Basis for Conclusions on IFRIC 16 (INT16_08-15_COMPdec21_01-22)

This Basis for Conclusions summarises the IFRIC’s considerations in reaching its consensus. Individual IFRIC members gave greater weight to some factors than to others.

The IFRIC was asked for guidance on accounting for the hedge of a net investment in a foreign operation in the consolidated financial statements. Interested parties had different views of the risks eligible for hedge accounting purposes. One issue is whether the risk arises from the foreign currency exposure to the functional currencies of the foreign operation and the parent entity, or whether it arises from the foreign currency exposure to the functional currency of the foreign operation and the presentation currency of the parent entity’s consolidated financial statements.

Concern was also raised about which entity within a group could hold a hedging instrument in a hedge of a net investment in a foreign operation and in particular whether the parent entity holding the net investment in a foreign operation must also hold the hedging instrument.

Accordingly, the IFRIC decided to develop guidance on the accounting for a hedge of the foreign currency risk arising from a net investment in a foreign operation.

The IFRIC published draft Interpretation D22 Hedges of a Net Investment in a Foreign Operation for public comment in July 2007 and received 45 comment letters in response to its proposals.

The IFRIC received a submission suggesting that the method of consolidation can affect the determination of the hedged risk in a hedge of a net investment in a foreign operation. The submission noted that consolidation can be completed by either the direct method or the step-by-step method. In the direct method of consolidation, each entity within a group is consolidated directly into the ultimate parent entity’s presentation currency when preparing the consolidated financial statements. In the step-by-step method, each intermediate parent entity prepares consolidated financial statements, which are then consolidated into its parent entity until the ultimate parent entity has prepared consolidated financial statements.

The submission stated that if the direct method was required, the risk that qualifies for hedge accounting in a hedge of a net investment in a foreign operation would arise only from exposure between the functional currency of the foreign operation and the presentation currency of the group. This is because each foreign operation is translated only once into the presentation currency. In contrast, the submission stated that if the step-by-step method was required, the hedged risk that qualifies for hedge accounting is the risk between the functional currencies of the foreign operation and the immediate parent entity into which the entity was consolidated. This is because each foreign operation is consolidated directly into its immediate parent entity.

In response to this, the IFRIC noted that IAS 21 The Effects of Changes in Foreign Exchange Rates does not specify a method of consolidation for foreign operations. Furthermore, paragraph BC18 of the Basis for Conclusions on IAS 21 states that the method of translating financial statements will result in the same amounts in the presentation currency regardless of whether the direct method or the step-by-step method is used. The IFRIC therefore concluded that the consolidation mechanism should not determine what risk qualifies for hedge accounting in the hedge of a net investment in a foreign operation.

However, the IFRIC noted that its conclusion would not resolve the divergence of views on the foreign currency risk that may be designated as a hedge relationship in the hedge of a net investment in a foreign operation. The IFRIC therefore decided that an Interpretation was needed.

The IFRIC considered whether the risk that qualifies for hedge accounting in a hedge of a net investment in a foreign operation arises from the exposure to the functional currency of the foreign operation in relation to the presentation currency of the group or the functional currency of the parent entity, or both.

The answer to this question is important when the presentation currency of the group is different from an intermediate or ultimate parent entity’s functional currency. If the presentation currency of the group and the functional currency of the parent entity are the same, the exchange rate being hedged would be identified as that between the parent entity’s functional currency and the foreign operation’s functional currency. No further translation adjustment would be required to prepare the consolidated financial statements. However, when the functional currency of the parent entity is different from the presentation currency of the group, a translation adjustment will be included in other comprehensive income to present the consolidated financial statements in a different presentation currency. The issue, therefore, is how to determine which foreign currency risk may be designated as the hedged risk in accordance with IAS 39 Financial Instruments: Recognition and Measurement^[1] in the hedge of a net investment in a foreign operation.

The IFRIC noted the following arguments for permitting hedge accounting for a hedge of the presentation currency:

(a) If the presentation currency of the group is different from the ultimate parent entity’s functional currency, a difference arises on translation that is recognised in other comprehensive income. It is argued that a reason for allowing hedge accounting for a net investment in a foreign operation is to remove from the financial statements the fluctuations resulting from the translation to a presentation currency. If an entity is not allowed to use hedge accounting for the exposure to the presentation currency of the group when it is different from the functional currency of the parent entity, there is likely to be an amount included in other comprehensive income that cannot be offset by hedge accounting.

