An accounting practice where the entries used to adjust the fair value of a derivative also include the value of the opposing hedge for the security
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What is Hedge Accounting?
Hedge accounting is a practice in accounting where the entries used to adjust the fair value of a derivative also include the value of the opposing hedge for the security. In other words, hedge accounting modifies the standard method of recognizing losses or gains on a security and the hedging instrument used to hedge the position.
Further, the hedge and position being hedged are recorded in the same accounting period. It may differ from other accounts that won’t record their hedges in the same accounting period, or the accounts may be stated separately and not combined like in hedge accounting.
Hedge accounting is useful for companies with a significant market risk on their balance sheet; it can be an interest rate risk, a stock market risk, or most commonly, a foreign exchange risk. Also, the value of the hedging instruments moves according to movements in the market; thus, they can affect the income statement and earnings. Yet, hedge accounting treatment will mitigate the impact and more accurately portray the earnings and the performance of the hedging instruments and activities in the company in question.
Hedge Accounting and IAS 39
Under IAS 39, derivatives must be recorded on a mark-to-market basis. Thus, if a profit is taken on a derivative one day, the profit must be recorded when the profit is taken. The same holds if there is a loss on the derivative.
If that derivative is used as a hedging tool, the same treatment is required under IAS 39. However, this could bring plenty of volatility in profits and losses on, at times, a daily basis. Yet, hedge accounting under IAS 39 can help decrease the hedging tool’s volatility. However, the treatment of hedge accounting for hedging tools under IAS 39 is exclusive to derivative instruments.
Numerical Example
Company A keeps only one marketable security position. It is a long position in the S&P 500 Index worth $5 million. It decides to hedge the long position by buying a put option position on the S&P 500 worth $1 million and long the 30-year U.S. Treasury for a position worth $2 million.
Under hedge accounting, the journal entry for the marketable security entry would only include the hedge done through a derivative instrument. Here, only one hedge uses a derivative, and it would be the long put option on the S&P 500. The hedge using the 30-year U.S. Treasury is not a derivative position; thus, it does not receive hedge accounting treatment under IAS 39.
In conclusion, the journal entry for Company A’s marketable securities would include the $5 million long position in the S&P 500 and the $1 million long put option on the S&P 500. The journal entry would be valued at $6 million.
Hedge Accounting and Foreign Exchange Risk
A very common occurrence of hedge accounting is when companies seek to hedge their foreign exchange risk. Due to the increase in globalization through trade liberalization and improvements in technologies, many companies can sell their products or provide their services in a foreign country with a foreign or different currency.
However, the practice inherently brings on risk for the company, specifically the foreign exchange risk. If a company runs its operations out of the United States and all its factories are located in the United States, it would need U.S. dollars to run and grow its operation. Thus, if the U.S.-based company were to do business with a Japanese company and receive Japanese yen, it would need to exchange the yen into U.S. dollars.
If the U.S.-based company were able to do the currency exchange instantly at a constant exchange rate, there would be no need to deploy a hedge. However, it is seldom the case. Often, in such a scenario, a contract would be written which specifies the amount of yen to be paid and a date in the future for the yen to be paid. Since the U.S.-based company is unsure of the exchange rate on the future date, it may deploy a currency hedge with a derivative. This is where hedge accounting would be used under IAS 39.
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