Accounting for corporate finance: foreign exchange: SSAP 20: hedging using the cover method: when not to use
This guidance applies to companies which have adopted SSAP 20 under Old UK GAAP.
Example: when the cover method cannot be used
Watwal Ltd has a French wholly owned subsidiary which experiences a sharp downturn in trading and becomes technically insolvent. The subsidiary has share capital of €500,000; the UK parent subscribes for further shares of €500,000 to enable the French company to pay its suppliers. This equity injection is financed by a €500,000 bank loan. The additional finance does not add significantly to the value of the subsidiary and although Watwal Ltd expects the French business to recover in time, it is unlikely to return to profitability in the short term.
It would not be appropriate for Watwal Ltd to offset exchange differences on the bank borrowing against exchange differences on the new €500,000 shareholding. If the shares were sold, they would not generate enough cash to repay the loan. The loan doesn’t function as an economic hedge to the shares - the company is in reality exposed to exchange differences on the loan. The company’s accounts wouldn’t show a true and fair view if these exchange differences did not go through the profit and loss account.
Note on IFRS, New UK GAAP and FRS 23 under Old UK GAAP
Companies adopting IFRS, New UK GAAP or FRS 23 of Old UK GAAP cannot use the cover method in their individual financial statements in respect of its subsidiaries, although a similar treatment is possible in respect of foreign branches and in the consolidated financial statements where it is described as a net investment hedge.