Hedging…what is it and why do companies hedge?
In general, hedging is a risk management tool. It is really any technique designed to reduce or mitigate risk.
A simple example of mitigation risk that most of us can relate to from a personal perspective is insurance. We often purchase insurance for our personal property such as cars or homes to mitigate our risk of loss in the event that our car or home is damaged.
Similarly, companies are exposed to a variety of risks, including various financial risks. And to mitigate future exposure to certain financial risk, a company often uses derivatives and hedging as part of their risk management strategy. Unfortunately, the accounting for derivatives does not always align with the risk management objectives.
ASC 815, Derivatives and Hedging, allows for special accounting for qualifying hedges to help better align the accounting with the economics of the risk management strategy.
ASC 815 provides for three different hedge types:
- Fair value hedges
- Cash flow hedges, and
- Hedges of a net investment in a foreign operation
In the remainder of this blog post, we will explore fair value hedging and cash flow hedging. Generally, the determination of whether to use a fair value hedge or a cash flow hedge depends on the type of transaction and the risk being hedged.
Fair Value Hedge
A fair value hedge is defined as a hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk.
To help with understanding a fair value hedge, let’s look at an example.
Assume a company has issued fixed-rate debt, but the majority of their interest-earning assets earn interest based on variable interest rates. The company is exposed to interest rate risk because if interest rates decline substantially, the income earned on their interest earning assets will be less, while the interest payable on their debt remains constant at the fixed rate.
To mitigate this risk, a pay-variable, receive-fixed interest rate swap could be used to “free” themselves from this fixed position. If the hedge qualifies for fair value hedge accounting, then the derivative unlocks the fixed-rate debt, protecting against exposure to changes in fair value of the debt.
Under fair value hedge accounting, the derivative must be recorded at fair value with changes in fair value presented in the same income statement line item as the earnings effect of the hedged item.
Additionally, the change in fair value of the hedged item due to the risk being hedged is recorded as an adjustment to the hedged item through the income statement in the same account line item that normally would be used for that underlying asset or liability.
Cash Flow Hedge
A cash flow hedge is defined as a hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk.
Cash flow hedges are used when hedging the variability of cash flows. For example, assume a company issues variable rate debt while the majority of their interest-earning assets are in the form of fixed interest receivables. They are at risk of changes in interest rates because if interest rates increase substantially, the income being earned on their interest earning assets will be constant or fixed, while the interest payable on their debt will fluctuate with the changes in rates.
To mitigate this risk, a receive-variable, pay-fixed interest rate swap could be used to protect against future cash flow uncertainty. If the hedge qualifies for cash flow hedge accounting, then the derivative fixes or locks-in the debt interest payments, protecting against changes in cash flows due to changes in interest rates.
Under cash flow hedge accounting, the derivative is recorded at fair value with changes in fair value of the derivative included in the assessment of effectiveness recorded in other comprehensive income.
The amounts that accumulate in other comprehensive income are reclassified to earnings in the same income statement line item that is used to present the earnings effect of the hedged item when the hedged item affects earnings.
There is no change in the way the hedged item is accounted.
Fair Value Hedge vs Cash Flow Hedge
In summary, a fair value hedge is used to mitigate risk created by fixed exposures such as fixed costs, prices, rates, or terms. Whereas a cash flow hedge is used to mitigate risk from variable exposures.
If you are interested in learning more about derivatives and hedge accounting, check out our comprehensive course collection on accounting for that will walk you through the accounting and reporting under ASC 815, as well as our Derivatives & Hedging topic page.
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