- What is hedging and how is it used?
- What is hedge accounting?
- Types of hedge accounting
- Why do businesses use hedge accounting?
- How does hedge accounting work?
- Advantages of hedge accounting
- Disadvantages of hedge accounting
- Accounting software for hedge accounting
Hedge accounting or hedging is an accounting practice that is used in companies that deal with components on their financial statements that have very fluctuating values. It is a practice that lets the accountant summarize and present the value of the specific asset or liability on the balance sheet simply and easily. It helps offset the risk and instability that would otherwise be present in the financials due to the market fluctuations. It states the impact of the risk management using financial instruments that reduce the company’s exposure to risks that could directly affect the bottomline.
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What is hedging and how is it used?
Every business has a risk but some more so than others. Businesses that involve financial assets or instruments that are subject to very high levels of volatility have a high risk. Some of these risks include commodity prices, interest rates, equity prices, foreign currency rates and credit risks. The risks in such businesses are counterbalanced with derivatives which is called hedging. The most common form of hedging is switching a floating interest rate to a fixed one. When there is a high risk, a hedge fund is used to reduce the risk to a more neutral position and lower the instability. It does not however guarantee that there will be a profit, it only offsets and counterbalances the risk.
What is hedge accounting?
As with all businesses, a high risk business that uses hedging will have to record it in their books of accounts. Generally, the hedge instruments that affect the fair value are recorded in the profit and loss statement. Since equity influences the fair value of a hedge fund, there could be discrepancies between the values of the hedge instruments and the hedged assets/liabilities. These differences will have to be reconciled by accountants within the boundaries of rules and regulations. The accounting methods used to reconcile these discrepancies and reduce the volatility that would be otherwise caused by contestant adjustments are called hedge accounting. Fair value accounting and marked to market accounting are other terms that are used to refer to hedge accounting.
So, when high market volatility could affect a portfolio’s stability, hedge accounting is the process used to create financial reports that include the vulnerable portfolio. This adjustment of the fair value of the instrument can cause big changes in the profit and loss account. As the reciprocal hedge counterbalances the fluctuations in the value of the portfolio, it keeps the profit and loss account more stable. If hedge accounting were not used the profit and loss account would swing wildly in response to the volatility in the market. It presents a more accurate value of the company’s assets based on what they are worth in current market conditions. But in a highly volatile market this may cause inaccuracy in the value represented. In futures trading this hedge accounting is updated daily and the profit and loss is based on the midpoint between the long and short positions. If hedge accounting were not used it would be very challenging to compute accounting reports and financial statements accurately.
Types of hedge accounting
Price change fluctuations, foreign exchange rate fluctuations and inflation can cause too much volatility in accounting that is offset by hedge accounting.
There are different types of hedge accounting but they all serve to minimize instability or volatility.
- Cash flow hedge
Cash flow is one of the most important aspects of a company. Investors judge the worthiness of a company by studying its cash flows. Cash flow also affects the credit rating of businesses. When the markets are very volatile, they can impact the cash flow in a company. This unstable nature of cash flow in some industries is undesirable. So to offset this, these companies create forward contracts with suppliers that are recorded as assets on the balance sheet to offset the fluctuations in cash flow by securing the contract prices.
- Fair value hedge
Floating interest rates can also be volatile and cause too many changes in accounting unless swapped for a fixed rate. Since the floating interest rate is a variable component that could cause losses on investments, it may be swapped for a fixed rate to stay more stable. Fair value hedges make it easier to compute and record the investment related values on the balance sheet despite the fluctuating interest rate.
- Net investment hedge
It is hedge that is used to keep cash flows more stable when dealing with volatility in foreign currency exchange rates. There are many GAAP rules and restrictions that must be complied with when using this hedge. Foreign currency debt and futures contracts can also be included in the net investment hedge.
Why do businesses use hedge accounting?
Accounting is used to keep tracks of the financial transactions in a company. It is also used to extract reports that summarize the transactions and give meaningful information. These reports have many uses such as submission to the authorities and for management and investors to assess the company’s financial activities. It is essential that the information that is presented in an accounting report be clear and easy to understand without complexities. Hedge accounting is one of the methods that is used to reduce the complexity caused in accounting reports due to unstable or volatile elements in the reports. The income statement, profit and loss account, as well as the balance sheet, are so much easier to understand when these volatile elements are counterbalanced with hedge accounts.
