Every business, regardless of its size or sector, is inherently exposed to risks. Hedge accounting is an accounting treatment that represents, within a business’s financial statements, the impact of risk management activities that use financial instruments to reduce exposure to particular risks that could affect profit or loss or other income.
Put simply, hedge accounting enhances the basis for recognising gains and losses on hedging instruments by matching the timing of their impact to profit or loss with the hedged items.
What is the purpose of hedge accounting?
The aim of this is to eliminate volatility in financial statements that otherwise would arise if the hedged items were accounted for separately under International Financial Reporting Standards (IFRS). There are three main asset categories that companies use hedge accounting for:
- Foreign currency exposures – for transaction exposures, such as forecasted purchases, revenues and expenses in foreign currencies, as well as foreign-currency-denominated assets and liabilities.
- Interest rate exposures – such as forecasted fixed-rate borrowing, variable-rate assets and liabilities, as well as fixed-rate assets and debt.
- Commodity exposures – these include forecasted purchases, sales and inventory.
How does hedge accounting work?
Hedge accounting is derived from hedging as a concept. As with the more commonly known hedge funds, this approach is used to lower the risk of overall losses by assuming an offsetting position in relation to a particular asset or liability. This is known as fair value accounting, or mark to market accounting.
This system of accounting is not compulsory, but it is commonly used by businesses that are exposed to the volatility of market risks, such as those that rely on foreign currency exchanges, as they are required, under accounting standards, to report the movement in fair market value of hedge instruments in their financial statements.
Not all hedging instruments qualify for hedge accounting, however, but forward contracts, purchased options and several combination options do.
These fair value of these instruments fluctuate based on market performance and are likely to have an impact on the company’s income statement over the life of the instrument and distort the performance of a business, which is why many businesses apply hedge accounting.
Accounting standards enable hedge accounting for three different designated categories:
- Cash flow hedge – designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognised asset or liability, or a forecasted intercompany transaction.
- Fair value hedge – designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability.
- Net investment hedge – designated for the net investment in a foreign operation.
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Why use hedge accounting
As discussed, the main benefit of using hedge accounting is to reduce income statement volatility, which could affect the overall performance of a business.
In particular, it allows businesses to minimise the profit and loss impact of their derivative activities and variations of the underlying investment gains and losses that would cause mismatches in the accounting of the hedging instrument and the hedged item.
This can help to improve the creditworthiness of a business that is reliant on volatile markets as it offers income statements that are predictable and steady, which can be attractive to investors and lenders.
As mentioned, the hedge accounting treatment is entirely elective and so it may only be beneficial for publicly listed businesses that are attempting to reduce volatility in income statements caused by their exposure to unpredictable markets.
Hedge accounting treatments should, therefore, be seen as an important element of many companies risk management strategy.
Evolution of hedge accounting under IFRS
The Financial Accounting Standards Board increased transparency in corporate financials by requiring derivatives to be measured at fair market value as assets or liabilities on companies’ balance sheets in the early 2000s by introducing FAS 133.
Unfortunately, using this method which relies on mark-to-market valuations, left a great deal of fluctuation in income statements.
As such FASB allowed companies to elect to use hedge accounting. The rules of this accounting method were, for some time, included in IAS 39, the traditional international accounting standard that defined principles for recognition and measurement of financial instruments.
However, the accounting standards it set were too rigid, which made hedge accounting too impractical in many cases. As a result, in 2017, a new hedge accounting standard, IFRS 9, was launched to simplify the process, provide greater flexibility and open up the benefits of hedge accounting to more companies.
It achieves this by improving the usefulness of the financial statements by better aligning hedge accounting with the risk management activities of an entity and removing or amending some of the prohibitions and rules within IAS 39 that frustrated businesses.
In particular, the changes allow non-financial entities to use hedge accounting and permits more use of hedge accounting for components of instruments and groups of contracts.
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