Hedge Accounting

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Hedge Accounting?

Hedge Accounting is an accounting method that allows companies to recognize the gains and losses on the hedging instruments against the exposure of the derivative instruments in the same financial period to reduce the income volatility that would arise if both elements were accounted for separately.

Hedge Accounting

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The new standard which defines hedge accounting in a fresher perspective would reduce the time, effort, and expense of the businesses. At the same time, investors would receive accurate and timely financial reportingFinancial ReportingFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making.read more. Though there would be detailed initial assessments, disclosures, risk management assessment, financial impact assessment, and data requirements, it would help is to attain the real value of the information.

Hedge Accounting Explained

Hedge accounting is a practice in accounting where the value of a derivative is adjusted according to its fair value of the hedged derivative. In simpler terms, cash flow hedge accounting helps in identifying the gains and losses for the derivatives that are hedge by adjusting or modifying their normal basis.   

Companies that are exposed to market risksMarket RisksMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more say foreign currency volatility, are more prone to incurring losses due to abrupt change in the value of the currency they are dealing with. To hedge themselves, they use financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more, such as forward contractsForward ContractsA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price).read more, options, or futures.

As per the International Financial Reporting Standards, such instruments need to be reported at fair values in the financial statements, at each reporting date, using ‘mark-to-marketMark-to-marketMarking to market (MTM) is the concept of recording the accounts, i.e., the assets and liabilities at their fair value or at the current market price, which varies with time rather than historical cost. It helps to represent the company's actual financial condition.read more’ value.

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Purpose

As per IFRS 9, the objective is to present, in the financial instruments, the effect of an entity’s risk management activities that use financial instruments and to reflect how those financial instruments are used to manage risk.

Types

Cash flow hedge accounting is accounted in three major types. Let us discuss them to understand the concept in detail.

#1 – Fair Value Hedge

The risk being hedged here is a change in the fair value of asset or liabilityAsset Or LiabilityWhat makes Assets & Liabilities different is that while the former refers to anything that a Company owns to gain long-term economic benefits, the latter refers to anything that the Company owes to other parties. read more or an unrecognized firm commitment attributable to a particular risk.

#2 – Cash Flow Hedge

The risk being hedged here is the firm’s exposure to variability in cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, currency risk, unrecognized firm commitment, or a highly probable forecast transaction.

#3 – Net Investment Hedge

When an entity has overseas subsidiaries, associates, joint venturesJoint VenturesA joint venture is a commercial arrangement between two or more parties in which the parties pool their assets with the goal of performing a specific task, and each party has joint ownership of the entity and is accountable for the costs, losses, or profits that arise out of the venture.read more or branches, then the currency risk that arises due to the translation of the net assets of these foreign operations into the parent entity’s functional currencyFunctional CurrencyThe term functional currency represents the currency of the location in which business operates primarily, earns a significant portion of revenue, and incurs the cost to generate such profits. In short, it is the home currency of that country where the corporate headquarter is situated.read more, gives rise to Net investment hedge.

Examples

Let us understand the concept of hedge accounting policy with the help of a couple of examples.

Example #1

  • On January 1, 2018, an entity purchased ten shares of Apple @ $10 each.
  • The entity enters into market index futures @ $3 each to hedge its position against the downfall of the share prices;
  • On December 31, 2019, the share price turned out to be $ 8 each, and the market index moves to $ 5 each.

The accounting would be done in the following manner-

January 1, 2018

ParticularsDebitCredit
Equity Investment in Apple$100
To Cash$100

December 31, 2018

ParticularsDebitCredit
Other Comprehensive Income$20
To Equity Investment$20
Derivative Asset$20
To OCI$20

We assume that the company used the fair value method to accountFair Value Method To AccountFair 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 for the transactions. OCI stands for Other Comprehensive incomeComprehensive IncomeOther comprehensive income refers to income, expenses, revenue, or loss not being realized while preparing the company's financial statements during an accounting period. Thus, it is excluded and shown after the net income.read more.

Example #2

Jack holds ten shares of Microsoft @ $50 each. To safeguard himself against the loss, if the share prices fall, he secures by taking a put option contract (right to sell the asset) at $ 10 per share for ten shares with a strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more of $ 45.

Under traditional accounting, they would have been accounted for separately, resulting in distortion of the company’s financial position. But in hedge accounting, they would be considered a bundle and accounted for.

Price of the shares (+) Price of the options contract

Therefore, the value of the contract would be

Example
  • =$500+$100
  • Total Value = $600

Recording

Companies that are exposed to market risksMarket RisksMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more say foreign currency volatility, are more prone to incurring losses due to abrupt changes in the value of the currency they are dealing with. To hedge themselves, they use financial instruments, such as forward contracts, options, or futures as a part of their hedge accounting policy.

As per the International Financial Reporting Standards, such instruments need to be reported at fair values in the fFFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read moreinancial statementsInancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, at each reporting date, using ‘mark-to-market’ value.

IFRS – 9

This Standard deals with accounting for financial instruments. It contains three main topics-

This response has emerged as a response to the global financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more and, specifically, banks criterion of measuring impairment losses.

IFRS 9 improves the decision usefulness of the financial instruments by aligning hedge accounting with the risk management activities of an entity.

The definition remains the same with an option lying in the hands of the management, whether to implement the accounting in the organization, keeping in mind the costs and benefits associated with it.

Importance

The primary purpose of a cash flow hedge accounting is to match the recognition of the derivative gains or losses with the underlying investment gains or losses. It is an alternative to the traditional accounting methodAccounting MethodAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods.read more, where both are accounted for as separate line items. The recognition of both the transactions in the same accounting periodSame Accounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more is the real benefit of hedge accounting, which is lacking in traditional accounting.

Solutions

It has been made clear by analysts and experts in the market that there is surely a need to change the method of how the hedge accounting policy of a company or an individual functions. Let us discuss the need and solutions for the same through the explanation below.

The existing standard, IAS 39, was not pragmatic as it was not linked to standard risk management practices. The detailed rules had made the implementation of hedge accounting uneconomical, defeating the very purpose for which the same was created.

Another significant reason that called for a change in the rules was its lack of matching conceptMatching ConceptThe Matching Principle of Accounting provides accounting guidance, stating that all expenses should be recognized in the income statement of the period in which the revenue related to that expense is earned. This means that, regardless of when the actual transaction is made, the expenses that are entered into the debit side of the accounts should have a corresponding credit entry in the same period.read more. A user was unable to grasp an entity’s risk management activities of an entity based on the traditional way of accounting.

Criteria

Following are the major criteria that need to be satisfied to qualify –

  • Identification of derivatives
  • Identification of hedged item
  • Identification of the nature of the risk which is being hedged
  • Assessment should be complete for how the derivative would hedge the exposure

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