Companies that invest in the stock market buy options that help protect them from unexpected losses and if they were all individually accounted for, the financial statements would become too lengthy and volatile. Companies that need foreign exchange can buy in advance or purchase it when they need it. It is common practice to buy a futures contract that allows the company to purchase the required foreign exchange when it is needed at the rate that is prevailing at that time. They hold the funds in local currency or in some other investment until it is needed. This is in order to prevent any loss that may occur if they buy the currency ahead of time and its value drops before the date when they actually use it.
The accounting department would list this future foreign exchange transaction as an accounts receivable hedge on the balance sheet. This is the estimated cost of the foreign exchange purchase. It will show the person viewing the report how the entire financial picture would change if the value of that transaction changes over time. If hedging were not used it would not be possible for this procedure to be accounted for in standard accounting practices.
Making hedge accounting entries
Profits and losses get recorded separately in traditional accounting practices. But in hedge accounting, the security and its hedge are recorded as one entry. Manually computing hedge accounts needs an accountant who is expert in using them and summarizing them for the balance sheet and other reports. However, accounting software makes it easier to use and implement hedge accounts at multiple levels and departments in the company.
How does hedge accounting work?
Hedge accounting is not a compulsory system but is often used in industries and companies that have a lot of volatility in the value of an asset or liability. These companies do still have to report their financials and can do so more simply when they use hedge accounting. Some examples are companies that pay in foregn currencies, rely on floating interest rates, purchases options and forward contracts. A hedge fund is used to lower the risk of losses. It offsets the values of the volatile asset or liability. In the important financial reports, hedge accounting is the best way to summarize and account for these important yet uncertain values.
The accounting process starts with the general ledger and the values of the investments and their corresponding hedges are recorded. This is then transferred to the financial statements of the company. Since the initial record is made by the bookkeepers and accountants in charge of the daily transactions, hedge accounting is very vulnerable to fraudulent practices. A computerized system such as Tally that allows centralized access to all the accounts instantly goes a long way in preventing such practices and enforcing accountability by allowing the company accountants to keep an eye on the hedge accounts in real time.
Advantages of hedge accounting
The practice of hedge accounting is used because it offers many advantages such as:
- More stability in financial documents
If every volatile item were individually listed on the financial statements they would become too long and far too complicated to read and understand. Compressing the values by using hedge accounting makes the reports easier to understand and more stable. It masks the numerous volatile factors in the report that may otherwise make investors nervous. This stability is essential to maintain the company’s attractiveness to investors and stakeholders.
- Risk management
Hedge accounting when properly implemented lowers the risk in factors such as cash flows, foreign exchange, debt, investment and interest rates. It helps the company gain momentum in profit making and expansion across geographies while minimizing risk. It is essential to managing risk in companies and industries that must work with market volatility and still maintain proper financial records.
Disadvantages of hedge accounting
- Complicated and potentially time consuming
Hedging summarizes a lot of information and must be done properly. It is essential that the accounts be properly and meticulously compiled when doing hedging. An intelligent accounting software helps accountants perform hedge accounting easily, quickly and accurately.
- Vulnerable to fraud
When left to the discretion of the bookkeepers, hedge accounting becomes very vulnerable to malpractices and fraud. There should be very strict regulations for the system and it should be carefully monitored. Accounting software makes enforcing these regulations and real time monitoring very easy.
Accounting software for hedge accounting
Implementing hedge accounting with a software that is not designed for it is very difficult. Manually computing the hedge account is an involved and time consuming process. Intelligently designed software that can handle the nuances of hedge accounting is essential for companies that use it. Tally is flexible enough to allow for hedge accounting entries. It also has very strictly security measures that help keep senior accountants and management an eye on the daily entries to enforce accountability. Tally’s audit features make it easier for the auditor to examine the financials and prevent malpractices. Accounting software offsets the inherent fraud risk and complexity of hedge accounts.
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