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Many multinational reporting entities conduct their currency hedging from a central treasury unit to reduce the cost of risk management and improve controls over derivative execution. After entering into derivative transactions with external counterparties, the central treasury unit will enter into an intercompany derivative to transfer the hedge to the operating entity with the risk to be hedged. To allow reporting entities that use a treasury center to comply with the ASC 815-20-25-30(a) requirement that the operating entity with the foreign currency exposure be a party to the hedging instrument, ASC 815 permits intercompany derivatives to be designated as the hedging instrument in a hedge of foreign currency risk in the consolidated financial statements of the reporting entity. Because this is an exception to the overall model, an intercompany derivative cannot be designated as the hedging instrument for hedges of risk other than foreign currency risk in the consolidated financial statements.
As discussed in ASC 815-20-25-61, an intercompany derivative may be the hedging instrument in certain cash flow hedging relationships of foreign currency risk.

ASC 815-20-25-61

An internal derivative can be a hedging instrument in a foreign currency cash flow hedge of a forecasted borrowing, purchase, or sale or an unrecognized firm commitment in the consolidated financial statements only if both of the following conditions are satisfied:
  1. From the perspective of the member of the consolidated group using the derivative instrument as a hedging instrument (the hedging affiliate), the criteria for foreign currency cash flow hedge accounting otherwise specified in this Section are satisfied.
  2. The member of the consolidated group not using the derivative instrument as a hedging instrument (the issuing affiliate) either:
    1. Enters into a derivative instrument with an unrelated third party to offset the exposure that results from that internal derivative
    2. If the conditions in paragraphs 815-20-25-62 through 25-63 are met, enters into derivative instruments with unrelated third parties that would offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivative instruments. In complying with this guidance the issuing affiliate could enter into a third-party position with neither leg of the third-party position being the issuing affiliate’s functional currency to offset its exposure if the amount of the respective currencies of each leg are equivalent with respect to each other based on forward exchange rates.

Although the requirement that there be an intercompany derivative contract may seem a formality, it has important implications. For example, the gain or loss on the third-party hedging contract executed by the treasury center must be “pushed down” to the hedging unit (i.e., recorded in the foreign entity’s financial statements). The intercompany derivative does not eliminate in consolidation. At the treasury center, a gain from the external derivative gets offset by the loss from the intercompany derivative; at the hedging unit, the gain from the intercompany derivative is recorded and not eliminated in consolidation.
For purposes of separate, standalone company financial statements, an intercompany derivative between a subsidiary and a parent company (or another affiliated entity) would be sufficient to qualify for hedge accounting regardless of whether the parent company has entered into an offsetting contract with an outside party. An additional third-party contract is not needed in this circumstance, because a parent company is a party external to the reporting entity from the perspective of the subsidiary’s standalone financial statements.
Example DH 8-8 addresses treasury center hedging of foreign currency sales of members of a consolidated group.
EXAMPLE DH 8-8
Treasury center hedge of foreign-currency sales
USA Corp is a US dollar (USD) functional currency reporting entity. USA Corp has a first-tier subsidiary (Euro Holding Co) in the United Kingdom that is a British pound sterling (GBP) functional currency entity. Euro Holding Co has a second-tier subsidiary (Deutsche AG) in Germany that is a euro (EUR) functional entity. USA Corp has another first-tier subsidiary (Central Treasury Co), which is a euro functional entity. The following diagram shows the organizational structure of USA Corp.
Central Treasury Co functions as a centralized treasury center for the consolidated group.
Deutsche AG forecasts USD sales and would like to enter into a foreign currency forward contract to deliver USD and receive EUR to hedge its exposure to USD.
Can Central Treasury Co execute a forward contract with an external party to deliver USD and receive EUR and designate it as a hedge of the foreign currency risk in Deutsche AG’s USD sales?
Analysis
Not without entering into an additional intercompany forward contract. Although Deutsche AG and Central Treasury Co are both euro-functional currency entities, Central Treasury Co cannot enter into a foreign currency hedging derivative on behalf of Deutsche AG because there is an intervening subsidiary that has a different functional currency (Euro Holding Co).
To qualify for hedge accounting, Central Treasury Co and Deutsche AG would have to enter into an intercompany forward contract under which Deutsche AG delivers USD and receives EUR and Central Treasury Co receives USD and delivers EUR. For Central Treasury Co, this intercompany forward will be offset by the forward contract that it enters into with the external party.
Deutsche AG would designate the intercompany derivative as the hedging instrument in a hedge of its USD sales. Central Treasury Co would carry both the intercompany derivative and the external forward contract at fair value through earnings (they should approximately offset each other). In the consolidated financial statements of USA Corp, the remaining hedging relationship would be Deutsche AG’s hedge of its foreign currency-denominated sales.

