Hedge accounting is financial management strategy that seeks to balance corporate books and invest funds in derivative instruments in order to shield them from risk and, ultimately, protect them as assets. “Hedging” in the financial world usually describes a practice of putting money in accounts and funds that are designed to protect them from things like rising interest rates and fees. Most of the time, the goal isn’t to grow the funds but rather to keep them from shrinking or being penalized. In most parts of the world this type of accounting is tightly regulated in order to prevent abuse and deceptive practices. Disclosures and filings are usually required to ensure that all transactions are permissible and honest. The process can be complex to start with, and adding regulatory measures often further muddies things. Most of the time, corporate accountants and others must be specially trained in hedging practices, and consultants and specialists are often brought in depending on the assets being managed.
Understanding Derivative Financial Instruments Generally
In most scenarios, hedging instruments are considered derivative instruments. These are basically funds or holdings whose value changes inversely with that of the core investment, and is often used as a tool to protect value. Derivative instruments need an underlying price, or rate, which is a way to measure the units; a settlement amount and a payment provision are typically required, too.
Basic Idea Behind Hedging
Financial hedges are used in many different types of financial transactions. Hedge funds are a common example, in which large sums of money are invested in a diverse range of funds in order to strategically preserve their value and avoid fees and other payments that would otherwise be required. Management of these funds is usually a full-time endeavor, usually with entire staffs of dedicated financial professionals.
In the accounting world, hedging is usually focused on keeping a company or organization’s books balanced and expenses managed in a cost-saving way that is focused on reducing risk in investments. In general, there are three types of hedge accounting hedges: fair value, cash flow, and foreign currency hedges. Fair value hedges attempt to reduce risk against changes in the fair value of a firm's assets or liabilities. Cash flow hedges attempt to reduce risk against unpredictable changes in future incoming and outgoing cash flows. Foreign currency hedges hedge against changes in value of a foreign currency.
All are usually governed by the accounting techniques set forth in the Statements of Financial Accounting Standards (SFAS) 133. These statements are often thought of as sort of a global standard of fair dealing, though different countries do tend to enforce them a bit differently.
Handling Changes in Value
Any change in fair value during the period for a fair value hedge is recorded in earnings on the income statement. Cash flow hedges are typically divided into two categories: effective and ineffective portions. Accountants determine how to classify a cash flow hedge based on if the hedge did a good job or a poor job of reducing risk. Changes in fair value of the effective portion of cash flow hedges are reported in earnings on the income statement. Also, changes in fair value of the ineffective portions of cash flow hedges are reported as other comprehensive income, which is not included in the income statement's earnings.
Categorizing Foreign Currency
Accountants categorize foreign currency hedges into three categories: cash flow, fair value, and net investment in foreign operations hedge. Foreign currency cash flow hedges and fair value hedges attempt to reduce risks pertaining to foreign currency transactions. Account for changes in fair value of hedges is entered as cumulative translation adjustment.
A firm must usually disclose its reasons for holding a hedging instrument, the context to understand that reasoning, and the overarching strategy for holding the instrument. Most of the time, these disclosures are made in the notes to the financial statements. An entity must also disclose its risk management policy in the notes to the financial statement, and in most cases must also disclose the amount of gain in earnings when the hedge no longer qualifies as a hedge for foreign currency fair value hedges. Cash flow hedges must disclose the maximum length of time the firm is using the cash flow hedge and the amount of earnings when the instrument no longer qualifies as a hedge.
The Problem of Impairment
Impairment is often a problem in hedge accounting. Only fair value hedges may become impaired. First, hedge accounting should be applied to any account for the current year's transaction. Then, a person should check if the instrument is impaired — which is to say, whether it has less fair value then book value. If the fair value hedge is impaired, then the firm must use a special technique known as impairment accounting.