Foreign currency-denominated financial assets and liabilities are required to be remeasured based on spot exchange rates in accordance with ASC 830, Foreign Currency Matters; the resulting transaction gain or loss is ordinarily included in net income. As a result, foreign currency-denominated assets and liabilities present an earnings exposure that reporting entities may choose to hedge using either the cash flow or fair value hedging models.

Only a derivative can be designated as the hedging instrument in a hedge of a foreign currency-denominated asset or liability.

ASC 320, Investments-Debt Securities, requires changes in the fair value of available-for-sale debt securities to be reported in other comprehensive income (OCI) until realized. The change in fair value of a foreign currency-denominated available-for-sale debt security, expressed in a reporting entity’s functional currency, is the total of (1) the change in market price of the security, expressed in the local currency and (2) the change in the exchange rate between the local currency and the reporting entity’s functional currency.

A foreign currency-denominated available-for-sale debt security (or a portion of one) can be hedged in either a cash flow or fair value hedging relationship; in practice, they are most often hedged using the fair value hedging model. When a derivative is designated as a hedge of changes in the fair value of a foreign currency-denominated available-for-sale debt security attributable to changes in foreign currency exchange rates, the change in fair value of the hedged security is initially recorded in OCI. The portion of the gain or loss attributable to changes in foreign currency rates is immediately reclassified from OCI into earnings. This reclassification is partially offset by the change in the fair value of the hedging derivative, which is also reported in earnings. Changes in the fair value of the available-for-sale debt security due to unhedged risks remain in OCI, as required by ASC 320.

See DH 8.4 for information on foreign currency cash flow hedges and DH 8.5 for information on foreign currency fair value hedges. Example DH 8-7 illustrates a fair value hedge of an available-for-sale security.

Cash flow hedge accounting can only be applied to hedges of recognized foreign currency-denominated assets and liabilities if the hedge eliminates all of the variability in the functional currency-equivalent cash flows. A currency swap that economically changes floating-rate foreign currency debt into floating-rate functional currency debt does not qualify as a cash flow hedge because the variability in functional currency-equivalent cash flows is not eliminated (i.e., the functional currency-equivalent interest payments are still floating); however, this type of swap could qualify as a hedging instrument in a fair value hedge. A currency swap that economically changes floating-rate foreign currency debt to fixed-rate functional currency debt qualifies as a cash flow hedge if the relationship is highly effective. An interest rate swap that economically changes floating-rate foreign currency debt into fixed-rate foreign currency debt also qualifies for cash flow hedge accounting, but it is a hedge of interest rate risk, not a hedge of foreign currency risk as the functional currency cash flows are not fixed.

The following sections illustrate these principles assuming a US dollar-functional currency entity borrows funds in euro and converts the borrowing into a US dollar obligation by entering into a cross-currency swap that matches the terms of the debt issued.

See DH 8.4 for information on foreign currency cash flow hedges and DH 8.5 for information on foreign currency fair value hedges. See DH 6 for information on interest rate risk hedges.

Because the functional currency-equivalent cash flows are not fixed, the hedging relationship does not qualify for cash flow hedge accounting; fair value hedge accounting is the only type of hedge accounting that can be applied.

Applying fair value hedge accounting will produce the same overall accounting results as not applying hedge accounting at all; the derivative will be measured at fair value with changes recorded in earnings and the foreign currency-denominated debt will be remeasured at the current spot exchange rate, as required by ASC 830. However, the income statement presentation of a fair value hedging relationship may better reflect the reporting entity’s objective (i.e., to hedge the currency risk of the debt) than not applying hedge accounting because the results of the derivative and the hedged item must be presented in the same income statement line item. For economic hedges, presentation would depend on the reporting entity’s election, as discussed in FSP 19.4.4. In addition, a reporting entity may elect to designate the swap as a fair value hedge if designation is consistent with its risk management strategy and/or the reporting entity would prefer to demonstrate to investors that the derivative met the requirements for hedge accounting in ASC 815.

Because the functional currency-equivalent cash flows are not fixed, the hedging relationship does not qualify for cash flow hedge accounting; fair value hedge accounting is the only type of hedge accounting that can be applied.

In applying fair value hedge accounting of both interest rate and foreign currency risk, a reporting entity would adjust the value of the foreign currency-denominated debt to reflect changes in foreign interest rates and then remeasure the debt at the current spot exchange rate, as required by ASC 830.

The functional currency-equivalent cash flows are fixed; therefore, this hedging relationship is eligible for either cash flow or fair value hedging. Cash flow hedge accounting is generally applied. Example DH 8-5 in DH 8.4.4 illustrates a cash flow hedge of fixed-rate foreign currency-denominated debt.

Since the functional currency cash flows are fixed, this hedging relationship is a cash flow hedge of both interest rate and foreign currency risk.

A forecasted foreign currency transaction, such as a forecasted sale denominated in a foreign currency, presents earnings exposure due to movements in foreign exchange rates and can be the hedged item in a cash flow hedging relationship. A derivative may be designated as hedging the foreign currency exposure due to variability in the functional currency-equivalent cash flows of a forecasted transaction if certain criteria are met. See DH 8.4 for additional information on applying cash flow hedge accounting.

As discussed in ASC 830-30-45-3, the net assets of a foreign subsidiary are translated into the reporting currency using the current exchange rate at each balance sheet date; the change in net assets due to changes in exchange rates is recorded in the cumulative translation adjustment (CTA) account (a component of OCI). Applying net investment hedge accounting allows a reporting entity to record the gain or loss on the hedging instrument in CTA, thereby offsetting the impact of the translation process.