(b) IAS 21 requires an entity to reclassify from equity to profit or loss as a reclassification adjustment any foreign currency translation gains and losses included in other comprehensive income on disposal of a foreign operation. An amount in other comprehensive income arising from a different presentation currency is therefore included in the amount reclassified to profit or loss on disposal. The entity should be able to include the amount in a hedging relationship if at some stage it is recognised along with other reclassified translation amounts.

The IFRIC noted the following arguments for allowing an entity to designate hedging relationships solely on the basis of differences between functional currencies:

(a) The functional currency of an entity is determined on the basis of the primary economic environment in which that entity operates (ie the environment in which it generates and expends cash). However, the presentation currency is an elective currency that can be changed at any time. To present amounts in a presentation currency is merely a numerical convention necessary for the preparation of financial statements that include a foreign operation. The presentation currency will have no economic effect on the parent entity. Indeed, a parent entity may choose to present financial statements in more than one presentation currency, but can have only one functional currency.

(b) IAS 39 requires a hedging relationship to be effective in offsetting changes in fair values or cash flows attributable to the hedged risk. A net investment in a foreign operation gives rise to an exposure to changes in exchange rate risk for a parent entity. An economic exchange rate risk arises only from an exposure between two or more functional currencies, not from a presentation currency.

When comparing the arguments in paragraphs BC12 and BC13, the IFRIC concluded that the presentation currency does not create an exposure to which an entity may apply hedge accounting. The functional currency is determined on the basis of the primary economic environment in which the entity operates. Accordingly, functional currencies create an economic exposure to changes in cash flows or fair values; a presentation currency never will. No commentators on the draft Interpretation disagreed with the IFRIC’s conclusion.

The IFRIC considered which entity’s (or entities’) functional currency may be used as a reference point for the hedged risk in a net investment hedge. Does the risk arise from the functional currency of:

(a) the immediate parent entity that holds directly the foreign operation;

(b) the ultimate parent entity that is preparing its financial statements; or

(c) the immediate, an intermediate or the ultimate parent entity, depending on what risk that entity decides to hedge, as designated at the inception of the hedge?

The IFRIC concluded that the risk from the exposure to a different functional currency arises for any parent entity whose functional currency is different from that of the identified foreign operation. The immediate parent entity is exposed to changes in the exchange rate of its directly held foreign operation’s functional currency. However, indirectly every entity up the chain of entities to the ultimate parent entity is also exposed to changes in the exchange rate of the foreign operation’s functional currency.

Permitting only the ultimate parent entity to hedge its net investments would ignore the exposures arising on net investments in other parts of the entity. Conversely, permitting only the immediate parent entity to undertake a net investment hedge would imply that an indirect investment does not create a foreign currency exposure for that indirect parent entity.

The IFRIC concluded that a group must identify which risk (ie the functional currency of which parent entity and of which net investment in a foreign operation) is being hedged. The specified parent entity, the hedged risk and hedging instrument should all be designated and documented at the inception of the hedge relationship. As a result of comments received on the draft Interpretation, the IFRIC decided to emphasise that this documentation should also include the entity’s strategy in undertaking the hedge as required by IAS 39.

In the draft Interpretation the IFRIC noted that, in financial statements that include a foreign operation, an entity cannot hedge the same risk more than once. This comment was intended to remind entities that IAS 39 does not permit multiple hedges of the same risk. Some respondents asked the IFRIC to clarify the situations in which the IFRIC considered that the same risk was being hedged more than once. In particular, the IFRIC was asked whether the same risk could be hedged by different entities within a group as long as the amount of risk being hedged was not duplicated.

In its redeliberations, the IFRIC decided to clarify that the carrying amount of the net assets of a foreign operation that may be hedged in the consolidated financial statements of a parent depends on whether any lower level parent of the foreign operation has hedged all or part of the net assets of that foreign operation and that accounting has been maintained in the parent’s consolidated financial statements. An intermediate parent entity can hedge some or all of the risk of its net investment in a foreign operation in its own consolidated financial statements. However, such hedges will not qualify for hedge accounting at the ultimate parent entity level if the ultimate parent entity has also hedged the same risk. Alternatively, if the risk has not been hedged by the ultimate parent entity or another intermediate parent entity, the hedge relationship that qualified in the immediate parent entity’s consolidated financial statements will also qualify in the ultimate parent entity’s consolidated financial statements.

