Assume a Parent enters currency forward contracts to fix the foreign currency cash flows of the following highly probable forecast transactions:
* Parent plans to remit foreign currencies to a newly established foreign subsidiary as opening capital (or to an existing foreign subsidiary as capital injection)
* Parent plans to collect foreign currencies from a foreign subsidiary as a dividend
In my view, these transactions do not qualify as cash flow hedge relationships in Parent's consolidated FS because they are intragroup forecast transactions that do not result in profit or loss (IFRS 9 6.3.5-6.3.6). In fact, cash flow hedge accounting does not really make sense in these transactions.
My question: can these transactions qualify as hedging relationships of net investment hedges as long as other criteria are met?
IFRIC 16 says that a hedged item under a net investment hedge is "an amount of net assets equal to or less than the carrying amount of the net assets of the foreign operation (para 2)" and "Parent could designate the forward foreign exchange risk (AG2)", so the second dividend case is relatively clear to me if I interpret Parent designates a part of net assets, which is to be distributed, of the foreign subsidiary as a hedged item.
The first case is tricky. The forecast capital remittance is not recognized and thus does not constitute the carrying amount of net assets, so IFRIC 16 does not apply directly. Nor does IFRS 9 provide guidance. But to me it sounds quite reasonable for Parent's management to have a hedging strategy of fixing the amount of initial investment in Parent's functional currency. Similarly, I am also wondering whether a foreign currency time deposit can be designated as a net investment hedging instrument if Parent, instead of entering a forward contract, sets aside some foreign currencies in advance solely for the capital remittance to a foreign subsidiary.
In addition, is my understanding correct that, if the above transactions are eligible net investment hedges, the hedge accounting are discontinued at the settlement of the forward contracts, and the cumulative gains/losses until then will remain in the translation reserve and will be disclosed in accordance with IFRS 7.24B(b)(iii) forever until Parent disposes of the foreign subsidiaries?
CF hedges of intragroup forecast capital transactions
Re: CF hedges of intragroup forecast capital transactions
Hello,
In my view, neither transaction can be designated as a hedged item under a net investment hedge. That's because in both cases the hedged items are forecast transactions, whereas the hedged item in a net investment hedge should be the net assets of a foreign operation that are included in the financial statements (IFRIC 16, paragraph 2)
Also, please note that IFRS 9 does not permit hedge accounting to be applied to hedges of inter-company transactions in consolidated accounts (IFRS 9, 6.3.5). The logic behind this is that intragroup transactions are eliminated on consolidation. However, the foreign currency risk of an intragroup monetary item is an exception to paragraph 6.3.5 because the resulting FX gains and losses on that balance are not fully eliminated on consolidation. Similarly, the foreign currency risk in forecast intragroup transactions that affect the consolidation profit or loss may qualify as hedged items. But neither situation seems to apply to your examples because 1) you don't have a recognised intragroup (monetary item) balance yet, and 2) neither transaction will affect the consolidated profit or loss.
The only situation in your examples that could qualify for hedge accounting is when the dividend is declared (example 2). In that case, you will have a recognised foreign currency receivable in the parent's accounts which gives rise to foreign currency gains and losses that do not fully eliminate on consolidation and thus affect the consolidated income statement. You could apply hedge accounting as from that moment (although hedge accounting will not add much value in that case because both hedged item and hedging instrument will be hitting P&L at the same time).
Your understanding in your last sentence seems correct.
Note: these are considerations for hedge accounting on the consolidated accounts only.
In my view, neither transaction can be designated as a hedged item under a net investment hedge. That's because in both cases the hedged items are forecast transactions, whereas the hedged item in a net investment hedge should be the net assets of a foreign operation that are included in the financial statements (IFRIC 16, paragraph 2)
Also, please note that IFRS 9 does not permit hedge accounting to be applied to hedges of inter-company transactions in consolidated accounts (IFRS 9, 6.3.5). The logic behind this is that intragroup transactions are eliminated on consolidation. However, the foreign currency risk of an intragroup monetary item is an exception to paragraph 6.3.5 because the resulting FX gains and losses on that balance are not fully eliminated on consolidation. Similarly, the foreign currency risk in forecast intragroup transactions that affect the consolidation profit or loss may qualify as hedged items. But neither situation seems to apply to your examples because 1) you don't have a recognised intragroup (monetary item) balance yet, and 2) neither transaction will affect the consolidated profit or loss.
The only situation in your examples that could qualify for hedge accounting is when the dividend is declared (example 2). In that case, you will have a recognised foreign currency receivable in the parent's accounts which gives rise to foreign currency gains and losses that do not fully eliminate on consolidation and thus affect the consolidated income statement. You could apply hedge accounting as from that moment (although hedge accounting will not add much value in that case because both hedged item and hedging instrument will be hitting P&L at the same time).
Your understanding in your last sentence seems correct.
Note: these are considerations for hedge accounting on the consolidated accounts only.
Re: CF hedges of intragroup forecast capital transactions
Thank you, DJP.
I think the second case transaction (dividend case) can technically be an eligible hedging relationship because, although the forecast dividend itself cannot be an eligible hedged item, the portion of net assets to be distributed can be one. For example, Parent's currency forward contract of 50 CU can be a hedging instrument to hedge a subsidiary's net assets of 100 CU even if 50 CU of the net assets are about to be distributed as a dividend, as long as relevant documentation is consistently prepared. It sounds as if the hedging documents needed to be made up to achieve a preferable accounting treatment, but I think that kind of made-up documentation is legal and common in "proxy hedging" situations.
As for the first case (capital contribution case), you are right; eligible hedged net assets have to be included in the financial statements. I am now convinced this case cannot be an eligible hedging relationship of a net investment hedge.
