What is Hedge Accounting? Accounting and Types Explained

Hedge accounting or hedging is an accounting practice that is used in companies that deal with components on their financial statements that have very fluctuating values. It is a practice that lets the accountant summarize and present the value of the specific asset or liability on the balance sheet simply and easily.

It helps offset the risk and instability that would otherwise be present in the financials due to the market fluctuations. It states the impact of the risk management using financial instruments that reduce the company’s exposure to risks that could directly affect the bottom line.

Hedge Accounting

What is Hedge Accounting?

Hedge accounting is a practice that allows the change in the value of a financial instrument, such as a mortgage, to be offset by the change in the value of the corresponding hedge.

Ordinarily, the hedge might be accounted for at fair value – with all changes appearing as profits or losses – while the hedged item might be accounted for on an accrual basis. If hedge accounting is not applied, there can be significant volatility in earnings even if there is a good real-world offset between the two.

The argument for hedge accounting, then, is that it more accurately reflects the economic reality and avoids misleading investors. The argument against is that, if applied too broadly, it could allow firms to hide gains or losses. As such, strict rules are set on when hedge accounting can be applied – and many derivatives users insist their hedging strategies comply with these rules.

In other words, hedging is used to decrease a portfolio’s vulnerability, and hedge accounting is used to report the corresponding financial information. The accounting process involves adjusting an instrument’s value to fair value, which typically culminates in significant changes in profit and loss. The changes to the value of the security and its reciprocal hedge are treated as one entry in hedge accounting. Profits and losses are therefore less likely to fluctuate dramatically.

Explanation

When an asset or a liability is hedged it limits the exposure of any extreme changes in its value. A fair value hedge is attributed to any item that has a fixed value. The hedge is done to mitigate primarily, the risk of loss so that any gain arising out of the hedged instrument can play as an uplifting item in the financial statement in case the value of the asset falls drastically and the hit taken on the profit reduces considerably due to the hedging position entered into.

Calculation methods

IAS 39 does not specify a single method for the calculation of the effectiveness of the hedge. The method used depends on the risk management strategy. The most common methods are:

  • Critical terms comparison – this method consists of comparing the critical terms (notional, term, timing, currency, and rate) of the hedging instrument with those from the hedged item. This method does not require any calculation.
  • Dollar offset method – this is a quantitative method that consists of comparing the change in fair value between the hedging instrument and the hedged item. Depending on the entity risk policies, this method can be performed on a cumulative basis (from inception) or on a period-by-period basis (between two specific dates). A hedge is considered highly effective if the results are within the range of 80%-125%.
  • Regression analysis – this statistical method investigates the strength of the statistical relationship between the hedged item and the hedging instrument. From an accounting perspective, this method proves whether or not the relationship is sufficiently effective to qualify for hedge accounting. It does not calculate the amount of ineffectiveness.

What is the purpose of hedge accounting?

The aim of this is to eliminate volatility in financial statements that otherwise would arise if the hedged items were accounted for separately under International Financial Reporting Standards (IFRS).

There are three main asset categories that companies use hedge accounting for:

  • Foreign currency exposures – for transaction exposures, such as forecasted purchases, revenues, and expenses in foreign currencies, as well as foreign-currency-denominated assets and liabilities.
  • Interest rate exposures – such as forecasted fixed-rate borrowing, variable-rate assets, and liabilities, as well as fixed-rate assets and debt.
  • Commodity exposures – these include forecasted purchases, sales, and inventory.

How does hedge accounting work?

Hedge accounting is derived from hedging as a concept. As with the more commonly known hedge funds, this approach is used to lower the risk of overall losses by assuming an offsetting position in relation to a particular asset or liability. This is known as fair value accounting or mark-to-market accounting.

This system of accounting is not compulsory, but it is commonly used by businesses that are exposed to the volatility of market risks, such as those that rely on foreign currency exchanges, as they are required, under accounting standards, to report the movement in the fair market value of hedge instruments in their financial statements.

Not all hedging instruments qualify for hedge accounting, however, but forward contracts, purchased options, and several combination options do.

The fair values of these instruments fluctuate based on market performance and are likely to have an impact on the company’s income statement over the life of the instrument and distort the performance of a business, which is why many businesses apply hedge accounting.

What is the purpose of hedge accounting?

