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The article explains the basic principles of hedging and the current accounting regulations as set out in IAS 39, Financial Instruments: Recognition and Measurement(IAS 39). The article concludes by considering the weaknesses of IAS 39 and how those weaknesses are addressed by the proposed changes issued by the IASB in September 2012.
Are you risk adverse? I think I am. For example, as a property owner I have an insurance policy to protect me from the risk of incurring a loss if my house were to burn down. Companies will face many risks and if they seek to cover these risks then they are said to be hedging. Hedging therefore is a risk management process whereby risk adverse companies firstly identify and quantify that they have a risk and secondly seek to cover that risk.
Risks come in many forms for companies. For example there is a risk that the fair value of assets and liabilities that they hold might increase or decrease, that in future the price of the goods they buy or sell might change, that interest rates on their borrowings or deposits might change, and that foreign exchange rates may move. A hedged item is defined as an item that exposes the entity to risk of changes in fair value or future cash flows and is designated as being hedged.
In order to protect themselves from losses on hedged items companies enter into contracts to cover any loss arising. These contracts often not only eliminate the risk but also eliminate any potential gain. These contracts are termed the hedging instrument. A hedging instrument is defined as a contract whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. Hedging instruments are normally a type of financial instrument known as a derivative.
I have written about the accounting for financial instruments (see 'Related links'). To recap, a financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. A derivative is so called because its value changes in response to the change in an underlying variable such as an interest rate, a commodity, a security price, or an index. Derivatives often require no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and are settled at a future date.
An example of a derivative is a forward contract. Forward contracts are contracts to purchase or sell a specific quantity of something, eg a commodity, or a foreign currency at a specified price determined at the outset, with delivery or settlement at a specified future date. For example a farmer may enter into a forward contract with a supermarket to sell in 12 months a specific amount of crop at a certain price. In this way the producer (the farmer) is protected from the risk of falling prices, and the consumer (the supermarket) is protected from the risk of rising prices. It therefore provides certainty.
Another example of a derivative is a futures contract. These contracts are similar to forwards but whereas forward contracts are individually tailored, futures are generic and are tradable in a market. Futures are generally settled through an offsetting (reversing) trade, whereas forwards are generally settled by the actual delivery of the underlying item or cash settlement.
If a derivative is held by a company and it is not designated as a hedging instrument then it is deemed to be held for speculation, ie for trading purposes. All derivatives must be recognised at fair value on the statement of financial of position - this is sometimes referred as being 'marked to market'. As the value of derivatives can be very unstable and so can generate large gains and losses in a short period, derivatives cannot be carried at historic cost (which is often nil anyway) as this would result in large gains and losses being unreported. If the derivative is not designated as a hedging instrument then any gains or losses arising are recognised in the statement of profit of loss. This is fair enough as the rightful place for trading profits and losses is the statement of profit or loss.