What Is Hedge Accounting?
Hedge accounting attempts to accurately reflect the performance of an investment by aligning the recognition of gains and losses on the derivatives with the underlying hedge transaction.
The method reduces the volatility created by the repeated adjustment to a financial instrument's value by combining the instrument and the hedge as one entry on the income statement.
Key Takeaways
- Hedge accounting aims to reflect the performance of an investment by aligning the recognition of gains and losses on the derivatives with the underlying hedge transaction on the income statement.
- There are three categories of hedge accounting: fair value hedges, cash flow hedges, and net investment hedges.
- The goal of hedging a position is to reduce a portfolio's volatility.
Why Hedge?
A hedge hopes to lower the risk of overall losses by assuming an offsetting position to a specific security. The hedge lessens the impact of associated losses attributed to interest rate, exchange rate, or commodity risk. Hedging thus reduces the volatility of the overall portfolio.
Hedge accounting has the same effect on financial statements. Accounting traditionally for complex financial instruments, and adjusting the value to reflect fair value can create large swings in profit and loss. Hedge accounting treats the changes in the market value of the reciprocal hedge and the original security as one entry so that these large swings are reduced.
Accounting Entries
Hedge accounting is used in corporate bookkeeping as it relates to derivatives. Derivatives are used to offset the risks associated with a security investment. Hedge accounting combines them as a single item, which reduces the appearance of volatility compared to reporting each individually.
Hedge accounting is an alternative to traditional methods for recording gains and losses. When treating the items individually—such as a specific security and its associated hedge—gains or losses of each are displayed independently.
Hedge accounting treats the two line items as one. Instead of listing one transaction of a gain and a separate, single transaction of a loss, the two are examined simultaneously to determine if there was an overall gain or loss between them. Then, only the net amount is recorded.
FASB Categories
The 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: A fair value hedge that meets the criteria in ASC 815 records the change in the derivative’s fair value in current-period earnings and adjusts the hedged item’s carrying amount by the amount of the change in the hedged item’s fair value.
- Cash Flow Hedges: Changes in the cash flows of the hedged risk must affect reported earnings. Examples include variable-interest-rate assets or liabilities, foreign-currency assets or liabilities, forecasted sales, and potential debt.
- Net Investment Hedges: A hedge of foreign currency exposure of a net investment in a foreign operation.An entity records the change in the hedging instrument’s fair value in the cumulative translation adjustment portion of OCI. OCI represents the balance between net income and comprehensive income.
Important
Hedge accounting can make financial statements simpler because they have fewer line items, but there is a potential for deception because the details are not recorded individually.
What Is the Risk of Not Using Hedge Accounting?
When hedge accounting is not used, changes in the fair values of derivative instruments are recognized in earnings in each reporting period and do not reflect the period in which the risks are hedged.
How Are Derivatives Used to Hedge a Position?
Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings. Derivatives are commonly traded on exchanges or OTC.
Is Hedge Accounting a Required Method?
Entities can choose to use hedge accounting or not. It is an optional method and some companies may not apply it to hedging relationships.
The Bottom Line
The FASB's ASC 815 made hedge accounting easier for companies to adopt but did not simplify it. Hedge accounting can be complex, and is an optional alternative for companies.
