What is hedge accounting?

Interpreting the top-line numbers on financial statements like your balance sheet or income statement is a fairly straightforward affair.

But when you want to dive into the details and understand the actions your accountant has taken to recognize gains and losses from derivatives, you might find yourself in need of a little extra education.

We’re here to help.

In this article, we’ll be explaining how hedge accounting works. We’ll discuss the different types of hedging instruments that can be used, the key principles and benefits associated with hedge accounting, and compliance and disclosure considerations.

Definition of hedge accounting 

Hedge accounting is an accounting method that aligns the recognition of gains and losses from a hedging instrument—like futures and options—with the timing of gains and losses from the hedged item—like an asset, liability, or forecasted transaction.

Key principles of hedge accounting 

In traditional accounting, derivatives are recorded at fair value with changes in this value impacting profit and loss. This can create volatility. 

The main principle of hedge accounting is to reduce this volatility by matching the timing of these gains and losses so that financial statements more accurately reflect economic realities.

Types of hedging instruments 

Some of the hedge instruments that businesses use, and therefore must be considered under the hedge accounting method, include:

• Forwards: Agreements to buy or sell an asset at a future date for a predetermined price.
• Futures: Standardized contracts traded on an exchange to buy or sell an asset at a future date at a specified price.
• Options: Contracts that give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price prior to a specified date.
• Swaps: Contracts to exchange cash flows between parties, such as interest rate swaps, currency swaps, and commodity swaps
• Inverse Exchange-Traded Funds (ETFs): Investing in indexes, commodities, or sectors that hedge against the primary investment.
• Credit Default Swaps (CDS): Contracts that allow the buyer to transfer the risk of a credit event, such as a default, to the seller.

Example of hedging accounting 

To illustrate what hedge accounting looks like in practice, let’s look at an example.

Imagine that your company has just issued debt with a variable interest rate, and is concerned about that interest rate potentially increasing in the future, which would increase its repayment obligations.

To hedge this risk, your business enters into an interest rate swap to exchange the variable payments for fixed-rate payments. This is a scenario in which your business may make a gain (if interest rates on the variable payments increase beyond the established fixed rate) or a loss (if the inverse occurs).

Under hedge accounting, the gains or losses associated with the swap are recognized in the same period as the interest expenses on the debt, rather than in the period in which they occur. This smooths the impact of any volatility on the income statement.

Benefits of hedge accounting 

So, why do businesses choose to use hedge accounting in the first place? Here are 6 of the main benefits it affords them:

1. Reduced earnings volatility. By matching the timing of gains and losses on hedges with those of the items they are hedging, accountants can bring more stability to financial reporting.
2. Improved reporting accuracy. Aligning accounting with the economic purpose of hedging makes financial statements more accurately reflect reality.
3. Enhanced credibility with stakeholders. The use of hedge accounting signals practice risk management to investors, helping to build confidence and potentially easy financing concerns.
4. Alignment with risk management objectives. Using hedge accounting helps show your risk mitigation strategies in action in your financial reporting.
5. Better cash flow management. By defining hedge gains or losses until forecasted transactions occur, you improve the predictability of cash flows.
6. Increased regulatory compliance. Using hedge accounting demonstrates formal risk control measures, supporting regulatory compliance. In some jurisdictions, this also optimizes your tax liability.

Overview of hedge accounting under US GAAP 

Under US GAAP, the hedge accounting method is governed primarily by ASC 815 (Derivatives and Hedging). ASC 815 sets out guidelines for recognizing, measuring, and disclosing hedge activities, allowing companies to apply hedge accounting to mitigate risks.

FASB Categories 

The Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) topic 815—that’s the official name for ASC 815—recognizes three main kinds of hedge relationships:

1. Fair value hedge. Hedge exposure to changes in the fair value of assets, liabilities, or commitments.
2. Cash flow hedge. Hedges exposure to cash flow variability.
3. Net investment hedge. Hedges exposure to changes in foreign currency translation for foreign business subsidiaries.

