What is 'Hedge Accounting'

Hedge accounting is a method of accounting where entries for the ownership of a security and the opposing hedge are treated as one. Hedge accounting attempts to reduce the volatility created by the repeated adjustment of a financial instrument's value, known as marking to market. This reduced volatility is done by combining the instrument and the hedge as one entry, which offsets the opposing movements.

BREAKING DOWN 'Hedge Accounting'

The point of hedging a position is to reduce the volatility of the overall portfolio. Hedge accounting has the same effect except that it's used on financial statements. For example, when accounting for complex financial instruments, such as derivatives, the value is adjusted by marking to market; this creates large swings in the profit and loss account. Hedge accounting treats the reciprocal hedge and the derivative as one entry so that large swings are balanced out.

Hedge accounting is used in corporate bookkeeping as it relates to derivatives. In order to lessen overall risk, hedging is often used to offset the risks associated with the derivatives. Hedge accounting uses the information from the derivative and the associated hedge as a single item, lessening the appearance of volatility when compared to reporting each individually.

Reporting With Hedge Accounting

Hedge accounting is an alternative to more traditional accounting methods for recording gains and losses. When treating the items individually, such as a derivative and its associated hedge fund, the gains or losses of each would be displayed individually. Since the purpose of the hedge fund is to offset the risks associated with the derivative, hedge accounting treats the two line items as one. Instead of listing one transaction of a gain and one of a loss, the two are examined to determine if there was an overall gain or loss between the two and just that amount if recorded.

This approach can make financial statements simpler, as they will have fewer line items, but some potential for deception exists since the details are not recorded individually.

Using a Hedge Fund

A hedge fund is used in order to lower the risk of overall losses by assuming an offsetting position in relation to a particular security or derivative. The purpose of the account is not to generate profit specifically but instead to lessen the impact of associated derivative losses, especially those attributed to interest rate, exchange rate or commodity risk. This helps lower the perceived volatility associated with an investment by compensating for changes that are not purely reflective of an investment's performance.

RELATED TERMS
  1. Hedging Transaction

    A hedging transaction is a position that an investor enters to ...
  2. Long Hedge

    A long hedge is a situation where an investor has to take a long ...
  3. Hedge Fund Manager

    A hedge fund manager is an individual who oversees and makes ...
  4. Hedge

    A hedge is an investment to reduce the risk of adverse price ...
  5. Double Hedging

    Double Hedging refers to a trading strategy in which an investor ...
  6. Cross Hedge

    A cross hedge is used to manage risk by investing in two positively ...
Related Articles
  1. Trading

    A Beginner's Guide to Hedging

    Learn how investors use hedging strategies to reduce the impact of negative events on investments.
  2. Trading

    Hedging basics: What is a hedge?

    Hedging is a widely misunderstood strategy, but it's not as complicated as you might think.
  3. Investing

    3 Things Divorcees With Hedge Fund Investments Should Know

    Hedge funds are assets that can be very difficult to divide during a divorce.
  4. Investing

    How To Start a Hedge Fund In the United States

    A general overview of how to start a hedge fund firm in the United States, including complying with state and federal regulations.
  5. Investing

    What Are Some Reasons to Invest in Hedge Funds Now?

    Financial news has been dominated in recent months by reports of hedge fund struggles. Are there any reasons why investors might consider hedge funds now?
  6. Investing

    Why Hedge Fund Managers Make Good Advisory Clients

    Super-busy hedge fund managers should be viewed as an opportunity for sophisticated financial advisors who can step in and offer their services.
  7. Investing

    Activist Hedge Funds: Follow the Trail to Profit

    Learn to profit by following the lead of hedge funds.
  8. Investing

    Investors Are Turning to ETFs Over Hedge Funds

    Exchange-traded funds have grown to surpass hedge funds in total assets, signalling a major shift in investor strategy.
RELATED FAQS
  1. Are there publicly traded hedge funds?

    See why a privately arranged hedge fund may decide to take its fund public, and how the investing public at large can gain ... Read Answer >>
  2. Where does a hedge fund get its money?

    Learn how a hedge fund is structured and how the managing partner of the fund finds and solicits investors with large amounts ... Read Answer >>
  3. How do real estate hedge funds work?

    Understand what a hedge fund is, how it differs from a mutual fund, and the function of real estate hedge funds. Read Answer >>
Trading Center