Hedge accounting can bring a number of advantages over traditional accounting methods. The core benefit is that by addressing the timings mismatch associated with standard derivative accounting, hedge accounting removes temporary volatility from the P&L. As a result, the financial statements will better reflect the company’s true economic performance.
Reducing the volatility in earnings results in a number of additional benefits:
- Enterprise value. Earnings volatility is negatively perceived by investors.
- Creditworthiness. Predictability in future earnings is a positive factor in creditworthiness.
- Risk management. Statements reflect better and more accurately how FX-risk is managed.
- Executive compensation. Compensation tied to performance, for example measured based on quarterly earnings, can incur unintended impacts from earnings volatility.
But it can also go very wrong, see this article from Reuters: Dutch housing coop Vestia seeks damages from Deutsche Bank for derivatives.
The three types of hedging relationships in IFRS 9 Financial instruments – Hedge accounting are as follows:
- fair value hedge : a hedge of the exposure to changes in fair value of a recognised asset or liability or an off-balance firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.
- cash flow hedge : a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction, and could affect profit or loss.
- hedge of a net investment in a foreign operation as defined in IAS 21 The effects of changes in Foreign Exchange Rates.
Hedges of a net investment in a foreign operation
An overseas equity investment, i.e. a subsidiary, associate or joint venture is hedged by a derivative or non-derivative contract. The net investment in a foreign operation under IAS 21 The Effects of Changes in Foreign Exchange Rates, is the amount of the reporting entity’s interest in the net assets of the operation, including any recognised goodwill.
On consolidation, any foreign exchange gains or losses on retranslation of the net assets of the foreign operation are recognised in other comprehensive income. This type of hedge shall be accounted for similarly to cash flow hedges:
- The effective portion of the foreign currency gain or loss on the hedging instrument shall be recognised in other comprehensive income (matched with the foreign exchange gains or losses on consolidation)
- The ineffective portion shall be recognised in the profit or loss.
When the hedged item is disposed of, the cumulative gains or losses in other comprehensive income shall be recognised as part of the profit or loss on disposal.
Case of a hedge of the net investment on a foreign subsidiary
Company W, whose functional currency is the Euro, has a wholly-owned US subsidiary, subsidiary D, whose functional currency is US dollars.
The carrying value of subsidiary D’s net assets is USD 70 million. Subsidiary D’s net assets include an inter-company borrowing of USD10 million received from company W, which is not expected to be settled in the foreseeable future.
Subsidiary D’s management predicts that it is highly probable that it will:
- earn a proﬁt of at least USD8 million; and
- pay a dividend of USD5 million to company W.
What can a hedge do?
Company W can hedge up to USD 80 million of its net investment in subsidiary D at the date of hedge designation. The USD80 million is represented by:
- USD70 million of subsidiary D’s net assets; and
- USD10 million inter-company loan. This loan could be designated as a hedged item, because it is not expected to be settled in the foreseeable future and therefore, in substance, forms part of company W’s net investment in subsidiary D (IAS 21 15).
Subsidiary D’s forecast proﬁts (USD8 million) and forecast inter-company dividend payments (USD5 million) cannot be included in the hedged item, because they do not form part of company W’s existing net investment. The undeclared forecast inter-company dividend payments (USD5 million) do not qualify as hedged items, because they will not affect reported net proﬁt or loss. As the proﬁts are earned, they increase the net investment and can then be included in the hedged item. When dividends are paid, the amount covered in the net investment hedge might need to be reduced correspondingly.
Variation – Hedging a foreign net investment with a FX liability of another subsidiary
Parent’s functional currency is the US dollar. Parent has two subsidiaries: Sub NZ in New Zealand and Sub J in Japan. The functional currency of Sub J is its local currency (Japanese yen).
Scenario 1: Sub NZ’s functional currency is its local currency (NZ dollar) Net investment hedge
Sub NZ issues yen-denominated notes. Parent is not permitted to designate the yen-denominated notes issued by Sub NZ as the hedging instrument in a hedge of its net investment in Sub J. This is because Sub NZ is not part of the operating unit that has the foreign currency exposure and Sub NZ has a functional currency different from that of the Parent.
Scenario 2: Sub NZ’s functional currency is the US dollar Net investment hedge
Sub NZ issues yen-denominated notes and Parent designates those notes payable as the hedging instrument in its hedge of its net investment in Sub J.
This is permissible because Sub NZ has the same functional currency as Parent and there are no intervening subsidiaries with a different functional currency.
On a consolidated basis, Parent translates Sub J’s financial statements from its functional currency into US dollars. Any foreign currency translation gains or losses are recorded in the equity component translation adjustment reserve through other comprehensive income. Net investment hedge
In its stand-alone financial statements, Sub NZ’s yen-denominated notes are remeasured at spot through earnings to its functional currency (the US dollar) at period-end because the hedging relationship and related hedge accounting exist only in the context of Parent’s consolidated financial statements. Net investment hedge
However, if Sub NZ’s yen-denominated notes are effective at hedging the exchange gains or losses arising on translation of Sub J’s financial statements from yen to US dollars, the gain or loss in Sub NZ’s stand-alone financial statements related to remeasuring the yen-denominated notes to US dollars is reclassified in consolidation to the equity component translation adjustment reserve through other comprehensive income (i.e. in Parent’s consolidated financial statements). Net investment hedge
See also: The IFRS Foundation Net investment hedge
Net investment hedge
Net investment hedge
Net investment hedge Net investment hedge Net investment hedge Net investment hedge Net investment hedge Net investment hedge