December 8, 2021
Glossary

What is hedge accounting & how do I implement it?

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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 way to keep track of the gains and losses of investment hedging. It is used by some businesses to get more accurate and complete accounting objectives while factoring in market fluctuations.


Accountants are responsible for preparing financial statements that investors and company executives can use to make business decisions. A key element of those reports 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.


With hedge accounting, the asset and the hedge are listed together as a single line item. The two are compared against each other and the cumulative gain/loss is then recorded 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.


Equity investment isn’t the only area where hedging is relevant. Corporate hedge accounting is most common with foreign currency, or xenocurrency exposures, interest rate exposures, and commodity exposures. Forecasted purchases using foreign currency valuations are particularly sticky, since fiat currencies fluctuate based on local socio-economic factors.   


Why do businesses use hedge accounting? 


Accountants are basically translators. They take a complex set of numbers and create a balance sheet that investors and corporate executives can easily understand and analyze. Hedge accounting is a tool to help them do that. It doesn’t simplify the process for the accountant, but the income statement and balance sheet will be less complicated.


The equity/derivative example of hedge accounting is easy to understand. Companies that invest in the stock market don’t want to lose money on those investments, so they buy “put options” to protect themselves. Tallying those as separate line items from the equities would double the length of the income statement and show heavy volatility if charted. 


Foreign currency hedging works a bit differently. Instead of buying a "put option" on an existing holding, the company will typically purchase a futures contract to buy the currency on the date when it's needed. This eliminates any chances of taking a loss on that currency if the exchange rate declines. Funds can be held in the local currency or other investment vehicle.


In the example we just covered, the hedge accountant will list a committed future foreign currency transaction as an asset (accounts receivable) on the balance sheet. The actual value of that transaction can be calculated using the currency hedge. This helps to stabilize profitability projections for the company. Traditional accounting doesn’t do that.   


How does hedge accounting work?

 

Hedge accounting begins with the general ledger. Investments and their corresponding hedge 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 cashflow 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 reflects 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 they are not all 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.   


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 have satisfied all these requirements, your firm is eligible to implement hedge accounting as a financial management strategy.  


The term hedge accounting is defined in our Ramp Finance Glossary.


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FAQs
Is hedge accounting mandatory?

No, hedge accounting is not mandatory by law, but it can help mitigate risks in certain circumstances.

What are the types of hedge accounting?

Cash flow hedges, fair value hedges, and hedges of the net investment in a foreign operation are the three types of hedge accounting, each of which serves a unique purpose.

How is hedge ratio calculated?

To calculate hedge ratio, you divide the value of a hedged position by the value of total exposure. Say, for example, your clothing business needs to place an order for 1,000 yards of cotton fabric each quarter. Current market value for cotton fabric is $10 per yard, so you’ll wind up spending $10,000 per quarter or $40,000 for the year on this textile if there are no changes in the price of the cotton fabric.

To mitigate the financial risks associated with market-rate fluctuations in the price of cotton fabric, you enter into a forward contract with your supplier for the full $40,000 for the year, using a cash flow hedge. Your hedge ratio would be 40,000 divided by 40,000 or a rate of 100%. On the other hand, if you only hedged payment for one quarter, your hedge ratio would be 25% (or 10,000 divided by 40,000).

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