The Purpose of Hedge Accounting
In today’s financial world, doing business with other countries requires taking into account the differences in currency, the differences in interest rates, and the differences in financial instruments. The marketplace has daily fluctuations in currency and in interest rates. Commodities face even wider swings and many are related to the countries buying or selling the commodity.
Most firms are concerned with risk management, have set goals and have strategic ways to accomplish these goals. Hedge accounting provides a way to do that. It also allows less fluctuation in profit and loss and in the balance sheet of the firm. The rule of marked to market may cause volatility in profit and loss. This volatility may affect how others view the firm. By matching the hedged item with the hedging instrument, the volatility is reduced.
An Example of Hedge Accounting
If a Melbourne firm enters into a contract to sell goods to a Chicago firm for $1,000,000 USD in three months and then intends, in that same time period, to buy goods valued at $200,000 USD and equipment valued at $200,000 USD, the remainder of $600,000 USD is eligible for a currency hedge contract expiring in three months. This hedge lowers the risk of the fluctuation between the US and AUS dollars. The bookkeeping in Melbourne requires matching the three hedged items with the hedging item in a way that satisfies the present IASB rules.
The Evolution of Hedge Accounting
In an effort to make hedge accounting less cost-intensive and less cumbersome, the IASB and AASB have worked through several evolutions of standards and rules regulating this phase of accounting. Recognising the accounting need to use hedging has led to a concerted effort to make it workable in more firms. The latest target date for implementing changes to the standards is set for 1 January 2015. The new model is in Chapter 6 in IFRS 9 (AASB 9).
A careful review of the latest standards will be necessary if a firm is presently using hedge accounting or intends to use it in the near future. If a firm sees the need to discontinue using hedge accounting, It may be easier to discontinue now.
Keeping Up With the Rules of Hedge Accounting
If a firm intends to use hedge accounting, there must be an accountant within the firm who is keeping current with the changing rules. Risking non-compliance is a serious threat and the climate for change involved in hedge accounting will be a challenge.
Should a Firm Use Hedge Accounting?
There are pros and cons to this question. Some CFOs do not like hedge accounting because of the present restatement from the other comprehensive income (OCI) to the profit and loss statement when the resolution of the hedging relationship expires. This can make a somewhat unexpected impact on the current operations of the firm.
There are alternatives to a direct hedged/hedging relationship. Some forms of commerce are naturals without invoking this relationship. If the purchase and sale of goods with a country using another currency directly match, there is no need to develop and use hedge accounting on these transactions.
If handled properly, the use of hedge accounting can be a great advantage to a firm. In reducing the risk of the difference in currencies in international transactions and even the fluctuations of interest rates within a country, risk management becomes manageable with hedge accounting.
Complying with the marked to market rules without hedge accounting can cause a fluctuation in the profit and loss that is difficult to explain to shareholders. Since this may happen from accounting period to accounting period, the explanation becomes more difficult to swallow.
Staying current with the changes in hedge accounting rules and standards is difficult but worthwhile in viewing the end product. Smoothing out the fluctuations in accounting reports becomes a matter of staying on top of the hedged and hedging pairings.
The new rules will also allow a rebalance of the hedging relationship, making it easier to resolve failing hedged pairings. Taking a long-term view of hedge accounting will help to set up future hedging relationships and make international financial transactions more appealing. A firm that does not use hedge accounting may be faced with decisions in the future that are not so appealing.