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Hedge Accounting 101

Hedge accounting offers a way for businesses to reduce volatility in their profit and loss statements. Here’s a closer look at how hedging works and how it’s recorded for accounting purposes.

What is hedging and how is it used?

There are inherent risks involved with some types of financial instruments, particularly those subject to volatile market fluctuations. Common types of risk include:

  • Foreign currencies

  • Interest rates

  • Equity prices

  • Commodity prices

  • Credit risks

Derivatives are used to offset these risks, a practice called hedging. For example, interest rate swaps might be used to transform a floating loan rate to a fixed rate.

The hedge fund reduces the risk of losses by occupying an offsetting position related to the security in question. However, hedging isn’t designed to generate profit, merely to mitigate risk. This reduces the investment’s volatility by offsetting the inherent risk that’s unrelated to performance.

Hedge accounting meaning

Under standard accounting methods, hedge instruments leading to changes in fair value are recorded in a Profit and Loss (P&L) statement. Hedged liabilities are measured at fair value through equity, which can lead to a discrepancy between the hedged asset (or liability) and the hedge instrument.

Hedge accounting describes the methods used to reconcile these differences, provided they meet all regulations. It adjusts the security’s fair value and its opposing hedge, treating the two entries as one. This is meant to reduce volatility created by repeated adjustments, a process also known as ‘mark to market’ or fair value accounting.

While hedging is used to reduce a portfolio’s volatility, hedge accounting applies to the corresponding financial statements. During the accounting process, adjusting an instrument’s value to fair value creates substantial fluctuations in profit and loss. With hedge accounting, these changes to the security’s value and reciprocal hedge are treated as a single entry. This reduces any sudden, large swings in the profit and loss statements.

Hedge accounting entries example

When using traditional accounting methods, gains and losses are recorded individually. When recording a hedge accounting entry, the two line items (security and reciprocal hedge) would be listed as a single entry instead. Both items are looked at together, with the overall profit or loss recorded as a single entry.

Hedge accounting methods and analysis

There are several accounting methods to choose from. The following are a few of the most common hedge accounting methods.

  • Dollar offset method: This compares the change in fair value between the hedged item and its hedging instrument. Accountants can choose from using the method from inception on a cumulative basis or between two fixed dates of an accounting term.

  • Critical terms comparison: With this hedge accounting method, terms such as the timing, currency, term, and rate of the instrument are compared to those of the hedged item. Unlike the dollar offset method, no calculations are required in this type of comparison.

  • Regression analysis: This approach uses a statistical analysis between the instrument and hedged item. It looks at the strength of the hedged relationship to see if the comparison is valid.

Benefits of hedge accounting

There are several benefits to using hedge accounting methods, including:

  • Mitigating risk

  • Simplifying financial statements

  • Preventing fluctuations in profit and loss statements

  • Steady income statements attract investment

Challenges in hedge accounting

For hedge accounting to be both accurate and useful, a few conditions must be met:

  • The hedge relationship must be documented and recorded from the start of the hedge.

  • The hedge relationship must be tested (by critical terms comparison, regression analysis, or the dollar offset method described above).

  • The hedging instrument and hedged item must be documented and identified.

Some analysis is therefore required throughout the hedging process to determine if the hedge relationship is effective.

Since the value of hedging instruments fluctuates along with market conditions, hedge accounting is an effective way for companies to stabilise gains and losses.

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