Special Hedge Accounting: Why Functional Currency Matters

A common misconception is that if you have a foreign currency transaction, you can simply hedge it and apply special hedge accounting.

However, the fact is that sometimes an exposure can be hedged, but it will not qualify for special hedge accounting. This brings frustration to corporations, particularly ones that have local currency functional subsidiaries around the world. There is a risk management price to be paid for that legal entity structure when it comes to special hedge accounting.

But fear not; all is not lost. There are often ways to qualify for special hedge accounting even when a company has local currency subsidiaries with local currency third party transactions.

Special Hedge Accounting Qualification Rules

ASC 815 is very clear about what type of foreign currency risk can and cannot qualify for special hedge accounting. The basic rule is that an anticipated foreign currency transaction (e.g. future revenue or expense) that are denominated in a currency other than an entity’s functional currency will qualify.

That means yen-denominated sales in a yen functional Japanese subsidiary will pose a currency risk in translation, but the exposure will not qualify for special hedge accounting. On the other hand, if that same entity had sales denominated in EUR or CNY, the Japanese subsidiary could take hedge accounting on those transactions. Same sale; different treatment.

Proxy Hedging

There is a clause in ASC 815-20-25-38d that states an allowable hedged item of foreign exchange risk includes: “A forecasted intra-entity transaction (for example, a forecasted sale to a foreign subsidiary or a forecasted royalty from a foreign subsidiary).”

A proxy hedge strategy allows a company to hedge an inter-company transaction (e.g. sale) to a foreign subsidiary when that transaction is backed by a third party transaction at the subsidiary level. If we revisit the yen sale out of Japan and take a step back, we could hedge the inventory sale between the parent and the Japanese subsidiary. If the inter-company sale was denominated in yen, the hedging party would be the U.S. parent, and if the inter-company sale was denominated in USD, the Japanese entity would hedge the purchase.

Conclusion

Companies that want to utilize hedge accounting are often surprised when their third party exposures do not qualify for special hedge accounting treatment. Local functional currency subsidiaries can distort the definition of an exposure. Proxy hedges may be the answer to protecting some, if not all, of your currency exposures.

Our Hedge accounting consultants have been successful in developing tailored hedge strategies that qualify for special hedge accounting using a variety of proxy hedge strategies.

Want to learn more about your customized hedge program options? Give us a call!