What Hedge Accounting Options Are Available To An Entity That Wants To Manage Foreign Currency Expos
A specific type of hedging transaction that entities can engage in aims to manage foreign currency exposure. These hedges are undertaken for the economic aim of reducing potential loss from fluctuations in foreign exchange rates. However, not all hedges are designated for special accounting treatment. Accounting standards enable hedge accounting for three different designated forex hedges:
- A cash flow hedge may be designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognized asset or liability, or a forecasted intercompany transaction.
- A fair value hedge may be designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability.
- A net investment hedge may be designated for the net investment in a foreign operation.
The aim of hedge accounting is to provide an offset to the mark-to-market movement of the derivative in the profit and loss account. For a fair value hedge this is achieved either by marking-to-market an asset or a liability which offsets the P&L movement of the derivative. For a cashflow hedge some of the derivative volatility into a separate component of the entity's equity called the cash flow hedge reserve.
Where a hedge relationship is effective (meets the 80%–125% rule), most of the mark-to-market derivative volatility will be offset in the profit and loss account.
To achieve hedge accounting requires a large amount of compliance work involving documenting the hedge relationship and both prospectively and retrospectively proving that the hedge relationship is effective.
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