FX Hedging Publication

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A S S U R A N C E A N D A DVISORYB U S I N E S S S ERVICES

Foreign currency hedges and hedges of net investmentsin foreign operationsIn accordance with IAS 39 Financial Instruments: Recognition and Measurement

I N T E R NAT I O NA L F I N A N C I A LR E P O RT I N G S TANDARDS


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Table of ContentsINTRODUCTION....................................................................................................................... 1

FAIR VALUE HEDGE............................................................................................................... 2

CAS H FLOW HEDGE .............................................................................................................. 3

ACCOUNTING TREATMENT FOR QUALIFYING HEDGES........................................... 3

HEDGE OF NET INVESTMENT IN FOREIGN OPERATION........................................... 3

HEDGE EFFECTIVENESS....................................................................................................... 4

TREATMENT WHEN HEDGE ACCOUNTING IS DISCONTINUED............................... 4

FOREIGN CURRENCY HEDGES........................................................................................... 5

EXAMPLES OF FOREIGN CURRENCY CASH FLOW HEDGES .................................... 5

EXAMPLE 1: A NTICIPATED SALES HEDGED WITH A FORWARD CONTRACT .................................................5 EXAMPLE 2: A NTICIPATED INTERCOMPANY SALES HEDGED WITH A FORWARD CONTRACT .......................8 EXAMPLE 3: A NTICIPATED SALES HEDGED WITH AN OPTION CONTRACT ...................................................9

EXAMPLES OF FOREIGN CURRENCY FAIR VALUE HEDGES.................................. 13

EXAMPLE 4: FIRM COMMITMENT HEDGED USING A FORWARD CONTRACT ...............................................13 EXAMPLE 5: HEDGE OF CHANGES IN FAIR VALUE OF AVAILABLE -FOR -SALE EQUITY INVESTMENTSATTRIBUTABLE TO FOREIGN CURRENCY RISK USING A FORWARD CONTRACT ..........................................17

EXAMPLES OF HEDGES OF FOREIGN-CURRENCY-DENOMINATED ASSETS ORLIABILITIES ............................................................................................................................ 22

EXAMPLE 6: FAIR VALUE HEDGE OF A FIXED RATE , FOREIGN CURRENCY -DENOMINATED LOANCONVERTED INTO A VARIABLE RATE , FUNCTIONAL CURRENCY LOAN USING A CROSS CURRENCY INTERESTRATE SWAP ..............................................................................................................................................22 EXAMPLE 7: CASH FLOW HEDGE OF A FIXED -RATE , FOREIGN CURRENCY DENOMINATED LOANCONVERTED INTO A FIXED RATE , FUNCTIONAL CURRENCY LOAN USING A CROSS CURRENCY SWAP ........26 EXAMPLE 8: CASH FLOW HEDGE OF A FIXED -RATE , FOREIGN -CURRENCY -DENOMINATED ZERO -COUPON

NOTE CONVERTED INTO A FIXED -RATE , FUNCTIONAL CURRENCY NOTE USING A FORWARD CONTRACT ...33

EXAMPLES OF HEDGES OF NET INVESTMENTS IN FOREIGN OPERATIONS..... 37

EXAMPLE 9: ACCOUNTING FOR A NET INVESTMENT ( NO HEDGE ACCOUNTING ) .......................................37 EXAMPLE 10: ACCOUNTING FOR A NET INVESTMENT (WITH HEDGE ACCOUNTING AND NOINEFFECTIVENESS )...................................................................................................................................41 EXAMPLE 11: ACCOUNTING FOR A NET INVESTMENT (WITH HEDGE ACCOUNTING WITHINEFFECTIVENESS PRESENT ) ......................................................... ........................................................... 43


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IntroductionThis publication is designed to provide an overview of the accounting requirements for hedge accounting,such as those contained in IAS 39, speciality guidelines and the forthcoming proposed amendments toIAS 39, but does not explain or refer to all of the complex rules relating to hedge accounting. Thisdocument is not intended to constitute advice in any particular circumstances and information containedin this document may be incorrect, incomplete or out of date. EYGM Limited gives you no warranty orassurance about the document and neither we nor any of our affiliates, nor any partner, officer, agent,employee or sub-contractor of EYGM Limited or any of our affiliates, will be liable to you or anyone elsefor any losses or damages arising in connection with it. As a result, you should not rely on this documentin any way and you use it at your own risk. You should consult your usual Ernst & Young contact beforeconcluding on the accounting treatment of specific transactions.

February 2005


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The International Accounting Standards Board (IASB) issued in December 2003 (as amended 2004)

the revised IAS 39 Financial Instruments: Recognition and Measurement (IAS 39) . This replaces theversion of the standard previously applied by entities currently reporting under International FinancialReporting Standards (IFRS) and will also be applicable for those entities adopting IFRS for 2005.

IAS 39 provides comprehensive guidance on the recognition and measurement of derivatives andhedging activities. Under IAS 39, all derivatives must be recognised and measured at fair value on the

balance sheet. However, where the derivative is hedging an asset or liability or highly probabletransaction, the balance sheet measurement of the derivative may not correspond with the basis on whichthe hedged item is recognised and measured in the balance sheet. In such cases, if all recognised gainsand losses on the (re-) measurement of the hedge instrument were to be recorded in profit and loss, thereported results for the period would therefore not reflect the economic reality of the hedge.

Hedge accounting attempts to match the timing of profit or loss recognition on the derivative with that ofthe item being hedged if specific hedge accounting criteria are met.

Key steps to achieving hedge accounting:

1. Identify the nature of the risk being hedged

2. Identify the hedged item or transaction

3. Identify the type of hedge fair value or cash flow

4. Identify the hedging instrument

5. Document the hedging relationship above, including the risk managementobjectives, strategy for undertaking the hedge and method to be used to test

effectiveness6. Demonstrate that the hedge has and will continue to be highly effective

7. Monitor effectiveness throughout the life of the hedge

Hedged items may include a recognised asset or liability, an unrecognised firm commitment, anuncommitted but highly probable forecast transaction, or a net investment in a foreign operation. Thehedged item may be a single asset, liability, commitment or transaction, or a group of such items as longas risk characteristics within the group are homogeneous. A portfolio of assets and liabilities is not (ingeneral) permitted to be a hedged item.

Any derivative that involves an external party can be designated as a hedge instrument, except for written

options (unless designated to offset a purchased option). A non-derivative financial asset or liability canonly be designated as a hedge of foreign currency risk.

Fair value hedgeA fair value hedge is defined as the hedge of the exposure to changes in the fair value of: A recognised asset or liability; or A (previously unrecognised firm) commitment to buy or sell an asset at a fixed price; or An identified portion of such an asset or liability, or firm commitment;that is attributable to a particular risk and could affect reported profit or loss.


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I A S 3 9 : F I N A N C I A L I N S T R U M E N T S : R E C O G N I T I O N A N D M E A S U R E M E N T

3 F O R E I G N C U R R E N C Y H E D G E S

The gain or loss on the hedge instrument is recognised in profit or loss in the period it arises. The

carrying amount of the hedged item is adjusted for the gain or loss attributable to the hedged risk and thechange in the fair value of the hedged item attributable to the hedged risk is recognised immediately in

profit or loss. To the extent that a hedge relationship is perfectly effective, these two amounts recognisedin profit or loss should, theoretically, offset each other.

Cash flow hedgeA cash flow hedge is defined as the hedge of the exposure to variability in cash flows attributable to a

particular risk associated with a recognised asset or liability, firm commitment, or a highly probableforecast transaction, which could affect profit or loss.

The effective portion of the gain or loss on the hedge instrument is recognised in equity. Any ineffective portion is recognised immediately in profit or loss. The gain or loss deferred in equity is recognised in profit or loss when the hedged cash flows or related non-financial asset or liability affects profit or loss.

Accounting treatment for qualifying hedges

Fair value hedges Cash flow hedges

1. Gain or loss on hedginginstrument

Recognised immediately in p&l

To the extent the hedge iseffective, in equity

2. Adjustment to hedged item Change in fair value due tothe hedged risk recognisedimmediately in p&l

N/A

3. Hedged effectiveness is recordedin p&l

By default Calculated

4. Gain or loss in equity istransferred to p&l

N/A At the same time as the change inthe hedged cash flows or relatednon-financial asset or liability isrecognised in p&l

Hedge of net investment in foreign operation

Hedge accounting for the hedge of a net investment in a foreign operation is accounted for in a similarmanner to a cash flow hedge. Fundamentally, IAS 39 embraces the traditional process of matchingforeign currency gains or losses on a derivative or liability against the revaluation of a foreign operation,

based on period end exchange rates. The gain or loss on the hedging instrument is recorded in equity tooffset the translation gains and losses on the net investment, to the extent that the hedge is highlyeffective. The ineffective portion of the hedge relationship is recognised in profit or loss.


