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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.