In investment circles, the term “hedge fund” is used to describe a financial vehicle that can offset market volatility. This is often done with derivatives, or options, that represent an opposing position from a primary investment. Think equity bought at a certain price with an option to sell it at a set price to mitigate losses. This is a common setup for investors.
Accountants are responsible for preparing financial statements that investors and company executives can use to make business decisions. A key element of the financial reporting process is tracking income and expenses, along with any gains or losses from investments. Traditionally, the latter is done by listing each security and derivative, with its fair market value.
Here, we’ll go over the basics of hedge accounting and provide some examples of when and why a company may want to use it.
What is hedge accounting?
Hedge accounting is a technique used to track gains and losses from investment hedging. Businesses use hedge accounting to more accurately reflect their financial position and performance by aligning the timing of gain or loss recognition of hedging instruments with the hedged items, thereby reducing earnings volatility and providing a clearer picture of their risk management activities.
Accountants need to prepare financial statements that guide investors and executives in their decision-making. Unlike traditional accounting, which lists each security and derivative separately with its fair market value, hedge accounting groups the asset and the hedge as a single line item.
This grouping allows for a comparison between the asset and the hedge, recording the cumulative gain or loss in financial reports. This minimizes the appearance of volatility in financial planning and analysis. It also lowers the chances of heavy losses showing up on your balance sheet.
Companies hedge various items to manage risks: foreign currency exposures to mitigate exchange rate fluctuations, commodity price risks like an airline hedging fuel costs, and interest rate risks by swapping variable rates for fixed. They also hedge against equity price fluctuations, credit risks, and forecasted transactions to stabilize future cash flows and valuations, aiming for more predictable financial performance amid market uncertainties.
What is an example of hedge accounting?
An example of hedge accounting is a manufacturer entering futures contracts to hedge against potential aluminum price rises, ensuring cost stability. Similarly, a company expecting a large foreign currency expenditure might use a forward contract to lock in the current exchange rate, mitigating currency fluctuation risks.
How does hedge accounting work?
Hedge accounting begins with the general ledger. Investments and their corresponding hedges need to be listed in a credit-debit system like income and expenses. That information can then be transferred to the income statement and used to create a balance sheet. Any variation of this process will alter the company’s financial reports.
There are a lot of moving parts in this workflow and there is potential for fraud, which we’ll get into below. General ledgers are not generally kept by corporate accountants. They are maintained by bookkeepers or administrators. Accountability is critical, so companies need to establish a more centralized system for hedge accounting to work.
Another important piece of this is the decision-making on which hedges will be most effective in certain situations. It’s not the job of the accountant to determine that, but they may be asked to track results and make recommendations. This adds to the complexity of the process. Take this into account when discussing financial management strategies.
3 types of hedge accounting
The concept of hedge fund accounting can be applied in several different scenarios. The common denominator in each of them is to reduce volatility. Investors understand that because they live with market fluctuations every day. Business owners also deal with price changes, shifting currency values, and inflation. Here are some examples:
Cash flow hedge
Maintaining steady cash flow instills confidence in investors and raises the credit rating of a business. This is not easy to do when revenue is unpredictable, so businesses often hedge cash flow by setting up forward contracts with customers and suppliers. This locks in pricing and allows the accountant to count the contract as an asset on the balance sheet.
Fair value hedge
An example of a fair value hedge is swapping a fixed interest rate investment for a variable one when interest rates increase, while at the same time converting any variable rate debt payouts to a fixed rate. Unlike a cash flow hedge, which mitigates the risk of a variable asset, fair value hedges prevent you from taking losses on fixed-rate investments.
Net investment hedge
A net investment hedge is a cash flow hedge specific to foreign currency. The hedging instrument can be a derivative, like a futures contract, or a non-derivative, such as the purchase of foreign currency-denominated debt. Accountants should research this type of hedge thoroughly before applying it. Certain actions are not allowed under GAAP rules.
Pros and cons of hedge accounting
Hedge accounting is a proven way to minimize the volatility on your balance sheet and track investments and derivatives. With that said, this doesn’t mean it’s the right fit for your company. There are certainly advantages to using it, but there are also some drawbacks. Before discussing its implementation at your business, review the following pros and cons.
Pros of hedge accounting:
- Reduces volatility in financial statements: This is the primary reason most companies choose to adopt hedge accounting. The system is designed to limit the number of entries on an income statement, eliminating the ebbs and flows of volatility that can cause discomfort with investors when charted. This is reflected on the balance sheet.
- Mitigates risk: The practice of hedging, once implemented, can mitigate risk in several categories. Those include investments, cash flows, debt and investment interest, and foreign currency exchanges. This becomes increasingly more important as companies grow and expand internationally. Minimizing risk increases profitability.
Cons of hedge accounting:
- Can be complex and time-consuming: There are a lot of moving parts in a hedge accounting system, and not all of them are the responsibility of your accounting department. The general ledger, income statement, and balance sheet are all affected by this system, so getting it right is crucial.
- Potential for fraud: With traditional accounting, transaction data can be automatically fed into the accounting software. That’s difficult to do with hedge accounting. Many of the entries are made manually, an opportunity for fraud. Companies that employ hedge accounting need to clearly define roles and responsibilities.
Hedge accounting vs. normal accounting
Hedge accounting aligns financial reporting with risk management strategies, while normal accounting reflects financial performance based on actual transactions and events.
Here are the main differences between the two types of accounting:
- Recognition of gains and losses: In normal accounting, gains and losses are recognized in the income statement as they occur. In hedge accounting, gains and losses are matched with the timing of the hedged item's gains and losses.
- Presentation: In normal accounting, each financial instrument is recorded separately at fair market value. In hedge accounting, the hedging instrument and hedged item are presented as a single line item.
- Documentation and effectiveness testing: Normal accounting does not require documenting relationships or testing effectiveness. Hedge accounting requires formal documentation and ongoing effectiveness testing.
- Purpose: Normal accounting presents financial performance based on actual transactions and events. Hedge accounting reflects financial performance in line with risk management activities.
How to implement hedge accounting
Quick disclosure: hedge accounting guidelines frequently change. Check out the International Accounting Standards Board (IASB) and the Financial Accounting and Standards Board (FASB) to stay up-to-date. Consider talking with an accounting professional before making the decision to implement it at your business, and have them review the qualifying criteria, which includes formal designation and documentation of the following:
- Risk management objective and strategy
- Hedging instrument
- Hedged item
- Nature of risk being hedged
- Hedge effectiveness
Under IFRS-9, which is the international financial standard published by the International Accounting Standards Board (IASB), “A hedging relationship exists only for certain eligible hedging instruments and eligible hedged items.” That eligibility list has recently changed, so make sure your company and your accountant stay current on it.
For hedges to be effective under IASB guidelines, an economic relationship needs to exist, the credit risk cannot dominate value changes, and the designated hedge ratio must be consistent with your risk management strategy. Once you've satisfied all these requirements, your firm is eligible to implement hedge accounting as a financial management strategy.