In its redeliberations, the IFRIC also decided to add guidance to the Interpretation to illustrate the importance of careful designation of the amount of the risk being hedged by each entity in the group.

The IFRIC discussed where in a group structure a hedging instrument may be held in a hedge of a net investment in a foreign operation. Guidance on the hedge of a net investment in a foreign operation was originally included in IAS 21. This guidance was moved to IAS 39 to ensure that the hedge accounting guidance included in paragraph 88 of IAS 39 would also apply to the hedges of net investments in foreign operations.

The IFRIC concluded that any entity within the group, other than the foreign operation being hedged, may hold the hedging instrument, as long as the hedging instrument is effective in offsetting the risk arising from the exposure to the functional currency of the foreign operation and the functional currency of the specified parent entity. The functional currency of the entity holding the instrument is irrelevant in determining effectiveness.

The IFRIC concluded that the foreign operation being hedged could not hold the hedging instrument because that instrument would be part of, and denominated in the same currency as, the net investment it was intended to hedge. In this circumstance, hedge accounting is unnecessary. The foreign exchange differences between the parent’s functional currency and both the hedging instrument and the functional currency of the net investment will automatically be included in the group’s foreign currency translation reserve as part of the consolidation process. The balance of the discussion in this Basis for Conclusions does not repeat this restriction.^[2]

Paragraph 14 of IFRIC 16 originally stated that the hedging instrument could not be held by the foreign operation whose net investment was being hedged. The restriction was included in draft Interpretation D22 (from which IFRIC 16 was developed) and attracted little comment from respondents. As originally explained in paragraph BC24, the IFRIC concluded, as part of its redeliberations, that the restriction was appropriate because the foreign exchange differences between the parent’s functional currency and both the hedging instrument and the functional currency of the net investment would automatically be included in the group’s foreign currency translation reserve as part of the consolidation process.

After IFRIC 16 was issued, it was brought to the attention of the International Accounting Standards Board that this conclusion was not correct. Without hedge accounting, part of the foreign exchange difference arising from the hedging instrument would be included in consolidated profit or loss. Therefore, in Improvements to IFRSs issued in April 2009, the Board amended paragraph 14 of IFRIC 16 to remove the restriction on the entity that can hold hedging instruments and deleted paragraph BC24.

Some respondents to the exposure draft Post-implementation Revisions to IFRIC Interpretations (ED/2009/1) agreed that a parent entity should be able to use a derivative held by the foreign operation being hedged as a hedge of the net investment in that foreign operation. However, those respondents recommended that the amendment should apply only to derivative instruments held by the foreign operation being hedged. They asserted that a non-derivative financial instrument would be an effective hedge of the net investment only if it were issued by the foreign operation in its own functional currency and this would have no foreign currency impact on the profit or loss of the consolidated group. Consequently, they thought that the rationale described in paragraph BC24B to support the amendment did not apply to non-derivative instruments.

In its redeliberations, the Board confirmed its previous decision that the amendment should not be restricted to derivative instruments. The Board noted that paragraphs AG13–AG15 of IFRIC 16 illustrate that a non-derivative instrument held by the foreign operation does not need to be considered to be part of the parent’s net investment. As a result, even if it is denominated in the foreign operation’s functional currency a non-derivative instrument could still affect the profit or loss of the consolidated group. Consequently, although it could be argued that the amendment was not required to permit non-derivative instruments to be designated as hedges, the Board decided that the proposal should not be changed.

The IFRIC also concluded that to apply the conclusion in paragraph BC23 when determining the effectiveness of a hedging instrument in the hedge of a net investment, an entity computes the gain or loss on the hedging instrument by reference to the functional currency of the parent entity against whose functional currency the hedged risk is measured, in accordance with the hedge documentation. This is the same regardless of the type of hedging instrument used. This ensures that the effectiveness of the instrument is determined on the basis of changes in fair value or cash flows of the hedging instrument, compared with the changes in the net investment as documented. Thus, any effectiveness test is not dependent on the functional currency of the entity holding the instrument. In other words, the fact that some of the change in the hedging instrument is recognised in profit or loss by one entity within the group and some is recognised in other comprehensive income by another does not affect the assessment of hedge effectiveness.

In the draft Interpretation the IFRIC noted Question F.2.14 in the guidance on implementing IAS 39, on the location of the hedging instrument, and considered whether that guidance could be applied by analogy to a net investment hedge. The answer to Question F.2.14 concludes:

IAS 39 does not require that the operating unit that is exposed to the risk being hedged be a party to the hedging instrument.