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Hedge effectivenessIAS 39 requires that hedge effectiveness be maintained in order to qualify for hedge accounting. It must

be demonstrated that the hedge relationship is highly effective: prospectively, at inception and throughout its life, the changes in the fair value and cash flows of the

hedge instrument must be expected to be highly effective in offsetting the changes in the fair value orcash flows of the hedged item; and

retrospectively, measured at each reporting period, the hedge must have been highly effective, so thatthe actual level of offset must have been within a range of 80-125%.

Hedge accounting must be discontinued, prospectively, when:

the hedge instrument expires, is sold or terminated or exercised; or the hedge no longer meets the effectiveness criteria; or the forecast transaction that is a subject to a cash flow hedge is no longer highly probable; or the entity revokes the designation.

Treatment when hedge accounting is discontinued

Treatment of Fair value hedges Cash flow hedges

1. Future changes in fair valueof hedging instrument

Continue to be taken to p&l Recognised immediately in p&l

2. Changes in fair value ofhedged item

Treat as if not hedgedFor hedges of interest-bearingassets, adjustment to date isamortised to p&l over the periodto maturity

N/A

Amounts recorded to date inequity:

a) hedged item still exists orstill expected to occur

b) hedged item or transactionsold or no longer expected tooccur

N/A

N/A

Transferred to p&l at the sametime as the change in the hedgedcash flows is recognised in p&l

Transferred to p&l immediately


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Foreign currency hedgesForeign currency hedges (fair value, cash flow and net investment), generally, need to meet the followingcriteria to qualify for hedge accounting: the hedged item must be denominated in a currency other than the entitys functional currency; or the hedge relationship is a hedge of a net investment in a foreign operation, as defined in IAS 21.

Examples of such transactions include: fair value hedge: a forward foreign exchange contract used to hedge the foreign currency exposure on

an available-for-sale equity instrument; cash flow hedge: a forward foreign exchange contract used to hedge the currency exposure of an

operating lease denominated in another currency; cash flow hedge: a forward foreign exchange contract entered into to hedge a highly probable forecast

sales transaction in a foreign currency.

The accounting for qualifying hedges of items denominated in a foreign currency follows the sameaccounting rules as other fair value and cash flow hedges. For hedges of foreign currency exposure offirm commitments IAS 39 allows companies to choose to apply either fair value or cash flow hedgeaccounting.

The following examples illustrate the possible accounting treatment of certain foreign currencytransactions. The presented treatment is not in all cases the only possible treatment.

Examples of foreign currency cash flow hedgesExample 1: Anticipated sales hedged with a forward contract

Example 2: Anticipated intercompany sales hedged with a forward contract

Example 3 : Anticipated sales hedged with an option contract

Example 1: Anticipated sales hedged with a forward contractABC SA and its subsidiary, DEF SA, both use the Euro as their functional currency. ABC wants to limitthe effect of currency fluctuations in its group accounts in the next quarter, by hedging forecasted yen-denominated sales by DEF. ABC expects DEF to sell 13,500,000 of goods on 30 June 20X1. Therefore,on 1 January 20X1, it enters into a six-month forward contract to sell 13,500,000 and receive 96,429on 30 June 20X1 (at a forward rate of 1: 140). Since ABC and DEF both have the same functionalcurrency, ABC is permitted to hedge the subsidiarys exposure, as IAS 39 IG F.2.14 does not require theoperating unit that is exposed to the risk being hedged, to be a party to the hedging instrument.


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The following table summarises the key data:

Date Spot rate at indicateddate

Forward rate for6/30/20X1

Forward contract fair value()

1/1/20X1 1: 135 1: 140

31/3/20X1 1: 140 1: 142 1,338 1

30/6/20X1 1: 144 1: 144 2,679 2

ABC documents the hedging relationship as follows:

Risk managementobjective and natureof risk being hedged

The objective of the transaction is to hedge highly probable anticipated yen salesagainst currency fluctuations.

Date of designation 1 January 20X1.

Hedging instrument A six-month forward contract to sell 13,500,000 and receive 96,429 on 30 June20X1.

Hedged item The forward contract is designated as a hedge of the highly probable anticipatedsales of 13,500,000 on 30 June 20X1.

How hedgeeffectiveness will beassessed

Because the critical terms of the forward contract and the forecast transactioncoincide (i.e., the currency, notional amount, and timing), changes in cash flowattributable to the risk being hedged are expected to be completely offset by the

hedging derivative. (Unless over- or under-hedging results because thetransaction does not occur in the amounts or at the times anticipated, or there is achange in the derivative counterpartys credit rating, there should be no hedgeineffectiveness). Counterparty credit risk will be continuously monitored.

How hedgeeffectiveness will bemeasured

Effectiveness will be measured by comparing the changes in the present value ofthe cash flow arising from the hedged forecast sale at the forward rate, with thechanges in the fair value of the forward contract.

1 ((13,500,000/140) - ( 13,500,000/142))/(1.015), with 1.5% representing ABCs assumed discountrate for one quarter (6% annualized).

2 (13,500,000/140) - (13,500,000/144).


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ABC would record the following journal entries:

On 1 January 20X1, no entry is required because the fair value of the forward contract is zero atinception.

DR CR

For the quarter ended 31 March 20X1:

Forward contract 1,338

Separate component of equity 1,338

To account for the change in the fair value of the forward contract.

For the quarter ended 30 June, 20X1:




Cash 2,679


To account for cash received on settlement of forward contract.

Accounts receivable 93,750

Sales 93,750

To record the sales transaction at the prevailing spot exchange rate onthe date of sale 3.


Sales 2,679

To reclassify the amount relating to the hedged item that affected

earnings from separate component of equity.

3 (13,500,000/ 144 per )


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Effect of thehedge on theincomestatement

The above hedge had the effect of locking in ABCs sales revenue on a 13,500,000sale at 96,429 (13,500,000/140 per Euro - the forward rate at the date of hedgedesignation), despite subsequent changes in the exchange rate. The hedged result isachieved by the combination of the actual revenue at the spot rates (93,750) and thegain on the forward contract (2,679), reclassified from the separate component ofequity at the date of the sale.

Example 2: Anticipated intercompany sales hedged with a forward contract Now assume a change in facts from Example 1, in that ABC operates through a Japanese subsidiary, GHICo. that has the Yen as its functional currency. The parent uses the Euro as its functional currency andwants to limit the effect of currency fluctuations on inventory sales to its Japanese subsidiary. ABCexpects to ship 13,500,000 of goods to the subsidiary on 30 June 20X1. The Japanese subsidiary expectsto sell 50% of the inventory received during the quarter ending 30 September 20X1, and the remainderduring the fourth quarter. On 1 January 20X1, ABC enters into a six-month forward contract to sell13,500,000 and receive 96,429 on 30 June 20X1 (forward rate 1: 140). The sale to the subsidiaryoccurs on 30 June 20X1.

In this case ABC is not allowed to apply hedge accounting for the forward contract in its consolidatedaccounts, as IAS 39 does not permit forecast intercompany transactions to be treated as the hedged item.Consequently the forward should be recorded at fair value with changes in profit or loss.

ABC would record the following journal entries:

On 1 January 20X1, no entry is required because the fair value of the forward contract is zero atinception.

DR CR

For the quarter ended 31 March 20X1:


Profit or loss 1,338


For the quarter ended 30 June 20X1:


Profit or loss 1,341



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DR CR

Cash 2,679


To account for cash received on settlement of forward contract.

Intercompany receivable 93,750

Intercompany sales 93,750

Cost of sales 4 93,750

Inventory 93,750

To record the intercompany transaction at the prevailing exchange rate on thedate of sale 5.

However, the Exposure Draft (ED) Cash Flow Hedge Accounting of Forecast IntragroupTtransactions will, if it is adopted, allow the consequent Yen sales by DEF to be treated as the subject ofa cash flow hedge, if highly probable. To be highly effective, the hedge would need to be extended so asto reflect the expected timing of DEFs sales. The hedge documentation will also need to be revised toreflect this new hedge designation. It should be noted that, unless the IASB introduces appropriatetransitional rule, that allow a retrospective change in the hedge designation, companies already reportingunder IAS 39 will not be able to apply hedge accounting of such transactions for periods prior to the newhedge being established.

Example 3: Anticipated sales hedged with an option contractXYZ SA anticipates a sale to a Canadian customer of CAD1,400,000 in six months. On 1 January 20X1,when the spot rate was 1 to CAD1.40, XYZ purchased an option to sell CAD1,400,000 on 30 June20X1, for 979,021 (1 : CAD1.43). The cost and the fair value of the option at inception was 32,000.The functional currency of XYZ is the Euro.

