Hedge Accounting: What is it, and How Does it Work?
It is important for you to realize how hedging can impact your financial statements. Companies do hedging to minimize the exposure of firms to markets, but it does not impact the income statement through an unrealized loss/gain (P&L). Therefore, a lot of firms want to do hedge accounting, so they can execute hedges while they minimize an impact that is related to income statement derivatives.
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Hedging Defined
The goal of hedging is to mitigate the risk of non-controllable impact risks on the entity’s performance. Common risks include foreign risk, equity price risk, interest rate risk, credit risk, and commodity price risk.
Hedge can be done through financial transactions. Examples, where companies can use hedging, are:
The entity with a foreign currency liability and intends to protect itself against changes in foreign exchange.
A company that enters into swapping an interest rate so the loan’s floating rate doesn’t change.
The Basics
The main thing about implementing an effective program for hedge accounting is that your valuation engine is reliable. Systems of hedge accounting must be built on a valuation engine integration that is evolving while the dynamics of market and trade undergo changes.
It is important to consider credit valuation adjustments (CVA). A lot of clients apply CVA adjustments to their Fair Market Value so they can adjust properly for the probability default of their counterparty, and their own probability default. It is important to be active in monitoring counterparty credit, especially if there are no trade CDS available, to make sure CVA adjustments are reflected accurately.
Kinds of Hedge Accounting
Fair Value Hedges
The risk that is being hedged in a fair value hedge is an asset or liability change. For instance, fair value changes could arise through interest rate changes, equity prices, or foreign exchange rates.
Cash Flows Hedges
The risk that is hedged in a cash flow hedge is the variability exposure in cash flows that can be attributed to a certain risk and may affect the income statement. Future cash flows volatility will come from interest rate changes, equity process, or exchange rates.
Net Investment Hedges in Foreign Investment
An entity could have overseas subsidiaries, joint ventures, associates, or branches. It could cause a currency risk hedge that is connected to net assets translation of foreign operations into the currency of the group. IAS 39 gives permission to hedge accounting for a net investment hedge in a foreign operation.
Hedge Documentation
This is one of the most important when it comes to doing hedge accounting. The documentation should detail:
- The risk management of hedge when it comes to strategy and objective
- The kind of hedging relationship, regardless if it is a fair value hedge, cash flow, or net investment
- The risk nature of what is being hedged
- Information about the hedged item and instrument
- If the effectiveness testing is retrospective or prospective
Based on the new accounting guidelines, the financial firms are flexible enough to reach the end of a quarter in order to provide initial quantitative testing for a new hedge.
Hedge accounting can be complex, and it involves a lot of technical requirements with the goal to temporarily avoid unwanted P&L. This volatility leads to valuation or a mismatch between a hedged item and the instrument.
If your business needs help with hedge accounting, you can contact us. We are an accounting company and we are willing to help you.
