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| IAS 21 Foreign Exchange Rates - Hedging a Net Investment |
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Issue Description: How to account for a hedge in a 'net investment hedge in a foreign operation' in a group's consolidated financial statements. Discussion at IFRIC Meeting November 2006: The staff presented two questions that they believed the IFRIC would need to consider when dealing with net investment hedging: What is the hedged risk: Is it the exposure between two entities with different functional currencies in a group or is it the exposure between the presentation currency of the group and the functional currency of the entity being hedged. The First would indicate that the group is hedging economic risk between two difference functional currencies, while the latter would be based on hedging an accounting exposure when consolidating in the hedged entity (into the presentation currency of the group). Where in the group can the hedging instrument be held: That is whether the hedging instrument must be held by the immediate parent or the ultimate parent of the hedged entity, or whether other entities in the consolidated groups should be allowed to hold the hedging instrument. What is the hedged risk? IFRIC members did not agree on whether the reading of paragraph 18 in IAS 21 indicates that consolidation occurs in one single process or whether it is done step-by-step. To solve this issue would be fundamental as a one-step consolidation (where entities are consolidated directly into the group) would indicate that exposure only arises when the entity's functional currency is translated into the group's presentation currency. The only exposure to hedge would then be the exposure between the presentation currency of the group and the functional currency of the hedged entity. Other IFRIC members thought that entities use net investment hedging to hedge dividends from foreign entities and that there is a real economic risk between entities with different functional currencies which is not considered if hedging a presentation currency was permitted. Where in the group can the hedging instrument be held? The staff had identified two different possible alternatives that the IFRIC discussed (note that the alternatives is based on that only economic exposure can be hedged): The hedging instrument can be held by any parent, from the immediate to the ultimate, which is exposed to economic risk with holding the foreign investment. The second option would be to allow any entity in the group to hold the hedging instrument as long as it is passed, through intra-group transactions, to the specified parent. Provided the hedging instrument is hedging the same functional currencies as those of the net investment and the specified parent, the gains and losses on the instrument would offset the economic exposure in the consolidated statements. IFRIC members discussed whether it would wish to diverge from US GAAP by allowing the first alternative. US GAAP only allows the group to hedge the risk between the immediate parent and the net investment while it allows the group to put the hedging instrument anywhere in the group. The second alternative would be closer to US GAAP, but would still diverge as it would allow the entity to hedge the exposure between the net investment and any parent between the immediate parent and the ultimate parent of the group. The IFRIC agreed to add this issue to its agenda. The staff was directed to clarify the scope, identify what the net investment could be, identify the risk being hedged and determine which instruments could be used. Discussion at the January 2007 IFRIC Meeting The IFRIC held its first substantive discussion on a project to provide guidance on the accounting for a hedge of a net investment in a foreign operation in group financial statements. Should the IFRIC clarify whether IAS 21 indicates a method of consolidation? The IFRIC discussed whether the mechanics of consolidation (for example, consolidate subsidiaries into intermediate parent companies before consolidating those intermediate parents in to the group parent (two-step) vs consolidate all subsidiaries in to the group parent directly (one-step)) should make a difference to this issue. After debating this issue for a while, the IFRIC decided that this was a separate issue and should not be considered as part of the Interpretation on hedging a net investment in a foreign operation. Scope What is the hedged risk? After debate, the IFRIC agreed that what is being hedged is the net investment in the foreign operation, which is not necessarily either a cash flow hedge or a fair value hedge. Net investment hedging is a separate category of hedge accounting. Which currency? The IFRIC agreed that a hedge of a net investment in a foreign operation is hedging the risk between the functional currency of the foreign operation and the functional currency of the reporting parent company. That is, if an intermediate parent company must prepare general purpose financial statements, it can hedge its net investment in a foreign operation on the basis of the intermediate parent's functional currency, even if that currency is different from that of the ultimate group parent company. Where can the hedging instrument be held? The IFRIC agreed that it did not matter