This option will be effective if the Euro strengthens to a rate of 1: CAD1.43 or greater and will beineffective if the Euro does not strengthen to that level. XYZ has defined its foreign exchange risk as

being in just one direction, and wants to preserve the upside foreign currency potential if the Euroweakens.

4 For this example it is assumed that the intercompany sales price equals inventory cost, so sales for ABCare equal to its cost of sales and there is no profit to be eliminated on consolidation. ABCs sales and cost

of sales figures will be offset on consolidation and ABCs intercompany receivable netted against GHIs payable balance.

5 (13,500,000/ 144 per ).


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IAS 39.74(a) allows either the full value of the option to be treated as the hedging instrument (in which

case there may be ineffectiveness due to changes in the options time value) or else only the intrinsicvalue to be designated, in which case changes in time value are recorded directly in profit or loss. XYZdecides to assess and measure the effectiveness of the hedge based on the changes in the intrinsic value ofthe option, as measured by the spot foreign exchange rate.

The anticipated sale takes place on 30 June 20X1, but in the amount of CAD1,300,000, CAD100,000 lessthan expected.

The following tables summarise the key data:

Date Spot rate CAD per Fair value () 6

1/1/20X1 1.40 32,000

31/3/20X1 1.45 30,000

30/6/20X1 1.50 45,688

Date Intrinsic value of option () 7 Time value of option () 6 Fair value of option ()

1/1/20X1 32,000 32,000

31/3/20X1 13,504 8 16,496 30,000

30/6/20X1 45,688 9 45,688

6 Derived from an option pricing model; amounts presented here are for purposes of illustration.

7 Strictly, the intrinsic value will be based on the spot rate only for what is termed an American option,that can be exercised at any time. In contrast a European option, which can only be exercised atmaturity, will be valued using forward rates and the intrinsic value should then be discounted to the

present value. However, IAS 39 permits the hedge relationship to be based on the spot rate, so thetreatment shown in this example would be valid for a European option, as long as it is understood that theintrinsic value is based on the spot rate rather than being the options true intrinsic value.

8 (CAD1,400,000/ 1.43) - (CAD1,400,000/ 1.45).

9 (CAD1,400,000/ 1.43) - (CAD1,400,000/ 1.50).


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XYZs hedge documentation is as follows:


The objective of the hedge transaction is to hedge cash flows related to thedownside foreign exchange risk associated with a highly probable saledenominated in CAD.

Date of designation 1 January 20X1

Hedging instrument Option to sell CAD1,400,000 on 30 June 20X1 for 979,021 (1 : CAD1.43).

Hedged item The option is designated as a hedge of a highly probable sales transaction ofCAD1,400,000, forecast to occur on 30 June 20X1.


Because the critical terms of the option contract and the anticipated transactioncoincide (i.e., currency, notional amount, and timing), the intrinsic value of theoption is considered to offset completely any changes in the expected cash flowsassociated with the anticipated transaction. Changes in the time value of theoption are excluded from the assessment of effectiveness, as permitted by IAS39.74 (a). Therefore, the only potential remaining source of ineffectiveness of thehedge relates to any decline in the credit rating of the counterparty to the option,or the possibility that the forecast transaction will not occur in the amounts or atthe times anticipated, both of which will be monitored.


Effectiveness will be measured by comparing the change in the intrinsic value ofthe option with the change in the value of the forecast CAD sales, measured at the

spot rate during the hedge period. If ineffectiveness occurs due to a decline in

the counterpartys credit rating, or a change in the amounts or timing of theforecast transaction, it will be measured by the change in fair value.

Changes in time value of the option will be reflected directly in earnings.

XYZ would record the following journal entries:

DR CR

On 1 January 20X1:

Purchased option 32,000

Cash 32,000

To record the cost incurred to purchase the option contract.


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DR CRFor the quarter ended 31 March 20X1:

Loss on hedging activities 15,504 10



To account for the change in fair value of the option contract, the change inits time value and the change in its intrinsic value that is effective as a hedgeof the anticipated sales transaction (assuming that the CAD1,400,000 of salesis still highly probable).

For the quarter ended 30 June 20X1:


Loss on hedging activities 16,496 11

Separate component on equity 32,184 12

To account for the change in fair value of the option contract, the change inits time value and the change in its intrinsic value that is effective as a hedgeof the anticipated sales transaction.

Cash 45,688


To record the cash received upon exercise of the option.

Accounts receivable 866,667

Sales 866,667

To account for the sales transaction, which is CAD100,000 less thanoriginally forecasted, at the prevailing spot exchange rate(CAD1,300,000/1.5).


Sales 42,425

To reflect the effective component of the hedge as the hedged transactionaffects earnings. 13

10 32,000 (30,000 - 13,504)

11 0 (30,000 - 13,504)

12 45,688 - 13,504

13 (CAD1,300,000 / CAD1,400,000) x 45,688).


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DR CRAssuming that the CAD100,000 sales shortfall was not apparent any soonerthan 30 June 20X1, the following entry would also be required to reflect theamount of the over-hedge in the income statement:


Gain on option contract 3,263

To reflect the ineffective portion of the intrinsic value of the option contractdue to overhedging, at the date that the occurrence of the remainingCAD100,000 of sales was no longer considered probable.


The total amount of recorded sales will be 909,092 (866,667 + 42,425) orCAD1,300,000 / 1.43. XYZ was thus effective in hedging the anticipated salestransaction at an exchange rate of CAD1.43 to the Euro. However, XYZ expensed

32,000 in option premium over the life of the hedge to achieve this objective, partially offset by a 3,263 gain from the derivative which overhedged sales thatnever materialised. 14 Once the receivable has been recognised, it would be separatelyeligible for hedge accounting.

Examples of foreign currency fair value hedgesExample 4: Firm commitment hedged using a forward contract

Example 5: Hedge of changes in fair value of available-for-sale equity investments attributable to foreigncurrency risk using a forward contract

Example 4: Firm commitment hedged using a forward contractOn 1 January 20X1, XYZ SA enters into an agreement to purchase 1,000 watches for 5,000 Swiss Francs(SF) per watch, to be delivered on 31 March 20X1. The contract meets the requirements of a firmcommitment. The resulting payable is expected to be settled on 30 April 20X1. On 1 February 20X1,XYZ decides to hedge the foreign currency exposure enters into a forward contract to exchange

3,500,000 for SF5,000,000 on 30 April 20X1 (at a forward rate of SF1.429 : 1). This forward contractis designated as a hedge of the firm commitment to purchase the watches on 31 March 20X1 and to settlethe balance owing on 30 April 20X1. Effectiveness will be assessed based on the forward rate.

14 Overhedging in this example was caused by an inaccurate projection of the number of units sold.However, each unit that was sold was perfectly hedged by a pro-rata portion of the derivative.


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IAS 39 permits a foreign currency hedge of a committed transaction to be treated either as a cash flow

hedge or a fair value hedge. The former treatment is likely to be less popular since it will result involatility in recorded equity. The following table summarises the key data:

Date Spot rateSF per

Forward rate ofcontract expiring

4/30/20X1 SF per

Fair value offorward contract

(discounted at 6%) ()

Change in fair value offorward contract

()

1/1/20X1 1.450

1/2/20X1 1.400 1.429

28/2/20X1 1.400 1.415 33,233 33,233

31/3/20X1 1.410 1.400 71,071 37,838

30/4/20X1 1.360 1.360 176,471 105,400

XYZs documentation of the hedging relationship is as follows:


The objective of the transaction is to hedge the change in the fair value of thefirm commitment caused by foreign exchange fluctuations. The hedged risk isthe change in the SF forward rate against the Euro.

Date of designation 1 February 20X1

Hedging instrument Forward contract to buy SF5,000,000 at forward rate of SF1.429 for each Euroon 30 April 20X1.

Hedged item The forward contract is designated as a hedge of the firm commitment to purchase 1,000 watches at SF5,000 per watch on 31 March 20X1 and thesubsequent foreign currency exposure of the accounts payable in SF on 30April 20X1. The hedge is accounted for as a fair value hedge, as allowed byIAS 39.87.


Because the critical terms (i.e., currency, notional amount, and timing) of theforward contract and the firm commitment coincide, the hedge is considered tocompletely offset changes in the fair value of the firm commitment attributableto changes in forward SF exchange rates. Counterparty credit risk will becontinuously monitored.


Hedge effectiveness will be measured based on overall changes in the value ofthe firm commitment, measured at the forward rate, compared to changes in thefair value of the forward contract. Any changes in the fair value of the firmcommitment after the inception of the hedge will be reflected on the balancesheet and through the profit or loss; changes in the fair value of the forwardcontract will also be reflected in earnings.


