Hedge accounting is an

accountancy Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "langua ...

practice, the aim of which is to provide an offset to the

mark-to-market Mark-to-market (MTM or M2M) or fair value accounting is accounting for the " fair value" of an asset or liability based on the current market price, or the price for similar assets and liabilities, or based on another objectively assessed "fair ...

movement of the

derivative In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. ...

in the

profit and loss account An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''stateme ...

. There are two types of

hedge A hedge or hedgerow is a line of closely spaced shrubs and sometimes trees, planted and trained to form a barrier or to mark the boundary of an area, such as between neighbouring properties. Hedges that are used to separate a road from adjoi ...

recognized. For a fair value hedge, the offset is achieved either by marking-to-market an asset or a liability which offsets the P&L movement of the derivative. For a cash flow hedge, some of the derivative volatility is placed into a separate component of the entity's equity called the

cash flow A cash flow is a real or virtual movement of money: *a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...

hedge reserve. Where a hedge relationship is effective (meets the 80%–125% rule), most of the mark-to-market derivative volatility will be offset in the profit and loss account. Hedge accounting entails much compliance - involving documenting the hedge relationship and both prospectively and retrospectively proving that the hedge relationship is effective.

Why is hedge accounting necessary?

All entities are exposed to some form of market risk. For example, gold mines are exposed to the price of gold, airlines to the price of jet fuel, borrowers to interest rates, and importers and exporters to exchange rate risks. Many

financial institution Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial inst ...

s and corporate businesses (entities) use

financial instrument Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...

s to hedge their exposure to different risks (for example

interest rate risk In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinc ...

foreign exchange risk Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises ...

commodity risk Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. A commodity enterpris ...

, etc.). Accounting for derivative financial instruments under International Accounting Standards is covered by IAS39 (Financial Instrument: Recognition and Measurement). IAS39 requires that all derivatives are marked-to-market with changes in the mark-to-market being taken to the

profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit (real property), a nonpossessory inter ...

and loss account. For many entities this would result in a significant amount of profit and loss volatility arising from the use of derivatives. An entity can mitigate the profit and loss effect arising from derivatives used for hedging, through an optional part of IAS39 relating to hedge accounting.

What hedge accounting options are available to an entity that wants to manage foreign currency exposure?

A specific type of hedging transaction that entities can engage in aims to manage foreign currency exposure. These hedges are undertaken for the economic aim of reducing potential loss from fluctuations in foreign exchange rates. However, not all hedges are designated for special accounting treatment. Accounting standards enable hedge accounting for three different designated forex hedges: *A

cash flow hedge {{finance-stub A cash flow hedge is a hedge of the exposure to the variability of cash flow that # is attributable to a particular risk associated with a recognized asset or liability. Such as all or some future interest payments on variable rat ...

may be designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognized asset or liability, or a forecasted intercompany transaction. *A fair value hedge may be designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability. *A net investment hedge may be designated for the net investment in a foreign operation.

References

{{Reflist

Sources

A summary of the IAS39 by Deloitte Touche Tohmatsu.

External links

Basic Fixed Income Derivative Hedging
- Article on Financial-edu.com.

Comparing Hedge Accounting Under GAAP and IFRS 9
Richard Steiman CPA
Types of accounting Derivatives (finance)

Why is hedge accounting necessary?

What hedge accounting options are available to an entity that wants to manage foreign currency exposure?

See also

References

Sources

External links