A Comprehensive Guide To Hedge Accounting

Introduction

Hedge accounting is a technique used by companies to reduce the effects of foreign currency fluctuations or any other financial risks on their accounts. It works within the financial reporting process and leverages financial instruments to minimize the influence of market volatility on earnings. This process makes the financial performance more predictable, enabling investors to get a better understanding of the business’s operations.

There are different types of hedge accounting strategies, each aligned with a specific form of risk. For instance, firms use fair value hedges to address the changes in the fair value of the assets or liabilities; cash flow hedges are used to manage risks due to volatility in the cash flows that are related to the anticipated transactions. These strategies not only help the firm in risk management but also ensure compliance with the relevant accounting standards, ensuring financial reporting accuracy, 

Knowledge of these specific forms of hedge accounting is crucial for firms operating in volatile environments and helps them avoid the risk of significant changes in financial statements. In this blog, we will understand what is hedge accounting, its types, advantages, and related complexities. 

What is Hedge Accounting?

Hedge accounting is an accounting practice where the entries utilized to adjust the fair value of the financial instrument also include the opposing hedge value. In simpler terms, hedge accounting enables you to offset the changes in the value of the financial instrument due to specific risks, with the change in the value of the associated hedge. 

Without hedge accounting businesses may face significant volatility resulting due to frequent revaluation of financial instruments to their ‘fair value’, also known as mark-to-market. Hedge accounting helps mitigate this by matching the valuation change of both hedged and hedging instruments. It is beneficial for companies that deal with market risks associated with fluctuations in interest rates, stock markets, commodity price volatility and exchange rate risk.

How Does Hedge Accounting Work? 

While hedge accounting is not a mandatory practice, it’s a valuable tool for businesses when it comes to financial risk management. Due to this, a lot of businesses leverage hedge accounting to offset the value of volatile assets and liabilities. 

The hedge accounting process is initiated with entries in the general ledger to record the value of assets, liabilities and corresponding hedging instruments. Investments and their corresponding hedges are listed in a credit-debit system just like income and expenses. The recorded transactions are then moved to the financial statements (income statement and balance sheet) of the company at the end of the accounting period. 

Hedge Accounting and IFRS 9 

Hedge accounting practices for entities reporting under International Financial Reporting Standards (IFRS) are governed by IFRS 9. IFRS 9 replaced IAS 39 due to various shortcomings. IAS 39 proved to be complex and inflexible, with businesses finding it difficult to align their risk management policies with IAS 39 hedge accounting requirements. 

IFRS 9 was introduced to improve and simplify hedge accounting for organizations. A key change that occurred was the removal of 80-125% hedge effectiveness to determine hedge qualification. This practice was found to be too rigid and quantitative. Now, under IFRS 9, companies only need to show the existence of an economic relationship between the hedged item and the hedging instrument, making the process more qualitative. 

Apart from this, IFRS 9 introduced a more flexible and broader range of eligible hedging instruments and hedged items. Since these changes aligned hedge accounting more closely with businesses actual risk management policies, the financial statements are more transparent and informative. 

IFRS qualifying criteria for hedge accounting

1. Companies need to provide formal documentation and designation of hedged items, hedging instruments, nature of the risk being hedged, and their risk management strategy. 
2. A valid hedge relationship exists only between the qualifying hedging instruments and hedged items, as defined by IFRS 9. 
3. To calculate hedge effectiveness, an economic relationship must exist between the hedging instrument and the hedged item. 
4. Hedge accounting for assets and liabilities can only be discontinued due to special circumstances. 

Advantages and Disadvantages of Hedge Accounting

Hedge accounting serves as a crucial tool for companies to manage risks stemming from market fluctuations and currency volatility. By employing various techniques, such as fair value hedges and cash flow hedges, companies can mitigate the impact of these uncertainties on their financial statements, ensuring greater stability in reported earnings and financial position.

However, despite these advantages, hedge accounting is very susceptible to fraud. Let’s understand in detail the pros and cons of hedge accounting. 

Advantages of hedge accounting

1. Less volatile and more stable financial statements: The key reason why businesses use hedge accounting is to reduce volatility in their financial statements.. If the volatility of every item is listed in the statement, it would become far too complicated for the stakeholders to understand. Hedge accounting takes care of this problem by reflecting the volatility of items on the balance sheet. Therefore, the financial statements are much more stable and easy to understand. 
2. Risk mitigation: Another important benefit of hedge accounting is that it reduces the risk factor of cash flow, investment, foreign exchange, and debt. If implemented properly, hedge accounting can help businesses, especially large companies, to gain more profit and expand across geographies. 

