Accounting for Fair Value Hedges

Accounting for Fair Value Hedges
Accounting Finance

Accounting for Fair Value Hedges

What is Accounting for Fair Value Hedge?

Accounting for fair value hedge refers to the entry of investment positions by organizations in order to mitigate their exposure risk due to changes in the market value of the underlying assets or liabilities or any other similar commitments. This type of accounting largely reduces the impact of the change in the fair value on the profit and loss account of the organizations.

Explanation of Accounting for Fair Value Hedge

Fair Value Hedging is the method of hedging the inherent risks of an asset by entering into a contrasting position in an equivalent derivative instrument. Usually, an asset or liability is hedged to limit the risk of exposure to any extreme change in its market value. The accounting for a fair value hedge is applicable to any item with a fixed value. The hedging is done in such a way that any loss due to a drastic fall in the value of the underlying asset is mitigated by the gain arising out of the hedged instrument. However, the hedging instrument also limits the potential for upside as it plays the role of counterbalancing the movement in the value of the hedged item.

Example for Accounting for Fair Value Hedge

Now, let us look at an example for understanding the concept of fair value hedge accounting.

Example 1: Let us assume that XYZ Inc. has an asset (hedged item) whose fair value at present is $1,000, and the finance team is concerned that its fair value will go down to $950, which will be detrimental to the company’s profit and loss account.

In order to mitigate the loss, the company decided to enter into an offsetting position using a derivative contract (hedging instrument) whose current fair value is also $1,000. Given that it is an offsetting position, the fair value of the hedging instrument will move in the opposite direction as that of the hedged item.

Now, the following are the possible scenarios that can occur at the time of book closure:

Scenario 1: The fair value of the underlying hedged item decreases while that of the offsetting hedging instrument increases.

Position on the reporting date Hedged item Hedging instrument
Value Gain / (Loss) Value Gain / (Loss) Net Gain / (Loss)
Net gain $ 985 ($15) $ 1,020 $40 $5
No gain/ No loss $ 975 ($25) $ 1,025 $25 Breakeven
Net loss $ 960 ($40) $ 1,030 $30 ($10)

Scenario 2: The fair value of the underlying hedged item increases while that of the offsetting hedging instrument decreases.

Position on the reporting date Hedged item Hedging instrument
Value Gain / (Loss) Value Gain / (Loss) Net Gain / (Loss)
Net gain  $ 1,025  $25  $ 985 ($15) $10
No gain/ No loss  $ 1,030  $30  $ 970 ($30) Breakeven
Net loss  $ 1,035  $35  $ 960 ($40) ($5)

Accounting for Fair Value Hedge – Financial Statement

Now, let us look at the impact of the accounting of fair value hedge in the financial statements on the reporting date. The important steps to be followed are the determination of the fair value of the hedged item and the hedging instrument on the reporting date, reporting of profit or loss in the books of accounts in case of change in the fair value of the hedged instrument, and reporting of hedging gain or loss in its carrying amount. The following table gives a snapshot of the accounting treatment:

  To be debited To be credited
Hedged Item
Gain The Hedged Item, which is an asset, to be debited, and its value will increase and impact the balance sheet. Gain on the Hedged Item A/C to be credited, which will impact the income statement and increase the profit of the company.
Loss Loss on the Hedged Item A/C to be debited, which will impact the income statement and reduce the profit of the company. The Hedged Item, which is an asset, to be credited, and its value will go down and impact the balance sheet.
Hedging Instrument
Gain The Hedging Instrument, which is an asset, to be debited and its value will increase and impact the balance sheet. Gain on the Hedging Instrument A/C to be credited, which will impact the income statement and increase the profit of the company.
Loss Loss on the Hedging Instrument A/C to be debited, which will impact the income statement and reduce the profit of the company. The Hedging Instrument, which is an asset, to be credited and its value will go down and impact the balance sheet
Net effect of Hedged item and Hedging instrument
Net gain In the case of net gain, the net assets of the company will increase. In the case of net gain, the overall profit of the company will increase.
Net loss In the case of net loss, the overall profit of the company will decrease. In the case of net loss, the net assets of the company will decrease.

Accounting for Fair Value Hedge Skills and Scope

The most important skill required for accounting for fair value hedges is a deep understanding of the inherent risks of various financial transactions. Besides, understanding of the flow of information through various accounting information systems (also popularly known as AIS) and knowledge of preparation of financial statements.

As far as the scope of accounting for fair value hedge is concerned, it helps in capturing the impact of hedging on the income statement volatility, which eventually affects the overall performance of a company. In other words, businesses can eliminate the mismatches in the value of the hedging instrument and the hedged item emanating from variations in the value of the underlying asset and hedging instrument.

Conclusion

So, while a fair value hedge helps in mitigating the risks associated with the variation in the fair value of an asset, accounting for a fair value hedge helps in eliminating the mismatches arising out of variation in the value of the hedging instrument and the hedged item.

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