What is this all about?
If investors purchase a security that comprises a high level of risk, they may accompany the purchase with an opposing item (usually a derivative, such as an option or future contract) referred to as a hedge.
This hedge experiences gains in value when the corresponding security (or ‘underlying asset’) sustains losses.
Under traditional accounting practices, a security and its hedge are treated as separate components when priced. Hedge accounting treats them as a single accounting entry that reflects the combined market values of the security and the hedge.
For example, suppose an investor, Jane, holds 10 shares of stock ABC priced at $10 each, worth a total of $100.
To hedge against the stock’s price falling, she buys a put option contract priced at $1 per share for 10 shares of stock ABC with a strike price of $8. Under traditional methods, these items and their prices would be recorded independently. Under hedge accounting, they would be recorded as one item. The value of the item under hedge accounting would be the price of the shares plus the market value of the options contract, $100 + $1(10) = $110.
So, the accounting for derivative instruments at fair value creates a common issue for organizations that hedge risks using such instruments. Specifically, such organizations may face an accounting mismatch between the derivative instrument which is measured at fair value, and the underlying exposure being hedged, as typically underlying exposures are recognized assets or liabilities that are accounted for on a cost or an amortized cost basis, or future transactions that have yet to be recognized. This accounting mismatch results in volatility in profit or loss reporting as there is no offset to the change in the fair value of the derivative instrument. Companies try to remove (or hedge) the volatility in profit or loss reporting as a result of this mismatch by using hedge accounting contracts.
Hedge accounting provides this offset by effectively eliminating/reducing the accounting mismatch through one of three ways:
- through a Fair Value Hedge, which is achieved by accounting for the underlying exposure, asset or liability (typically referred to as the hedged item) by adjusting the carrying value for changes in the hedged risk, which would then offset, to the extent effective, the change in the fair value of the derivative instrument, or
- through a Cash Flow Hedge where changes in the fair value of the derivative instrument are deferred in shareholders equity, to the extent effective, until the underlying exposure impacts the income statement in the future, or
- through a Net Investment Hedge, which is a variation on a cash flow hedge, used to hedge foreign exchange risk associated with net investments in foreign currency denominated operations.
Some other term in hedge accounting:
Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument.
Hedge ratio – The relationship between the quantity of the hedging instrument and the quantity of the hedged item in terms of their relative weighting.
A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that
- exposes the entity to risk of changes in fair value or future cash flows; and
- is designated as being hedged.
A hedging instrument is a designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.
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