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Hedge Accounting - the Dark Science Hedging is a complex and difficult business, ill understood by markets and badly served by current accounting practices. It doesn't help that hedging usually involves the use of derivative financial instruments, long regarded as the dark science of finance.

Hedge Accounting - the Dark Science

by Darrel Scott, IASB Member

On the face of it, it seems odd that a practice utilised by so few companies other than financial institutions, and usually for something as mundane as risk management, should enjoy the attention that is accorded to hedging. However, a little thought quickly reveals some insight - hedging is a complex and difficult business, ill understood by markets and badly served by current accounting practices. It doesn’t help that hedging usually involves the use of derivative financial instruments, long regarded as the dark science of finance.

In this article, I intend talking a little about what we are doing about current accounting practices.

At the heart of any financial reporting relationship is the professional scepticism that exists between investors and managers of companies. Hedging activities contain all of the ingredients for exaggerating the discord in a relationship premised on scepticism. Hedging seeks to address well-understood basic risks in individual industries through the introduction of elaborate, complex, and often misunderstood financial instruments. These instruments usually behave in a predictable way, but occasionally go off the charts in an entirely unpredictable way. Essentially, what is a laudable business aim, the reduction of inherent risks, can seem to an outsider to effectively introduce new and unpredictable risks to the way a known and understood business operates. This perception has been exacerbated by the recent global crisis. During the course of the crisis, the complexity, some would say over-complexity, of derivative instruments, and lack of consistency and transparency in their reporting was exposed.

A minor change in the value of a derivative will often lead to a major change in its balance sheet value.

The essence of a good risk management strategy is that when it is working, it is invisible, and therefore to an outside observer, of no consequence. However, when it fails, it becomes instantly and dramatically observable and the consequences are, almost inevitably, negative. But just as important, when seeking to understand risk management strategies, is the balance sheet presence of derivative instruments. They have, by their very nature, a small balance sheet footprint. Derivatives, like icebergs, hide most of their bulk out of sight below the surface. Whereas a minor change in the value driver of an on-balance sheet item will lead to a similarly minor change in its balance sheet value, a minor change in the value of a derivative will often lead to a major change in its balance sheet value. Since balance sheets are a point in time measurement, it is often difficult to represent the potential balance sheet and income statement impact of a derivative instrument that for the most part remains below the surface.

It is in this dark and murky place that the IASB is endeavouring to amend hedge accounting rules. Currently part of the financial instrument accounting standard, IAS 39, these accounting rules were primarily intended to address accounting mismatches.

Mismatch

Accounting standards as they are currently written, define two distinct approaches to the valuation of assets and liabilities on the balance sheet. The historical cost approach is by far the most easily understood and traditionally more easily accepted method of accounting. Under the historical cost convention, a balance sheet item is valued at its original cost, less any reduction attributable to usage. The value is cash flow based, and is reliable. Arguably, cost presents the best indicator of value where an entity intends retaining the asset or liability. Fair value on the other hand, is a methodology for accounting that is somewhat newer and was introduced primarily for use with financial instruments. As the name implies, it reflects the current fair value of items on the balance sheet at any point in time. Fair value always presents the user of financial statements with a current view of the balance sheet, but arguably can be misleading when there is not a liquid market to price an instrument, and/or where the entity has no intent, ability or need to dispose of an asset or liability.

Since the two valuation methods often produce substantially different answers, and since it is often appropriate that they are both used within the same set of financial statements, their use can give rise to a financial statement mismatch. A mismatch arises when an asset and a corresponding liability are measured on different basis, giving rise to different values for essentially the same event. Existing accounting under IAS 39, and prospective accounting under IFRS 9 permit changes in measurement methodology where it will reduce mismatches.

These matching exceptions however prove impossible under certain circumstances. Those circumstances include in particular hedging activities.

Hedging

Hedging is a business activity undertaken when an enterprise seeks to reduce an inherent economic risk, by acquiring a financial instrument with risk characteristics opposite to those it seeks to hedge. The hedged item is usually an integral part of an entities business, and is often a financial instrument or obligation. The hedging instrument may also be an inherent part of an entities business (a natural hedge), but is more often a financial instrument and usually a derivative instrument. Derivative instruments are popular as hedges because they require little capital outlay and can be tailored to the specific risk the entity is trying to hedge.

In current and prospective financial instrument accounting practice, derivatives must be accounted for at fair value. Hedged items, because of their nature as core to the business, are often accounted for at historic cost. This gives rise to mismatches.

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