Case 19-4 Giant Manufacturing Giant Manufacturing LLC (Giant) is a public entity that manufactures power transmission belts and fluid power product. Giant owns a 100 percent direct interest in subsidiaries Small Sub 1 and Small Sub 2. Giant has U.S. dollar (USD) functional currency. Small Sub 1 and Small Sub 2 have euro (EUR) functional currencies. Organizational Chart Giant (USD) (Holds EUR Debt) (Holds Swap) -100%- -100%- Small Sub 1 (EUR) Small Sub 2 (EUR) Case Facts Because of its consolidated interest in EUR-denominated subsidiaries, Giant is exposed to the risk of adverse changes in the EUR/USD exchange rate in its consolidated financial statements. Changes in the EUR/USD exchange rate affect the currency translation account that is recorded within other comprehensive income. As part of its risk management program to hedge its exposure to the EUR/USD exchange rate, Giant plans to use (1) a EUR/USD cross-currency swap (the "Cross-Currency Hedging Instrument") and (2) a Euro-denominated note that is issued and outstanding with third parties and is not reported at fair value (the "EUR Debt-Hedging Instrument") to protect the value of designated monetary amounts of its net investments in EUR functional currency subsidiaries (i.e., Small Sub 1 and Small Sub 2) against changes in the EUR/USD exchange rate. Giant entered into the receive floating rate (3-month USD LIBOR plus a fixed spread) pay floating rate (3-month EUR EURIBOR plus a fixed spread) Cross-Currency Hedging Instrument on March 17, 2019. Between the hedge designation date and the maturity date of the Cross-Currency Hedging Instrument, Giant is using the Cross-Currency Hedging Instrument to hedge the risk of changes in the USD equivalent value of a portion of its net investment balance in Small Sub 1 attributable to changes in the EUR/USD exchange rate. The EUR Debt-Hedging Instrument is an outstanding note that was issued by Giant, has a EUR 240 million notional amount, is due July 15, 2027, and pays interest at a rate of 5.75 percent per annum. Between the hedge designation date and the maturity date of the EUR Debt-Hedging Instrument, Giant is using the EUR Debt-Hedging Instrument to hedge the previously unhedged risk of changes in the USD equivalent value of a portion of its net investment balance in Small Sub 2 attributable to changes in the EUR/USD exchange rate. See Handout 1 and Handout 2 for a summary of Giant's hedging documentation considerations for the Cross-Currency Hedging Instrument and EUR Debt-Hedging Instrument, respectively. Giant wants to apply hedge accounting to both hedging relationships. The assessment of hedge effectiveness, if applicable, will be on a pretax basis. On August 28, 2017, the FASB issued Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (ASU 2017-12). For public business entities, the amendments in ASU 2017-12 are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early application is permitted in any interim period after issuance of ASU 2017-12. Giant has made this election. Required: 1. Define the type of hedging arrangement that Giant is attempting to use with the Cross-Currency Hedging Instrument and EUR Debt-Hedging Instrument to hedge against changes in foreign currency exposure. In other words, are these cash flow hedges, fair value hedges, or net investment hedges? 2. What documentation requirements must Giant meet for its hedges to qualify for hedge accounting? Identify the appropriate Codification reference to support your response. 3. Does the hedging relationship associated with the Cross-Currency Hedging Instrument qualify for hedge accounting? Assume that Giant prepared its hedge documentation at the inception of the hedging relationship. 4. Does the hedging relationship associated with the EUR Debt-Hedging Instrument qualify for hedge accounting? Assume that Giant prepared its hedge documentation at the inception of the hedging relationship. Case 19-4 Handout 1 Giant Manufacturing Cross-Currency Swap Documentation Note that capitalized terms not defined herein are defined within the case facts. The following represents details and facts associated with the proposed hedging instruments and hedge designation. (Note that for purposes of this case scenario, some of this information may not be relevant to the questions.) Giant's risk management objective for this transaction is to protect EUR 120 million of Giant's first