A. Situation without Hedging
a) Realized gains and losses
Realized gains and losses can result from sales or other activities within the financial year.
The activities must have been completed, invoiced and paid in foreign currency.
In this case, the gains and losses are just booked into the accounts “other operating income” and “other operating expenses”, no other bookings must be made and there is no correction/adjustment for tax purposes.
b) Unrealized gains and losses: Accounting in HGB
Unrealized currency translation gains or losses can only result from the conversion of balance sheet items on the balance sheet date in accordance with section 256a HGB.
Normally in this case, activities have been completed (and invoiced, but actually the completion is relevant) in foreign currency, but not paid.
So there are receivables and payables in foreign currency.
According to section 256a HGB, following disctinction has to be made:
- long term assets and liabilities in foreign currencies (term > 1 year): to be converted at the mean spot exchange rate on the reporting date. But it is forbidden for such long term items to go above the historical acquisition cost due to the currency conversion only.
Example: a long term asset with a historical acquisition cost of 100 EUR (after historical conversion) may not be accounted with 120 EUR after conversion at year end.If after conversion the value is below the historical acquisition cost, it must be accounted with the lower value (for the above example, a value of 90 EUR would be accounted).
For liabilities, the example would be the other way around (from 100 EUR to 120 EUR is OK, from 100 EUR to 90 EUR not allowed).
- short term assets and liabilities in foreign currencies (term < 1 year): to be converted at the mean spot exchange rate on the reporting date. In contrary to the long term assets and liabilities, there is no above mentioned restriction for short term assets and liabilities.
So for the example above, the short term asset would be accounted with 120 EUR and the unrealized gain 20 EUR would result from this.
- If the value is below the historical acquisition cost, the accounting with the lower value must be made (no difference between long term and short term).
So to sum it up, unrealized gains and losses can only result from:
- currency translation of assets or liabilities on balance sheet date, if their value is below the historical value
- currency translation of short term assets or liabilities on balance sheet date, if their value is above the historical value
c) Unrealized gains and losses: tax law
Basically, the above mentioned method from HGB is also relevant for the tax balance sheet.
But two additional consequences must be considered:
- If the value after conversion goes below the historical values, which would result in unrealized loss (and reduce the taxes), the lower value may be booked in the tax balance sheet if this is a permanent impairment (section 6 subsection 1 Nr. 2 EStG).
This is an option in tax law.
If the impairment is not permanent, the lower value may not be booked.
A permanent impairment is normally accepted by the tax authorities, if the value is still at the same level or even lower on the date of the preparation of financial statements.
- If the value after conversion is higher than the historical values, which would result in unrealized gain (and increase the taxes), the higher value may not be booked in tax balance sheet. The historical cost of asset or liability is the highest possible value in the tax balance sheet (§ 6 para 1 Nr. 2 EStG). So if a gain results from currency conversion of short term items in HGB (see b) ), the gain must be eliminated in the tax balance sheet.
So to sum it up, a situation without hedging is quite comfortable for tax purposes.
1) If there are unrealized losses from currency translation of short term assets or liabilites, they must be booked in HGB, and they may be booked in tax balance sheet if they are permanent, so the taxes could decrease from unrealized currency losses.
2) If there are unrealized gains from currency translation of short term assets or liabilites, they must be booked in HGB, but they may not be booked in tax balance sheet, so the taxes do not increase from unrealized currency gains.
B. Situation with Hedging
a) Realized gains and losses
No difference to the situation without Hedging, see A.a)
b) Unrealized gains and losses: Accounting in HGB
According to section 254 HGB (hedge accounting) if assets, debts, pending transactions or transactions (=underlying contracts) that are expected with a high degree of probability are combined with financial instruments to compensate for opposing changes in value or cash flows from the occurrence of comparable risks (=hegding transaction), the changes in value of both underlying and the hedging transaction must be offset.
Hedging of currency risk normally means that there should be a separate derivative contract (forward or future contract) to hedge the underlying asset or liability.
In case of hedge accounting according to section 254 HGB, the normal currency translation rule of section 256a HGB is not relevant. All gains and losses of an effective hedge are recorded, no matter whether long-term or short-term, and netted in balance sheet and in the P&L statement. But if the hedge is partially not effective, the hedge accounting may not be used for the not effective part.
Please note:
An extensive documentation is required for hedge accounting.
According to IDW RS HFA 35 (a mandatory statement from the Institute of German Auditors)
the documentation must show that the hedging instrument is objectively suitable for hedging the specified risk
at the time the hedging relationship is established and during its existence and that it is therefore likely to be (prospectively) effective.
The documentation must therefore include the following information in addition to the clear declaration of intent by the balancing party:
1. Type of risk to be hedged as well as goals (including the planned hedging period) and strategy (s) of the accounting party with regard to the hedging of the risk
2. Identification and description of the underlying transaction
3. Identification and description of the financial instrument used as a hedging instrument, including its suitability for effectively hedging the risk
4. separate inventory management of the underlying transaction and the hedging instrument
5. Information on the prospective effectiveness of the hedging relationship
6. Method (s) of prospective assessment of the effectiveness of the hedging relationship
7. Method (s) for calculating the amount of previous ineffectiveness based on the hedged risk.
c) Unrealized gains and losses: tax law
According to § 5 Abs. para 1a sentece 2 + para 4a sentence 2 EStG, the hedge accounting from the HGB financial statement must be taken over into the tax balance sheet and tax P&L.
So to sum it up, a situation with hedging is not very comfortable for tax purposes.
Losses AND gains which are netted in HGB due to hedge accounting are taken over into the tax balance sheet and P&L.
Without hedging, such netting would not take place and gains would not be taken over into the tax balance sheet (see above under A.)
Furthermore, consider the cost of documentation due to hedge accounting.
C. Deferred taxes
The temporary differences between accounting of gains and losses from currency translation between HGB and tax balance sheet will normally lead to deferred taxes.
Currency translation gains, which have to be accounted in German GAAP (HGB) balance sheet, but may not be shown in the tax balance sheet, increase the HGB equity compared to tax equity and therefore result in deferred tax liabilities.
Currency translation losses, which have to be accounted in German GAAP (HGB) balance sheet, but may only be shown in the tax balance sheet if they are permanent, in case of non-permanent losses decrease only the HGB equity compared to tax equity and therefore result in deferred tax assets.
A big or middle-sized incorporated company must consider deferred tax liabilities and has an option to show deferred tax assets.
A small-sized incorporated company may consider deferred taxes (option).