Hedges of a net investment in a foreign operation

What is net investment in a foreign operation?

As per Ind AS 21, net investment in any foreign operation is the amount of the reporting entity’s interest in the net asset of that operation. Such foreign operations may be subsidiaries, associates, joint ventures or branches. Ind AS 21 requires an entity to determine the functional currency of each of its foreign operations as the currency of the primary economic environment of that operation. When translating the results and financial position of a foreign operation into a presentation currency, the entity is required to recognise foreign exchange differences in other comprehensive income until the foreign operation is disposed off.

An entity may have a monetary item that is receivable from or payable to a foreign operation. An item for which settlement is neither planned nor likely to occur in the foreseeable future is a part of the entity’s net investment in that foreign operation. Such monetary items may include long-term receivables or loans. They do not include trade receivables or trade payables.

The entity that has a monetary item receivable from or payable to a foreign operation may be any subsidiary of the group. For example, an entity has two subsidiaries, A and B. Subsidiary B is a foreign operation. Subsidiary A grants a loan to Subsidiary B. Subsidiary A’s loan receivable from Subsidiary B would be part of the entity’s net investment in Subsidiary B if settlement of the loan is neither planned nor likely to occur in the foreseeable future. This would also be true if Subsidiary A were itself a foreign operation.

Exchange differences arising on a monetary item that forms part of a reporting entity’s net investment in a foreign operation is recognised in profit or loss in the separate financial statements of the reporting entity or the individual financial statements of the foreign operation, as appropriate. In the financial statements that include the foreign operation and the reporting entity (eg, consolidated financial statements when the foreign operation is a subsidiary), such exchange differences shall be recognised initially in other comprehensive income and reclassified from equity to profit or loss on disposal of the net investment.

When a monetary item forms part of a reporting entity’s net investment in a foreign operation and is denominated in the functional currency of the reporting entity, an exchange difference arises in the foreign operation’s individual financial statements. If such an item is denominated in the functional currency of the foreign operation, an exchange difference arises in the reporting entity’s separate financial statements. If such an item is denominated in a currency other than the functional currency of either the reporting entity or the foreign operation, an exchange difference arises in the reporting entity’s separate financial statements and in the foreign operation’s individual financial statements. Such exchange differences are recognised in other comprehensive income in the financial statements that include the foreign operation and the reporting entity (ie, financial statements in which the foreign operation is consolidated or accounted for using the equity method).

Disposal of foreign operation

On the disposal of a foreign operation, the cumulative amount of the exchange differences relating to that foreign operation, recognised in other comprehensive income and accumulated in the 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.

When is hedge accounting applicable?

Hedge accounting of the foreign currency risk arising from a net investment in a foreign operation will apply only when the net assets of that foreign operation are included in the financial statements. The item being hedged with respect to the foreign currency risk arising from the net investment in a foreign operation may be an amount of net assets equal to or less than the carrying amount of the net assets of the foreign operation.

Treatment for hedge accounting in the case of net investment hedge

Ind AS 109 requires the designation of an eligible hedged item and eligible hedging instruments in a hedge accounting relationship. If there is a designated hedging relationship, in the case of a net investment hedge, the gain or loss on the hedging instrument that is determined to be an effective hedge of the net investment is recognised in other comprehensive income and is included with the foreign exchange differences arising on translation of the results and financial position of the foreign operation.

Scope of hedges of net investment

The scope here is applicable to an entity that hedges the foreign currency risk arising from its net investments in foreign operations and wishes to qualify for hedge accounting in accordance with Ind AS 109. Such an entity is referred to as a parent entity and to the financial statements in which the net assets of foreign operations are included as consolidated financial statements. All references to a parent entity apply equally to an entity that has a net investment in a foreign operation that is a joint venture, an associate or a branch.

What is a fair value hedge?

Fair value hedging as the name implies strives to hedge the fair value of an existing asset or liability and certain other firm commitments. In a fair value hedge, the fair value changes to the hedging instrument and the hedged item are recognised in profit and loss account.
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Steps involved in fair value hedge accounting

Identify the hedged item Identify the hedging instrument Designation/qualifying criteria of the hedge Hedge effectiveness requirements to be fulfilled Account for the hedging relationship Rebalancing and discontinuance of hedge accounting
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Accounting for fair value hedge

The hedge should be designated at the inception of the hedging relationship and a formal designation and documentation of the same required. The documentation should contain the entity’s risk management strategy and objective for undertaking the hedge. The effect of the credit risk involved in the hedging instrument, viz, the counterparty credit risk should not be such that it would vitiate the fair value changes of the hedging instrument.
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Accounting for the forward element

Change in the fair value of the forward element of a forward contract that hedges a transaction related hedged item should be recognised in other comprehensive income to the extent it relates to the hedged item. The cumulative change in the fair value arising from the forward element of the forward contract shall be accounted for as follows:
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Treatment of time value /forward points in derivatives

An entity is allowed to designate only the change in the intrinsic value of an option contract in a hedging instrument. Similarly an entity can also designate only the change in the spot value of a forward contract in a hedging instrument. In such cases, the time value of the option/forward points is accounted for depending upon the type of the hedged item that the option/forward contract hedges. The option/forward contract could be to either to hedge a transaction-related hedged item or a time-period-related hedged item.
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Accounting for the time value of options

The time value of options contract may be separated from the fair value of options contracts and the entity can designate only the change in the intrinsic value of the option. If the entity chooses to do so, then the time value of the option contract is dealt with in the following manner:
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Hedge effectiveness requirements

Rebalancing is permitted for the purpose of maintaining the hedge ratio to comply with the hedge effectiveness requirements. Changes to designate quantities of a hedged item or hedging instrument for a different purpose do not constitute rebalancing.
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Rebalancing by changing the hedge ratio

Rebalancing is a new concept introduced by a major amendment to IFRS 9 during November 2013. Rebalancing means adjustments made to the quantities of the hedged item or the hedging instrument of an existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements.
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Discontinuance of hedge accounting

As per the new requirements, hedge accounting cannot be voluntarily discontinued. Hedge accounting can be discontinued only if the hedge effectiveness requirements are not met or that the hedging instrument is liquidated. Even when the hedge effectiveness requirements are not met, the entity should adjust the hedge ratio through the process of rebalancing and continue with hedge accounting so long as the hedging relationship continues to meet the risk management objectives of the enterprise.
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What is a Cash flow hedge?

A cash flow hedge is a hedge of the exposure to variability in cash flows attributable to a particular risk associated with a recognised asset or liability or a component thereof. It covers future interest payments on variable-rate debt. It also covers a highly probable forecast transaction. The requirement is that such cash flows should affect the profit and loss account.
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