Derivatives Implementation Group

Statement 133 Implementation Issue No. H1

QUESTION

Must the criteria in paragraphs 40(a) and 40(b) of Statement 133 required for a foreign currency cash flow hedge also be applied to a foreign currency fair value hedge and a hedge of the net investment in a foreign operation? Those paragraphs require that either (1) the operating unit that has the foreign currency exposure is a party to the hedging instrument or (2) another member of the consolidated group that has the same functional currency as that operating unit (subject to certain restrictions) is a party to the hedging instrument and that the hedged transaction (or exposure) be denominated in a currency other than the hedging unit's functional currency.

RESPONSE

Yes. The requirements in paragraphs 40(a) and 40(b) are applicable to foreign currency cash flow hedges, foreign currency fair value hedges, and hedges of the net investment in a foreign operation. Under the functional currency concept of FASB Statement No. 52, Foreign Currency Translation, exposure to a foreign currency exists only in relation to a specific unit's designated functional currency cash flows. Therefore, exposure to foreign currency risk must be assessed at the unit level. A unit has exposure to foreign currency risk only if it enters into a transaction (or has an exposure) denominated in a currency other than the unit's functional currency. Due to the requirement in Statement 52 for remeasurement of assets and liabilities denominated in a foreign currency into the unit's functional currency, changes in exchange rates for those currencies will give rise to exchange gains or losses, which results in direct foreign currency exposure for the unit but not for the parent company if its functional currency differs from its unit's functional currency. The functional currency concepts of Statement 52 are relevant if the foreign currency exposure being hedged relates to (a) an unrecognized foreign-currency-denominated firm commitment or a recognized foreign-currency-denominated asset or liability that may be hedged in a fair value hedge, (b) a foreign-currency-denominated forecasted transaction, an unrecognized foreign-currency-denominated firm commitment, or the forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability that may be hedged in a cash flow hedge, or (c) a net investment in a foreign operation.

Because a parent company whose functional currency differs from its subsidiary's functional currency is not directly exposed to the risk of exchange rate changes due to a subsidiary transaction that is denominated in a currency other than a subsidiary's functional currency, the parent cannot hedge that risk. Accordingly, a parent company that has a different functional currency may not directly hedge a subsidiary's recognized asset or liability, unrecognized firm commitment or forecasted transaction denominated in a currency other than the subsidiary's functional currency. Also, a parent that has a different functional currency may not hedge a net investment of a first-tier subsidiary in a second-tier subsidiary. However, a subsidiary may enter into an intercompany hedge contract with the parent company, and that contract can be a hedging instrument in the consolidated financial statements if the parent company enters into an offsetting contract (pursuant to paragraph 36 or 40A for the appropriate hedge relationship) with an unrelated third party to hedge the exposure it acquired from issuing the derivative instrument to the subsidiary that initiated the hedge.

If a subsidiary has the same functional currency as the parent company or other member of the consolidated group, the parent company or that other member of the consolidated group may, subject to certain restrictions, enter into a derivative or nonderivative instrument that is designated as the hedging instrument in a hedge of that subsidiary's foreign currency exchange risk in consolidated financial statements.

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.