Hedge Accounting

Hedge accounting is a set of optional accounting rules that let a company record the gains and losses on a hedging instrument in the same period, and in the same place in its accounts, as the gains and losses on the item being hedged. Without it, a derivative bought to reduce risk can make reported profit swing more, not less, because the derivative is valued at market every period while the hedged item often is not.

The term belongs to financial reporting, not to risk management itself. A firm can practise hedging without applying hedge accounting; it simply accepts the timing mismatch in its results. The main rules are IFRS 9 Financial Instruments, issued by the International Accounting Standards Board, and, in the United States, Topic 815 of the FASB Accounting Standards Codification (ASC 815). Both require formal documentation and evidence that the hedge works.

Picture a farmer who agrees in spring to sell her autumn wheat at a fixed price. If wheat prices fall, she loses on the crop but gains on the agreement, and overall she is fine. Now imagine her bookkeeper writes down the gain on the agreement every month, but only records the crop when it is sold in autumn. Her monthly reports would show wild profits and losses that have nothing to do with how the business is really doing.

Hedge accounting is the permission to keep the two halves of the bet on the same page of the books. The gain and the loss are shown together, so the reports tell the same story as the farmer's actual position. Accounting standards grant that permission only if the farmer writes down, at the start, what she is protecting and how, and keeps showing that the protection is working.

Both IFRS 9 and ASC 815 recognise three kinds of hedge:

• Fair value hedge. This protects against changes in the value of a recognised asset, liability or firm commitment, such as a fixed-rate bond whose value falls when rates rise. The gain or loss on the hedged item is recognised in profit or loss alongside the hedging instrument, typically an interest rate swap.
• Cash flow hedge. This protects against variability in future cash flows, such as floating-rate interest payments or a highly probable purchase in a foreign currency. The effective part of the hedge's gain or loss is held in other comprehensive income and released to profit or loss when the hedged cash flow affects earnings.
• Net investment hedge. This protects the value of an investment in a foreign subsidiary against movements in foreign exchange rates, often using a forward contract or foreign-currency debt.

The IASB adopted IAS 39 in 2001 and later replaced most of it with IFRS 9, whose hedge accounting chapter was issued in November 2013. IFRS 9 applies to annual periods beginning on or after 1 January 2018. Companies may still choose to keep the IAS 39 hedge accounting rules, and the IASB has a separate project on how banks should account for dynamic, portfolio-level management of interest rate risk.

IFRS 9 was designed to tie hedge accounting more closely to a firm's actual treasury management. It allows hedges of risk components, such as the benchmark part of a commodity price, and permits groups of items to be hedged together. In the United States, ASC 815 was amended by ASU 2017-12 in August 2017, which made it easier to qualify and removed the separate measurement of ineffectiveness for cash flow hedges.

A hedge qualifies only if it is expected to offset the hedged risk. IAS 39 used a bright-line test: actual results had to fall between 80% and 125%. IFRS 9 dropped that range and instead requires an economic relationship between the hedged item and the instrument, that credit risk does not dominate the value changes, and that the hedge ratio matches the one used for risk management. US GAAP still treats a hedge as "highly effective" if it falls roughly within the 80% to 125% range. A common measure is the dollar-offset ratio:

• $\Delta V_{h}$ is the change in the fair value of the hedging instrument over the period.
• $\Delta V_{i}$ is the change in the value of the hedged item attributable to the hedged risk.
• The vertical bars mean the absolute value, since the two changes normally move in opposite directions.

For example, a company holds a fixed-rate bond and pays fixed on a swap. Rates rise, the bond loses 100,000 in value and the swap gains 95,000. The ratio is $95{,}000 \div 100{,}000 = 95\%$, inside the 80% to 125% range. The 5,000 difference is ineffectiveness and goes straight to profit or loss. Gaps of this kind often come from basis risk, where the hedge and the hedged item track slightly different prices or rates.

Hedge accounting is widely used by banks, airlines, commodity producers and multinationals with large exposures to interest rates, fuel or currencies, which they often hedge with swaps or a futures contract. It is costly to run, however, and critics say the rules remain complex.

• Documentation burden. The relationship, risk objective and testing method must be documented at inception; a hedge cannot be designated after the fact.
• Discontinuation. If the hedge stops qualifying, or a forecast transaction becomes unlikely, amounts held in reserves may have to be released to profit or loss.
• Natural hedges. A natural hedge, such as matching foreign revenue with foreign costs, needs no hedge accounting because no derivative is involved.
• Instrument limits. Written options generally cannot be designated as hedging instruments, and mark-to-market swings on undesignated derivatives still hit earnings.

• IFRS Foundation: IFRS 9 Financial Instruments
• Financial Accounting Standards Board (FASB)