previously unhedged net investment in Small Sub 1 (the hedged item) against the risk of adverse changes in the EUR/USD exchange rate. Giant's strategy is to hedge the risk of changes in the USD equivalent value of a portion of its net investment in its consolidated EUR subsidiaries attributable to changes in the EUR/USD exchange rate between the designation date and maturity date of the Cross-Currency Hedging Instrument using the Cross- Currency Hedging Instrument (the hedging instrument). Giant's cross-currency swap has the following terms: o O Index: EUR/USD exchange rate. Pay notional: EUR 120 million. Pay rate: 3-month EUR-EURIBOR (plus a fixed spread of 3.3225%). Receive notional: USD 120 million. Receive rate: 3-month USD-LIBOR (plus a fixed spread of 3.25%). Effective date: March 31, 2019. Maturity date: March 31, 2024. o 0 o Both legs of the swap have the same repricing intervals and dates, which are every three months on the last business day of each March, June, September, and December, subject to the modified following-business-day convention based on New York and London business days. The Cross-Currency Hedging Instrument is designated as a net investment hedge of the risk of changes in the previously unhedged EUR balance of Giant's beginning net investment balance at the inception of the hedging relationship) in Small Sub 1. Hedge effectiveness will be assessed quarterly on the basis of overall changes in the fair value of the Cross-Currency Hedging Instrument (i.e., on the basis of changes in forward rates). The assessment of effectiveness and the measurement of ineffectiveness (described below) will be on a pretax basis. The critical terms of the Cross-Currency Hedging Instrument match those of the hedged net investment (e.g., the notional amount of the Cross-Currency Hedging Instrument matches the amount of the net investment designated as being hedged); therefore, Giant expects there to be zero hedge ineffectiveness. Case 19-4 Handout 2 Giant Manufacturing EUR-Denominated Note Documentation Note that capitalized terms not defined herein are defined within the case facts. The following represents details and facts associated with the proposed hedging instruments and hedge designation. (Note that for purposes of this case scenario, some of this information may not be relevant to the questions.) Giant's risk management objective for this transaction is to protect EUR 240 million of Giant's first previously unhedged net investment in Small Sub 2 (the hedged item) against the risk of adverse changes in the EUR/USD exchange rate. Giant's strategy is to hedge, using the EUR Debt-Hedging Instrument (the hedging instrument), the risk of changes in the USD equivalent value of a portion of its net investment in its consolidated EUR subsidiaries attributable to changes in the EUR/USD exchange rate between the designation date and maturity date of the EUR Debt-Hedging Instrument. The note issued by Giant includes the following terms: O Issuer: Giant Manufacturing LLC. o Notional: EUR 240 million. o Issue date: June 26, 2019. o Coupon rate: 5.75% per annum. o Maturity date: July 15, 2027. The EUR Debt-Hedging Instrument, which is not reported at fair value, is designated as a net investment hedge of the risk of changes in the previously unhedged EUR balance of Giant's beginning net investment balance at the inception of the hedging relationship) in Small Sub 2. Hedge effectiveness will be assessed quarterly by confirming that the designated net investment's net equity balance at the beginning of any period collectively continues to equal or exceed the balance outstanding on Giant's EUR- denominated debt (i.e., the EUR Debt-Hedging Instrument) and that all other critical terms of the hedging instrument and hedged net investments continue to match (e.g., the underlying currencies). If there are no changes in the critical terms of the hedging relationship, then the hedging relationship will be considered to be perfectly effective. The assessment of effectiveness and the measurement of ineffectiveness (described below) will be on a pretax basis. The critical terms of the EUR Debt-Hedging Instrument match those of the hedged net investment (e.g., the notional amount of the EUR Debt-Hedging Instrument matches the amount of the net investment designated as being hedged); therefore, Giant expects there to be zero hedge ineffectiveness. Case 