This was the only basis for the IFRIC’s conclusion regarding which entity could hold the hedging instrument provided in the draft Interpretation. Some respondents argued that the Interpretation should not refer to implementation guidance as the sole basis for an important conclusion.^[3]

In its redeliberations, the IFRIC considered both the International Accounting Standards Board’s amendment to IAS 21 in 2005 and the objective of hedging a net investment described in IAS 39 in addition to the guidance on implementing IAS 39.

In 2005 the Board was asked to clarify which entity is the reporting entity in IAS 21 and therefore what instruments could be considered part of a reporting entity’s net investment in a foreign operation. In particular, constituents questioned whether a monetary item must be transacted between the foreign operation and the reporting entity to be considered part of the net investment in accordance with IAS 21 paragraph 15, or whether it could be transacted between the foreign operation and any member of the consolidated group.

In response the Board added IAS 21 paragraph 15A to clarify that ‘The entity that has a monetary item receivable from or payable to a foreign operation described in paragraph 15 may be any subsidiary of the group.’ The Board explained its reasons for the amendment in paragraph BC25D of the Basis for Conclusions:

The Board concluded that the accounting treatment in the consolidated financial statements should not be dependent on the currency in which the monetary item is denominated, nor on which entity within the group conducts the transaction with the foreign operation.

In other words, the Board concluded that the relevant reporting entity is the group rather than the individual entity and that the net investment must be viewed from the perspective of the group. It follows, therefore, that the group’s net investment in any foreign operation, and its foreign currency exposure, can be determined only at the relevant parent entity level. The IFRIC similarly concluded that the fact that the net investment is held through an intermediate entity does not affect the economic risk.

Consistently with the Board’s conclusion with respect to monetary items that are part of the net investment, the IFRIC concluded that monetary items (or derivatives) that are hedging instruments in a hedge of a net investment may be held by any entity within the group and the functional currency of the entity holding the monetary items can be different from those of either the parent or the foreign operation. The IFRIC, like the Board, agreed with constituents who noted that a hedging item denominated in a currency that is not the functional currency of the entity holding it does not expose the group to a greater foreign currency exchange difference than arises when the instrument is denominated in that functional currency.

The IFRIC noted that its conclusions that the hedging instrument can be held by any entity in the group and that the foreign currency is determined at the relevant parent entity level have implications for the designation of hedged risks. As illustrated in paragraph AG5 of the application guidance, these conclusions make it possible for an entity to designate a hedged risk that is not apparent in the currencies of the hedged item or the foreign operation. This possibility is unique to hedges of net investments. Consequently, the IFRIC specified that the conclusions in the Interpretation should not be applied by analogy to other types of hedge accounting.

The IFRIC also noted that the objective of hedge accounting as set out in IAS 39 is to achieve offsetting changes in the values of the hedging instrument and of the net investment attributable to the hedged risk. Changes in foreign currency rates affect the value of the entire net investment in a foreign operation, not only the portion IAS 21 requires to be recognised in profit or loss in the absence of hedge accounting but also the portion recognised in other comprehensive income in the parent’s consolidated financial statements. As noted in paragraph BC25, it is the total change in the hedging instrument as result of a change in the foreign currency rate with respect to the parent entity against whose functional currency the hedged risk is measured that is relevant, not the component of comprehensive income in which it is recognised.

In response to requests from some respondents for clarification, the IFRIC discussed what amounts from the parent entity’s foreign currency translation reserve in respect of both the hedging instrument and the foreign operation should be recognised in profit or loss in the parent entity’s consolidated financial statements when the parent disposes of a foreign operation that was hedged. The IFRIC noted that the amounts to be reclassified from equity to profit or loss as reclassification adjustments on the disposition are:

(a) the cumulative amount of gain or loss on a hedging instrument determined to be an effective hedge that has been reflected in other comprehensive income (IAS 39 paragraph 102), and

(b) the cumulative amount reflected in the foreign currency translation reserve in respect of that foreign operation (IAS 21 paragraph 48).

The IFRIC noted that when an entity hedges a net investment in a foreign operation, IAS 39 requires it to identify the cumulative amount included in the group’s foreign currency translation reserve as a result of applying hedge accounting, ie the amount determined to be an effective hedge. Therefore, the IFRIC concluded that when a foreign operation that was hedged is disposed of, the amount reclassified to profit or loss from the foreign currency translation reserve in respect of the hedging instrument in the consolidated financial statements of the parent should be the amount that IAS 39 requires to be identified.

