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.