Net investment hedge
Also written Hedge of a net investment in a foreign operation · Net Investment Hedging
A hedge of the foreign exchange risk on a net investment in a non-integral foreign operation, with the effective gains and losses on the hedging instrument recognised directly in equity.
In plain language
An Indian company that owns a foreign subsidiary has a problem every time it prepares consolidated accounts. The subsidiary's net assets are in, say, US dollars. To consolidate them they are translated into rupees, and if the rupee has strengthened, the same dollar net assets are worth fewer rupees. Nothing happened to the subsidiary's business; the exchange rate moved.
The workbook describes the exposure precisely: an investor in a non-integral operation is exposed to changes in the carrying amount of the net assets of the foreign operation arising from the translation of those assets into the reporting currency of the investor.
A net investment hedge uses a foreign currency derivative to offset that translation effect. It is the third of the three hedge accounting types recognised by the ICAI Guidance Note, and under Ind AS 109 it is treated similar to cash flow hedges: the effective part goes to equity, not profit and loss.
How it works
The four principles (Chapter 9, section 9.1.1, Net Investment Hedging):
| # | Principle |
|---|---|
| 1 | Foreign exchange gains and losses on a net investment in a non-integral foreign operation are recognised directly in equity, through translation of its net assets for consolidation |
| 2 | Gains and losses on foreign currency derivatives used as hedging instruments are recognised directly in equity to the extent the hedge is effective |
| 3 | The ineffective portion is recognised in profit and loss immediately |
| 4 | The net deferred foreign currency gains and losses — from both the net investment and the hedging instruments — are recognised in profit and loss on disposal of the foreign operation |
So while the company holds the subsidiary, the translation loss and the hedge gain sit side by side in equity and largely cancel. Only when it sells the subsidiary does the accumulated net amount move to profit and loss.
How the three types compare:
| Type | Hedged risk | Effective portion |
|---|---|---|
| Fair value hedge | Change in value of a recognised item or firm commitment | Profit and loss |
| Cash flow hedge | Variability of future cash flows | Equity |
| Net investment hedge | FX on net assets of a foreign operation | Equity, recycled on disposal |
A worked example
Illustrative. The company, amounts and rates are hypothetical; the treatment follows the workbook's four principles.
Surya Pumps Ltd owns a non-integral subsidiary in the US with net assets of USD 10,00,000. It sells 1,000 lots of USDINR futures (USD 1,000 each, so USD 10,00,000 notional) at 83.50 and designates them as a hedge of its net investment.
At the year-end the rupee has strengthened to 82.70.
Translation loss on net assets = (83.50 − 82.70) × 10,00,000 = Rs 8,00,000
Gain on short futures = (83.50 − 82.70) × 1,000 × 1,000 = Rs 8,00,000
| Equity | Profit and loss | |
|---|---|---|
| Translation loss on the subsidiary | (8,00,000) | — |
| Effective gain on the futures | 8,00,000 | — |
| Net this year | nil | nil |
If the hedge were only partly effective — say the futures gained Rs 8,30,000 because the futures price moved slightly more than the spot rate used for translation — then Rs 8,00,000 would go to equity and the Rs 30,000 excess, the ineffective portion, straight to profit and loss.
Five years later, Surya sells the subsidiary. Whatever net deferred gain or loss has accumulated in equity from translation and hedging is now recognised in profit and loss.
Why NISM asks about it
Chapter 9 (Accounting and Taxation), section 9.1.1, lists the hedge of a net investment in a foreign operation as the third type of hedge accounting and sets out its four principles; section 9.1.3 restates it under Ind AS 109 as similar to cash flow hedges. The Chapter 9 sample question on hedge accounting models has all of the above as its answer, which requires knowing this third type exists.
Common exam traps
- The hedged item is a net investment in a foreign operation — not a receivable, not a future purchase.
- The workbook's wording is a non-integral foreign operation.
- Effective portion to equity, ineffective portion to profit and loss immediately — the same split as a cash flow hedge.
- Recycled to profit and loss only on disposal of the foreign operation.
- It is not a fair value hedge, even though it concerns the value of net assets; the accounting follows the cash flow hedge pattern.
- The Guidance Note lists three hedge types; this is the one most often forgotten.
Check yourself
1.The ICAI Guidance Note on Accounting for Derivatives Contract recognises which types of hedging for hedge accounting?
- a)All of the above
- b)The fair value hedge accounting model
- c)The cash flow hedge accounting model
- d)The hedge of a net investment in a foreign operation
Show the answer
Answer: (a) All of the above
This Guidance Note recognises the following three types of hedging:
The fair value hedge accounting model is applied when hedging the risk of a fair value change of assets and liabilities already recognized in the balance sheet, or a firm commitment that is not yet recognized.
The cash flow hedge accounting model is applied when hedging the risk of changes in highly probable future cash flows or a firm commitment in a foreign currency.
The hedge of a net investment in a foreign operation.
Ind AS 109 recognises the same three: Fair Value Hedge · Cash Flow Hedge · Net Investment Hedge.
Where the effective gains go differs by model. For a fair value hedge, to the statement of profit and loss. For a cash flow hedge, any gain or loss that is determined to be an effective hedge is recognized in equity, for e.g. cash flow hedge reserves — because this is intended to avoid volatility in the statement of profit and loss in a period when the gains and losses on the hedge item are not recognized therein. For a net investment hedge, directly in equity to the extent that the hedge is considered to be effective.
And in every case: the ineffective portion of the gains and losses on the hedging instruments is recognised in the statement of profit and loss immediately.
Designation is a choice: an entity is permitted but not required to designate a derivatives contract as a hedging instrument.
If it does not: it will be measured at fair value and changes in fair value will be recognized immediately in the statement of profit and loss.
Where this is taught
- Series IV · Chapter 9: Accounting and Taxation of IRDintroduced here
- Series XVI · Chapter 9: Accounting and Taxationintroduced here
- Series I · Chapter 9: Accounting and Taxation of ETCDintroduced here
Related terms
- Other Comprehensive IncomeGains and losses that Ind AS requires or permits to bypass the profit and loss account — they change shareholders' equity and never touch earnings per share.
- Cash flow hedgeA hedge of the variability of future cash flows — such as a highly probable foreign currency receipt — whose effective gains and losses are held in equity until the hedged cash flow hits profit and loss.
- Currency futuresA standardised exchange-traded contract to buy or sell one currency against another on a future date at a price fixed today; in India, cash-settled in rupees, USD 1,000 a lot for USDINR.
- Fair value hedgeA hedge of the exposure to changes in fair value of a recognised asset or liability, or an unrecognised firm commitment, attributable to a particular risk that could affect profit and loss.
- Hedge accountingAn optional accounting treatment that matches the timing of gains and losses on a designated hedging derivative with the item it hedges, instead of taking the derivative's fair value changes straight to profit and loss.
- Hedge effectivenessThe degree to which changes in the fair value or cash flows of a hedged item, attributable to the hedged risk, are offset by changes in the fair value or cash flows of the hedging instrument.
- Hedged itemThe asset, liability, cash flow or firm commitment that carries the risk being protected — the exposure a hedging instrument is designated against, and without which there is no hedge at all.