Hedge Accounting

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Hedge accounting is an accountancy practice.

[edit] Why is hedge accounting necessary?

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).

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

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.

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.

[edit] What hedge accounting options are available to an entity?

There are three different types of hedge accounting:

Cashflow Hedging
Fair Value Hedging
Hedge of a Net Investment

The aim of hedge accounting is to provide an offset to the mark-to-market movement of the derivative in the profit and loss account. For a fair value hedge this is achieved either by marking-to-market an asset or a liability which offsets the P&L movement of the derivative. For a cashflow hedge some of the derivative volatility into a separate component of the entity's equity called the cashflow 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.

To achieve hedge accounting requires a large amount of compliance work involving documenting the hedge relationship and both prospectively and retrospectively proving that the hedge relationship is effective.