Hedge Accounting

A method of accounting where entries for the ownership of a security and the opposing hedge are treated as one. Hedge accounting attempts to reduce the volatility created by the repeated adjustment of a financial instrument's value, known as marking to market. This reduced volatility is done by combining the instrument and the hedge as one entry, which offsets the opposing movements.

Hedge accounting modifies the usual accounting treatment of a hedging instrument and/or a hedged item to enable gains and losses on the hedging instrument to be recognised in the income statement in the same period as offsetting losses and gains on the hedged item. This is a matching concept. A pre-requisite for hedge accounting is that a hedging instrument, normally a derivative, is designated as an offset to changes in the fair value or cash flows of a hedged item.

Why hedging and hedging accounting
1.Most business activity involves risks and uncertainties, and it is necessary of elaborating effective financial strategies in order to manage these risks and uncertainties.
2.One way in which this can be done is to enter into transactions that expose the entity to risk and uncertainty that fully or partially offsets one or more of the entity’s other risks and uncertainties, transactions known as ‘hedges’.
3.The instrument acquired to offset risk or uncertainty is known as ‘hedging instrument’ and the risk or uncertainty hedged is known as ‘hedged item’.
4.When certain criteria are met, International Accounting Standard (IAS) 39 “Financial instruments: Recognition and Measurement” permits entities to apply special accounting treatment, so-called ‘hedge accounting‘.
Types of Hedge Accounting
1.Cash flow Hedging
2.Fair Value Hedging
3.Hedge of a Net Investment