Derivatives Implementation Group

   The gain or loss on a hedging derivative instrument (or the foreign currency transaction gain or loss on the nonderivative hedging instrument) that is designated as, and is effective as, an economic hedge of the net investment in a foreign operation shall be reported in the same manner as a translation adjustment to the extent it is effective as a hedge. (Emphasis added.)

The phrase "to the extent it is effective as a hedge" determines the amount of ineffectiveness that is recognized in earnings. However, Statement 133 does not provide detailed guidance regarding the application of that phrase or how to determine the amount of hedge ineffectiveness in a net investment hedge.

RESPONSE

Question 1

Paragraph 42 provides guidance for hedging the foreign currency exposure of a net investment in a foreign operation. Paragraph 42 states, in part, that "the gain or loss on a hedging derivative instrument (or the foreign currency transaction gain or loss on the nonderivative instrument) that is designated as, and is effective as, an economic hedge of the net investment in a foreign operation shall be reported in the same manner as a translation adjustment to the extent it is effective as a hedge." If a derivative is used as the hedging instrument, that guidance should be interpreted to permit an entity to measure the amount of ineffectiveness in a net investment hedge using either a method based on changes in spot exchange rates or a method based on changes in forward exchange rates. However, an entity must consistently use the same method for all its net investment hedges in which the hedging instrument is a derivative; use of the spot method for some net investment hedges and the forward method for other net investment hedges is not permitted. Entities that have already adopted Statement 133 have a one-time opportunity to change the method of measuring the amount of ineffectiveness from the forward-rate-based method to the spot-rate-based method or vice versa. That one-time opportunity would need to be implemented no later than in the first fiscal quarter that begins after January 10, 2001; early application in the fiscal quarter that includes January 10, 2001 is permitted. The change in the method of measuring the amount of ineffectiveness should be made as of the beginning of the fiscal quarter in which the change is initially applied. For hedging relationships existing at the beginning of the fiscal quarter in which the change is initially applied, those relationships should be considered to have been dedesignated as of that date and a new hedging relationship designated to which the new method would be applied prospectively. The above interpretation of paragraph 42 can also be applied to purchased options used as hedging instruments in a net investment hedge.

Method Based on Changes in Forward Rates

If the notional amount of the derivative designated as a hedge of a net investment in a foreign operation matches (that is, equals) the portion of the net investment designated as being hedged and the derivative's underlying relates solely to the foreign exchange rate between the functional currency of the hedged net investment and the investor's functional currency, all changes in fair value of the derivative should be reported in the same manner as a translation adjustment (that is, reported in the cumulative translation adjustment section of OCI). In that case, no hedge ineffectiveness would be recognized in earnings (including the time value component of purchased options or the interest accrual/periodic cash settlement components of qualifying receive-floating-rate, pay-floating-rate and receive-fixed rate, pay-fixed-rate cross-currency interest rate swaps). However, recognition of hedge ineffectiveness in earnings is required if (a) the notional amount of the derivative does not match the portion of the net investment designated as being hedged, (b) the derivative's underlying exchange rate is not the exchange rate between the functional currency of the hedged net investment and the investor's functional currency, or (c) the hedging derivative is a cross-currency interest rate swap as permitted by Implementation Issue H9 in which both legs are not based on comparable interest rate curves (for example, pay foreign currency based on 3-month LIBOR, receive functional currency based on 3-month commercial paper rates). If the derivative has multiple underlyings-one based on foreign exchange risk and one or more not based on foreign exchange risk-as discussed in Statement 133 Implementation Issue No. H9, "Hedging a Net Investment with a Compound Derivative That Incorporates Exposure to Multiple Risks," that derivative cannot be used as the hedging instrument in a net investment hedge unless it is a receive-floating-rate, pay-floating-rate interest rate swap that meets the criteria in Implementation Issue H9.

The measurement of hedge ineffectiveness due to the differences described above between the hedging derivative and the hedged net investment is as follows:

1. Different Notional Amounts. If the notional amount of the derivative designated as a hedge of the net investment does not match the portion of the net investment designated as being hedged, the amount of hedge ineffectiveness required to be recognized in earnings must be measured by comparing the change in fair value of the actual derivative designated as the hedging instrument and the change in fair value of a "hypothetical" derivative contract that has a notional amount that matches the portion of the net investment being hedged. (Refer to the final paragraph below for situations in which the hedge of a net investment in a foreign operation is hedging foreign currency risk on an after-tax basis, as permitted by paragraph 71 of Statement 133.) The "hypothetical" derivative must also have a maturity that matches the maturity of the actual derivative designated as the net investment hedge.