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The following journal entries would be recorded by XYZ:

On 1 January 20X1, no entry is required because the firm commitment is not yet hedgedonly changesin the fair value of firm commitments that are part of a fair value hedging relationship are recorded in thefinancial statements.

On 1 February 20X1, no entry is required. The fair value of the firm commitment should only berecorded when there is a change in fair value subsequent to the hedge designation date. Any changes inthe fair value of the firm commitment before designation date are not recorded. Further, the forwardcontract has no value at its inception.

DR CR

For the month ended 28 February 20X1:


Gain on forward contract 33,233

To record change in fair value of forward contract.

Loss on firm commitment 33,233

Fair value of firm commitment 33,233

To record change in fair value of firm commitment. (Note: Only thechange in the fair value of the firm commitment since the hedgeinception (1 February 20X1) is recorded.)

For the month ended 31 March 20X1:

Forward contract: 37,838


To record change in fair value of forward contract.

Loss on firm commitment 37,838


To record change in fair value of firm commitment.


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DR CR Inventory 3,546,099

Accounts payable 3,546,099

To record purchase of inventory at the prevailing exchange rate at31 March 20X1. 15


Inventory 71,071

To adjust inventory value to reflect the hedge of the firm commitment.

For the month ended 30 April 20X1:



To record the change in fair value of forward contract, continuing to reflect itat fair value even after the hedging relationship has ended.

Loss on retranslation of accounts payable 130,372

Accounts payable 130,372To remeasure the carrying amount of accounts payable at the prevailingspot rate. 16

Accounts payable 3,676,471

Cash 3,676,471

To record payment of accounts payable. 17

Cash 176,471


To record net settlement of forward contract.

15 SF5,000,000/ 1.41

16 (SF5,000,000/1.36) - 3,546,099

17 SF5,000,000/1.36


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Effectivenessof the hedge

The ultimate settlement of the accounts payable after delivery of the watches wasdesignated as the hedged item, for the period the accounts payable was outstanding,from 31 March to 30 April 20X1. The loss on the revaluation of the payable of

130,372 is offset by the gain from the forward contract of 105,400 during the monthof April. The inventory is carried at 3,475,028, 24,972 less than the final net cashoutflow of 3,500,000. XYZ experienced a net loss of 24,972 during April caused bythe convergence between the forward rate (upon which the derivatives fair value is

based) and the spot rate (upon which the accounts payable remeasurement is based).

Example 5: Hedge of changes in fair value of available-for-sale equity investments

attributable to foreign currency risk using a forward contractJKL GbH acquires 100,000 shares of Yorkshire Jewellers plc for 1.00 per share on 1 January 20X1, andclassifies the investment as an available-for-sale financial asset. Yorkshire Jewellers is listed on theLondon Stock Exchange only and all transactions in the company are denominated in GBP. Thefunctional currency of JKL is the Euro. JKL decides to hedge the risk of currency fluctuations on thisavailable-for-sale asset over the next six months and enters into a forward contract to sell 100,000 on30 June 20X1, at an exchange rate of 0.62 per Euro (1.613 : 1). IAS 39.74 allows either changes inthe full fair value of the forward contract to be reflected in the hedge (in which case there should beineffectiveness) or only the effect of any changes in the spot price, in which case there should be noineffectiveness, but the difference between the spot and forward rate will be reflected in the profit or lossover the life of the hedge.

The following table summarises the key data:

Date Share price () Spot rate per Forward rate of contract expiring 6/30/20X1 per

1/1/20X1 1.00 0.60 0.62

31/3/20X1 1.50 0.65 0.66

30/6/20X1 2.00 0.70 0.70


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XYZs hedge documentation is as follows:


The objective of the hedge transaction is to hedge the available-for-sale equitysecurity against exchange rate fluctuations for a period of six months. Byisolating and hedging the foreign currency risk, JKL seeks to accept only theequity price risk of its holding in Yorkshire Jewellers.


Hedging instrument A forward contract to sell 100,000 on 30 June 20X1, at an exchange rate of0.62 per Euro.

Hedged item The forward contract is designated as a hedge of the changes in fair value of theavailable-for-sale equity investment in Yorkshire Jewellers attributable to foreign

currency exchange risk.How hedgeeffectiveness will beassessed

Hedge effectiveness will be assessed based on overall changes in the spot rate,included in the changes in the fair value of the available-for-sale security,compared to the original cost of 100,000 (or fair value if lower). Changes in thedifference between the forward rate and the spot rate are excluded from theassessment of hedge effectiveness and will be recorded directly in earnings. Noother ineffectiveness is anticipated because the notional amount of the forwardcontract coincides with the initial investment in the shares. Any variability in thefair value of the shares below 100,000 will affect the assessment of hedgeeffectiveness. If such a decline occurs, the hedge ratio will be adjusted.Counterparty credit risk will be continuously monitored.


The forward contract will be carried at fair value with changes reflected directlyin the income statement. In addition, the portion of the change in fair value of thehedged available-for-sale investment attributable to changes in the hedged foreignexchange rate will be reflected directly in earnings. Over the life of the hedge, aloss of 5,377 will be reflected in earnings based on the spot/forward differenceat inception ((100,000/0.60)-(100,000/0.62)).


22/52



Date Total value ofshares 18

Value ofshares

remeasuredto Euros 19

Gain onavailable-for-salesecurity

()

Cumulativechanges in

forward rate()

Forwardcontract fair

value(discountedat 6%) ()

Changein spot

Changein fwd

1/1/20X1 100,000 166,667

31/3/20X1 150,000 230,769 64,102 9,775 20 9,631 12,821 (3,190)

30/6/20X1 200,000 285,714 54,945 18,433 21 18,433 10,989 7,444

DR CR

On 1 January 20X1, JKL would record the following journal entry:

Investment in available-for-sale financial asset 166,667

Cash 166,667

Initial investment to acquire Yorkshire Jewellers.

Before recording any journal entries for the quarter ended 31 March 20X1, JKL would have to performan analysis to determine what portion of any increase (or decrease) in the fair value of the YorkshireJewellers investment related to changes in the equity price and what portion related to changes inexchange rates. Therefore, JKL would prepare the following analysis:

Gain as a result of changes in the equity price

(150,000 - 100,000)/ 0.65)

76,923

Loss as a result of changes in foreign exchange rates

((100,000/ 0.65) - (100,000/ 0.60), measured at spot rate

(12,821)

Total gain 64,102

18 Number of shares x share price.

19 Total value of shares /spot rate.

20 (100,000/ 0.62) - (100,000/ 0.66).

21 (100,000/ 0.62) - (100,000/ 0.70).


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20

As of 31 March 20X1, the fair value of the forward contract was 9,631. The difference between the

12,821 loss and 9,631 gain is the result of the change in the difference between the forward rate andthe spot rate and is excluded from the assessment of effectiveness. This excluded difference is accountedfor in earnings.

DR CR

The following journal entries would then be recorded by JKL at 31 March20X1:



To account for the change in the equity price of the available-for-sale

investment.

Exchange loss on investment 12,821


To account for the change in the fair value of the available-for-saleinvestment attributable to changes in the foreign exchange rate.




As at 30 June 20X1, JKL would perform a similar analysis:

Gain as a result of changes in the equity price

(200,000 - 150,000)/ 0.70)

71,429

Loss as a result of changes in foreign exchange rates as measured by spot rates on theoriginal 100,000 balance

((100,000/ 0.70) - (100,000/ 0.65))

(10,989)

Loss as a result of changes in foreign currency as measured by spot rates on theincremental 50,000 balance arising during the prior period

((50,000/ 0.70) - (50,000/ 0.65))

(5,495)

Total gain 54,945


24/52



In the quarter to 30 June 20X1, the fair value of the forward contract increases by 8,802 (18,433 - 9,631).

DR CR

The following journal entries would then be recorded by JKL at 30 June20X1:



To account for the change in the equity price of the available-for-sale asset.

Exchange loss on investment 10,989


To account for the change in the fair value of the investment in the available-for-sale financial asset attributable to changes in the foreign exchange rate onthat part of the investment designated as the hedged item (i.e., the exchangeloss on the original 100,000 investment).



To account for the remaining change in fair value of the available-for-salefinancial asset not considered part of the designated foreign currency hedge(i.e., the exchange loss on the incremental 50,000 equity appreciation that

occurred in the first quarter) in equity, since the investment is not a monetaryasset that would otherwise be retranslated through profit or loss.




Cash 18,433


To account for settlement of the forward contract.