Some respondents to the draft Interpretation argued that the method of consolidation creates a difference in the amounts included in the ultimate parent entity’s foreign currency translation reserve for individual foreign operations that are held through intermediate parents. These respondents noted that this difference may become evident only when the ultimate parent entity disposes of a second tier subsidiary (ie an indirect subsidiary).

The difference becomes apparent in the determination of the amount of the foreign currency translation reserve that is subsequently reclassified to profit or loss. An ultimate parent entity using the direct method of consolidation would reclassify the cumulative foreign currency translation reserve that arose between its functional currency and that of the foreign operation. An ultimate parent entity using the step-by-step method of consolidation might reclassify the cumulative foreign currency translation reserve reflected in the financial statements of the intermediate parent, ie the amount that arose between the functional currency of the foreign operation and that of the intermediate parent, translated into the functional currency of the ultimate parent.

In its redeliberations, the IFRIC noted that the use of the step-by-step method of consolidation does create such a difference for an individual foreign operation although the aggregate net amount of foreign currency translation reserve for all the foreign operations is the same under either method of consolidation. At the same time, the IFRIC noted that the method of consolidation should not create such a difference for an individual foreign operation, on the basis of its conclusion that the economic risk is determined in relation to the ultimate parent’s functional currency.

The IFRIC noted that the amount of foreign currency translation reserve for an individual foreign operation determined by the direct method of consolidation reflects the economic risk between the functional currency of the foreign operation and that of the ultimate parent (if the parent’s functional and presentation currencies are the same). However, the IFRIC noted that IAS 21 does not require an entity to use this method or to make adjustments to produce the same result. The IFRIC also noted that a parent entity is not precluded from determining the amount of the foreign currency translation reserve in respect of a foreign operation it has disposed of as if the direct method of consolidation had been used in order to reclassify the appropriate amount to profit or loss. However, it also noted that making such an adjustment on the disposal of a foreign operation is an accounting policy choice and should be followed consistently for the disposal of all net investments.

The IFRIC noted that this issue arises when the net investment disposed of was not hedged and therefore is not strictly within the scope of the Interpretation. However, because it was a topic of considerable confusion and debate, the IFRIC decided to include a brief example illustrating its conclusions.

In response to respondents’ comments, the IFRIC clarified the Interpretation’s transitional requirements. The IFRIC decided that entities should apply the conclusions in this Interpretation to existing hedging relationships on adoption and cease hedge accounting for those that no longer qualify. However, previous hedge accounting is not affected. This is similar to the transition requirements in IFRS 1 First-time Adoption of International Financial Reporting Standards paragraph 30,^[4] for relationships accounted for as hedges under previous GAAP.

The Board amended paragraph 14 in April 2009. In ED/2009/01 the Board proposed that the amendment should be effective for annual periods beginning on or after 1 October 2008, at the same time as IFRIC 16. Respondents to the exposure draft were concerned that permitting application before the amendment was issued might imply that an entity could designate hedge relationships retrospectively, contrary to the requirements of IAS 39. Consequently, the Board decided that an entity should apply the amendment to paragraph 14 made in April 2009 for annual periods beginning on or after 1 July 2009. The Board also decided to permit early application but noted that early application is possible only if the designation, documentation and effectiveness requirements of paragraph 88 of IAS 39 and of IFRIC 16 are satisfied at the application date.

The main changes from the IFRIC’s proposals are as follows:

(a) Paragraph 11 clarifies that the carrying amount of the net assets of a foreign operation that may be hedged in the consolidated financial statements of a parent depends on whether any lower level parent of the foreign operation has hedged all or part of the net assets of that foreign operation and that accounting has been maintained in the parent’s consolidated financial statements.

(b) Paragraph 15 clarifies that the assessment of effectiveness is not affected by whether the hedging instrument is a derivative or a non-derivative instrument or by the method of consolidation.

(c) Paragraphs 16 and 17 and the illustrative example clarify what amounts should be reclassified from equity to profit or loss as reclassification adjustments on disposal of the foreign operation.

(d) Paragraph 19 clarifies transitional requirements.

(e) The appendix of application guidance was added to the Interpretation. Illustrative examples accompanying the draft Interpretation were removed.

(f) The Basis for Conclusions was changed to set out more clearly the reasons for the IFRIC’s conclusions.