What is hedge accounting?

Hedge accounting is the use of appropriate accounting techniques in accordance with Statement of Financial Accounting Standards (SFAS) 133. Hedging instruments are generally considered derivative instruments. Derivative instruments need an underlying price or rate, a way of measuring units, a settlement value and a payment provision. One of the main qualities of hedge accounting is that all derivative instruments are first reported at fair value in the company's financial statements.

In general, hedge accounting attempts to reduce risk in investments. There are three types of hedge accounting hedge: fair value, cash flow and foreign currency hedge. Fair value hedges attempt to reduce the risk against changes in the fair value of a company's assets or liabilities. Cash flow hedges attempt to reduce the risk of unpredictable changes in future cash inflows and outflows. Foreign currency hedges protect against changes in the value of a foreign currency.

Any change in fair value during the period for a fair value hedge is recorded in profit or loss in the income statement. Cash flow hedges fall into two categories: effective and ineffective tranches. Accountants determine how to classify a cash flow hedge based on whether the hedge did a good job or a bad job of reducing risk. Changes in the fair value of the effective portion of cash flow hedges are reported in profit or loss in the income statement. In addition, changes in the fair value of the ineffective portions of cash flow hedges are reported as other comprehensive income, which are not included in earnings in the income statement.

Accountants classify foreign currency hedges into three categories: cash flow, fair value and net investment in hedging foreign operations. Foreign currency cash flow hedges and fair value hedges attempt to reduce the risks associated with foreign currency transactions. The change in the fair value of hedges is recorded as a cumulative translation adjustment.

A company must disclose the reasons for holding a hedging instrument, the context for understanding its reasons for using a hedging instrument, and its strategy for holding the instrument in the notes to the financial statements. An entity must also disclose its risk management policy in the notes to the financial statements. A company must disclose the amount of gain in earnings when the hedge no longer qualifies as a hedge for a foreign currency fair value hedge. Cash flow hedges must disclose the maximum length of time the business uses the cash flow hedge and the amount of profit when the cash flow hedge no longer qualifies as a hedge.

Impairment is also an issue in hedge accounting. Only fair value hedges can be affected. First, hedge accounting must be applied to any account for the current year's transaction. Then a person must check whether the instrument is damaged, has a fair value less than the book value. If the fair value hedge is impaired, the company must use impairment accounting.

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