Disadvantages of hedge accounting

1. Complex and time-consuming: While IFRS 9 has simplified the hedge accounting process, the process is still complex. A lot of collaboration is required between the accounting team and risk management team, which often demands time and resources to maintain the hedge accounting system. 
2. Prone to fraud: Day-to-day business transactions can be recorded in the accounting software automatically, however, that is not the case for hedge accounting. A lot of hedge accounting entries are done manually, making it prone to fraud and malpractices. 

What are the Three Different Types of Accounting Hedge Models?

Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) topic 815 addresses derivatives and hedging. There are three different types of hedge accounting models, as described in ASC 815:

1. Fair value hedges
2. Cash flow hedges
3. Net investment hedges

All three categories of hedge accounting are distinguished by their accounting and reporting requirements. Let’s understand them in detail.

What is a Fair Value Hedge?

A fair value hedge is an instrument used to mitigate the company’s exposure to volatility and fluctuations in the fair value of the asset or liability. To be eligible for hedge accounting, changes in the fair value of the underlying asset or liability must have the potential to affect the company’s earnings.

Fair value hedge example

Here’s a fair value hedge accounting example to understand the above-mentioned concept in detail. Consider Company A, a manufacturing corporation that owns a raw material inventory worth $100,000. Due to market volatility, Company A is concerned that the fair value of its inventory might decline to $80,000.

To hedge against this potential loss in value, Company A decides to enter into a futures contract for the same quantity of raw material, which is currently valued at $100,000. This futures contract will allow Company A to sell the raw material at the current market price in the future, effectively locking in its value. 

If the fair value of the raw material inventory decreases to $80,000 as anticipated, the value of the futures contract will increase, offsetting the decrease in the inventory’s value. Conversely, if the fair value of the inventory remains at $100,000 or increases, the value of the futures contract will decrease accordingly, but Company A will still benefit from the stable value of its inventory. 

In this case, Company A is employing a fair value hedging strategy to reduce its exposure to changes in the fair value of its inventory by using a futures contract. This helps in maintaining a balance in the company’s assets and liabilities despite market fluctuations. 

What is a Cash Flow Hedge?

A cash flow hedge is utilized to minimize the risk of future cash flow fluctuations arising from an already-held asset or liability or a planned transaction. According to the International Accounting Standards (IAS) and IFRS 9, such hedges can qualify for hedge accounting if the changes in the cash flow can potentially affect the income statement.

Some of the items that could be hedged under the cash flow hedge include fluctuating interest rates on assets or liabilities, foreign currency-denominated assets or liabilities, and forecasted transactions such as acquisitions, sales, and borrowings. 

Cash flow hedge example

To understand the cash flow hedge better, let us take the example of a company XER, which has upcoming expenses related to buying inventory. They plan to purchase 1000 tonnes of steel at $2000 per tonne, anticipating a cash outflow of $200,000 to purchase the steel. However, due to market fluctuations, the steel price now rises to $3000 per tonne, resulting in an increased cash outflow of $300,000. This translates to an additional cash outflow of $100,000 that the company had not accounted for. This is where a cash flow hedge comes in handy. By entering into a future contract, Company XER can lock in $2000 per tonne as steel price through a forward contract. Then, irrespective of the increase in the price of steel, the company would still make the same net payment, and thus, the forward contract is the hedging tool.

What is a Net Investment Hedge?

A net investment hedge is concerned with the hedging of a company’s foreign currency exposure. This type of hedge accounting is used to minimize the chances of fluctuations in reported earnings that could arise from the future sale of a net investment in a foreign operation.

Net investment hedge example

For instance, Company A, a US-based multinational with a subsidiary in Europe (Company B), faces currency risk due to fluctuations in the exchange rate between USD and EUR. To safeguard its investment in Company B from currency depreciation, Company A employs a net investment hedge strategy. This involves using forward exchange contracts or currency swaps to offset potential losses arising from unfavorable exchange rate movements. For instance, Company A might enter into a forward contract to sell euros and buy US dollars at a predetermined rate, thus mitigating the impact of EUR depreciation on its investment.

However, net investment hedging entails complexities and risks, including accounting treatment under relevant financial reporting standards (e.g., ASC 830 in the US) and potential costs associated with derivative contracts. Despite these challenges, such hedging strategies enhance the quality of financial reporting by directly converting the value of Company A’s investment in Company B to its functional currency, reducing uncertainty. Therefore, careful evaluation of hedging strategies in consultation with financial professionals is essential for aligning risk management objectives with regulatory requirements and optimizing financial performance.