But, at the same time, I am still concerned about the management's intention to fix the initial investment in a foreign operation in their functional currency, so I am wondering if the cash flow hedge accounting (basis adjustment) can apply to the following transaction:
Day 1. Parent enters a currency forward contract of 50 CU.
Day 2. Parent settles the contract and remits cash of 50 CU to an existing or newly established Foreign Subsidiary as a capital.
Day 3. Foreign Subsidiary purchases 50 CU of Property, Plant and Equipment.
Can Parent in its consolidated FS transfer the cumulative hedging gain/loss from the contract from the CF hedge reserve to the initial carrying amount of the PP&E in accordance with IFRS 9 6.5.11 (d)(i)?
I think the second case transaction (dividend case) can technically be an eligible hedging relationship because, although the forecast dividend itself cannot be an eligible hedged item, the portion of net assets to be distributed can be one. For example, Parent's currency forward contract of 50 CU can be a hedging instrument to hedge a subsidiary's net assets of 100 CU even if 50 CU of the net assets are about to be distributed as a dividend, as long as relevant documentation is consistently prepared. It sounds as if the hedging documents needed to be made up to achieve a preferable accounting treatment, but I think that kind of made-up documentation is legal and common in "proxy hedging" situations.
As for the first case (capital contribution case), you are right; eligible hedged net assets have to be included in the financial statements. I am now convinced this case cannot be an eligible hedging relationship of a net investment hedge.
But, at the same time, I am still concerned about the management's intention to fix the initial investment in a foreign operation in their functional currency, so I am wondering if the cash flow hedge accounting (basis adjustment) can apply to the following transaction:
Day 1. Parent enters a currency forward contract of 50 CU.
Day 2. Parent settles the contract and remits cash of 50 CU to an existing or newly established Foreign Subsidiary as a capital.
Day 3. Foreign Subsidiary purchases 50 CU of Property, Plant and Equipment.
Can Parent in its consolidated FS transfer the cumulative hedging gain/loss from the contract from the CF hedge reserve to the initial carrying amount of the PP&E in accordance with IFRS 9 6.5.11 (d)(i)?
Re: CF hedges of intragroup forecast capital transactions
I understand your solution for example 2 (although I think you mean the portion of net assets equal to the amount of dividends to be received; not distributed, right?) In any case, yes, the mechanics would work and I believe this was common practice under IAS 39. However, I think it will be difficult to argue that this designation is consistent with the risk management objective (IFRS 9, B6.3.16). I would advise having a talk with your auditors in advance.
As for example 1 I am not sure if I understand the proposed solution. What would the hedged item be in this hedge relationship in order to park the fair value changes of the derivative in OCI?
As for example 1 I am not sure if I understand the proposed solution. What would the hedged item be in this hedge relationship in order to park the fair value changes of the derivative in OCI?
Re: CF hedges of intragroup forecast capital transactions
Yes, the risk management strategy/objective is problematic in the dividend case, but the real situation I’m facing is much more problematic or bizarre; transactions and hedge accounting exist while hedging strategy or document does not 
I am studying to fix the problems from the accounting stand point, and I believe hopefully I can manage it as long as the transaction itself could technically be an eligible hedging instrument.
As for the capital contribution case, my interest is shifting and now I’m interested in whether Parent’s currency forward contract can qualify as a hedging instrument for the forecast purchase of non-financial assets at a foreign subsidiary. It should be legal in a consolidated FS to hold hedging instruments and hedged items at different entities within a group, but the fact that Parent and Foreign Subsidiary have different functional currencies makes me puzzled in determining the hedged FX risk and accounting for the transactions in the consolidated FS.
I am studying to fix the problems from the accounting stand point, and I believe hopefully I can manage it as long as the transaction itself could technically be an eligible hedging instrument.As for the capital contribution case, my interest is shifting and now I’m interested in whether Parent’s currency forward contract can qualify as a hedging instrument for the forecast purchase of non-financial assets at a foreign subsidiary. It should be legal in a consolidated FS to hold hedging instruments and hedged items at different entities within a group, but the fact that Parent and Foreign Subsidiary have different functional currencies makes me puzzled in determining the hedged FX risk and accounting for the transactions in the consolidated FS.
Re: CF hedges of intragroup forecast capital transactions
Do I assume correctly that the non-financial asset purchase at the sub is denominated in the subs' functional currency?
Re: CF hedges of intragroup forecast capital transactions
Right. For example, EUR-based Parent buys 50 USD at the forward exchange market to hedge USD-based Foreign Subsidiary’s forecast purchase of 50 USD PP&E.
Re: CF hedges of intragroup forecast capital transactions
I see. I think you should be able to designate the purchase of the PPE in a foreign currency in the consolidated accounts as a cash flow hedge. This would just imply a bit of more operational work in the consolidation process because during the life of the derivative you would have to reclassify the related fair value changes entries from P&L to OCI, and after the derivative's settlement you would have to include an adjustment to the PPE balance in the consolidated accounts (for the amount that the derivative has settled for) and also adjust the PPE's depreciation. The mechanics of a cash flow hedge are much easier if the hedge also takes place at the entity level, because all these entries would automatically flow into the consolidated accounts without the need of any manual adjustment. (But in your case, hedging the FX risk in the PPE purchase at the entity level would not be possible because it's a risk that does not exist at the entity level.)
Re: CF hedges of intragroup forecast capital transactions
Thank you, DJP and Marek. It’s great to know cross-entity hedge accounting is observed in practice. And, yeah, I am aware it’s on a consolidated FS only and requires complicated adjustments over the life of the PP&E item. But I think the operation is similar to that for unrealized profit elimination from PP&E, so it’s probably manageable.