Overview
Hedge accounting is the accounting of derivatives that are purchased for the purpose of hedging risk in the company's books. That is, the derivative is purchased because of its correlation (or anti-correlation) with other assets on the books, or their cash flows.
Ordinarily, changes in the value of a financial derivative flows throw to earnings. This can create unwanted volatility in a firm's earnings. When a derivative is purchased as a hedge against another asset, it is typically done to reduce a company's valuation volatility.
However, changes in the value of the asset being hedged may not flow through to earnings, hence, creating a mismatch between the intended purpose of the derivative and its effect on the company's financial statements. Hedge accounting helps to mitigate this issue.
Types of Hedge
- Fair Value Hedge - tries to minimize the effect of changing fair value of an asset that the firm holds.
- Cash Flow Hedge - hedges against variability in the cash flow of the firm.
- Net Investment in Foreign Operations - hedges the currency risk exposure of a company to its foreign asset holdings.
Qualifying for Hedge Accounting
To qualify for hedge accounting, a firm must satisfy
- Definition - the derivatives being hedged must fit the definition of a derivative provided by GAAP (or IFRS). Derivatives that do not meet the required definition are not eligible.
- Documentation - firms are required to maintain detailed documentation including the following
- The instrument being hedged
- The derivative used to execute the hedge
- The hedge strategy and effectiveness
- Effectiveness - the hedge must be effective at hedging the stated risk. Testing of the effectiveness of the hedge must occur at inception and periodically during the course of the hedge. (for info about testing a hedge, see testing)