Did your company ever face problems such as unfavorable changes in the exchange rate during export and import operations? Maybe when purchasing raw materials or selling goods, the situation on the market developed in such a way that you were forced to make deals at unfavorable prices for you? Did you take out a bank loan at one interest rate and return it at a higher rate? Ultimately, all this leads to additional losses, and the larger your business, the greater the loss.
Companies around the globe are affected by a variety of risks. The risk can come in various forms. For example, it can be credit risk, foreign exchange risk, price, or inflation risk. Businesses have to try to manage these risks as it is part of cash flow management.
These risks are managed using various types of hedging instruments that allow mitigating the volatility these companies are exposed to. There’s an operational element to this process, but there is also an accounting element in terms of how these numbers get reported. This allows getting a good understanding of how well the company is actually managing their risk, which is quite important not only for the management itself but also from the valuation perspective.
Does every company follow hedge accounting? The answer is definitely no. However, if the company can present detailed records of their transactions that show a true picture of their financial activity, they have an option to turn to hedge accounting and receive all the benefits it has to offer.
Despite the successful application of hedging all over the world, managers of many companies continue to ignore losses from the risks mentioned above. Often this happens due to a misunderstanding of the essence of the problem, ignorance of hedging mechanisms, and an unwillingness to learn hedge accounting. Today, we will try to explain the basics.
Hedge accounting
Hedge accounting implies a way of matching the changes in fair value or changes in future cash flows of a business in the financial statements to the changes in the value of the financial instrument, either through profit or loss or other comprehensive income.
This process has its own specific, separate rules that go against any other rules that come with accounting standards. In other words, if you want to hedge something, the accounting process for that transaction will be completely different from what you would typically do following the standard accounting rules.
For instance, when valuing inventory, the lower of cost or net realizable value concept is no longer applicable because if you are trying to protect the value of your inventory using a specific hedge accounting transaction, there are separate rules that you will need to apply. This difficulty in accounting and risks associated with hedging make many companies choose to steer clear of hedging as a risk management strategy and miss all the benefits it can bring.
Example
To make the hedge accounting concept easier to understand, let’s go over an example. First, we should make it clear that the company cannot just decide to resort to hedge accounting. Although hedge accounting is optional, one has to meet specific requirements to qualify. Now, let’s get to our example. For hedge accounting, you obviously need a hedged item.
A hedged item is a specific item that exposes the business to the risk of changes in future cash flows or changes in fair value. For instance, you are a business operating in the USA with USD being your functional currency. You have a contract with a Korean company for the purchase of goods. This future possible contract is the hedged item.
This is a 100,000 KRW deal, but it is going to happen in six months. In other words, the cash flow will occur only later. Obviously, during this period, the exchange rate is going to change between now and then. This risk of change in the exchange rate is the hedged risk. The risk being hedged against can be pretty much any market risk, such as commodity price, foreign currency, and interest rate.
The management is faced with the task of managing this risk. One of the options is hedging. You can buy a forward foreign exchange contract and fix the USD/KRW rate. Accordingly, the forward foreign exchange contract serves as a hedging instrument in our example. Note that in the real world, the company might be facing several risks associated with one specific item at once and might need more than one hedging instrument to manage these risks.
This financial instrument is the key moment because this is what you use to offset the gains or losses on fair value or gains or losses on the cash flows of the designated item or, to be more specific, its change in value is going to offset the change in the value of cash flows. Thus, what happens is that the hedging instrument protects the hedged item against the hedged risk.
