Hedge Accounting

What is hedge accounting?

Hedge accounting is an accounting concept that treats security fair value entries and opposing hedges as one. It significantly reduces the volatility created by constant adjustments to a financial instrument’s value, also known as mark-to-market or fair value accounting.

Businesses are exposed to risks, and hedge accounting aims to reduce those that can affect potential profits or losses. The impact of financial risks is high.

Hedge accounting minimizes the adverse effects of many financial failures. Since managing hedges can be a task, companies use treasury management software for seamless management and risk assessment.

Why is hedge accounting necessary?

Hedge accounting reduces the volatility risk from hedged items accounted for separately under the International Financial Reporting Standards (IFRS).

Companies use hedge accounting for the following purposes:

• Foreign currencies: Many businesses deal with a lot of foreign assets and liabilities. Apart from this, they could also have forecasted expenditures, obtain revenues, and make purchases in foreign currencies.
• Interest rates: Companies can also incur interest rates from borrowing fixed-rate or variable-rate assets.
• Commodities: Commodity prices are unpredictable, and hedge accounting combats the risks of fluctuating prices and price volatility.

How does hedge accounting work?

Hedge accounting lowers the risk of loss. Businesses exposed to volatility and dealing with a high volume of foreign transactions use it.

Fair values need to be reported regularly. These values frequently fluctuate due to volatile markets. This affects a company's income statement or financial statements and disrupts its performance. Businesses use different models of hedge accounting to deal with this.

Hedging instruments

Hedging instruments are financial products that allow traders to reduce the risk of underlying assets. While hedging doesn’t completely remove risk from asset classes such as cash, shares, or even foreign exchanges, it does soften the blow if things go wrong.

A trader opens a position on a particular asset, the profitability of which increases when another position suffers losses.

Companies use the following risk hedging instruments:

• Contract for difference (CFD) is an agreement that allows the exchange of an asset’s price difference when opening and closing. Traders commonly use hedge accounting with CFD to sell long or short stocks.
• Options allow holders to buy or sell assets at a particular price within a timeframe. This set price is known as the strike price. Options are categorized into calls and puts. While call options allow holders to buy an asset at or before its expiration at a strike price, put options let the holder sell an asset at or before its expiration.
• Future contracts are legal agreements that bind two companies to exchange an asset at a specific price on a specific date. Futures contracts require an asset to be exchanged before a payment is made, but they can also be settled in cash.

Types of hedge accounting

There are three different hedging activities, each with its own pros and cons. Here are three of them, along with hedge accounting examples: 

• A fair value hedge deals with the risk of fluctuations in the fair market value of assets, liabilities, or other firm commitments. These hedges move in the opposite direction to the hedged items. This means they can be used to offset losses.
   
  • Example of a fair value hedge: Say a company owns an asset valued at $8,000, and there is a risk that the asset's value will drop to $6,000. To combat the depreciation, the company would take an “offsetting position” with an $8,000 derivative contract. Since the entity is in an offsetting position, the derivative contract moves opposite to the hedged item. This protects the asset from fair market value changes.

• A cash flow hedge is a risk management strategy that combats changes in assets during cash flow accounting. The factors involved are fluctuations in exchange rates, interest rates, and asset prices.
   
  • Example of a cash flow hedge: Say a company buys 50 tons of metal and sells it at $1,000 per ton. The company would spend $50,000 to buy the metal. What if the price of the metal increases to $2,000 per ton? The company would now have to deal with an unexpected extra expense of $50,000. So what should the company do? It can enter into a cash flow hedge contract so that the payment remains the same even if metal prices increase.

• A net investment hedge offsets changes in the value of its subsidiary's net assets with a derivative. This counteracts foreign exchange risks.
   
  • Example of a net investment hedge: Suppose a company does business in United States dollars (USD) and has a foreign operation that deals in Canadian dollars (CAD). At the hedging date, the company can include the total value of the subsidiary’s net assets as the hedged item.

Effectiveness of hedge accounting 

The effectiveness of a hedge is the extent to which its value changes against a given exposure. Hedge effectiveness is measured in three ways:

• Economic relationship: The change in the value of the hedged item and the hedging instrument should be inversely proportional. 
• Credit risk: The changes in the instrument’s or asset’s credit risk shouldn't be larger than the changes in the economic relationship. 
• Hedge ratio: An appropriate hedge ratio needs to be maintained throughout the life of a hedge.

A hedging relationship is the criteria for including the fair value of derivatives on the balance sheet. This is done to normalize the use of hedge accounting. This relationship is like a contract for mitigating risk on an asset and includes tests and methods for valuation.

Section 39 of International Accounting Standards (IAS)  requires both elements of a hedging relationship to be tested. IAS 39 ensures that the de-risking of the hedge reflects on the general ledger.

Benefits of hedge accounting

Hedge accounting has multiple benefits, such as reducing volatilities and the potential to increase creditworthiness:

• Minimized volatility: Hedge accounting recognizes gains and losses on instruments by matching the timing of their impact on profit or loss with the hedged items. The main goal of hedge accounting is to reduce volatile income statements that could affect a business’ overall performance.

• Increased creditworthiness: It further helps reduce the impact of profit and loss due to derived activities. This improves a business’ creditworthiness since it can produce steady income statements. Investment companies and lenders prefer this.
• Reduced profit and loss volatility: This is one of the main benefits of hedge accounting. Hedge accounting removes temporary volatilities from profit and loss statements, providing a better picture of a company's performance.