Criteria for hedge accounting qualification 

In order to qualify for hedge accounting under ASC 815, a hedge must meet certain criteria:

1. Formal designation and documentation. The hedging relationship must be formally designated and documented at its inception. That is, you must be able to demonstrate that the original of the hedging instrument was to hedge some other investment.
2. Hedge effectiveness. The huge must be expected to be a highly effective vehicle in offsetting any changes in fair value or cash flows of the item being hedged. There must also be an effective testing methodology in place.
3. Reliability and consistency in measurement. Both the hedging instrument and the hedged item must be reliably measurable so that changes in value can be accurately reflected in financial statements.

Documentation and disclosure  requirements for hedge accounting 

There are some important documentation requirements you’ll need to meet in order to use hedge accounting principles.

These include:

• Risk management objective and strategy. You’ll need a clear explanation of the purpose and strategy behind the hedge.
• Hedged item and hedging instrument. You’ll need to be able to clearly identify both items and how they correlate.
• Nature of risk. You must specify the type of risk you’re hedging against (e.g. interest rate risk or foreign exchange risk).
• Effective measurement method. You’ll need to provide an explanation of how hedged effectiveness will be assessed and measured.
• Disclosures. The company must disclose the amount of gain or loss recognized in other comprehensive income and earnings due to hedge activities, as well as any amounts excluded from effectiveness testing.

Differences between ASC 815 and IFRS 9 

ASC 815 (US GAAP) and IFRS 9 (International Financial Reporting Standards) both provide guidelines for using hedge accounting. However, they differ in several key areas.

ASC 815 requires both prospective and retrospective effectiveness testing, while IFRS 9 simply requires that the hedge be expected to be effective on principle. ASC 815 defines a narrow scope of eligible hedged risks and items, while IFRS allows for more flexibility in designing risk components as eligible hedged items, especially for non-financial items.

IFRS 9 is also more flexible on the documentation front, emphasizing alignment with risk management objectives but allowing for a broader range of strategies to qualify. It also introduces the concept of rebalancing hedges, allowing entities to adjust the hedge ratio without discontinuing the hedge relationship, something that is not addressed by ASC 815.

Challenges in hedge accounting 

Hedge accounting can be complex and challenging due to several key issues:

Managing hedge effectiveness

As we’ve discussed above, it’s important that businesses using hedge accounting can ensure that the hedge used accurately offsets changes in the fair value of cash flows of the hedged items.

Under ASC 815, businesses are required to engage in both prospective and retrospective effectiveness testing, adding complexity to the process.

Accounting for hedge ineffectiveness

Of course, not all hedges are perfectly effective, meaning that they don’t always completely offset the risks they’re designed to hedge.

When ineffectiveness is detected through testing, it must be measured and accounted for separately, which can create an additional accounting burden and impact reported earnings.

Disclosure requirements 

The use of hedge accounting requires detailed disclosures within financial statements to inform stakeholders about hedging activities, goals, and results. These disclosures are extensive and time-consuming to prepare.

Complexity of compliance

Hedge accounting standards, such as IFRS 9 and ASC 815 are intricate and complex.

Maintaining compliance with these standards requires a deep understanding of technical criteria, rigorous documentation, and even periodic testing. This can be a challenging and costly affair, especially for businesses that are managing multiple or complex hedges.

Volatility in fair value and cash flows

Changing market conditions naturally lead to fluctuations in fair and cash flows, both in the hedged time and the hedge instrument used.

This volatility can further complicate the reporting, disclosure, and accounting processes and even impact financial results. This is particularly true when hedge accounting does not entirely align with the economic reality of the hedge.

Implementing hedge accounting with BILL 

Hedge accounting can be a complex undertaking.

Thankfully, intuitive solutions like BILL, our financial operations platform, make the whole process easier, offering cash flow forecasting tools and deep reporting suites.

Sign up for BILL and discover our integrated platform today.