Define Hedge Accounting

Hedge accounting treats inputs to change the fair value of a security and its opposing hedge as one. By limiting volatility, hedge accounting, also referred to as fair value accounting or mark-to-market, reduces the impact of periodic changes to a financial instrument’s value. Combining the instrument and hedge into one entry reduces volatility by offsetting opposing movements.

Understanding Hedge Accounting

A hedge fund reduces total loss risk by taking an offsetting position in a particular investment. The hedge fund account aims to reduce lost profits, notably from interest rates, exchange rates, and commodity risks. This reduces investment volatility by accounting for non-performance-related changes.

Hedging an investment reduces portfolio volatility. This accounting works similarly, but on financial statements. Accounting for complicated financial instruments at fair value causes colossal profit and loss fluctuations. Hedge accounting reduces significant swings by treating reciprocal hedge and original securities market value movements as one entry.

Corporate bookkeeping utilizes hedge accounting for derivatives. Using derivatives can reduce the total risk associated with a security. Compared to reporting each security and derivative separately, hedge accounting reduces volatility.

Recording Hedge Accounting

This accounting offers an alternative to typical ways of recognizing gains and losses. When treated separately, a security and its hedge fund would show their gains or losses. The hedge fund offsets security risks; therefore, hedge accounting regards the two line items as one. Instead of recording one gain and one loss, the two are analyzed to see if they had a net gain or loss, and the net amount is noted.

This method simplifies financial accounts by reducing line items and increasing the risk of deceit by not recording data individually.

What are the three hedge accounting models?

Topic 815 of the Accounting Standards Codification (ASC) covers derivatives and hedging. ASC 815 defines three hedge accounting categories:

• Fair-value hedges
• Cash flow hedges
• Net investment hedges

What is a fair-value hedge?

A fair value hedge protects corporations from volatility and asset or liability fair value variations. Hedge accounting applies when asset or liability fair value changes might influence the company’s reported profitability. Inventory and foreign currency assets and liabilities may qualify for fair value hedging.

A cash flow hedge?

A cash flow hedge reduces the volatility of cash flows from an asset, obligation, or expected transaction. Hedge accounting applies when the asset, obligation, or future transaction’s cash flows might alter the company’s reported results. Variable interest rate assets or liabilities, foreign currency assets or liabilities, projected purchases or sales, and debt issuances may qualify for cash flow hedging.

A net investment hedge?

A net investment hedge hedges a company’s foreign currency exposure and reduces reported earnings risk from the disposal of a net investment in a foreign activity.

The Verdict

FASB’s new ASC 815 makes this accounting easier for corporations to adopt but not straightforward. Even with the modifications, accounting may be complex, and some organizations may not utilize it since it’s more complicated than other accounting subjects, says Gautam Goswami, CPA, national assurance partner at BDO.

Conclusion

• One entry adjusts the fair value of a security and its hedge in hedge accounting.
• Hedging reduces volatility from non-performance-related investment value variations.
• This accounting includes fair value, cash flow, and net investment hedges.