CFM8011 - Accounting for foreign exchange: hedging using the cover method

The ‘cover method’

A UK company that makes an overseas investment, denominated in a non-sterling currency, will frequently fund the investment by borrowing in the same currency. The borrowing hedges the investment. If, for example, a company pays $100 million for shares in a US subsidiary and funds the purchase by a $100 million bank loan, any change in the sterling value of the investment because of exchange movements will be cancelled out by an equal change in the value of the loan.

But straightforward application of the basic rules in SSAP20 would give an unreasonable result in this situation. The shares are a non-monetary asset and would be carried at the historical exchange rate. The loan is a monetary liability and would be re-translated to the closing rate at the end of each accounting period, with the exchange loss or gain being taken to profit and loss account. This would mean that the company’s profits would include an exchange gain or loss where, in reality, the company has no exposure to dollar/sterling exchange rates: exchange differences on the borrowing are ‘covered’ by exchange differences on the shares.

Where an equity investment denominated in a foreign currency is hedged by a loan, SSAP20 allows a company to re-translate the investment at the balance sheet date as if it were a monetary item. Exchange differences on the shares are taken to reserves. Exchange differences on the hedging loan are also taken to reserves, and offset against the gain or loss on the shares. Any excess that can’t be offset is taken to profit and loss account.

This method of accounting is sometimes called the ‘cover method’. Its use is subject to certain conditions, which are discussed at CFM8012.

See CFM8011a for an example of the use of the cover method.