Hedge AccountingDefined with Examples

Running a business always carries a risk.

You run the risk of hiring an incompetent employee, your supplier of a very specialized product might suspend its operations, or there is risk of investing in a stock that may lose its value.

These are just some of the risks that you’ll face when you’re running a business.

Be that as it may, some transactions are inherently riskier than others.

Particularly, financial instruments that are subject to volatile market fluctuations carry an inherent risk.

For example, the price of a commodity that you regularly use in the production of your products may increase well beyond projections.

Due to the unexpected increase, your actual profit margin will probably be lower than the budgeted profit margin.

You may even have to increase your sales price just to avoid a loss.

Another example of such a transaction is when you enter into a loan contract that does not have a fixed interest rate.

The contract may state that the interest rate will follow the prevailing market rate.

Because of this, it becomes hard to budget for the interest expense related to the loan.

There is also the risk of the prevailing market rate becoming significantly higher, resulting in a higher interest expense.

With the rise in globalization, businesses can now sell their products or offer their services in another country.

This also resulted in businesses dealing in foreign currencies.

This practice carries an inherent risk for the business, or more specifically, the risk associated with foreign exchange.

This wouldn’t be an issue if the business can instantly do currency exchange at a constant rate, but that rarely happens in the real world.

Thus, the business carries the risk of incurring a foreign exchange loss.

It is because of these risks that businesses resort to hedging.

 

What is hedging?

Because of the inherently risky nature of some transactions and financial instruments, the practice of hedging is sought by businesses.

The main goal of hedging is to, at the very least, reduce the impact of the risks that come with certain financial instruments.

This in turn helps reduce the volatility associated with a financial instrument.

It does this by compensating for changes that are not related to the instrument’s performance.

To summarize, hedging aims to lower the impact of losses rather than to generate profit.

The common types of risk that hedging can mitigate are the following:

• Interest rate risk
• Foreign exchange risk
• Equity price risk
• Credit risk
• Commodity price risk

With hedging, the business can mitigate the impact of the above risks.

It does not completely remove the risk of loss as the availing of a hedge comes with a cost.

But the cost of the hedge is usually lower than the loss the business would have incurred had it not availed of hedging.

For example, a business can opt to transform a floating loan rate to a fixed rate by availing of an interest rate swap.

This mitigates the impact of interest rate risk.

By having a fixed rate, the business won’t have to worry about volatile market fluctuations that can affect its interest payments.

Another example, a business has a liability in a foreign currency.

The business is afraid that it may pay more due to foreign currency changes.

To protect itself against the risk of incurring foreign exchange loss, the business availed of a currency option (a hedge).

The business can then opt to exercise the option if the business will incur a loss due to the currency exchange. Thus, mitigates the impact of foreign exchange risk.

What is hedge accounting?

Hedge accounting is another method of accounting where adjustments to the fair value of a financial instrument and its corresponding hedge are entered into one entry.

Essentially, any change in the value of a financial instrument is offset by the change in the value of its corresponding hedge.

By doing this, the volatility in earnings is greatly reduced.

In a traditional accounting setting, there could be large swings in earnings due to repeated adjustments to a hedge’s value.

Changes in the fair value of the financial instrument are immediately recorded as profit or loss.

We refer to this as the principle of mark-to-market.

In contrast, the changes in the value of the hedged item will most probably be accounted for on an accrual basis.

This creates a scenario where there can be significant volatility in earnings as a result of accounting for changes in the fair value of the hedge on a mark-to-market basis.

This becomes more obvious if the value of the hedge is high to begin with.

Hedge accounting reduces this volatility by offsetting the changes in the fair value of the hedge and the hedged item.

The main argument for using hedge accounting is that it more accurately reflects a business’s economic situation.

It also avoids misleading investors due to large swings in earnings that are essentially paper profit.

Hedge accounting ultimately hopes to result to more accurate financial statements.

That said, there are still arguments against citing that it could allow businesses to hide gains or losses.

Which defeats the purpose of not misleading investors.

To combat this, the business will have to follow strict rules if it wants to apply hedge accounting.

Types of hedges

There are three commonly known types of hedges: fair value hedges, cash flow hedges, and foreign currency hedges.

Fair value hedge

A fair value hedge is used to mitigate the impact of the risk of changes in the fair value of an asset, liability, or an unrecognized firm commitment.

It is more so used to mitigate the risks associated with fixed exposures such as fixed rates, costs, prices, etc.

For example, let’s say that a business entered into a fixed-rate loan contract.

This means that the business will have to pay the interest rate stated in the contract no matter what the prevailing market rate is.

The business contemplates that the prevailing interest rate might decrease in the coming years.

But because it already entered into a fixed-rate loan contract, it cannot take advantage of the projected decrease in interest rate.

To remedy this, the business avails of a pay-variable, received-fixed interest rate swap so that it can free itself from the risk associated with the fixed interest rate.

The business is essentially able to mitigate the risk of being locked into a fixed-rate loan.

Cash flow hedge

A cash flow hedge is used to mitigate the risk of variations in cash flows associated with an asset, liability, or forecasted transaction.

It is more so used to mitigate the risks from variable exposures such as rapid changes in commodity price.

For example, a business wants to protect itself from the volatility of the price of a certain commodity.

To do this, the business enters into a futures contract to buy the commodity at a certain date, at a certain price.

When the date of purchasing the commodity arrives, the business will pay for it according to the price stated in the contract no matter the value of the commodity is.

Thus, the business mitigates the risk of paying a price higher than what was agreed upon.

Foreign currency hedge

As its name may suggest, a foreign currency hedge is used to mitigate the risk associated with foreign currency transactions.

It is applicable for businesses that regularly transact in foreign currency.

For example, a US business is regularly trading with a business in Japan.

The transactions between these two businesses are always made in Yen, the Japanese currency.

As such, the US business carries a risk of translating the Japanese currency into less US dollars than it paid for.

To combat this, the US business may opt to avail of a foreign currency hedge.

With the help of the hedge, the US business is able is to mitigate the impact of the loss that can be incurred due to foreign currency translation.

The challenges in hedge accounting

While hedge accounting has become available as an option for businesses, most still do not opt to use it and instead go with traditional accounting.

This might be due to the complexity of the accounting method.

To successfully implement an accurate and functional hedge accounting system, the following conditions will have to be met:

• The business must document and record the hedge relationship from the start of the hedge;
• The business must constantly these the hedge relationship. This can be done by using certain hedge accounting methods (dollar offset method, critical terms comparison, or regression analysis);
• The business must document and identify the hedging instrument and hedged item

If successfully met, the result is a more stable recognition of profits and/or losses.

No longer will the business have sporadic earnings due to the changes in the fair value of its hedging instruments.