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22

Effectivenessof the hedge

JKL, by isolating the unfavourable effects of the weakening of the British Poundagainst the Euro and hedging that loss, was able to reflect a greater percentage of theappreciation of the Yorkshire Jewellers equity investment in the separate component ofequity as part of the IAS 39 adjustment than if no hedge were in place. A cumulativegain of 142,857 is recorded rather than the 119,047 (285,714 - 166,667) if noforward contract had been taken out. A 5,377 loss was reflected in the incomestatement related to the forward points (i.e., the spot/forward differential at inception)of the forward contract.

Examples of hedges of foreign-currency-denominated assets or liabilitiesExample 6: Fair value hedge of a fixed rate, foreign currency denominated loan converted into variablerate, functional currency loan using a cross currency interest rate swap

Example 7: Fair value hedge of a fixed rate, foreign currency denominated zero coupon note convertedinto fixed rate, functional currency note using a cross currency interest rate swap

Example 8: Cash flow hedge of a fixed-rate, foreign currency denominated zero coupon note convertedinto fixed rate, functional currency note using a forward contract

Example 6: Fair value hedge of a fixed rate, foreign currency-denominated loan convertedinto a variable rate, functional currency loan using a cross currency interest rate swap

MNO Incs functional currency is the USD. On 31 December 20X0, MNO borrows 100 million Euros fora term of five years at an annual coupon of 5.68%.

Also on 31 December 20X0, MNO enters into a five-year cross-currency interest rate swap in which itwill receive fixed Euros at a rate of 5.68% on 100 million and pay floating USD LIBOR plus 0.536% on$102 million. There will be a final exchange of principal at maturity of the contract based on the initial$102:EUR100 spot relationship between the USD and the Euro (at maturity MNO will receive 100million and pay $102 million). Both the debt and the swap will pay annual coupons on 31 December. Thecompany designates the cross currency interest rate swap as a fair value hedge of the changes in the fairvalue of the loan due to both interest and foreign exchange rates.

The spot $/ foreign exchange rates, Euro LIBOR rates 22, /$ basis swap spreads and one year USD

LIBOR on 31 December, each year over the life of the hedge are presented in the following table.Although not required for the accounting treatment of the debt and derivative, these are the basis for thevaluations that are used in the accounting.

22 Assumes, for simplicity, that Euro LIBOR does not vary with tenor (ie,, that the forward yield curve isflat).


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31/12/X0 31/12/X1 31/12/X2 31/12/X3 31/12/X4 31/12/X5Spot $/ exchangerate

1.0200 1.0723 1.0723 1.1273 1.1851 1.2458

LIBOR rate 5.160% 5.151% 5.040% 4.854% 4.480% N/A

Basis swap spread (0.02)% (0.02)% (0.02)% (0.02)% (0.02)% N/A

One-year $ LIBOR 6.00% 5.50% 6.00% 6.50% 7.00% N/A

MNOs hedge documentation is as follows:

Risk managementobjective and nature ofrisk being hedged

The objective of the hedge transaction is to hedge the changes in the fair valueof the foreign currency denominated debt relating to changes in foreigncurrency exchange rates and the benchmark (Euro LIBOR) interest rate.

Date of designation 31 December 20X0

Hedging instrument A five-year cross currency interest rate swap in which the company willreceive fixed Euros at a rate of 5.68% on 100 million and pay floating USDat LIBOR plus 0.536% on $102 million, with an exchange of the respectivenotional amounts at maturity.

Hedged item The company designates the cross currency interest rate swap as a fair valuehedge of the changes in the fair value of the loan due to both interest rate risk

and foreign exchange risk.How hedgeeffectiveness will beassessed

The hedge relationship is expected to be highly effective because the notionalamount of the cross currency interest rate swap coincides with that of the debt,and all cash flows coincide between the debt and the swap. Meanwhile, EuroLIBOR is deemed to be a component of the Euro interest rate on the debt.Accordingly, no portion of the change in fair value of the cross-currencyinterest rate swap is expected to be ineffective. Counterparty credit risk will becontinuously monitored.

How hedgeeffectiveness will be

measured

In accordance with fair value hedge accounting methodology under IAS 39,the change in fair value of the debt attributable to changes in Euro interest

rates will be calculated and then this adjusted value will be remeasured at spotrates through earnings under IAS 21. The change in the fair value of the crosscurrency interest rate swap is also recorded in earnings.


27/52

24

The changes in fair value of the debt attributable to changes in both Euro interest rates and spot foreign

exchange rates, and the values and changes in value (in USD) of the cross currency interest rate swap areshown in the following table. To simplify the example, all yield curves are assumed to be flat,throughout.

(in millions) 31/12/X0 31/12/X1 31/12/X2 31/12/X3 31/12/X4 31/12/X5

A Spot exchange rate($/)

1.0200 1.0723 1.0723 1.1273 1.1851 1.2458

B. Adjusted value of debt( )23

(100.000) (100.032) (100.322) (100.567) (100.647) 0.0000

C. Carrying amount ofdebt at spot rate ($)(A*B)

(102.000) (107.265) (107.575) (113.366) (119.274)

D. Cumulative change invalue of debt ($102-C)

(5.265) (5.575) (11.366) (17.274)

E. Change in $ in carryingamount of debt during

period ($)

(5.265) (0.310) (5.791) (5.908) 17.274

F. Fair value of crosscurrency interest rateswap($)

0.000 5.333 5.642 11.472 17.357

G. Change in fair value ofswap during period ($)

5.333 0.310 5.830 5.885 (17.357)

23 Present value of debt based on fixed-rate payments (5.68%) plus principal, discounted at current Euro

LIBOR rate plus initial spread of 0.52%. For example, at 31 December 20X1, the fair value of debt of 100.032m = 5.68/(1+ 0.5151+.0052) + 5.68/(1 + 0.5151 + .0052) 2 + 5.68m/(1+0.5151+.0052) 3 +105.68m/ (1 + 0.5151+ .0052) 4.


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Changes in the carrying value of the debt and the swap are recognised immediately in earnings. Notice

that in the year 20X2, Rows (E) and (G) perfectly offset. This result occurred only because the spotexchange rate did not change from 20X1 to 20X2.

DR CR

The following journal entries would be made by MNO in the first year:

Interest expense 6,156,720 24

Cash (paid to debt holders) 6,090,664 25

Cash (net payment on swap) 66,056 26

To record initial expense

Cross-currency swap 5,333,333

Foreign currency retranslation gain 5,230,000 27

Swap revaluation gain 103,333 28

To record the change in fair value of the cross-currency swap.

Foreign currency retranslation loss 5,230,000 27

Debt instrument 5,265,000

Debt revaluation loss 35,000 28

To record the change in fair value of the debt instrument.

To adjust carrying value of debt: first, for the effect of fair value hedge of interest rate risk, and second,to reflect remeasurement of the newly adjusted debt carrying value at the new spot rate (Steps B and C inthe table above).

The journal entries for the other periods would be similar to the entries above.

Effect of the hedge onthe income statement

Interest expense, formerly fixed as applied to a foreign denominated principal,has been converted through the effect of the fair value hedge to a USD LIBOR

based floating interest expense.

24 ($102 x 6.036%)

25 100 x 5.68% x 1.073 (spot exchange rate).

26 ($102 x 6.536%) - (100 x 5.68% x 1.73) million.

27 (100 x 1.0723 - 100 x 1.02)

28 $5,265,000 - $5,230,000


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26

Example 7: Cash flow hedge of a fixed-rate, foreign currency denominated loan convertedinto a fixed rate, functional currency loan using a cross currency swapCompany ABCs functional currency is the USD. On 1 January 20X1, ABC borrows 100 million. Theloan has a term of five years and pays an annual coupon of 5.68%.

Also on 1 January 20X1, ABC enters into a five-year swap in which it will receive fixed Euros at a rateof 5.68% on 100 million and pay fixed USD at a rate of 6.536% on $102 million. There will be a finalexchange of principal on maturity of the contract based on the original $102:100 spot exchange rate.Both the debt and the swap pay annual coupons on December 31.

ABC designates the cross-currency swap as a cash flow hedge of its exposure to changes in its functionalcurrency equivalent cash flows on the debt. (It would have to be a cash flow hedge since the company is

seeking to eliminate its exposure to variability in the local currency (principal and of interest payments).In general, the conversion of fixed to fixed, or floating to fixed, are cash flow hedges, while fixed tofloating or floating to floating swaps are fair value hedges).

The spot foreign exchange rates for USD/EUR over the life of the hedge are as follows:

1/1/X1 31/12/X1 31/12/X2 31/12/X3 31/12/X4 31/12/X5

Spot $/ exchange rate 1.0200 1.0723 1.0723 1.1273 1.1851 1.2458

ABCs hedge documentation is as follows:


The objective of the transaction is to hedge the changes in the cash flows of theforeign currency denominated debt related to changes in foreign currencyexchange rates in order to fix the functional currency cash flows.


