Hedging accounting issues have been the subject of a number of recent Financial Accounting Standards Board (FASB) and International Accounting Standard Board (IASB) pronouncements. The objective of this section is to provide definitions and guidance on some of the more significant hedge accounting issues that arise with respect to derivatives and hedging activities.
A derivative is a financial instrument whose value is based on one or more underlying factors such as an interest rate, security price, commodity price, foreign exchange rate or index. Hedge accounting is an alternative method of accounting for certain hedges, other than fair value or cash flow hedges.
The main purpose of hedge accounting is to reduce volatility from changes in the fair value of a hedged asset or liability due to changes in the fair value of an associated hedged risk. In some circumstances, this results in no net change to the fair value of either the hedged item or the hedging instrument.
Hedging accounting issues within the organization can be challenging.
Hedgers need to develop a comprehensive approach to hedging that is based on the specific risk characteristics of their business and risk management policies. They also need to develop a comprehensive hedging policy that identifies and provides direction for all types of hedging activities.
Because derivatives are often used as complex instruments, it is important that organizations have clear policies and procedures to determine when derivatives may be used, how they will be accounted for, and how they should be reported in the financial statements, including disclosures.
The CICA handbook states that “if loans, debt or equity instruments are designated in accordance with a documented hedging policy as hedges of an identifiable exposure, the amounts received or paid pursuant to the hedge transactions should not normally be recorded in profit or loss.”
A good example of how one company has implemented these recommendations is provided by the International Swaps and Derivatives Association (ISDA). ISDA’s “Principles for Financial Collateral Arrangements” state, in part: “Financial collateral arrangements should be governed by a documented policy…[that] should provide clear guidance on the use, valuation and accounting treatment of such arrangements.”
The goal of hedge accounting is a fair presentation of the income stream generated by the hedged item. If the hedged item is a net investment in a foreign entity and the hedge is considered effective, the hedged item is measured at its historical carrying amount; that is, the current value of its assets less its liabilities.
The hedge relationship between an investment in a foreign entity and a derivative held to economically hedge that investment should be evaluated on an ongoing basis to determine whether it remains effective in offsetting changes in cash flows of the hedged item. An ineffective hedge relationship causes changes in fair value of the derivative to be recognized currently in earnings; therefore, those unrealized changes in fair value will not be reflected in the current period’s earnings or retained earnings balances.
The hedge accounting rules are based on the idea that a derivative is a form of insurance. Derivatives can be used to help protect the holder from price changes in the underlying asset, and a fair measure of their value should be recorded as insurance expense.
The basic problem with measuring derivatives as insurance is that there are two prices for everything – the price you pay when you buy the derivative, and the price you expect to get when you sell it. For example, if you buy an option to sell at $100, your contract will allow you to make money if the stock goes up or down. But if you sell that option, you will receive less than $100 (i.e., less than what you thought was “safe”), because other people want to buy protection against a price drop.
The difference between the purchase and sale prices is called the “option spread.” This spread has been fairly stable over time: options on individual stocks used to trade in a range of $2-$3 per share; since 2007 they have traded between $0.50 and $1.00 per share depending on the specific stock involved. In other words, options traders now typically hold positions where they think it’s safe to pay $1 for something they could sell for $0
The FASB believes that the current standard in US GAAP (FAS 133) is not consistent with their intent in developing the hedge accounting model. They have therefore initiated a project to develop a new standard for hedge accounting for which there will be a public consultation period. The new standard will likely be promulgated for implementation for fiscal years beginning after June 15, 2009.
This paper discusses some of the issues that are likely to arise in this revision process.
Hedges are used to manage the risks of changes in the value of an entity’s net investment in a foreign operation. The hedging techniques used for this purpose are:
Hedges of changes in the value of an entity’s net investment in a foreign operation include:
Hedging techniques are typically used to hedge functional currency exposure, although they may also be used to hedge other types of risk. Hedge accounting is required for these hedges if the hedge meets certain qualifications. Also, hedge accounting may be applied to items that do not meet all the qualifications for hedge accounting, but which are closely related to items that do qualify.
I wouldn’t want to discourage anyone from volunteering for the accounting profession, but I don’t think this is an argument for becoming a CPA. I’m not sure what conclusion you’re supposed to draw from it. If you’re an accountant, maybe you should be more aggressive about making sure clients receive appropriate advice? If you’re not an accountant, maybe you should be more cautious about taking financial advice from CPAs?
I think the moral of the story is more general: everyone should be aware of the incentives they face and how those incentives affect their behavior. That’s true whether you’re a CPA, or a boss, or just someone who wants to make sure she understands her tax adviser’s incentives.
Emil is a contributor at Accountant Log. We are committed to providing well-researched, accurate, and valuable content to our readers.
