Effectiveness in
net investment hedges
Note that the descriptions above
refer mostly to cash flow and fair value hedges.
Measuring effectiveness in net investment hedges remains
a less-explored area but one that’s likely to generate
less income statement volatility overall. That’s mostly
because there’s a shortcut methodology, of sorts,
available to hedgers as long as they match the size of
the investment with the hedge, and use the same exchange
rate.
Net investment
hedges are in a class of their own in FAS 133, outside
the cash flow and fair value hedge relationships. They
are a carryover from the FAS 52 days and offer a variety
of anomalies or exceptions that do not exist in other
areas of FAS 133. For example, FAS 133 allows hedgers to
use a combination of a cash and derivative instrument,
or a cash instrument (e.g., a borrowing) to hedge a net
investment risk, whereas elsewhere in FAS 133 on only
derivatives can qualify for hedge accounting
treatment.
Issue H8, which forms the basis for net
investment effectiveness guidance, was revised by the
FASB Staff on February 28, 2001. It handles two basic
questions:
(1) How should an entity measure the
amount of ineffectiveness that must be recognized in
earnings for a derivative instrument designated as a
hedge of a net investment in a foreign operation?
(2) And, how should an entity measure the
amount of ineffectiveness that must be recognized in
earnings for a non-derivative instrument designated as a
hedge of a net investment in a foreign operation?
The Staff notes
that FAS 52 dictated that the entire amount of the
translation gain or loss on the net investment is to be
recognized in the cumulative translation adjustment
account, which is one component of other comprehensive
income (OCI). Meanwhile, FAS 133 says that the gain or
loss on a hedging derivative that is “designated as, and
is effective as an economic hedge of the net investment
in a foreign operation” should be reported “in the same
manner as a translation adjustment to the extent it is
effective as a hedge.” This basically means, like in
other areas of FAS 133, if the hedge is ineffective, the
ineffective portion should be recognized in income on a
current basis.
Since FAS 133 itself did not offer clues on
how to measure ineffectiveness in net investment hedges,
the Staff offered the following rules:
If a company uses a derivative to hedge
its net investment risk, it can an measure the amount of
ineffectiveness using either a method based on changes
in spot exchange rates or a method based on changes in
forward exchange rates (as long as it chooses one method
for all net investment derivative hedges). The same rule
applies to purchased option hedges.
Changes in Forward Rates.
As long as the hedge
and hedged item match perfectly in terms of their
notional, duration, currency etc., “ all changes in fair
value of the derivative should be reported in the same
manner as a translation adjustment (that is, reported in
the cumulative translation adjustment section of OCI),”
the FASB Staff notes. “In that case, no hedge
ineffectiveness would be recognized in earnings
(including the time value component of purchased options
or the interest accrual/periodic cash settlement
components of qualifying receive-floating-rate,
pay-floating-rate and receive-fixed rate, pay-fixed-rate
cross-currency interest rate swaps).”
This is a shortcut approach
of sorts, which allows companies to avoid income
statement volatility as long as they match up the hedge
with the net investment. However, if:
(1) The notional
amounts do not match;
(2) The exchange
rate differs;
(3) The
derivative is a compound one with multiple underlying
such as a cross-currency interest rate swap (DIG issue
H9):
Ineffectiveness has to be measured and
recorded.
If the hedge falls into one of the above
three categories, companies will have to measure
ineffectiveness using hypothetical derivative
methodology. In either one of the cases, the hedgers
will have to create a derivative that does not “suffer”
from the mismatch problem and compare the fair value of
their actual hedge against the “perfect” hedge, and
record in income any ineffectiveness that they assess.
(Meanwhile, the changes in value of the hypothetical
derivative should be recorded in OCI). Note too, that
ineffectiveness due to both over-hedging and
under-hedging needs to be recorded.
Of course, at the inception
of the hedge, the company must be able to assess
prospective effectiveness, so if the company opts to
designate a derivative with a different notional or
currency, it must demonstrate that it expects the hedge
to be a highly effective economic
offset.
Changes in spot rates.
Alternatively,
companies may opt to assess effectiveness using changes
in the spot rate method. If (a) the notional amounts are
the same, and (b) the exchange rate underlying the
derivative and the net investment are the same; and (c)
the hedging derivative is a cross-currency,
interest-rate swap, “the change in the fair value of the
derivative attributable to changes in the difference
between the forward rate and spot rate would be excluded
from the measure of hedge ineffectiveness and that
difference would be reported directly in earnings. Also
reported directly in earnings would be the interest
accrual/periodic cash settlement components of
qualifying receive-floating-rate, pay-floating-rate and
receive-fixed rate, pay-fixed-rate cross-currency
interest rate swaps. Meanwhile, the effective portion of
the hedge should be reported in OCI.
Again, if the derivative and the hedged
item differ in some way (notional amount, currd
ectiveness.
The same basic rules apply here as well.
As long as the hedge and hedged item match up perfectly,
there should be no ineffectiveness. All changes in value
would flow through OCI.
However, the Staff notes, if the notional
amounts or currency bases are different, then
“ineffectiveness must be recognized in earnings by
comparing the foreign currency transaction gain or loss
based on the spot rate change (after-tax effects, if
appropriate) of that non-derivative instrument to the
transaction gain or loss based on the spot rate change
(after-tax effects, if appropriate) that would result
from the appropriate "hypothetical" non-derivative
instrument that does not incorporate those differences.”
Any difference between the spot-rate change of the
"hypothetical" non-derivative instrument and the actual
non-derivative hedge will have to be recorded in income.
There are some other DIG issues that
discuss this topic. In particular, issues H9
and H10.
