Special hedge accounting is appropriate for hedges of the currency exposure associated with net investments in foreign operations, which give rise to translation gains or losses that are recorded in the currency translation account (CTA) in shareholders’ equity. Derivatives and non-derivatives (i.e., assets or liabilities denominated in the same currency as that of the net investment) may be designated as hedges of these exposures. (815-20-25-66) Effective results of such hedges are recognized in the same manner as a translation adjustment. Ineffective portions of hedge results are recognized in earnings. (815-20-35-1)
Hedge accounting for net investments in foreign operations is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, gains or losses of the derivative will be recorded in earnings.
Reporting entities have complete discretion to hedge relationships at will and later re-designate them, assuming all hedge criteria remain satisfied.
Prerequisite requirements to qualify for hedge accounting treatment (815-20-25)
- Hedges must be documented at the inception of the hedge, with the objective and strategy stated, along with an explicit description of the methodology used to assess hedge effectiveness. This documentation must include the identification of the hedged item and the hedging instrument and the nature of the risk being hedged.
- The hedge must be expected to be “highly effective,” both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to those changes in the fair value of the hedged item that are due to the risk being hedged.