where within the consolidated group the hedging instruments were held. In addition, some IFRIC members and Board observers were of the view that it was not necessary that the functional currency of the entity holding the hedging instrument and the parent should be the same. (This is a potential difference with US GAAP.) IFRIC members also noted the existing guidance in IAS 39 IG.F.2.14, which addresses intragroup hedging activities. Senior IFRIC staff was uncomfortable with this conclusion and thought that some restriction on where the instrument could sit within the group is necessary. It could be that where within the consolidated group the hedging instrument was situated might affect the amounts recognised in the financial statements and financial statement geography. The IFRIC will discuss these issues at a subsequent meeting. The project staff asked whether the IFRIC was interested in the alternative of adopting the US GAAP requirements for net investment hedging. There was no support for this idea. The IFRIC will continue the development of a Draft Interpretation at a subsequent meeting. Discussion at the March 2007 IFRIC Meeting The IFRIC continued their discussion of the accounting for a hedge of a net investment in a foreign operation (See January 2007 IASPlus Report). The discussion at this meeting concentrated on two main issues: (1) where within a group can the hedging instrument be held; and (2) which net investment risk is eligible to be hedged? Where can the hedging instrument be held? The IFRIC agreed that a hedging instrument can be held by any entity within the group, provided that the instrument is considered effective, that is, the functional currency of the net investment and the functional currency of the parent are the same currencies as those on which the hedging instrument's value is based. Which risk is eligible to be hedged? There was no interest among IFRIC for adopting the restrictions in US GAAP, which states that an entity can only hedge its direct exposure to a net investment in a foreign operation. Instead, the IFRIC thought that the accounting should reflect economic reality. The IFRIC concluded that, at the consolidated level, the hedgeable risk created by a net investment could be any risk between the net investment in a foreign operation and any immediate, intermediate or ultimate parent in the chain. This is commonly called the 'bottom up approach'. There was some discussion about how best to communicate IFRIC's consensus, whether an Interpretation should be issued or through developing Implementation Guidance for IAS 21. The staff was asked to return at the next meeting with a recommendation. Discussion at the May 2007 IFRIC Meeting The IFRIC discussed some 'sweep issues' related to a proposed Draft Interpretation on the accounting for a hedge of a net investment in a foreign operation. Translation to a presentation currency After considerable debate, the IFRIC agreed that IAS 39 Implementation Guidance issue F2.14 is applicable to the hedge of a net investment, and there is no requirement to use internal hedging instruments. In other words, the translation gain or loss can be used as part of the hedging instrument. This approach would permit an entity to hold a hedging instrument anywhere within the consolidated group. However to obtain a qualifying instrument that would be effective both prospectively and retrospectively, the amounts included in the foreign currency translation reserve must be considered when testing effectiveness. If the foreign currency translation reserve is not included in the effectiveness tests the instrument may not be deemed eligible. What exposure arises from the net investment? The IFRIC agreed that an entity can hedge up to the full extent of its carrying amount in a net investment regardless of whether that net investment has investments in other foreign operations, because IAS 39 does not require a risk reduction notion when using hedge accounting. Effective date and transition The IFRIC agreed that the Draft Interpretation should propose prospective application of the [draft] Interpretation. IFRIC members noted that it was probably impracticable to require retrospective application given the documentation requirements for hedge accounting. Approval The IFRIC Chairman asked whether, based on the provisional Draft Interpretation and the discussions today, any IFRIC members would not support the Draft Interpretation. None of the IFRIC members indicated a dissent. However, some IFRIC members wanted to see the next revision of the Draft Interpretation before making a definitive determination about whether further discussion by the IFRIC is necessary. Next Steps The staff will present a revised Draft Interpretation to the IFRIC as soon as possible, with the intention that it will be passed to the IASB for negative clearance as provided in the IFRIC's Due Process Handbook. Provided that the IASB does not object to its publication, a Draft Interpretation should be published by July 2007. IFRIC D22 Issued 19 July 2007 On 19 july 2007, the IFRIC published for comment IFRIC Draft Interpretation D22 - Hedges of a Net Investment in a Foreign Operation. Comment deadline is 19 October 2007. Discussion at the January 2008 IFRIC Meeting The staff presented to the IFRIC their analysis of comment letters received on the IFRIC's draft Interpretation D22 Hedges of a Net Investment in a Foreign Operation. The staff noted that the majority of the comments received welcomed that IFRIC deals with this issue. It also noted that the areas of concern in the comment letters where the same as the ones the IFRIC aimed to address:
The staff pointed out that the fundamental issues have to be addressed firstly and after that minor and drafting issues could be dealt with. On the first issue the IFRIC agreed that no further deliberation is necessary. One IFRIC member noted that the final Interpretation must be clear, why an entity can hedge twice from a risk management perspective, but not achieve hedge accounting treatment. Another IFRIC member pointed out that the words in the Interpretation must make clear that a foreign operation can be hedged for the same risk twice or more with two or more parents provided different net assets are hedged by these parents. On the second issue, one commentator has raised the issue if the amount of net assets to be eligible for hedge accounting can be determined either on a 'sum of net assets of the individual foreign operations' basis or if it could be determined on a sub-consolidated net assets basis. The IFRIC had a lengthy discussion on the topic and concluded that many concerns could be addressed by looking at a detailed example (to be drafted by the staff on the basis of an example from one of the comment letters). One IFRIC member noted that such an example must be clear about the reporting entity looked at and whether the focus is its separate financial statements or consolidated financial statements. It was also highlighted that the terminology must be consistent to avoid confusion. One IFRIC member noted that the principles that have already been agreed on must be revisited and probably be revised in the light of the conclusions drawn from such a detailed example. The IFRIC agreed with the staff, and some IFRIC members highlighted again that all designations must be in accordance with the risk management policies and that the final Interpretation should not force entities to change their hedging strategies. The IFRIC then discussed the third issue on the location of the hedging instrument. Some commentators expressed concern about the IFRIC's tentative conclusion that the location of the hedging instrument should not have influence on the effectiveness of the hedging relationship. This conclusion was based on a reference made to the Implementation Guidance on IAS 39 (IAS 39 IG F.2.14). The staff noted that they believe the conclusion made is correct but believe a more compelling rationale for this conclusion seems to be appropriate. It argued that the rationale rests on the purpose of net investment hedging and that this purpose should not be affected by the location of the hedging instrument. The IFRIC members seemed to have a general sentiment that it should not matter where the hedging instrument is located. One IFRIC member expressed some concern about the recycling of the deferred gains or losses. Some IFRIC members also expressed the view that no matter what kind of hedging strategy an entity employs for risk management purposes, in the consolidated financial statements of the ultimate parent it should not make a difference. The IFRIC agreed that these issues should also be addressed in the detailed example to be drafted by the staff as proposed in the discussion on the previous issue. One IFRIC member highlighted that the focus of the example should not be solely on the hedged item but the example should explicitly deal with hedging instrument. The next steps are that the staff will draft the detailed example and seek early input and feedback from the IFRIC members. This example will then be discussed at the March IFRIC meeting with the goal to reach final agreement on the principles of the draft Interpretation. Discussion at the March 2008 IFRIC Meeting Preliminary discussion of comprehensive example At the January 2008 IFRIC meeting, the IFRIC discussed the comments received on its Draft Interpretation D22 Hedges of a Net Investment in a Foreign Operation. As a result of the deliberations, the staff was asked to provide a comprehensive example to confirm some of the principles underlying the draft Interpretation. The principles the staff tried to demonstrate were:
The staff presented various scenarios of net investment hedges involving cash instruments or derivatives to illustrate the principles. The examples contained the necessary calculations and journal entries in detail. One IFRIC member noted that the examples are meant to prove the principles, as the spreadsheets were set up using those principles. The IFRIC discussed some points using the spreadsheets in depth. Method of consolidation Some IFRIC members were particularly concerned with the assumption that the direct method of consolidation is the correct one and other methods must be adjusted to result in the same figures as the direct method. The chairman told IFRIC members that the Interpretation does not prescribe any method of consolidation but reflects the standards as currently applicable. The staff noted that the question does not deal with the consolidation procedure itself but with effectiveness testing. Overhedging and hedging the same risk twice It was also confirmed that an entity cannot hedge the same risk twice, and some