Accounting for Fair Value Hedges

The accounting done by the company with respect to the hedge of exposure of fair value change of the item be it a asset for the company or it is a liability that is attributable to the particular risk and the same can result in profit or loss generation to the company is known as the Accounting for the Fair Value Hedges.

Accounting for Fair Value Hedges

A fair value hedge is a hedge of the exposure to changes in the fair value of an asset or liability or any such item that is attributable to a particular risk and can result in either profit or loss. A fair value hedge relates to a fixed value item.

Fair value hedge pertains to a fixed value item. The necessary steps involved accounting for fair valueAccounting For Fair ValueFair value accounting is the process of maintaining items in financial statements at their fair value and current valuation. Mark to market mechanism is applied at specified periods to change the value of items and show them as per their fair value in the market.read more hedges are as follows:

  1. Determine the fair value of both the hedged item and the hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more instrument used on the date of reporting financial statements.
  2. If there is a change in the fair value of the hedged instrument, recognize the profit/loss in the books of accounts.
  3. Lastly, recognize the hedging gain or loss on the hedged item in its carrying amount.

Accounting for Fair Value Hedge Example

Company Fair has an asset with a current fair value of $ 2000, and the management is concerned that the fair value of the hedge will go down to $ 1900. This will result in a loss to the company.

To offset this loss, the company enters into an offsetting position through a derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more, which also has a fair value of $ 2000. Since this is an offsetting position, its fair value will move in the opposite direction as that of the hedged item.

At the time of the closure of books, the following scenarios are possible:

Case #1 – Decrease in the fair value of the hedged item and a simultaneous increase in the fair value of the offsetting hedged instrument

Sl. No.Position on reporting dateValue of Hedged ItemGain / Loss on Hedged ItemValue of Hedged InstrumentGain / Loss on Hedged InstrumentNet Gain / Loss
1Net Loss $ 1,920.00($80.00) $ 2,060.00$60.00($20.00)
2Net Gain $ 1,970.00($30.00) $ 2,040.00$40.00$10.00
3No Loss / No Gain $ 1,950.00($50.00) $ 2,050.00$50.00Neither loss nor gain

Case #2 – Increase in the fair value of the hedged item and a simultaneous decrease in the fair value of the offsetting hedged instrument

Sl. No.Position on reporting dateValue of Hedged ItemGain / Loss on Hedged ItemValue of Hedged InstrumentGain / Loss on Hedged InstrumentNet Gain / Loss
4Net Loss $ 2,040.00 $ 40.00 $ 1,950.00($50.00)($10.00)
5Net Gain $ 2,050.00 $ 50.00 $ 1,970.00($30.00)$20.00
6No Loss / No Gain $ 2,050.00 $ 50.00 $ 1,950.00($50.00)Neither loss nor gain

Accounting for Fair Value Hedges – Journal Entries

What will be Debited?What will be Credited?
In the case of the Hedged Item
a) Loss on the hedging item on the reporting dateDebit the loss to Loss on the Hedged Item A/c
This will have an effect on the Profit & Loss A/c and reduce the profit of the company.
Credit the Hedged item. Since this is an asset, the value of the asset will go down, and this will affect the Financial Position i.e., Balance Sheet of the companyBalance Sheet Of The CompanyA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.
b) Gain on the hedging item on the reporting dateDebit the Hedged item. Since this is an asset, the value of the asset will go up, and this will affect the Financial Position i.e., Balance Sheet of the company.Credit the gain to Gain on the Hedged Item A/c
This will have an effect on the Profit & Loss A/c and increase the profit of the company.
In the case of the Hedging Instrument
a) Loss on the hedging instrument on the reporting dateDebit the loss to Loss on the Hedged Instrument A/c
This will have an effect on the Profit & Loss A/c and reduce the profit of the company.
Credit the Hedged Instrument. Since this is an asset, the value of the asset will go down, and this will affect the Financial Position i.e., Balance Sheet of the companyBalance Sheet Of The CompanyA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more
b) Gain on the hedging instrument on the reporting dateCredit the Hedged item. Since this is an asset, the value of the asset will go up, and this will affect the Financial Position, i.e., Balance Sheet of the company.Credit the gain to Gain on the Hedged Instrument A/c
This will have an effect on the Profit & Loss A/c and increase the profit of the company.
Net effect of both the Hedging Item and the Hedging Instrument
Net loss on the date of reportingNet loss will decrease the overall profit of the company.Net reduction in the Net Assets of the companyNet Reduction In The Net Assets Of The CompanyNet Fixed Assets is a financial metric used to calculate the overall value of a firm’s fixed assets. You can calculate it by deducting the total depreciation or liabilities from the total amount paid for all the fixed assets. read more
Net gain on the date of reportingNet increase in the Net AssetsThe Net AssetsThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW).read moreThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW).read moreThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW).read more of the companyNet gain will increase the overall profit of the company.

Accounting for Fair Value Hedges Video

 
 

This has been a guide to Accounting for Fair Value Hedges. Here we discuss fair value hedge journal entries along with practical examples. You may learn more about accounting from the following articles –

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