22420 Chap.11 Hedge Accounting
Hedge Accounting
Why hedge accounting exists
A forward exchange contract is a financial instrument at fair value.
Hedge accounting lets its gains and losses be reported in the same period and place as the exposure it protects, but only when it genuinely reduces risk, which is why strict criteria apply.
Two types
In a fair value hedge of a recognised payable or receivable, both the item’s exchange difference and the forward’s change go to profit or loss and largely offset.
In a cash flow hedge of a highly probable forecast transaction, the forward’s changes wait in a reserve in other comprehensive income and are reclassified when the transaction is recognised.
Two exercises to master
The subject’s self-study set works a forward contract hedging an inventory payable and a forward hedging a forecast export sale.
Between them they cover both hedge types, both rate directions and the reclassification step, so they are the patterns to rebuild before the final exam.
What this chapter covers
- 01
Forward contracts as financial assets or liabilities
- 02
Why hedge accounting is restricted
- 03
Fair value hedge of a recognised payable
- 04
Spot rate for the item, forward rate for the contract
- 05
Cash flow hedge of a forecast sale
- 06
The cash flow hedge reserve and reclassification
- 07
Rate quotation: multiply or divide
- 08
The locked-in rate as the net result
Worked example · free
Hedging a US dollar payable with a forward contract
- 11 April: inventory and payable at US$100,000 × 1.48 = $148,000; the forward starts at nil.
- 130 June: the payable rises to $152,000, a $4,000 loss; the forward is worth (1.53 − 1.50) × 100,000 = $3,000, a gain.
- 131 July: the payable falls to $145,000, a $7,000 gain; the forward moves to −$5,000, an $8,000 loss.
- 1Settlement: $145,000 to the supplier plus $5,000 on the forward, $150,000 in total.
Key terms
- Forward exchange contract
- An agreement to exchange currencies at a set rate on a specified future date.
- Fair value hedge
- A hedge of a recognised asset or liability whose instrument gains and losses go to profit or loss beside the item’s own changes.
- Cash flow hedge
- A hedge of a highly probable forecast transaction whose instrument changes are held in a reserve until the transaction is recognised.
- Cash flow hedge reserve
- The equity reserve, fed through other comprehensive income, that holds cash flow hedge gains and losses.
Hedge Accounting FAQ
Why are there strict criteria for hedge accounting?
Because some managers once labelled speculative holdings as hedges to make risk look smaller. Hedge accounting is allowed only to show genuine risk reduction, so an instrument held to speculate goes straight to profit or loss.
Where do gains on a cash flow hedge go before the sale?
Into a cash flow hedge reserve through other comprehensive income. When the forecast sale is recognised, the reserve is reclassified into it, so revenue ends at the locked-in rate.
Is the hedged inventory remeasured?
No. Inventory is a non-monetary item, so it stays at the spot rate on the transaction date. Only the payable and the forward contract are remeasured as exchange rates move.
How is a forward contract’s fair value found with a 0% discount rate?
Take the change in the forward rate for the settlement date since the contract began, multiply it by the foreign currency amount, and sign it from the holder’s side: a contract to buy gains when the forward rate rises, and a contract to sell loses.
Does hedge accounting change the cash paid?
No. The forward’s cash settlement plus the payment for the hedged item equals the currency amount at the contract rate. Hedge accounting changes only when and where the gains and losses are reported.
Exam move
For each hedge question, decide first whether the exposure is already recognised, which tells you the hedge type. Then set out a two-column table with the item on spot rates and the forward on forward rates, and finish by checking that the total cash equals the currency amount times the contract rate. Finish by recording one cash flow hedge through the reserve and its reclassification on the sale date.
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