    

2. Different Currencies. If the derivative designated as the hedging instrument has an underlying foreign exchange rate that is not the exchange rate between the functional currency of the hedged net investment and the investor's functional currency (a "tandem currency" hedge), the amount of hedge ineffectiveness required to be recognized in earnings must be measured by comparing the change in fair value of the actual cross-currency hedging instrument with the change in fair value of a "hypothetical" derivative contract that has as its underlying the foreign exchange rate between the functional currency of the hedged net investment and the investor's functional currency. The "hypothetical" derivative must also have a maturity and repricing and payment frequencies for any interim payments that match the maturity and repricing and payment frequencies for any interim payments of the actual derivative designated as the net investment hedge.

    

3. Multiple Underlyings. In accordance with Implementation Issue H9, the only derivatives with multiple underlyings permitted to be designated as a hedge of a net investment are receive-floating-rate, pay-floating-rate cross-currency interest rate swaps that meet certain criteria. Implementation Issue H9 also permits receive-fixed-rate, pay-fixed-rate cross-currency interest rate swaps to be designated as a hedge of a net investment. If a receive-floating-rate, pay-floating-rate cross-currency interest rate swap is designated as the hedging instrument in a net investment hedge, the amount of hedge ineffectiveness required to be recognized in earnings must be measured by comparing the change in fair value of the actual cross-currency interest rate swap designated as the hedging instrument with the change in fair value of a "hypothetical" receive-floating-rate, pay-floating-rate cross-currency interest rate swap in which the interest rates are based on the same currencies contained in the "hypothetical" swap and both legs of the "hypothetical" swap have the same repricing intervals and dates. If a receive-fixed-rate, pay-fixed-rate cross-currency interest rate swap is designated as the hedging instrument in a net investment hedge, the amount of hedge ineffectiveness required to be recognized in earnings must be measured by comparing the change in fair value of the actual cross-currency interest rate swap designated as the hedging instrument with the change in fair value of a "hypothetical" receive-fixed-rate, pay-fixed-rate cross-currency interest rate swap in which the interest rates are based on the same currencies contained in the "hypothetical" swap. The "hypothetical" derivative must also have a maturity that matches the maturity of the actual cross-currency interest rate swap designated as the net investment hedge.

It should be noted that, in order to designate a derivative as a hedge of a net investment, an entity is required to have an expectation that the derivative will be effective as an economic hedge of foreign exchange risk associated with the hedged net investment. Accordingly, if any difference in notional amount, currencies, or underlyings (as described in the paragraphs above) is present, the entity must establish an expectation that the actual derivative designated as the hedging instrument will be effective as an economic hedge. For example, if an entity designates a derivative that has an underlying exchange rate involving a currency other than the functional currency of the net investment, that exchange rate must be expected to move in tandem with the exchange rate between the functional currency of the hedged net investment and the investor's functional currency. The determination of whether the derivative qualifies for net investment hedge accounting should be consistent with the approach used in the prior application of Statement 52 to determine whether a hedging instrument would be economically effective as a net investment hedge. Under Statement 133, use of a currency different from the exposed currency is not limited to cases in which it is not practical or feasible to hedge in the exposed currency if all other qualifying criteria are met.

If any differences described above exist between the hedging derivative and the hedged net investment, changes in value of the "hypothetical" derivative must be recorded in the cumulative translation adjustment section of OCI. Any difference between the change in fair value of the "hypothetical" derivative and the actual hedging derivative must be recognized in earnings. Because the provisions of paragraph 42, which in large part were carried forward from Statement 52, clearly imply that hedge ineffectiveness must be recognized currently in earnings, ineffectiveness in a net investment hedge must be recognized in earnings for both overhedges and underhedges. As a result, if the change in the fair value of the actual derivative designated as the hedging instrument exceeds the change in fair value of the "hypothetical" derivative contract, the difference represents an overhedge that must be recognized in earnings. Similarly, if the change in fair value of the actual derivative designated as the hedging instrument is smaller than the change in fair value of the "hypothetical" derivative contract, the difference represents an underhedge that must be recognized in earnings. (The recognition of hedge ineffectiveness for an underhedge of an entity's net investment in a foreign operation deliberately differs from the accounting for cash flow hedges.)

