Hedge accounting

Those who prepare their accounts in accordance with IFRS or US GAAP have the option of recognizing fluctuations in value directly in equity and thus significantly influencing the company's earnings!

The following explanations relate to hedge accounting in accordance with the International Accounting Standards (IAS).

Until the beginning of the 2000s, hedge accounting was only practiced in the USA in accordance with SFAS 133. Since then, the International Accounting Standards have also addressed this topic and the separate article IAS 39 was created, which was integrated into the existing regulations in a harmonious, but in practice often controversial and complicated manner. In most cases, those who prepare their accounts in accordance with IFRS have no choice as to whether certain content is adopted or not. With one exception: hedge accounting in accordance with IAS 39 is optional and can, but does not have to be applied.

Permanent change

Accounting standards, especially IFRS, are subject to frequent changes. This also applies to IAS 39, which was replaced by IFRS 9 and is still in a constant state of flux. The IFRS Bulletin should therefore be consulted regularly for the current status of hedge accounting.

Fundamentals

Values, whether currently on the balance sheet or only arriving in the future, are subject to permanent fluctuations for many reasons. One very common reason is currency fluctuations. Either on fixed assets / investments (translational) or future cash flows (transactional). In conventional accounting, these fluctuations are booked 1:1, e.g. HGB / OR / Swiss Gap FER, via the income statement, which often leads to undesirable secondary results that can have a significant impact on a company's profit or loss. However, currency fluctuations in particular can be offset by hedges of the underlying transaction. Nevertheless, these fluctuation results are still recognized in the income statement unless hedge accounting is applied.

As the issue of valuation and correct allocation of the hedging instrument to the underlying transaction can be very complex, the task of hedge accounting is not so much the correct posting from the income statement to the balance sheet, but rather the correct valuation.

Overview of the points relevant to hedge accounting

This means that you must always be aware of how the underlying transaction must be classified and also how it relates to the hedging transaction. If these characteristics match symmetrically, currency fluctuations can now be recognized directly in equity instead of periodically in the income statement.

Requirements for hedge accounting

• The hedge must be extremely effective (previously at least 80%, maximum 120%).
• High probability that the underlying transaction will occur and that it represents a risk for the company.
• A hedge must be effective for the entire term.
• A detailed description of the purpose of the hedge is required.

Example of a cash flow hedge

• Reliability of the budget / financial and liquidity plan must be verified.
• Financial and operational ability to execute the planned measures must be given.
• Probability of occurrence of the underlying transaction must be as good as certain.
• The duration of the hedge must be taken into account: the longer an event is in the future, the more uncertain its probability becomes.

Example of cash flow hedge documentation

This example shows a 1:1 hedge. However, portfolios can also be created, whereby care must be taken to ensure that there is a correlation within the portfolio with a high value and that the hedging instrument also matches the risk of the portfolio.

Not everything can be accounted for using hedge accounting

Hedging instruments

In principle, only instruments that are suitable for this purpose are suitable for hedging. This does not include, for example, obligations such as written (sold) options, short sales or equity instruments. Transactions within a group of companies are also not suitable for hedge accounting because the risks within the group cancel each other out. If a subsidiary wishes to apply hedge accounting, it must prove that its hedging transaction was ultimately concluded with a third party (via the parent company). Hedging instruments that only cover part of the entire risk period are also not suitable for hedge accounting.

Underlying transactions

Underlying transactions are assumed to contain similar values. For example, cash flows from future purchases cannot be hedged together with cash flows from future sales using the same instrument.It should go without saying that hedged items must be clearly identifiable and the effectiveness of the hedge must be demonstrable and its allocation clear.

Summary

Hedge accounting is an excellent technique for presenting fluctuations in value without affecting profit or loss and thus for reporting the company's results more objectively and without unpleasant side effects. However, the requirements are very high and can change from time to time. It is therefore essential to obtain competent support during the introduction and also periodically to check for suitability. In other words, expertise must not only be available in relation to accounting, but also in understanding the hedging process as such.