Definition of Accounting for Fair Value Hedges
An investment position entered by an organization to mitigate or eliminate the exposure of a change in the fair value of an asset or liability or any such item like a commitment from a risk that can impact the profit and loss account of the organization.
Explanation
When an asset or a liability is hedged it limits the exposure of any extreme changes in its value. A fair value hedge is attributed to any item that has a fixed value. The hedge is done to mitigate primarily, the risk of loss so that any gain arising out of the hedged instrument can play as a uplifting item in the financial statement in case the value of the asset falls drastically and the hit taken on the profit reduces considerably due to the hedging position entered into.
Example of Accounting for Fair Value Hedges
ABC Ltd. owns an asset which has a current fair value of $1,000 and due to the current market scenario it is forecasted that the value will fall down to $900 and result in a loss. To hedge this loss, the company enters into a derivative contract which has a value of $1,000 same value as the asset. The fair value of the derivative contract will have an opposite value since it is an offsetting position.
As expected, if the value of the asset decreases and the value of the hedge instrument increases
| Sr. No | Profit / Loss | Fair Value of Hedged Asset | Profit / Loss on Hedged Item | Value of Hedged Instrument | Profit / Loss on Hedged Instrument | Net Profit / Loss |
| 1 | Net Loss | $900.00 | -$100.00 | $1,050.00 | $50.00 | -$50.00 |
| 2 | Net Profit | $980.00 | -$20.00 | $1,030.00 | $30.00 | $10.00 |
| 3 | Break Even | $990.00 | -$10.00 | $1,010.00 | $10.00 | Break Even |
In case, there is a decrease in the value of the hedge instrument and increase in the value of the asset
| Sr. No | Profit / Loss | Fair Value of Hedged Asset | Profit / Loss on Hedged Item | Value of Hedged Instrument | Profit / Loss on Hedged Instrument | Net Profit / Loss |
| 1 | Net Loss | $1,100.00 | $100.00 | $950.00 | -$50.00 | -$50.00 |
| 2 | Net Profit | $1,050.00 | $50.00 | $970.00 | -$30.00 | $20.00 |
| 3 | Break Even | $1,050.00 | $50.00 | $950.00 | -$50.00 | Break Even |
How to Account for Fair Value Hedge?
Accounting a fair value hedge can be performed by following the below steps:
- On the date of entry on the financial statement, the value for the asset whose value is being hedged and the instrument which is being used for hedging needs to determine.
- When there is any change in the fair value of the asset, record it in the financial statement. This change can either be a profit or a loss depending on the current value of the asset for which hedging was done.
- The current value of the instrument used for hedging needs to be identified. Just like in the previous step, whether it is a profit or a loss needs to be recorded on the financial statement.
Accounting for Fair Value Hedges Journal Entries
The below entries are based on the date of reporting the entries on the financial statement.
|
Asset / Hedged Instrument |
Scenarios | Debit |
Credit |
| Asset | Value of The Asset Increases | The increase in the value of the asset should be debited, i.e the Asset should be debited. Record this as an increase in the asset value which will positively impact the financial statement | The Gain on the Hedged Asset A/C should be credited. As a result the gain in the value will show an increased profit |
| Value of The Asset Decreases | The Loss on the Hedged Asset A/C should be debited. Since this is a reduction in the value of the asset this will reduce the profit on the financial statement | The decrease in the value of the asset should be credited i.e the Asset should be credited. Record this as a decrease in the asset value which will negatively impact the financial statement | |
| Hedged Instrument | Value of the Hedged Instrument Increases | The increase in the value of the hedged instrument should be debited, this gain will positively impact the financial statement | The gain needs to be credited to the Gain on the Hedged Instrument A/C |
| Value of the Hedged Instrument Decreases | The decrease needs to be recorded by debiting the Loss on the Hedged Instrument A/C. Since this is a decrease in the value of the instrument, this will negatively impact the financial statement | The hedged instrument needs to be credited |
Fair Value Hedge vs Cash Flow Hedge
- Fair value hedge is hedging against the risk on the fair value of an asset which is expected to impact the financial statement whereas as a cash flow hedge aims at mitigating the risk associated with the cash flows.
- The cash flow hedge mitigates the vulnerability of a cash flow related to an asset, liability or a transaction that is related to a particular risk. A cash flow hedge is formulated in a way that it minimizes the risk that a company might end up paying more for a raw material than what it expects.
Conclusion
Fair Value Hedging refers to the practice of hedging risks on the value of an asset by entering into a position that might result in an equivalent amount of stability, this thereby does not impact the financial statements as much as it would had there not been a hedge position. Unlike a cash flow hedge, a fair value hedge mitigates the risk associated with an asset on the basis of the fair value of the asset. The performance of the hedged instrument decides whether the hedging position entered was fruitful and practically minimized or mitigated the risk to the extent that the cost and efforts involved in entering the hedge position were worth. Fair value hedging can result into magnified losses if the hedging instrument does not perform well since the value of the asset is expected to fall.
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