If ineffectiveness must be recognized in earnings because the hedging instrument involves multiple differences (that is, different notional amounts, currencies, and underlyings), the amount of ineffectiveness can be determined by a single comparison to the appropriate "hypothetical" derivative contract that does not incorporate those differences.

Paragraph 71 of Statement 133 permits hedging foreign currency risk on an after-tax basis, provided that the documentation of the hedge at its inception indicated that the assessment of effectiveness, including the calculation of ineffectiveness, will be on an after-tax basis (rather than on a pre-tax basis). If an entity has elected to hedge foreign currency risk on an after-tax basis, it must adjust the notional amount of its derivative appropriately to reflect the effect of tax rates. In that case, the "hypothetical" derivative contract used to measure ineffectiveness should have a notional amount that has been appropriately adjusted (pursuant to the documentation at inception) to reflect the effect of the after-tax approach.

Method Based on Changes in Spot Rates

If (a) the notional amount of the derivative designated as a hedge of a net investment in a foreign operation matches (that is, equals) the portion of the net investment designated as being hedged, (b) the derivative's underlying exchange rate is the exchange rate between the functional currency of the hedged net investment and the investor's functional currency, and (c) the hedging derivative is a cross-currency interest rate swap as permitted by Implementation Issue H9, the change in the fair value of the derivative attributable to changes in the difference between the forward rate and spot rate would be excluded from the measure of hedge ineffectiveness and that difference would be reported directly in earnings. The interest accrual/periodic cash settlement components of qualifying receive-floating-rate, pay-floating-rate and receive-fixed rate, pay-fixed-rate cross-currency interest rate swaps would also be reported directly in earnings. The effective portion of the change in fair value should be reported in the same manner as a translation adjustment (that is, reported in the cumulative translation adjustment section of OCI). The effective portion that would be reported in the cumulative translation adjustment section of OCI should be determined by looking to changes in spot exchange rates. The spot-to-spot changes in value reported in the cumulative translation adjustment section of OCI should not be discounted.

If (a) the notional amount of the derivative does not match the portion of the net investment designated as being hedged, (b) the derivative's underlying exchange rate is not the exchange rate between the functional currency of the hedged net investment and the investor's functional currency, or (c) the hedging derivative is a cross-currency interest rate swap as permitted by Implementation Issue H9 in which both legs are not based on comparable interest rate curves (for example, pay foreign currency based on 3-month LIBOR, receive functional currency based on 3-month commercial paper rates), the effective portion that would be reported in the cumulative translation adjustment section of OCI of a hypothetical derivative that does not incorporate those differences must be compared to the change in fair value of the actual derivative to determine the hedging ineffectiveness. Any difference must be recognized in earnings. The "hypothetical" derivative must also have a maturity and repricing and payment frequencies for any interim payments that match the maturity and repricing and payment frequencies for any interim payments of the actual derivative designated as the hedging instrument in the net investment hedge.

Question 2

If the notional amount of the nonderivative instrument matches the portion of the net investment designated as being hedged and the nonderivative instrument is denominated in the functional currency of the hedged net investment, the translation gain or loss determined under Statement 52 by reference to the spot exchange rate between the transaction currency of the debt and the functional currency of the investor (after tax effects, if appropriate) should be reported in the same manner as the translation adjustment associated with the hedged net investment (that is, reported in the cumulative translation adjustment section of OCI). In that case, no hedge ineffectiveness would be recognized in earnings.

Recognition of hedge ineffectiveness in earnings is required if (a) the notional amount of the nonderivative instrument does not match the portion of the net investment designated as being hedged or (b) the nonderivative instrument is denominated in a currency other than the functional currency of the hedged net investment. In that case, ineffectiveness must be recognized in earnings by comparing the foreign currency transaction gain or loss based on the spot rate change (after tax effects, if appropriate) of that nonderivative instrument to the transaction gain or loss based on the spot rate change (after tax effects, if appropriate) that would result from the appropriate "hypothetical" nonderivative instrument that does not incorporate those differences. Any difference between the spot rate change of the "hypothetical" nonderivative instrument and the actual hedging nonderivative instrument must be recognized in earnings. That is, ineffectiveness must be recognized in earnings for both overhedges and underhedges. The "hypothetical" nonderivative must also have a maturity that matches the maturity of the actual nonderivative designated as the net investment hedge.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.