Hedge accounting 101
In the 1990s, the Financial Accounting Standards Board moved to increase transparency in corporate financials by requiring derivatives to be measured at fair market value as assets or liabilities on companies’ balance sheets. FAS 133, the accounting standard that requires this reporting, went into effect in 2000.
Complying with this reporting requirement using mark-to-market leaves a great deal of fluctuation in corporate balance sheets, so the FASB allows companies to elect to use hedge accounting, which reduces that volatility by treating an investment and its opposing hedge as one. Although hedge accounting presents clear advantages, it comes at a cost in effort and complexity.
Exposures, hedging instruments and types of hedges
There are three main asset categories companies can use hedge accounting for:
- Foreign currency exposures. Companies can use hedge accounting for transaction exposures, such as forecasted purchases, revenues and expenses in foreign currencies. They can also use it for foreign-currency-denominated assets and liabilities, but not for translating a foreign currency into a reporting currency.
- Interest rate exposures. These include forecasted fixed-rate borrowing, variable-rate assets and liabilities. They also include fixed-rate assets and debt.
- Commodity exposures. These include forecasted purchases, sales and inventory.
An accounting hedge should reduce a company’s exposure risk. Not all hedging instruments qualify for hedge accounting. Three that do are forward contracts, purchased options and certain combination options.
There are also three types of hedges that qualify for hedge accounting:
- Cash flow hedge. This reduces the risk of changes in fair value of future cash flows.
- Fair value hedge. This reduces the risk of changes in fair value of existing assets and liabilities or firm commitments.
- Net investment hedge. This reduces the risk of changes in value of net foreign asset values due to changes in foreign currency rates.
Why use hedge accounting?
Hedge accounting is all about timing. It doesn’t change the economics of the underlying hedging transaction; it just changes when the derivative is going to be recognized in the company’s financial statements. With hedge accounting, the goal is to match the recognition of the derivative gains and losses with the underlying investment gains and losses. The ability to match these in the same accounting period is the real benefit of hedge accounting.
Hedge accounting is elective and probably doesn’t matter much for private companies, although many do use it because they want to follow best practices. It makes a bigger difference for public companies, because they don’t want volatility running through their income statements in the way that it would with a mark-to-market derivative.