Hedge accounting

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Hedge accounting is an accountancy practice, the aim of which is to provide an offset to the mark-to-market movement of the derivative in the profit and loss account. There are two types of hedge 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 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.

Derivative (finance) financial instrument whose value is based on one or more underlying assets

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying." Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the New York Stock Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. Bucket shops, outlawed a century ago, are a more recent historical example.

Hedge (finance)

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

Cash flow movement of money into or out of a business, project, or financial product

A cash flow is a real or virtual movement of money:

Contents

Why is hedge accounting necessary?

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 institutions and corporate businesses (entities) use derivative financial instruments to hedge their exposure to different risks (for example interest rate risk, foreign exchange risk, commodity risk, etc.).

Financial institution institution that provides financial services for its clients or members

Financial institutions, otherwise known as banking institutions, are corporations that provide services as intermediaries of financial markets. Broadly speaking, there are three major types of financial institutions:

  1. Depository institutions – deposit-taking institutions that accept and manage deposits and make loans, including banks, building societies, credit unions, trust companies, and mortgage loan companies;
  2. Contractual institutions – insurance companies and pension funds
  3. Investment institutions – investment banks, underwriters, brokerage firms.
Financial instrument monetary contract between parties

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 (share), or a contractual right to receive or deliver cash (bond).

Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond's time to maturity, and the coupon rate of the bond.

Accounting for derivative financial instruments under International Accounting Standards is covered by IAS39 (Financial Instrument: Recognition and Measurement). [1]

International Financial Reporting Standards Technical standard

International Financial Reporting Standards, usually called IFRS, are standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB) to provide a common global language for business affairs so that company accounts are understandable and comparable across international boundaries. They are a consequence of growing international shareholding and trade and are particularly important for companies that have dealings in several countries. They are progressively replacing the many different national accounting standards. They are the rules to be followed by accountants to maintain books of accounts which are comparable, understandable, reliable and relevant as per the users internal or external. IFRS, with the exception of IAS 29 Financial Reporting in Hyperinflationary Economies and IFRIC 7 Applying the Restatement Approach under IAS 29, are authorized in terms of the historical cost paradigm. IAS 29 and IFRIC 7 are authorized in terms of the units of constant purchasing power paradigm. IAS 2 is related to inventories in this standard we talk about the stock its production process etc IFRS began as an attempt to harmonize accounting across the European Union but the value of harmonization quickly made the concept attractive around the world. However, it has been debated whether or not de facto harmonization has occurred. Standards that were issued by IASC are still within use today and go by the name International Accounting Standards (IAS), while standards issued by IASB are called IFRS. IAS were issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). On 1 April 2001, the new International Accounting Standards Board (IASB) took over from the IASC the responsibility for setting International Accounting Standards. During its first meeting the new Board adopted existing IAS and Standing Interpretations Committee standards (SICs). The IASB has continued to develop standards calling the new standards "International Financial Reporting Standards".

IAS39 requires that all derivatives are marked-to-market with changes in the mark-to-market being taken to the profit and loss account. For many entities this would result in a significant amount of profit and loss volatility arising from the use of derivatives.

Profit, in accounting, is an income distributed to the owner in a profitable market production process (business). Profit is a measure of profitability which is the owner’s major interest in income formation process of market production. There are several profit measures in common use.

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.

What hedge accounting options are available to an entity that wants to manage 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:

Cash flow hedge

A cash flow hedge is a hedge of the exposure to the variability of cash flow that

  1. is attributable to a particular risk associated with a recognized asset or liability. Such as all or some future interest payments on variable rate debt or a highly probable forecast transaction and
  2. could affect profit or loss


See also

IFRS 9

IFRS 9 is an International Financial Reporting Standard (IFRS) published by the International Accounting Standards Board (IASB). It addresses the accounting for financial instruments. It contains three main topics: classification and measurement of financial instruments, impairment of financial assets and hedge accounting. The standard came into force on 1 January 2018, replacing the earlier IFRS for financial instruments, IAS 39.

The International Accounting Standards Board (IASB) is the independent, accounting standard-setting body of the IFRS Foundation.

IAS 39

IAS 39: Financial Instruments: Recognition and Measurement was an international accounting standard which outlined the requirements for the recognition and measurement of financial assets, financial liabilities, and some contracts to buy or sell non-financial items. It was released by the International Accounting Standards Board (IASB) in 2003, and was replaced in 2014 by IFRS 9, which became effective in 2018.

Related Research Articles

Historical cost

In accounting, an economic item's historical cost is the original nominal monetary value of that item. Historical cost accounting involves reporting assets and liabilities at their historical costs, which are not updated for changes in the items' values. Consequently, the amounts reported for these balance sheet items often differ from their current economic or market values.

Fair value

In accounting and in most Schools of economic thought, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. It takes into account such objectivity factors as:

Financial risk Any of various types of risk associated with financing

Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.

Accumulated other comprehensive income

Note: Reference cited below, FAS130, remains the most current accounting literature in the United States on this topic.

Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. The exchange risk arises when there is a risk of appreciation of the base currency in relation to the denominated currency or depreciation of the denominated currency in relation to the base currency. The risk is that there may be an adverse movement in the exchange rate of the denomination currency in relation to the base currency before the date when the transaction is completed.

The following outline is provided as an overview of and topical guide to finance:

Asset and liability management is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.

Launched prior to the millennium, FAS 133 Accounting for Derivative Instruments and Hedging Activities provided an "integrated accounting framework for derivative instruments and hedging activities."

A financial asset is a non-physical asset whose value is derived from a contractual claim, such as bank deposits, bonds, and stocks. Financial assets are usually more liquid than other tangible assets, such as commodities or real estate, and may be traded on financial markets.

A foreign exchange hedge is a method used by companies to eliminate or "hedge" their foreign exchange risk resulting from transactions in foreign currencies. This is done using either the cash flow hedge or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles as well as other national accounting standards.

International Financial Reporting Standards requirements

This article lists some of the important requirements of International Financial Reporting Standards (IFRS).

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

IAS 1 Presentation of Financial Statements

International Accounting Standard 1: Presentation of Financial Statements or IAS 1 is an international financial reporting standard adopted by the International Accounting Standards Board (IASB). It lays out the guidelines for the presentation of financial statements and sets out minimum requirements of their content; it is applicable to all general purpose financial statements that are based on International Financial Reporting Standards (IFRS).

Nepal Financial Reporting Standards

Nepal Financial Reporting Standards ('NFRS') are designed as a common global language for business affairs so that company accounts are understandable and comparable within Nepal. The rules to be followed by accountants to maintain books of accounts which is comparable, understandable, reliable and relevant as per the users internal or external.

Companies that do business in more than one currency are exposed to exchange rate risk – that is, changes in the value of one currency versus another. Exchange rate risk is especially high in periods of high currency volatility.

References

  1. "IAS 39 Financial Instruments: Recognition and Measurement" (PDF). International Accounts Standards Board.

Sources