Hedging instrument A five-year cross currency swap in which the company will receive fixed Euros ata rate of 5.68% on 100 million and pay fixed USD at 6.536% on $102 million. Inaddition, the agreement requires an exchange of the notional amounts at maturity.

Hedged item The company designates the cross-currency swap as a cash flow hedge of thechanges in the cash flows of the loan resulting from foreign currency risk.

How hedgeeffectiveness will be

assessed

Because the notional amount of the cross-currency swap equals that of the debt,and all cash flow dates and interest rates coincide between the debt and the

swap, it is concluded that there should be no ineffectiveness in the hedge design.However, every period the company will assess counterparty credit risk, and thecontinued probability of the hedged cash flows as to amount and timing.


Ineffectiveness will be measured using the hypothetical derivative method.This method compares the change in fair value of the designated hedginginstrument to the change in fair value of a hypothetical derivative that has termsthat exactly match the critical terms of the hedged item. Because the notionalamount of the cross-currency swap equals that of the debt, and all cash flowdates and interest rates coincide between the debt and the swap, the actualhedging instrument being used in this case is the same as the hypothetical

swap with exactly matching terms.


30/52



The fair values (in USD) of the /$ cross currency swap (which equals the hypothetical /$ cross-

currency swap), the ineffectiveness of the hedge recognised in earnings, and the balance initially added tothe separate component of equity for each of the years ended 31 December are as follows:

(in $ millions) 1/1/X1 31/12/X1 31/12/X2 31/12/X3 31/12/X4 31/12/X5

Fair value of actual swap 29 3.544 5.642 12.401 18.310 22.580

Ineffectiveness 30

Change in period (to equity) 3.544 2.098 6.759 5.909 4.270

The change in the carrying amount of the foreign-currency-denominated debt due to changes in spotexchange rates each period is as follows:

(in $ millions) 1/1/X1 31/12/X1 31/12/X2 31/12/X3 31/12/X4 31/12/X5

Debt remeasured at spotexchange rates

(102.000) (107.230) (107.230) (112.727) (118.507) (124.580)

Cumulative change incarrying value of debt

(5.230) (5.230) (10.727) (16.507) (22.580)

Change in carrying valueof debt in period

(5.230) (5.497) (5.780) (6.073)

29 As noted above, the actual swap is identical to a hypothetical swap that would be used.

30 There is no ineffectiveness in this example as a result of the application of the hypotheticalderivative method. If there were differences in the fair values of the actual swap and the hypotheticalswap caused by differences in critical terms between the actual swap and a perfect hypothetical swap, theseparate component of equity would be adjusted to an amount equal to the lesser of the cumulative

change in the fair value of the actual swap or the cumulative change in fair value of the hypotheticalswap. Any additional amount necessary to record the actual swap at fair value would be reflected asineffectiveness in earnings.


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28

The change in the carrying value of the debt in each period is recognised immediately in earnings through

the remeasurement process in accordance with IAS 21, The Effects of Foreign Exchange rates (asamended March 2004) (IAS 21). IAS 39 provides that an offsetting portion of the separate componentof equity balance attributable to changes in the spot exchange rates is also immediately reclassified intoearnings.

The following table shows the adjustments to the separate component of equity (SCE) over the period:

(in $ millions) 31/12/X1 31/12/X2 31/12/X3 31/12/X4 31/12/X5

Change in fair value of actual swapinitially recorded in SCE

3.544 2.098 6.759 5.909 4.270

Reclassification to earnings to offset loss

on retranslation of debt

(5.230) (5.497) (5.780) (6.073)

Net change in SCE during period (1.686) 2.098 1.262 0.129 (1.803)

SCE balance at beginning of period (1.686) 0.412 1.674 1.803

SCE at end of period (1.686) 0.412 1.674 1.803

The change in the carrying value of the debt from remeasurement is recognised immediately in earnings,as is the reclassification from the separate component of equity. The income statement effect, includinginterest expense, is set out below for each year ended 31 December:

(in $ millions) 20X1 20X2 20X3 20X4 20X5

Interest expense 31 (6.667) (6.667) (6.667) (6.667) (6.667)

Loss on debt from retranslation (5.230) (5.497) (5.780) (6.073)

Hedge gain reclassified from SCE 5.230 5.497 5.780 6.073

31 Interest expense is calculated based on paying fixed 6.536% on USD 102 million from the cross-

currency swap. The interest paid at 5.68% on the EUR 100 million debt is completely offset (both in cashflow and IAS 21 remeasurement effects) by the 5.68% received on EUR 100 million under the cross-currency swap.


32/52



Notice that in 20X2, there were no revaluation gains or losses and no hedge gains or losses because the

spot exchange rate did not change from 20X1 to 20X2.

$DR $CR

Journal entries for the first year to 31 December 20X1:


Cash (paid to creditor) 6,090,664 33

Cash (paid to swap counterparty) 576,056 34

Retranslation loss 5,230,000

Foreign currency denominated debt 5,230,000To adjust carrying amount of foreign currency denominated debtdue to change in the spot rate.


Separate component of equity 1,686,000

Retranslation gain 5,230,000

To record fair value of cross-currency swap in the balance sheetwith entries to the separate component of equity and a

reclassification to income to offset retranslation of hedged debt.

Journal entries for the second year to 31 December 20X2:

Interest expense 6,666,720, 35



To record interest expense based on swap fixed rate.

No entry is made to retranslate the debt as the spot exchange rate has not changed since 31 December 20X1.

32 (USD 102 x 6.536%)

33 (EUR 100 x 5.68% x 1.0723)

34 ((USD 102 x 6.536%) (EUR 100 x 5.68% x 1.0723))

35(USD 100 x 6.536%)

36 (EUR 100 x 5.68% x 1.0723)


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30

$DR $CR



To record change in fair value of cross-currency swap in the balance sheetwith an entry to the separate component of equity.

Journal entries for the third year on 31 December 20X3:


Cash (paid to creditor) 6,403,06438


To record interest expense based on actual swap fixed rate.


Foreign currency denominated debt 5,497,000

To adjust carrying amount of foreign currency denominated debt due tochange in the spot rate.



Transaction gain 5,497,000

To record change in fair value of cross-currency swap in the balance sheetwith entries to the separate component of equity and a reclassification toincome to offset the revaluation of the hedged debt.

37 (USD 102 x 6.536%)

38 (EUR 100 x 5.68% x 1.1273)

39 ((USD 102 x 6.536%)(EUR 100 x 5.68% x 1.1273))


34/52



$DR $CR Journal entries for the fourth year to 31 December 20X4:


Cash (received from swap counterparty) 64,648 41





To adjust carrying amount of foreign currency denominated debt due tochange in the spot rate.




To record change in fair value of cross currency swap in the balance sheetwith entries to the separate component of equity and a reclassification to

income to offset the revaluation of the hedged debt.

Journal entries for the fifth year to 31 December 20X5:


Cash (received from swap counterparty) 409,424 44



40 (USD 102 x 6.536%)

41 ((USD 102 x 6.536%) - (EUR 100 x 5.68% x 1.1851))

42 (EUR 100 x 5.68% x 1.1851)

43 (USD 102 x 6.536%)

44 ((USD 102 x 6.536%) - (EUR 100 x 5.68% x 1.2458)),

45 (EUR 100 x 5.68% x 1.2458),


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32

$DR $CR



To adjust carrying amount of foreign currency-denominated debt due tochanges in the spot rate.




To record change in fair value of cross currency swap in the balancesheet with entries to the separate component of equity and areclassification to income to offset translation loss on hedged debt priorto termination of swap.

Cash (received from swap counterparty) 22,580,000


Cash (paid to creditor) 124,500,000


To record settlement of debt and cross-currency swap.


Since the hedge was considered completely effective as a result of using thehypothetical derivative method, there is no hedge ineffectiveness recognised inearnings. The transaction loss on remeasuring the debt is completely offset by thegains reclassified from the separate component of equity. The resulting incomestatement effect for each period is simply the interest expense fixed by the actual swap.There are no fluctuations in the income statement as a result of changes in foreign

currency rates.


