Hedge accounting can bring a number of advantages over traditional accounting methods. The core benefit is that by addressing the timings mismatch associated with standard derivative accounting, hedge accounting removes temporary volatility from the P&L. As a result, the financial statements will better reflect the company’s true economic performance.
Reducing the volatility in earnings results in a number of additional benefits:
- Enterprise value. Earnings volatility is negatively perceived by investors.
- Creditworthiness. Predictability in future earnings is a positive factor in creditworthiness.
- Risk management. Statements reflect better and more accurately how FX-risk is managed.
- Executive compensation. Compensation tied to performance, for example measured based on quarterly earnings, can incur unintended impacts from earnings volatility.
But it can also go very wrong, see this article from Reuters: Dutch housing coop Vestia seeks damages from Deutsche Bank for derivatives
Example: Time value of options – transaction related hedged item3
The case: Gains/losses arising on the effective portion of hedging instruments carried at fair value in a qualifying cash flow hedge.
Entity X is a copper producer and enters into a put option to hedge sales that are forecast to take place on 30 September 20X4:
- On 1 January 20X4 Entity X enters into a put option to sell 1,000 tonnes of copper for CU50/tonne. The put option expires on 30 September 20X4 (assume that the hedge is 100% effective)
- The copper spot price on 1 January 20X4 is CU50/tonne
- Entity X pays CU2,000 for the put option
- Initial time value (i.e. fair value; less, intrinsic value) is CU2,000. [i.e. CU2,000 – ((CU50-CU50) x 1,000 tonnes)]
1 January 20X4
To recognise the purchase of the option.
Subsequently, on 1 March 20X4:
- The fair value of the option is CU5,000
- The copper spot price is CU46/tonne
- Intrinsic value is CU4,000 [i.e. (CU50-CU46) x 1,000 tonnes)], the effective portion of the option
- The time value of the option (i.e. fair value; less, intrinsic value) is CU1,000 [i.e. CU5,000 – CU4,000].
1 March 20X4
DR OCI – Option time value reserve
CR OCI – Cash flow hedge reserve
To recognise the change in fair value of the option, taking the change in the intrinsic component (the hedging instrument) to the CFH reserve, and recognising the change in time value in the option time value reserve.