19-4 Giant Manufacturing Giant Manufacturing LLC (Giant) is a public entity that manufactures power transmission belts and fluid power product. Giant owns a 100 percent direct interest in subsidiaries Small Sub 1 and Small Sub 2. Giant has U.S. dollar (USD) functional currency. Small Sub 1 and Small Sub 2 have euro (EUR) functional currencies. Organizational Chart Giant (USD) (Holds EUR Debt) (Holds Swap) -100%- -100%- Small Sub 1 (EUR) Small Sub 2 (EUR) Case Facts Because of its consolidated interest in EUR-denominated subsidiaries, Giant is exposed to the risk of adverse changes in the EUR/USD exchange rate in its consolidated financial statements. Changes in the EUR/USD exchange rate affect the currency translation account that is recorded within other comprehensive income. As part of its risk management program to hedge its exposure to the EUR/USD exchange rate, Giant plans to use (1) a EUR/USD cross-currency swap (the "Cross-Currency Hedging Instrument") and (2) a Euro-denominated note that is issued and outstanding with third parties and is not reported at fair value (the "EUR Debt-Hedging Instrument") to protect the value of designated monetary amounts of its net investments in EUR functional currency subsidiaries (i.e., Small Sub 1 and Small Sub 2) against changes in the EUR/USD exchange rate. Giant entered into the receive floating rate (3-month USD LIBOR plus a fixed spread) pay floating rate (3-month EUR EURIBOR plus a fixed spread) Cross-Currency Hedging Instrument on March 17, 2019. Between the hedge designation date and the maturity date of the Cross-Currency Hedging Instrument, Giant is using the Cross-Currency Hedging Instrument to hedge the risk of changes in the USD equivalent value of a portion of its net investment balance in Small Sub 1 attributable to changes in the EUR/USD exchange rate. The EUR Debt-Hedging Instrument is an outstanding note that was issued by Giant, has a EUR 240 million notional amount, is due July 15, 2027, and pays interest at a rate of 5.75 percent per annum. Between the hedge designation date and the maturity date of the EUR Debt-Hedging Instrument, Giant is using the EUR Debt-Hedging Instrument to hedge the previously unhedged risk of changes in the USD equivalent value of a portion of its net investment balance in Small Sub 2 attributable to changes in the EUR/USD exchange rate. See Handout 1 and Handout 2 for a summary of Giant's hedging documentation considerations for the Cross-Currency Hedging Instrument and EUR Debt-Hedging Instrument, respectively. Giant wants to apply hedge accounting to both hedging relationships. The assessment of hedge effectiveness, if applicable, will be on a pretax basis. On August 28, 2017, the FASB issued Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (ASU 2017-12). For public business entities, the amendments in ASU 2017-12 are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early application is permitted in any interim period after issuance of ASU 2017-12. Giant has made this election. Required: 1. Define the type of hedging arrangement that Giant is attempting to use with the Cross-Currency Hedging Instrument and EUR Debt-Hedging Instrument to hedge against changes in foreign currency exposure. In other words, are these cash flow hedges, fair value hedges, or net investment hedges? 2. What documentation requirements must Giant meet for its hedges to qualify for hedge accounting? Identify the appropriate Codification reference to support your response. 3. Does the hedging relationship associated with the Cross-Currency Hedging Instrument qualify for hedge accounting? Assume that Giant prepared its hedge documentation at the inception of the hedging relationship. 4. Does the hedging relationship associated with the EUR Debt-Hedging Instrument qualify for hedge accounting? Assume that Giant prepared its hedge documentation at the inception of the hedging relationship. Case 19-4 Handout 1 Giant Manufacturing Cross-Currency Swap Documentation Note that capitalized terms not defined herein are defined within the case facts. The following represents details and facts associated with the proposed hedging instruments and hedge designation. (Note that for purposes of this case scenario, some of this information may not be relevant to the questions.) Giant's risk management objective for this transaction is to protect EUR 120 million of Giant's