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Example 8: Cash flow hedge of a fixed-rate, foreign-currency-denominated zero-coupon noteconverted into a fixed-rate, functional currency note using a forward contractOn 1 July 20X1, DEF, a Swiss Franc (SF) functional currency entity, issues a zero coupon debtinstrument denominated in Euros with a notional amount of 154,767 for 96,098, that will mature on30 June 20X6. The interest rate implicit in the debt is 10%46. On 1 July 20X1, 96,098 is equivalent toSF100,000, based on the spot exchange rate of 1.0406. On 1 July 20X1, DEF enters into a forwardcontract to buy 154,767 in five years at the forward exchange rate of 1.0901 (Swiss Franc costSF168,719) and designates the forward contract as a hedge of the variability of the SF functionalcurrency equivalent cash flows on the debt. The initial spot/forward difference, or forward points, totalSF68,719 over the five years and implies a SF interest rate of 11.028% annually for the five year

period 47. Because the currency, notional amount and maturity of the debt and the forward contract match,

DEF concludes that no ineffectiveness will result.

The market data, period end balances, and journal entries from cash flow hedge accounting are shown below:

Date Spot rateSF/ 48

Forwardrate SF/ 49

Change inforwardrates 50

Carryingamount ofdebt in 51

Carryingamount of

debtretranslatedat spot rate

(SF)

Debtaccreted at

implicitinterest rate

(SF)

Forwardcontact fair

value(SF) 52

30/6/X1 1.0406 1.0901 0.0000 96,098 100,000 100,000

30/6/X2 1.1000 1.1850 0.0949 105,708 116,278 111,028 11,199

30/6/X3 1.1000 1.1631 0.0730 116,279 127,906 123,272 9,217

30/6/X4 1.1000 1.1417 0.0516 127,906 140,697 136,867 6,969

30/6/X5 1.1000 1.1207 0.0306 140,697 154,767 151,960 4,419

30/6/X6 1.1100 1.1100 0.0199 154,767 171,791 168,719 3,072

** Numbers are rounded to simplify calculations

46 96,098 (1.10) 5 = 154,767

47 The fifth root of 168,719/100,000 is 1.11028.

48 As a simplistic assumption, the spot rate does not change during 20X2-20X5 to illustrate and highlightthe effect of the imputed interest rate charges.

49 The forward rate at 30 June 20X1, is calculable from the market five-year interest rates for each of thetwo currencies: 1.0901 = 1.0406[(1 + 0.11028) 5/(1 + 0.10) 5]

50 Current forward rate less initial forward rate (i.e., 20X3 is calculated as 1.1631-1.0901 = 0.073)

51 Carrying amount accretes at a 10% effective interest rate each year.

52 The fair value of the forward is calculated by comparing the current forward rate for 30 June 20X6 tothe contracted forward rate, and discounting the difference at a risk free rate, assumed to be 7% in all

periods.


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34

DEFs documentation of the hedge is as follows:


The objective of the hedge transaction is to hedge the risk of variability infunctional currency equivalent cash flows associated with the foreign currencydenominated loan due to changes in forward rates.

Date of designation 1 July 20X1

Hedging instrument Forward contract to buy 154,767 in five years at the forward rate of 1.0901 (SFcost SF168,719).

Hedged item The forward contract is designated as a hedge of the changes in the cash flowsrelating to the changes in foreign currency forward rates relating to the debt.


Since the critical terms of the derivative and the hedged debt are identical(timing and amount of all cash flows), the change in value of the derivativewill be considered to completely offset the changes in the hedged cash flow.Accordingly, there should be no ineffectiveness in the hedge design. However,every period the company will assess counterparty credit risk, and the continued

probability of the hedged cash flows as to amount and timing.


Over the life of the hedge, interest expense of SF68,719 (the amount of theforward points) will be reflected in interest expense based on the interest rateimplied in the forward contract; other changes in the fair value of the forwardcontract are attributable to spot fluctuations and are effective as a hedge of theultimate payable in . Hedge ineffectiveness is measured by use of the

hypothetical derivative method; however, the actual hedging instrument beingused in this case is the same as the hypothetical forward with exactly matchingterms that should be used. Accordingly, no ineffectiveness is anticipated.


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The following illustrates the accounting (debits/(credits)) for the transaction during its life :

30 June Cash(SF)

Forward (SF)

Debt(SF)

SCE(SF)

Interestexpense

(SF)

Translationloss (gain)

(SF)20X1 Issue debt 100,000 (100,000) 20X2 Accrue interest

on debt(10,286) 53 10,286

20X2 Revalue debt(includingaccruedinterest) to spotrate

(5,993) 5,993

20X2 Mark forwardto FV 11,199 (5,948) 742 (5,993)

100,000 11,199 (116,279) (5,948) 11,028 20X3 Accrue interest

on debt(11,628) 54 11,628

20X3 Mark forwardto FV

(1,982) 1,366 616


on debt(12,791) 54 12,791


(2,247) 1,443 804


on debt(14,070) 54 14,070


(2,550) 1,526 1,024


on debt(15,617) 54 15,617

20X6 Revalue to debtto spot

(1,407) 1,407


(1,347) 1,613 1,141 (1,407)

100,000 3,072 (171,791) 68,719

** Numbers rounded to simplify calculations.

53 ( 96,098 x 10% x 1.0703 SF/)

54 (Prior year balance x 10% interest x foreign currency rate of 1.1)


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36

SFDR SFCR Journal entries at the inception of the loan on 1 July 20X1:

Cash 100,000

Debt 100,000

To record Euro zero coupon note in SF.

No entry is required for the forward contract, which has a fair value ofzero.

Journal entries for the year to 30 June 20X2:

Interest expense 10,286

Debt 10,286

To accrue interest and translate at period end spot rate.

Retranslation loss 5,993

Debt 5,993

To record translation loss on the debt.



To record the derivative at fair value.


Interest expense 742

Retranslation loss 5,993

To reclassify an amount out of the separate component of equity (1) to increase interest expense to theEuro yield of 11.028% and (2) to offset the retranslation loss on the debt.

Comparable entries would be recorded for the remaining four years of the life of the debt based on theamounts indicated in the table, above.


Interest expense totalling SF68,719 is recognised on an effective interest basis overthe life of the five year hedge. The SF68,719 is equivalent to the original spot:forwarddifference at 1 July 20X1. The changes in the spot:forward difference attributablesolely to currency risk (after stripping out the effective interest portion) are recorded ina separate component of equity and reclassified to income to offset any incomestatement effects of remeasuring the zero coupon debt instrument at spot rates.


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Examples of hedges of net investments in foreign operationsThe following examples illustrate the accounting for net investment hedges:

Example 9: Accounting for a net investment (no hedge accounting)

Example 10: Accounting for a net investment (with hedge accounting and no ineffectiveness)

Example 11: Accounting for a net investment (with hedge accounting with ineffectiveness present)

Example 9: Accounting for a net investment (no hedge accounting)RST plc (with a GBP functional currency) has a German subsidiary, Ludwig Industries, that uses theEuro as its functional currency. RST acquired its 100% interest in Ludwig on 1 July 20X1, for2,000,000 when the exchange rate was 1.50 per . During the year RST charges Ludwig 1 million inservice charges, which are recorded by Ludwig at 1,750,000 (the average spot rate for the year) andwhich are still not paid by the year end. Below are the balance sheets of RST and Ludwig as of 1 July20X1, and 31 December 20X1.

1 July 20X1 (Date of Acquisition) 31 December 20X1*

Balance Sheets RST () Ludwig () RST () Ludwig ()

Assets 10,000,000 6,000,000 14,000,000 10,000,000

Investment in Ludwig 2,000,000 2,000,000

Intercompany AccountLudwig 1,000,000

12,000,000 6,000,000 17,000,000 10,000,000

Liabilities 8,000,000 3,000,000 8,000,000 3,500,000

Intercompany AccountRST 1,750,000

Equity 4,000,000 3,000,000 9,000,000 4,750,000

12,000,000 6,000,000 17,000,000 10,000,000

Net income for the six months ending 31 December20X1

5,000,000 1,750,000

* Prior to currency related closing journal entries and consolidation by RST.


