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 value hedges are as follows:

1. Determine the fair value of both the hedged item and the hedging 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 Hedges Video Explanation

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 contract, 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 date	Value of Hedged Item	Gain / Loss on Hedged Item	Value of Hedged Instrument	Gain / Loss on Hedged Instrument	Net Gain / Loss
1	Net Loss	$ 1,920.00	($80.00)	$ 2,060.00	$60.00	($20.00)
2	Net Gain	$ 1,970.00	($30.00)	$ 2,040.00	$40.00	$10.00
3	No Loss / No Gain	$ 1,950.00	($50.00)	$ 2,050.00	$50.00	Neither 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 date	Value of Hedged Item	Gain / Loss on Hedged Item	Value of Hedged Instrument	Gain / Loss on Hedged Instrument	Net Gain / Loss
4	Net Loss	$ 2,040.00	$ 40.00	$ 1,950.00	($50.00)	($10.00)
5	Net Gain	$ 2,050.00	$ 50.00	$ 1,970.00	($30.00)	$20.00
6	No 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 date	Debit 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 company.
b) Gain on the hedging item on the reporting date	Debit 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 date	Debit 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 company
b) Gain on the hedging instrument on the reporting date	Credit 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 reporting	Net loss will decrease the overall profit of the company.	Net reduction in the Net Assets of the company
Net gain on the date of reporting	Net increase in the Net Assets of the company	Net gain will increase the overall profit of the company.

Recommended Articles

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 -

• Hedge Ratio Definition
• What is Carrying Amount?
• Accounting for Derivatives
• Statement of Comprehensive Income