Accounting for Fair Value Hedges Journal Entries

The below entries are based on the date of reporting the entries on the financial statement.

Asset / Hedged InstrumentScenariosDebitCredit
AssetValue of The Asset IncreasesThe increase in the value of the asset should be debited, i.e the Asset should be debited. Record this as an increase in the asset value which will positively impact the financial statementThe Gain on the Hedged Asset A/C should be credited. As a result the gain in the value will show an increased profit
Value of The Asset DecreasesThe Loss on the Hedged Asset A/C should be debited. Since this is a reduction in the value of the asset this will reduce the profit on the financial statementThe decrease in the value of the asset should be credited i.e the Asset should be credited. Record this as a decrease in the asset value which will negatively impact the financial statement
Hedged InstrumentValue of the Hedged Instrument IncreasesThe increase in the value of the hedged instrument should be debited, this gain will positively impact the financial statementThe gain needs to be credited to the Gain on the Hedged Instrument A/C
Value of the Hedged Instrument DecreasesThe decrease needs to be recorded by debiting the Loss on the Hedged Instrument A/C. Since  this is a decrease in the value of the instrument, this will negatively impact the financial statementThe hedged instrument needs to be credited

Types of hedge accounting

Price change fluctuations, foreign exchange rate fluctuations and inflation can cause too much volatility in accounting that is offset by hedge accounting.

There are different types of hedge accounting but they all serve to minimize instability or volatility.

Cash flow hedge

Cash flow is one of the most important aspects of a company. Investors judge the worthiness of a company by studying its cash flows. Cash flow also affects the credit rating of businesses. When the markets are very volatile, they can impact the cash flow of a company. This unstable nature of cash flow in some industries is undesirable. So to offset this, these companies create forward contracts with suppliers that are recorded as assets on the balance sheet to offset the fluctuations in cash flow by securing the contract prices.

Fair value hedge

Floating interest rates can also be volatile and cause too many changes in accounting unless swapped for a fixed rate. Since the floating interest rate is a variable component that could cause losses on investments, it may be swapped for a fixed rate to stay more stable. Fair value hedges make it easier to compute and record the investment-related values on the balance sheet despite the fluctuating interest rate.

Net investment hedge

It is a hedge that is used to keep cash flows more stable when dealing with volatility in foreign currency exchange rates. There are many GAAP rules and restrictions that must be complied with when using this hedge. Foreign currency debt and futures contracts can also be included in the net investment hedge.

Accounting for Fair Value Hedges Journal Entries

Disclosures

When a company applies hedge accounting, it is required to disclose how it applies its risk management strategy and the effects on its financial performance and future cash flows. It is possible that economic and/or geopolitical uncertainty could affect these disclosures and a company will need to use judgment to determine the specific disclosures that are relevant and necessary for its business.

Examples of specific disclosures include:

  • changes in how the company manages risks;
  • impacts on hedge ineffectiveness;
  • forecast transactions that were subject to hedge accounting but are no longer expected to occur, and the related reclassifications to profit or loss, and
  • reclassifications of irrecoverable losses from the cash flow hedge reserve to profit or loss.

Actions for management

  • Evaluate whether forecast transactions designated as hedged items in cash flow hedges continue to be highly probable. If a transaction is not highly probable, then consider whether it is still expected to occur.
  • Determine whether any changes in the contractual terms of a hedged financial instrument resulting from the economic and/or geopolitical uncertainty affect the instrument’s eligibility to be a hedged item.
  • Evaluate whether changes in the credit risk of hedging instruments and hedged items arising from economic and/or geopolitical uncertainty affect the assessment of hedge effectiveness and the measurement of hedge ineffectiveness.
  • Evaluate whether accumulated losses in the cash flow hedge reserve will be recovered in future periods.

Hedge Accounting and IAS 39

Under IAS 39, derivatives must be recorded on a mark-to-market basis. Thus, if a profit is taken on a derivative one day, the profit must be recorded when the profit is taken. The same holds if there is a loss on the derivative.

If that derivative is used as a hedging tool, the same treatment is required under IAS 39. However, this could bring plenty of volatility in profits and losses on, at times, a daily basis. Yet, hedge accounting under IAS 39 can help decrease the hedging tool’s volatility. However, the treatment of hedge accounting for hedging tools under IAS 39 is exclusive to derivative instruments.

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