8.8.1 Netting of exposures on certain currency cash flow hedges

A treasury center can aggregate intercompany derivatives executed in the same foreign currency and then enter into third-party contracts to offset the net exposure (rather than offset each intercompany derivative contract individually) by currency, provided the conditions in ASC 815-20-25-62 and ASC 815-20-25-63 are met. ASC 815 does not permit the netting of intercompany derivatives that are used in fair value hedges, net investment hedges, or cash flow hedges of recognized assets and liabilities.

ASC 815-20-25-62

If an issuing affiliate chooses to offset exposure arising from multiple internal derivatives on an aggregate or net basis, the derivative instruments issued to hedging affiliates shall qualify as cash flow hedges in the consolidated financial statements only if all of the following conditions are satisfied:

  1. The issuing affiliate enters into a derivative instrument with an unrelated third party to offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivatives.
  2. The derivative instrument with the unrelated third party generates equal or closely approximating gains and losses when compared with the aggregate or net losses and gains generated by the derivative instruments issued to affiliates.
  3. Internal derivatives that are not designated as hedging instruments are excluded from the determination of the foreign currency exposure on a net basis that is offset by the third-party derivative instrument. Nonderivative contracts shall not be used as hedging instruments to offset exposures arising from internal derivatives.
  4. Foreign currency exposure that is offset by a single net third-party contract arises from internal derivatives that mature within the same 31-day period and that involve the same currency exposure as the net third-party derivative instrument. The offsetting net third-party derivative instrument related to that group of contracts shall meet all of the following criteria:
    1. It offsets the aggregate or net exposure to that currency.
    2. It matures within the same 31-day period.
    3. It is entered into within three business days after the designation of the internal derivatives as hedging instruments.
  5. The issuing affiliate meets both of the following conditions:
    1. It tracks the exposure that it acquires from each hedging affiliate.
    2. It maintains documentation supporting linkage of each internal derivative and the offsetting aggregate or net derivative instrument with an unrelated third party.
  6. The issuing affiliate does not alter or terminate the offsetting derivative instrument with an unrelated third party unless the hedging affiliate initiates that action.

ASC 815-20-25-63

If the issuing affiliate alters or terminates any offsetting third-party derivative (which should be rare), the hedging affiliate shall prospectively cease hedge accounting for the internal derivatives that are offset by that third-party derivative instrument.

For foreign currency cash flow hedges of recognized assets and liabilities, the treasury center cannot net its exposures. This prohibition raises the question of whether it is permissible to net exposures when a forecasted transaction results in the recognition of a resulting foreign currency-denominated receivable or payable (or the issuance of foreign currency debt) once the forecasted transaction has occurred. This is discussed in ASC 815-20-25-64.

ASC 815-20-25-64

A member of a consolidated group cannot meet the offsetting criteria by offsetting exposures arising from multiple internal derivative contracts on a net basis for foreign currency cash flow exposures related to recognized foreign-currency-denominated assets or liabilities. That prohibition includes situations in which a recognized foreign-currency-denominated asset or liability in a fair value hedge or cash flow hedge results from the occurrence of a specifically identified forecasted transaction initially designated as a cash flow hedge.

Because of this prohibition, a reporting entity that is offsetting net exposures must stop applying hedge accounting for each intercompany derivative if and when the hedged forecasted transaction results in the acquisition of a foreign currency-denominated asset or the incurrence of a foreign currency-denominated liability. If, at that point, the hedging unit wishes to continue the cash flow hedge or initiate a fair value hedge by using an intercompany derivative, the treasury center must enter into an offsetting contract with a third party on a “one-for-one” or gross basis (i.e., without netting any other exposures).
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