designations/designated amounts would not be valid as they would result in overhedging. One member noted that this would normally not occur in practice as it would also make no sense to overhedge from an economic perspective. Location of the hedging instrument Some IFRIC members highlighted that the method of consolidation could affect the amounts recognised if the hedging instrument is not held within the (sub-)group containing the hedged item (that is, the net investment). Recycling The discussion then switched to the issue of recycling once the net investment or the entity containing the hedging instrument is disposed of. It was noted that this could lead to practical implications and complications, as the amounts in the respective foreign currency translation reserve must be identifiable to allow the correct timing of recycling that results from assuming IAS 39 overrides IAS 21 when it comes to hedge accounting. Some members expressed concerns over the theoretical foundation and the practical application of this approach. The chairman noted that it would not be in the scope of this Interpretation to provide guidance on this issue as this would be a general hedge accounting issue. Some members still did not seem to be convinced. The IFRIC continued its debate on the issues of the method of consolidation and recycling. While there seemed to be agreement that the Interpretation should not prescribe the method of consolidation, some members asked the staff to include words as a caveat to remind entities that they would have to track the amounts in the foreign currency translation reserve relating to hedge accounting, which could be challenging in large and complex group structures. One member also cited possible transitional issues. Another IFRIC member believed implementing the IFRIC approach correctly could be a huge task for some entities. The IFRIC also discussed which examples should go into the final Interpretation as illustrative examples, but did not make a final decision. The staff was also asked to align the example that currently is contained in the draft Interpretation. Other issues raised by commentators The staff also asked the Board to confirm its preliminary conclusions on certain issues raised by commentators to the draft Interpretation. Could a parent entity apply hedge accounting in its separate financial statements? How should the hedged amounts be accounted for? Yes, but that would be a different type of hedge (for example, a fair value hedge). No further clarification is required. The IFRIC agreed. How should an entity account for the ineffectiveness resulting from a decrease in a net investment value during the term of hedge? All ineffectiveness will be recognised in profit or loss. No exception exists for net investment hedges. Such an ex post overhedge would result in ineffectiveness. No further clarification is required. The IFRIC agreed. Should the transitional requirements be clarified? Some commentators asked for clarification on the transitional provision with regard to applying the Interpretation prospectively. The staff proposed to amend the transitional paragraph as follows:
"...when first applying the Interpretation. If an entity had designated a transaction as a hedge of a net investment but the hedge does not meet the conditions for hedge accounting in this Interpretation, the entity shall apply IAS 39 to discontinue prospectively that hedge accounting." The IFRIC agreed. Is an intra-group loan defined by IAS 21 paragraph 15 in the scope of this interpretation? Could such an intra-group loan be a part of the net investment? Yes, this is obvious from the Standard. No further clarification is required. The IFRIC agreed, however one member questioned if this really was the question the commentator asked as it was so obvious. Does a hedge relationship designated at a lower group level require hedge documentation also at the higher group levels in order for the lower level hedge to qualify for hedge accounting at any higher level? The IFRIC had a lengthy discussion on this issue, notably if an entity would be required at a higher level to 'unhedge', that is, explicitly state that it does not want to continue hedge accounting coming from a lower level in the group. The IFRIC finally agreed that this is out of the scope of this interpretation as it would be general guidance on how to document hedging relationships. Accordingly, the IFRIC agreed with the staff recommendation not to provide further clarification. Should the interpretation include the reason the hedging instruments may not be held by the foreign operation that is being hedged? No, as this is would allow the net investment to hedge itself as the instrument is part of the net investment. The IFRIC agreed. Then the staff asked the IFRIC whether it agreed with the staff view that the following questions are addressed by the examples presented. One member expressed concerns as the examples would not be contained in the final Interpretation.
The IFRIC agreed not to address these issues in the final Interpretation. Way forward The staff was asked to amend the draft Interpretation in the light of this meeting's discussions and integrate selected examples. The staff will return at the May IFRIC meeting with a new draft of the Interpretation for clearance by IFRIC.
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