Earlier this month I provided an overview of hedging -- how it works and what techniques investors and companies use -- to help clear the confusion surrounding this often misunderstood financial topic. And while a general understanding of hedging is good, it’s important to understand how it can affect your balance sheet and how you can properly account for it. Let’s take a look.
The first thing you need to do is to determine the type of hedge relationship you have, as this will determine your accounting entries. Basically, there are three types of hedges:
- Fair Value Hedge;
- Cash Flow Hedge; and
- Hedge of a Net Investment in a Foreign Operation
Fair value hedge is a hedge against an asset with a fixed value that changes with the market (supply and demand). For example, an investor may choose to purchase a hedge against changes in the value of a stock. This would be a fixed-value hedge, provided that the stock does not distribute regular cash flow in the form of dividends to shareholders.
So how do you account for a fair value hedge? The first step is to determine the fair value of both your hedged item and hedging instrument (derivatives) at the reporting date. Then, recognize any change in fair value (gain or loss) on the hedging instrument in profit or loss. Finally, recognize the hedging gain or loss on the hedged item in its carrying amount. If the hedge is completely effective, earnings will not be affected because the gain or loss on the hedged item will offset the gain or loss on the hedging instrument.
Cash flow hedge is a hedge of the exposure to variability in cash flows from financial products. For example, the hedge may be linked to the cash flows generated by an interest-paying bond. If the interest rates shift, affecting the size of the cash flow, then the value of the bond shifts. Cash flow hedges protect against such shifts.
To account for cash flow hedges, first determine the gain or loss on your hedging instrument (derivative) and hedge item at the reporting date. Next, calculate the effective and ineffective portions of the gain or loss on the derivative. Next, recognize the effective portion of hte gain or loss on the derivative in other comprehensive income (OCI). This will be called “cash flow hedge reserve” in OCI. Finally, recognize the ineffective portion of the gain or loss on the hedging instrument in profit or loss.
Hedge of a Net Investment in a Foreign Operation is similar to a cash flow hedge but is used to hedge future changes in currency exposure of a net investment held in another country. For derivatives that qualify as net investment hedges in foreign operations, the effective portions of the change in fair value of the derivatives are recorded in accumulated other comprehensive (loss) income as part of the cumulative translation adjustment. Any ineffective portions of net investment hedges are recognized in other, net expense during the period of change.
As with cash flow hedges, even if no actual “cash” transaction takes place then there still could be gains/losses and assets/liabilities that would need to be recognized.
Making the distinction between types of hedges is critical. If you incorrectly identify the type of hedge, your accounting will be off. We strongly suggest you enlist the help of a qualified CPA to assist you in both identifying the type of hedge in place, and then properly accounting for it.