first previously unhedged net investment in Small Sub 1 (the hedged item) against the risk of adverse changes in the EUR/USD exchange rate. Giant's strategy is to hedge the risk of changes in the USD equivalent value of a portion of its net investment in its consolidated EUR subsidiaries attributable to changes in the EUR/USD exchange rate between the designation date and maturity date of the Cross-Currency Hedging Instrument using the Cross- Currency Hedging Instrument (the hedging instrument). Giant's cross-currency swap has the following terms: o O Index: EUR/USD exchange rate. Pay notional: EUR 120 million. Pay rate: 3-month EUR-EURIBOR (plus a fixed spread of 3.3225%). Receive notional: USD 120 million. Receive rate: 3-month USD-LIBOR (plus a fixed spread of 3.25%). Effective date: March 31, 2019. Maturity date: March 31, 2024. o 0 o Both legs of the swap have the same repricing intervals and dates, which are every three months on the last business day of each March, June, September, and December, subject to the modified following-business-day convention based on New York and London business days. The Cross-Currency Hedging Instrument is designated as a net investment hedge of the risk of changes in the previously unhedged EUR balance of Giant's beginning net investment balance at the inception of the hedging relationship) in Small Sub 1. Hedge effectiveness will be assessed quarterly on the basis of overall changes in the fair value of the Cross-Currency Hedging Instrument (i.e., on the basis of changes in forward rates). The assessment of effectiveness and the measurement of ineffectiveness (described below) will be on a pretax basis. The critical terms of the Cross-Currency Hedging Instrument match those of the hedged net investment (e.g., the notional amount of the Cross-Currency Hedging Instrument matches the amount of the net investment designated as being hedged); therefore, Giant expects there to be zero hedge ineffectiveness. Case 19-4 Handout 2 Giant Manufacturing EUR-Denominated Note Documentation Note that capitalized terms not defined herein are defined within the case facts. The following represents details and facts associated with the proposed hedging instruments and hedge designation. (Note that for purposes of this case scenario, some of this information may not be relevant to the questions.) Giant's risk management objective for this transaction is to protect EUR 240 million of Giant's first previously unhedged net investment in Small Sub 2 (the hedged item) against the risk of adverse changes in the EUR/USD exchange rate. Giant's strategy is to hedge, using the EUR Debt-Hedging Instrument (the hedging instrument), the risk of changes in the USD equivalent value of a portion of its net investment in its consolidated EUR subsidiaries attributable to changes in the EUR/USD exchange rate between the designation date and maturity date of the EUR Debt-Hedging Instrument. The note issued by Giant includes the following terms: O Issuer: Giant Manufacturing LLC. o Notional: EUR 240 million. o Issue date: June 26, 2019. o Coupon rate: 5.75% per annum. o Maturity date: July 15, 2027. The EUR Debt-Hedging Instrument, which is not reported at fair value, is designated as a net investment hedge of the risk of changes in the previously unhedged EUR balance of Giant's beginning net investment balance at the inception of the hedging relationship) in Small Sub 2. Hedge effectiveness will be assessed quarterly by confirming that the designated net investment's net equity balance at the beginning of any period collectively continues to equal or exceed the balance outstanding on Giant's EUR- denominated debt (i.e., the EUR Debt-Hedging Instrument) and that all other critical terms of the hedging instrument and hedged net investments continue to match (e.g., the underlying currencies). If there are no changes in the critical terms of the hedging relationship, then the hedging relationship will be considered to be perfectly effective. The assessment of effectiveness and the measurement of ineffectiveness (described below) will be on a pretax basis. The critical terms of the EUR Debt-Hedging Instrument match those of the hedged net investment (e.g., the notional amount of the EUR Debt-Hedging Instrument matches the amount of the net investment designated as being hedged); therefore, Giant expects there to be zero hedge ineffectiveness