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    Hedging Relationship Statements

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    Respond to following statements.
    1. All hedging relationships must be "highly effective" to qualify for special financial treatment. What is meant by the term highly effective and why is its measurement important for financial managers?

    Hedge accounting can be defined as a method of reflecting a commercially hedged position in the accounts, so that the revaluation of the derivative does not pass through income statement until the transaction concerned occurs. Hedge accounting can mitigate volatility when there are balanced positions so that only real exposures give rise to income volatility. Hedge accounting allows firms to override the normal accounting treatment of IAS 39, but for IASB, it is a privilege and must be earned. To apply hedge accounting rates, the transaction must meet the strict requirements defined in IAS 39, which are considered complex. Hedge accounting requires the item being hedged and the hedging instrument to be identified and designated as such since the inception of the hedge. The hedge item can be a recognized asset or liability, an unrecognized firm commitment or a highly probable forecast translation.
    2. All hedging relationships must be "highly effective" to qualify for special financial treatment. What is meant by the term highly effective and why is its measurement important for financial managers?
    Being highly effective refers to the extent to which changes in the fair value or cash flows of the hedging instrument offset the changes in fair value or cash flows of the hedged item. In a highly effective hedge, the hedge will come close to completely evening this out, though some room for error is allowed. It is important for financial managers because it can help to offset mismatches caused by different basis of accounting between hedged items and hedging instruments
    3. If a U.S. company uses the current rate method to translate the financial statements of foreign subsidiary A into dollars and the currency of country A is strengthening against the dollar, would you expect the U.S. company to recognize translation gains or losses? Where would these gains or losses show up in the financial statements?
    The reporting currency is defined as the currency in which the MNC prepares its consolidated financial statements. That currency is usually the currency in which the parent firm keeps its books, which in turn is usually the currency of the country in which the parent is located and conducts most of its business. Under the current rate method, all balance sheet accounts are translated at the current exchange rate, except for stockholders' equity. This is the simplest of all translation methods to apply. The common stock account and any additional paid-in capital are carried at the exchange rates in effect on the respective dates of issuance. Year-end retained earnings equal the beginning balance of retained earning plus any additions for the year. Translation gains and losses are handled differently according to the current rate method in comparison to other methods. Under the current rate method, translation gains and losses are handled only as an adjustment to net worth through an equity account named the cumulative translation adjustment account. Nothing passes through the income statement.
    4. If a U.S. company uses the current rate method to translate the financial statements of foreign subsidiary A into dollars and the currency of country A is strengthening against the dollar, would you expect the U.S. company to recognize translation gains or losses? Where would these gains or losses show up in the financial statements?
    One way that companies may hedge their net investment in a subsidiary is to take out a loan denominated in the foreign currency. Some firms experience natural hedging because of the distribution of their foreign currency denominated assets and liabilities. It is possible for parent companies to hedge with intercompany debt as long as the debt qualities under the hedging rules. Others choose to enter into instruments such as foreign exchange forward contracts, foreign exchange option contracts and foreign exchange swaps. Fx rate changes cannot always be anticipated and hedging has risks and costs.

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    Solution Preview

    1. All hedging relationships must be "highly effective" to qualify for special financial treatment. What is meant by the term highly effective and why is its measurement important for financial managers?

    Hedge accounting can be defined as a method of reflecting a commercially hedged position in the accounts, so that the revaluation of the derivative does not pass through income statement until the transaction concerned occurs. Hedge accounting can mitigate volatility when there are balanced positions so that only real exposures give rise to income volatility. Hedge accounting allows firms to override the normal accounting treatment of IAS 39, but for IASB, it is a privilege and must be earned. To apply hedge accounting rates, the transaction must meet the strict requirements defined in IAS 39, which are considered complex. Hedge accounting requires the item being hedged and the hedging instrument to be identified and designated as such since the inception of the hedge. The hedge item can be a recognized asset or liability, an unrecognized firm commitment or a highly probable forecast translation.

    Highly effective is a term that ensures that the hedge fund is capable of producing results from the derivative that can correspond to no less than 80% and no more than 120% of the associated changes of the item being hedged. Therefore, the ability for the hedge to be ...

    Solution Summary

    The expert determines what is meant by the term highly effective and why measurements are important for financial managers.

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