words, the net investment translation loss was not completely offset by the hedge. This deficit was exactly the change in fair value of the FX forward due to the forward points.
• Secondly, EUR 639,000 was recorded in profit or loss because the hedge experienced some ineffectiveness. The main source of ineffectiveness was the credit risk associated with the counterparty to the FX forward, which caused a difference between the terms of the forward and the hypothetical derivative.
• Finally, the hedge was also highly effective because the net assets of the foreign operation remained USD 500 million. Had the subsidiary experienced a large loss for the year ending in December 20X1, causing the net assets of SubCo to be less than the hedged amount, the change in fair value corresponding to the excess notional would have been recorded in profit or loss.

6.8.6 Accounting Entries – Forward Points Excluded from Hedging Relationship

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:

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

6.8.7 Implications of the FX Forward Points

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:

1. If ABC decided to include the forward points in the hedging relationship, most of the value associated with the forward points would end up in the translation differences account and not in profit or loss. As a result, the translation differences account would show a large EUR 7,143,000 deficit because the effective amount on the FX forward (EUR 23,421,000) was notably lower than the loss on the net investment (EUR 30,564,000), as shown in Figure 6.13. That deficit was mostly due to the forward points. Conversely, had the interest rate differential implied an appreciation of the USD relative to the EUR the effect would have been the opposite: the translation differences account would have shown a large surplus.
2. If ABC decided to exclude the forward points from the hedging relationship, all the value associated with the forward points (a EUR 6,504,000 loss) would end up in profit or loss, and not in the translation differences account. The translation differences account would show no deficit because all the loss on the net investment (EUR 30,564,000) was fully offset by the gain on the hedge, as shown in Figure 6.14.

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.

6.9.1 Hedging Relationship Documentation

At its inception, ABC documented the hedging relationship as follows:

6.9.2 Hedge Effectiveness Assessment

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:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a foreign operation that exposes the group to currency retranslation risk and it is reliably measurable. The hedging instrument is eligible as it is a non-derivative financial instrument.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the fair value changes in the hedging relationship.
3. The weightings of the hedged item and the hedging instrument (i.e., hedge ratio) are designated based on the quantities of hedged item and hedging instrument that the entity actually uses to meet the risk management objective, unless doing so would deliberately create ineffectiveness.

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.

6.9.3 Hedge Effectiveness Assessment Performed at Hedge Inception

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:

1. Because the critical terms (such as the nominal amount, maturity and underlying) of the hedging instrument and the hedged item matched, it was concluded that the hedging instrument and the hedged item had values that would generally move in the opposite directions, and hence that an economic relationship existed between the hedged item and the hedging instrument. This conclusion was supported by the quantitative assessment documented below.
2. Because the credit rating of counterparty to the hedging instrument was relatively strong (rated A+ by Standard & Poor's) the effect of credit risk did not dominate the value changes resulting from that economic relationship.
3. The hedge ratio designated (1:1) was the one actually used for risk management and it did not attempt to avoid recognising ineffectiveness. Therefore, it was determined that a hedge ratio of 1:1 was appropriate.

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.

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.

6.9.4 Other Relevant Information

The net investment translation into EUR was calculated using the EUR–USD spot rate at each relevant date:

(*) 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:

(*) 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.

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

6.9.5 Accounting Entries

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:

1. To record the bond issuance on 1 January 20X0

   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).

2. To record the closing of the accounting period on 31 December 20X0

   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.

3. The change in the bond's carrying amount due to the movement of the EUR–USD exchange rate was a gain of EUR 6,299,000. As the hedge had no ineffectiveness, all this change was recorded in the translation differences account:
4. Under the bond, ABC paid on 31 December 20X0 a USD 26 million coupon after converting EUR 20,472,000 into USD on the FX spot market. The bond's USD interest expense was translated using the average EUR–USD rate for the annual interest period as interest accrued over time, resulting in EUR 20,553,000. The USD 26 million coupon payment was translated into EUR using the EUR–USD spot rate on the coupon payment date, resulting in EUR 20,472,000. The difference in translation rates gave rise to a EUR 81,000 gain.
5. To record the closing of the accounting period on 31 December 20X1

   Following a similar approach to the accounting entries made on 31 December 20X0:

6. To record the closing of the accounting period on 31 December 20X2

   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:

6.9.6 Final Remarks

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:

• ABC's profit or loss statement was exposedx to declines in the EUR–USD FX rate arising from the coupon payments.
• At bond maturity, ABC had to repay the USD 500 million notional. ABC had to exchange in the FX spot market an amount of EUR equivalent to USD 500 million. As a result, a severe decline in the EUR–USD FX rate could have had strong implications for the entity's cash resources.