Net investment hedge accounting considerations (under IFRS)

Authored by David Passarinho, treasury accounting expert at Huawei Global Finance UK

Translation risk is the foreign exchange risk associated with the translation of net investments in foreign operations into a group’s presentation currency when preparing consolidated financial statements. As exchange rates change, so will the value of the net investment, creating foreign exchange gains and losses in the consolidated financial statements which are recognised in a separate component of equity. Foreign operation may refer to subsidiaries, branches, associates, joint ventures or joint operations.

Because presentation currency is a free choice - although most groups choose the functional currency of the parent, translation risk is often seen as ‘just an accounting issue’ rather than an economic risk. Some might argue that there’s no need to hedge it. 

But this view is flawed if indeed the presentation currency is the same as the ultimate parent’s functional currency. For example, adverse movements on exchange rates will result in a decrease of the consolidated equity which may trigger debt covenants and will ultimately impact cash flows if they persist. For this reason, hedging net investments is a strategic decision that treasurers should consider, bearing in mind that it may cause unwanted effects.¹

Net investments are normally hedged economically through using financing (e.g. borrowings denominated in the same currency of the foreign operation), or derivatives (e.g. FX forward contracts). 

However, even though the exposure may be economically hedged, the default accounting rules under IFRS will create a mismatch in the presentation of gains and losses of the hedged item and hedging instrument in the consolidated financial statements. This is because the translation of the net investment (hedged item) is recognised in equity (Cumulative Translation Reserve) through OCI - outside profit or loss, whereas gains and losses on the hedging instrument are, by default, taken to profit or loss - whether they arise from re-conversion to closing exchange rates (financing) or fair value changes (derivatives).

This accounting mismatch results in unwanted volatility in the consolidated income statement, which could impact important financial metrics (e.g. earnings per share).

Having created this problem, IFRS 9 Financial Instruments allows us to solve it with net investment hedge accounting, but there are some catches that treasurers should be aware of:

1. Hedge accounting is only possible if there is an economic risk, not just an accounting risk. This means that the group’s presentation currency must also be the ultimate parent’s functional currency (see above) and not some other currency. Use of another currency does not create an economic risk - it is just accounting.
2. Derivative and non-derivative financial instruments - such as foreign currency debt -can be used in a net investment hedge accounting relationship. However, an economic relationship must exist between gains and losses on the net investment and gains and losses on the hedging instrument.  One must go up in value when the other goes down and not randomly.
3. The hedged item can be an amount of net assets equal to, or less than, the carrying amount of a parent’s net investment in the foreign operation in its consolidated financial statements. Because net investments are constantly changing in amount (for example through earning profits or making losses, both of which may be unpredictable), it is usual to designate only a portion of a net investment, say for example “the first US$100M of the net investment in subsidiary X”.
4. The hedging instrument may be held by any company in the consolidated group so long it is entered into with an external counterparty. But note that the foreign currency exposure on a foreign net investment may qualify for hedge accounting only once in the consolidated financial statements. If hedge accounting is applied by a lower level parent, it must be reversed before being applied by the ultimate parent.
5. Finally - and similar to any other type of hedge accounting relationship: 

• the actual hedge ratio used for accounting should be the same as that used for risk management purposes, 
• the hedge relationship must be documented and tested (at inception and at each reporting date); and 
• the effect of credit risk cannot dominate the value changes that result from the economic relationship between the hedged item and the hedging instrument.

Where all these conditions have been met, IFRS 9 allows us to take the gains and losses on the hedging instrument via OCI into the Cumulative Translation Reserve to offset gains and losses on the revaluation of the net investment in the foreign operation.

Hedge accounting is a little demanding. Applying it to a net investment hedge has the benefit of removing volatility from the consolidated income statement, but it comes at the cost of an increased administrative burden due to the need of maintaining hedge accounting documentation and having adequate systems and internal controls in place. 

However, all hedge accounting is optional and the costs and benefits need to be weighed before applying it.
 

^{1   The article Treasury essentials: Translation risk by Will Spinney provides an excellent insight on translation risk}