To qualify for net investment hedge accounting, the qualifying criteria for all other foreign currency hedges, discussed in DH 8.3
, must be met. These criteria require that the party to the hedge be either (1) the operating unit that has the foreign currency exposure or (2) another member of the consolidated group that has the same functional currency as the operating unit (provided there are no intervening entities with a different functional currency).
Either a derivative or nonderivative can be the hedging instrument in a net investment hedge. Question DH 8-11, Question DH 8-12, and Question DH 8-13 illustrate this.
Question DH 8-11
USA Corp has two subsidiaries: Nikkei Corp (based in Japan) and Aussie Corp (based in Australia). The functional currency of each subsidiary is the local currency in its respective country. Aussie Corp has Japanese yen-denominated debt. Can USA Corp designate Aussie Corp’s Japanese yen-denominated debt as a hedge of USA Corp’s net investment in Nikkei Corp?
No. Since (1) USA Corp (the operating unit with the foreign currency exposure) is not a party to the hedging instrument (i.e., the Japanese yen-denominated debt) and (2) USA Corp and Aussie Corp do not have the same functional currency, the requirements in ASC 815-20-25-30
have not been met.
Question DH 8-12
Can a reporting entity designate a net investment hedge of its investment in a foreign equity method investee?
Yes. Although an equity method investment is not eligible to be a hedged item with respect to fair value hedges and cash flow hedges, a reporting entity may hedge the foreign currency risk of its equity method investments.
Question DH 8-13
Reporting entities that do not assert indefinite reinvestment of a net investment must recognize a deferred tax liability for any applicable foreign withholding taxes on historical earnings and profits. Since the withholding tax obligation is typically denominated in the currency of the foreign entity, does this deferred tax liability meet the definition of a financial instrument that is eligible to be designated as a hedge of a net investment in a foreign operation?
No. Only a nonderivative financial instrument can be designated as a hedging instrument in a net investment hedge (provided the qualifying criteria are met). A financial instrument is defined as cash, evidence of an ownership interest in an entity, or a contract that imposes the contractual right/obligation either to (1) receive/deliver cash or another financial instrument or (2) exchange financial instruments on potentially favorable/unfavorable terms.
Because the withholding tax does not meet the definition of a financial instrument it would not qualify to be designated as a hedging instrument in a net investment hedge.
As discussed in DH 9.9
, there are two methods a reporting entity can use to assess the effectiveness of a net investment hedge: (1) based on spot rates and (2) based on forward rates. A reporting entity must document the method it chooses and consistently apply it. The forward method may not be used when the hedging instrument is a nonderivative.
Unlike fair value and cash flow hedges, ASC 815
does not prescribe specific documentation criteria for hedges of net investments in foreign operations. However, the hedge designation documentation of a net investment hedge should be prepared with the same detail as other types of hedges, which is discussed in DH 5.7
. Additionally, a reporting entity should document the elections specific to net investment hedges, such as:
- Whether effectiveness will be assessed based on the beginning, ending or some other balance of the net investment
- How frequently any redesignation will be made pursuant to ASC 815-35-35-27 and Example 1 in ASC 815-35-55-1
- Whether hedge effectiveness will be assessed using the spot or forward method