Hedge accounting is the practice of accounting which handles the financial components which are usually fluctuating. It helps the accountant to summarize and then present the asset easily on balance sheet. It reduces the problem cause due to changing values of financial statements.
If you are doing business then risk is the most common factor. But this risk increases when business involves assets which are volatile in nature. Such as commodity prices. interest rates equity prices and credit risks. So in order to balance these types of risks hedging is used. The common hedging is changing floating interest rates to fix rates. In condition of higher risk, hedging funds are use to lower the loss.
Those who uses hedge accounting to lower the risk, have to mention all the records in their accounts’ book. The instruments that affects the fair value of are recorded in the profit and loss statement. Since the fair value of fund is there can be discrepancies between instruments and assets. These differences are reconcile by the accountant, without breaking any rule. So by reconciling they reduce the volatility and reduces risk. Thus, this whole process is called hedge accounting.
Types of Hedge Accounting
There are mainly three types of hedge accounting.
- Cash flow hedge– it is important element of company. By cash flow only investors judge about the worth of company, as it affects the credit ratings. The volatility in market affects the cash flow. So to avoid this companies create contracts with the suppliers that are recorded an asset on balance sheet
- Fair value hedge– floating interest rate can cause too many changes in accounting unless it is swapped. For fix rate. 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-here 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.
Accounting helps to keep the record, which will further helps to track and analysis the market value of company. By hedging the floating assets come in stable condition, which will be easy to handle. This all is done by the accountant. It helps the company to lower the risk about volatility of financial instruments. 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.
- More stability in financial documents
- risk management