Hedge accounting definition
/What is Hedge Accounting?
Hedge accounting involves offsetting changes in the fair value of a financial instrument with changes in the fair value of a paired hedge. Hedges are used to reduce the risk of losses by taking on an offsetting position in relation to a financial instrument. The result tends to be relatively modest ongoing changes in the reported fair value of financial instruments. This accounting applies to anything being hedged, such as foreign exchange positions, cash flows, and interest rates.
Related AccountingTools Course
Accounting for Derivatives and Hedges
Understanding Hedge Accounting
The intent behind hedge accounting is to allow a business to record changes in the value of a hedging relationship in other comprehensive income (except for fair value hedges), rather than in earnings. This is done in order to protect the core earnings of a business from periodic variations in the value of its financial instruments before they have been liquidated. Once a financial instrument has been liquidated, any accumulated gains or losses stored in other comprehensive income are shifted into earnings.
When a business uses a derivative as a hedge, it can elect to designate the derivative as belonging to one of the following three hedging classifications:
Fair Value Hedge
In a fair value hedge, the derivative is used to hedge the risk of changes in the fair value of an asset or liability, or of an unrecognized firm commitment.
Cash Flow Hedge
In a cash flow hedge, the derivative is used to hedge variations in the cash flows associated with an asset or liability, or of a forecasted transaction.
Foreign Currency Hedge
In a foreign currency hedge, the derivative is used to hedge variations in the foreign currency exposure associated with a net investment in a foreign operation, a forecasted transaction, an available-for-sale security, or an unrecognized firm commitment.
If a derivative instrument is designated as belonging within one of these classifications, the gains or losses associated with the hedge are matched to any gains or losses incurred by the asset or liability with which the derivative is paired.
Advantages of Hedge Accounting
There are several advantages to hedge accounting. The main advantage is that it reduces fluctuations in the reported profit or loss on a reporting entity’s income statement. Because of this reduced level of variation, investors consider the reporting entity to be a better investment, and so are more likely to provide it with funding. Second, the use of hedges is a good way to mitigate the risk associated with unusual fluctuations in the value of financial instruments.