What’s the Difference Between a Cash Flow Hedge and a Fair Value Hedge?

A cash flow hedge addresses the variability of the future cash flow related to a recognized asset or liability or a forecasted transaction. A fair value hedge is used to manage the risks associated with fluctuations in the fair value of an already recognized asset or liability. It aims at hedging changes in fair value that are due to a particular risk, such as market fluctuations in interest rates or product prices. 

Find below a detailed comparison of the differences between a cash flow hedge and a fair value hedge. 

What Is The Difference Between Hedge Accounting & Normal Accounting?

Now that we have understood what hedge accounting is, let’s take a look at how it exactly differs from normal accounting. 

Curate your Own Account Hedging Strategy via HighRadius Cash Forecasting Software

HighRadius Cash Forecasting Software helps businesses make data-driven decisions based on accurate future cash predictions. Here’s what it can do for your business.

1. Seamless Data Integration and Aggregation: This cash forecasting software can integrate with various financial systems, such as ERP systems, bank accounts, and other relevant data sources to gather real-time cash flow data with a 100% automated bank integration feature.
2. Historical Analysis: This software can analyze historical cash flow data to identify patterns, trends, and seasonality and provide insights into how cash is typically generated and spent over time. This improves the global inflow and outflow forecast accuracy by 95%.
3. Accurate Cash Forecasting: The system uses machine learning algorithms, capturing variables such as customer payment behavior, invoice data, purchase orders, and economic indicators to generate accurate forecasts. It also enables the use of custom-based models for different cash flow categories (Heuristic models for payroll and taxes forecasting and AI models for A/R and A/P forecasting) for building accuracy up to 95%.

   This helps businesses to become aware of their risks beforehand and pick an effective currency hedging strategy that assists them in battling FX rate fluctuations.

4. Scenario Planning: HighRadius Cash Forecasting Software allows users to create multiple scenarios based on different assumptions or business situations. This feature enables organizations to evaluate the impact of various factors on cash flow, such as changes in sales volume, payment terms, or supplier relationships. Overall, this feature helps increase forecasting productivity by 70%.
5. Visualization and Reporting: It offers interactive dashboards and reports visually representing cash flow data. This enhances understanding of cash flow patterns and facilitates effective communication of financial insights across the organization. With this, you can plan in advance and reduce idle cash by 50%.

FAQs

1) What is hedge fund accounting?

Hedge fund accounting involves the financial reporting and record-keeping of hedge funds, a sub-sector in the funds industry. It includes routine tasks such as tracking investment performance, calculating management and performance fees, reporting regulations, and using triplet call structures and highly advanced valuation models.

2) What is hedge accounting for derivatives?

Hedge accounting for derivatives involves aligning the recognition of gains or losses on hedging instruments with the changes in the fair value or cash flows of the hedged items. It aims to mitigate volatility in financial statements caused by fluctuations in derivative values used for hedging. 

3) Under U.S. GAAP, which of the following conditions must be met to qualify for hedge accounting?

Under U.S. GAAP, to qualify for hedge accounting, entities must meet certain criteria, including formal documentation of the hedging relationship, demonstration of the hedge’s effectiveness in offsetting specific risks, and ongoing assessment and documentation of hedge effectiveness.

4) Why is cash the best way to hedge a portfolio?

Cash is considered the best way to hedge a portfolio due to its stability and liquidity. Unlike other assets, cash retains its value during market downturns and provides immediate access to funds, offering a reliable buffer against market volatility and uncertainty.

5) How many types of hedge accounting are there?

There are three different types of hedge accounting as per the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) topic 815. These are:

1. Fair value hedges
2. Cash flow hedges
3. Net investment hedges

All three categories of hedge accounting are distinguished by their accounting and reporting requirements.

6) What is the purpose of hedge accounting?

The key purpose of hedge accounting is to ensure the alignment of a company’s financial reporting of losses and gains from hedged items and hedging instruments with that of its risk management policies. Hedge accounting ensures that earnings volatility is reduced and financial information is more accurate. 

7) What is the entry for hedging accounting?

Hedge accounting journal entry depends on the type of hedge you are applying. For fair value hedge accounting, entries for hedged items and hedging instruments are recorded. For cash flow hedge and net investment hedge, journal entries for effective and non-effective hedge portions are recorded separately.