What Is Hedge Accounting?

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What Is Hedge Accounting?

Hedge accounting is a method of accounting in which entries to adjust the fair value of a security and its opposing hedge are treated as one. Hedge accounting attempts to reduce the volatility created by the repeated adjustment to a financial instrument's value, known as fair value accounting or mark to market. This volatility is reduced by combining the instrument and the hedge as one entry, which offsets the opposing's movements.

KEY TAKEAWAYS

Hedge accounting uses one entry to adjust the fair value of a security and its opposing hedge.

The purpose of a hedge is to reduce volatility associated with value fluctuations on an investment that is not directly related to the investment's performance.

There are three categories of hedge accounting: 

fair value hedges, 

cash flow hedges, and

Net investment hedges.

Understanding Hedge Accounting

A hedge fund is used to lower the risk of overall losses by assuming an offsetting position in relation to a particular security. The purpose of the hedge fund account is not necessarily to generate profit but instead to lessen the impact of associated losses, especially those attributed to interest rate, exchange rate, or commodity risk. This helps lower the perceived volatility associated with an investment by compensating for changes that are not purely reflective of an investment's performance.

The point of hedging a position is to reduce the volatility of the overall portfolio. Hedge accounting has the same effect except that it is used on financial statements. For example, when accounting for complex financial instruments, adjusting the value of the instrument to fair value creates large swings in profit and loss. Hedge accounting treats the changes in market value of the reciprocal hedge and the original security as one entry so that large swings are reduced.

Hedge accounting is used in corporate bookkeeping as it relates to derivatives. In order to lessen overall risk, derivatives are often used to offset the risks associated with a security. Hedge accounting uses the information from the security and the associated derivative as a single item, lessening the appearance of volatility when compared to reporting each individually.

Recording Hedge Accounting

Hedge accounting is an alternative to more traditional accounting methods for recording gains and losses. When treating the items individually, such as a security and its associated hedge fund, the gains or losses of each would be displayed individually. Since the purpose of the hedge fund is to offset the risks associated with the security, hedge accounting treats the two line items as one. Instead of listing one transaction of a gain and one of a loss, the two are examined to determine if there was an overall gain or loss between them and just the net amount is recorded.

 This approach can make financial statements simpler, as they will have fewer line items, but some potential for deception exists since the details are not recorded individually.

What are the Three Different Hedge Accounting Models?

Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) topic 815 addresses derivatives and hedging. There are three categories of hedge accounting described in ASC 815:

Fair value hedges

Cash flow hedges

Net investment hedges

What Is a Fair Value Hedge?

A fair value hedge is used to hedge against a company's exposure to volatility and changes in the fair value of an asset or liability. In order to qualify for hedge accounting, the potential changes in the asset or liability's fair value must have the potential to affect the company's reported earnings. Examples of items that may qualify for fair value hedging include inventory and assets or liabilities denominated in a foreign currency.

What Is a Cash Flow Hedge?

A cash flow hedge is used to reduce the exposure to volatility of cash flows from an existing asset or liability or a forecasted transaction. In order to qualify for hedge accounting, the potential changes in cash flows from the asset, liability, or future transaction must have the potential to affect the company's reported earnings. Examples of items that may qualify for cash flow hedging include variable interest rate assets or liabilities, assets or liabilities denominated in a foreign currency, forecasted purchases or sales, and forecasted debt issuances.

What is a Net Investment Hedge?

A net investment hedge is used to hedge a company's foreign currency exposure and reduce the potential reported earnings risk that may occur upon the future disposition of a net investment in a foreign operation.

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