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The applicable exchange rates are as follows:

per

Spot rate at 7/1/20X1 1.50

Twelve month forward rate at 7/1/20X1 1.54

Average spot rate from 7/1/20X1 to 12/31/20X1 1.75

Spot rate at 12/31/20X1 2.00

Six month forward rate at 12/31/20X1 2.02

Net Investment-Initial Acquisition

The spot rate at the date of the acquisition should be used initially to remeasure Ludwigs accounts to thefunctional currency of RST. The balance sheets below reflect the initial entries:

Balance sheets1 July 20X1

Ludwig () Spot rate Ludwig () RST () Consolidationadjustments ()

Consolidated balance sheet ()

Assets 6,000,000 1.50 4,000,000 10,000,000 14,000,000

Investment inLudwig

2,000,000 (2,000,000)

Total 6,000,000 4,000,000 12,000,000 (2,000,000) 14,000,000

Liabilities 3,000,000 1.50 2,000,000 8,000,000 10,000,000

Equity 3,000,000 1.50 2,000,000 4,000,000 (2,000,000) 4,000,000

Total 6,000,000 4,000,000 12,000,000 (2,000,000) 14,000,000


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Net InvestmentTranslation as of 31 December 20X1

If RST decided not to hedge any of the foreign currency exposures, the consolidated balance sheet as of31 December 20X1 would be as follows:

Balance sheets31 December 20X1

Ludwig * () SpotRate

Ludwig()

RST () Consolidationadjustments ()

Consolidated balance sheet ()

Assets 10,000,000 2.00 5,000,000 14,000,000 19,000,000

Investment inLudwig

2,000,000 (2,000,000)

IntercompanyaccountLudwig

1,000,000 (1,000,000)

Total 10,000,000 5,000,000 17,000,000 (3,000,000) 19,000,000

Liabilities 3,500,000 2.00 1,750,000 8,000,000 9,750,000

Intercompanyaccount

2,000,000 2.00 1,000,000 (1,000,000)

Equity 3,000,000 1.50 2,000,000 4,000,000 (2,000,000) 4,000,000

Separatecomponent ofequity translation loss

(607,143) (607,143)

Profit or loss current year

1,750,000 1.75 1,000,000 5,000,000 6,000,000

Profit or loss retranslation

(250,000) 1.75 (142,857) (142,857)

Total 10,000,000 5,000,000 17,000,000 (3,000,000) 19,000,000

* After currency related closing entries.

As of 31 December 20X1 the carrying amount of the intercompany account (prior to remeasurement) was 1,750,000 in Ludwigs books. However, because the intercompany account is denominated in GBP,

Ludwig still has to remeasure this balance at the end of the reporting period.Carrying amount of intercompany account (prior to remeasurement) 1,750,000

Remeasure intercompany account at year end spot rates (1,000,000 * 2.00) 2,000,000

Exchange loss included in net earnings of Ludwig (250,000)

Exchange loss translated using average spot rate as part of the consolidation process in RST (250,000/ 1.75)

(142,857)

The effect is to record an exchange loss of 142,857 in the consolidated income statement.


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Initial net investment At 31 December 20X1, the initial net investment should be accounted for in

accordance with IAS 21. This Standard requires that equity accounts be translated at historical exchangerates and that assets and liabilities be translated at the current spot rates. This translation process willexpose the company to foreign currency risk between the historical and current rates. Any gains or lossesassociated with this risk are recognised in a separate component of equity.

The exchange loss associated with the initial net investment as of 31 December 20X1, will be:

Net assets translated at spot rates as of 31 December 20X1(3,000,000 / 2.00 ) 1,500,000

Initial investment translated at historical rates(3,000,000 / 1.50) 2,000,000

Translation loss (500,000)

The 500,000 translation loss should be recorded in a separate component of equity as foreign currencytranslation.

Net income for the six months The net income for Ludwig after taking into account intercompanyexchange loss is:

Net income before exchange loss 1,750,000

Exchange loss relating to intercompany account (250,000)

Net income 1,500,000

Because the loss is accounted for in the income statement of Ludwig, it should also be accounted for inthe consolidated income statement. The net income is translated at the average spot rate whereas therelated assets are converted at the year end spot rate. This creates an inherent currency risk between theyear end and average exchange rates.

Net assets arising from net income translated at the spot rate as of 31/12/20X1(1,500,000 / 2.00)

750,000

Net income translated at average exchange rate (1,500,000 / 1.75) 857,143

Translation loss related to net income (107,143)

The net effect of the exchange rate fluctuation is a loss of 607,143 (500,000 + 107,143) that isrecorded in the separate component of equity as foreign currency translation.


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Example 10: Accounting for a net investment (with hedge accounting and no ineffectiveness)Assume the same fact pattern as Example 9, except that RST decided on 1 July 20X1, to limit its foreigncurrency exposure as it relates to the initial net investment, by entering into a forward contract to sell

5,000,000 at a forward rate of 1.54 (:) in 12 months and to designate it, after taking account of tax at arate of 40%, as a hedge of the net investment.

RSTs hedge documentation is as follows:


The objective of the hedge transaction is to protect the net investment in theforeign operation, on an after-tax basis, against adverse changes in the forwardexchange rate.


Hedging instruments Forward contract to sell 5,000,000 at forward rate of 1.54 to the on 30 June20X2.

Hedged items The forward contract is designated as an after tax hedge of the net investmentopening balance as of 1 July 20X1.


Hedge effectiveness will be assessed based on overall changes in fair value ofthe forward contract (that is, based on changes in forward rates) on an after-tax

basis. Because the critical risks of the forward contract and the net investmentcoincide, there should be no ineffectiveness. Counterparty credit risk will becontinuously monitored.


The hypothetical derivative method will be used to measure hedge effectiveness.Any difference between the change in fair value of the actual derivative and thehypothetical derivative will be reflected in earnings. However because the actualderivative coincides with the hypothetical derivative, there should be no hedgeineffectiveness.

At 1 July 20X1, the fair value of the forward contract was zero. As of 31 December 20X1, the exchangerate was 2.00 Euros to the and the six-month forward rate was 2.02. The fair value of the forwardcontract entered into would then be:

GBP receivable at six-month forward rate as of 31/12/20X1 (5,000,000 / 2.02) 2,475,247

GBP receivable on terms of forward contract (5,000,000 / 1.54) 3,246,753

Difference between forward contract and forward rates 771,506

Fair value of forward contract (771,506 discounted at 6%) 749,353

Less: Tax effect (40%) (299,741)

Fair value, net of tax 449,612


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RST has designated this forward contract as a hedge of the initial net investment and there should be noineffectiveness. IAS 39 requires that such a hedge is accounted for as follows:

a) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge isrecognised directly in equity through the statement of changes in equity; and

b) the ineffective portion is recognised in profit or loss.

Any gain or loss on the hedging instrument relating to the effective portion of the hedge that has beenrecognised directly in equity is recognised in profit or loss on disposal of the foreign operation.

DR CR

The journal entry at 31 December 20X1 will be as follows:

Forward contract (fair value) 749,353Deferred tax 299,741


To account for the effect of hedge of net investment.

(* Assuming that the gain or loss on the forward contract is taxed only on settlement)

To summarise the retranslation of the exposure and the related hedge:

The initial translation loss 500,000

Gain on forward contract hedge (net of tax) 449,612

Net loss foreign currency translation 50,388

Translation of net income not hedged 107,143

Total effect of foreign currency translation 157,531

The hedge was not 100% effective in offsetting all the changes in the foreign currencies because of thedifference between the spot and forward exchange rates. This will typically be the case because thederivative is required to be measured at fair value while the net investment is measured at the spotexchange rate.

Effect of the hedge on theincome statement

The above hedge (after tax) offsets the 500,000 translation lossaccounted for in the foreign currency translation by 449,612.


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Example 11: Accounting for a net investment (with hedge accounting with ineffectiveness present)Assume the same fact pattern as Example 9 except that RST decided on 1 July 20X1, to limit its foreigncurrency exposure as it relates to the initial net investment by using a forward contract in Swedish Krona(SK) to hedge the exposure. Assume that the relationship of the Krona and the Euro to the GBP isdemonstrated to be highly correlated and the Swedish Krona is expected to be effective in offsettingchanges in value attributable to the hedged risk during the period that the hedge is designated.Accordingly, RST entered into a forward contract to sell SK100,000,000 (assuming a tax rate of 40%) ata forward rate of SK31.2 in 12 months and designated it as a hedge of the net investment.

The applicable exchange rates are as follows:

/ SK/

Spot rate at 7/1/20X1 1.50 30.00

Twelve-month forward rate at 7/1/20X1 1.54 31.20

Average spot rate from 7/1/20X1 to 12/31/20X1 1.75 N/A

Spot rate at 12/31/20X1 2.00 40.20

Six-month forward rate at 12/31/20X1 2.02 40.60


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RSTs hedge documentation is as follows:

Risk managementobjective and nature ofrisk being hedged

The objective of the hedge transaction is to protect the net investment in theforeign operation against adverse changes in forward exchange rates.


Hedging instruments Forward contract to sell SK100,000,000 (tax rate 40%), at forward rate ofSK31.2 for each GBP on 30 June 20X2. It is expected that changes in theEuro and Swedish Krona will be highly correlated as they relate to the GBP.

Hedged items The forward contract is designated as a hedge of the net investment opening balance as of 1 July 20X1.


Hedge effectiveness will be assessed on the dollar offset method bycomparing changes in the net payments that will be indicated by therespective forward curves over the hedge horizon for the Swedish Kronacompared to the Euro. Counterparty credit risk will be continuouslymon

Documents

FX Hedging Publication