Hedge accounting is an

accountancy Accounting, also known as accountancy, is the process of recording and processing information about economic entities, such as businesses and corporations. Accounting measures the results of an organization's economic activities and conveys ...

practice, the aim of which is to provide an offset to the mark-to-market movement of the

derivative In mathematics, the derivative is a fundamental tool that quantifies the sensitivity to change of a function's output with respect to its input. The derivative of a function of a single variable at a chosen input value, when it exists, is t ...

in the profit and loss account.

Types

There are two types of

hedge A hedge or hedgerow is a line of closely spaced (3 feet or closer) 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 ...

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 Cash flow, in general, refers to payments made into or out of a business, project, or financial product. It can also refer more specifically to a real or virtual movement of money. *Cash flow, in its narrow sense, is a payment (in a currency), es ...

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.

Necessity

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 A financial institution, sometimes called a banking institution, is a business entity that provides service as an intermediary for different types of financial monetary transactions. Broadly speaking, there are three major types of financial ins ...

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 Interest rate risk is the risk that arises for bond owners from fluctuating interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The ...

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 arise ...

, commodity risk, 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.

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 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

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Sources

A summary of the IAS39 by Deloitte Touche Tohmatsu.

External links