In general hedging describes financial transactions that are used to reduce the risk of an underlying transaction. The hedge transaction itself bears a risk that is adverse to the risk of the hedged item so that below the line the two risks even out and offset each other.
Theoretically a hedge could eliminate the underlying risk completely if the hedge instrument would be 100% negatively correlated to the hedged item. This is called a "perfect hedge". In reality this can hardly be found (Hausin et al. 2008). Furthermore the investor has to pay a premium on the hedge for the comfort of reduced risk. The premium on the other hand reduces the effectiveness of the whole investment due to higher cost of the whole transaction.
An example of a typical hedge transaction would be investing in a stock and at the same time buying a put option or a future contract to sell the stock at a set price. This deal would hedge the volatility risk of the stock price (Hedge).
The components of financial risk related to financial instruments are the following:
market risk: the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices;
the factors of market risk are:
currency risk: the risk that the fair value or future cash flows of a financial instrument will be affected by changes in foreign exchange rates;
interest rate risk: the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates;
price risk: the risk that the fair value or future cash flows of a financial instrument will change as a result of market prices changes, caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market;
credit risk: the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation;
liquidity risk: the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities or in selling quickly a financial asset, at its fair value. (Bunea-Bontas, Bacovia 2009)
Those risks can be hedged by the use of derivatives. Derivatives are financial instruments which derive their value from the value of some other financial instrument or variable. The fair value of derivatives changes with the changes of the hedged item (i.e. changes of interest rate, security price, commodity price, currency rate, stock exchange indices value) (Bunea-Bontas, Bacovia 2009). The most important categories of derivatives are future/forward contracts, swaps and options.
1.2 What is hedge accounting?
Hedge accounting deals with the accounting treatment of two or more financial instruments, which are assigned to be associated with each other in order to mitigate a certain economic risk. The intention of hedge accounting is to report the opposite developments of the hedged item and the hedging instrument in a way that the gains of one item compensate the losses of the other item. This basically means that hedge accounting ensures that an offsetting gain or loss (e.g. changes in fair value or cash flow) from a hedging instrument affects the firm's profit and loss account in the same period as the gain or loss from the hedged item.
1.3 Hedge accounting according to IAS & IFRS
The most important international standard dealing with accounting issues on financial instruments and hedge accounting is IAS 39 - Financial Instruments: Recognition and Measurement. The objective of this Standard is to establish principles for recognizing and measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items.
As the use of derivatives has become more and more intensive, concern about their accounting has increased. The main concern is that derivatives are traditionally off balance sheet items and there is little disclosure about the risks implied by their use. IAS 39 is an effort along the direction of an improved transparency by means of strict rules for the accounting of derivatives (Bunea-Bontas, Bacovia 2009).
Before IAS 39, the value of a derivative was recorded off the balance sheet, thus reflecting minor effects of risk management. Accounting principles and disclosures requirements in the previous international accounting standards were not keeping up with the rapid development, increasing complexity and constantly changing of financial instruments. An effective financial presentation of certain risks, based on improved rules of recognition and measurement, became vital for the users', and especially the investors', understanding of financial reports for their decision-making processes.
In order to improve the quality of financial reporting, and increase the level of transparency and international comparability, International Accounting Standard Board (IASB) issued IAS 39, containing a suite of important innovations in accounting treatments of financial instruments, such as:
recognition of financial derivatives used for hedges in the balance sheet;
measurement of financial derivatives based on fair value;
subsequent recognition of changes in fair value, according to hedge effectiveness (Bunea-Bontas, Bacovia 2009).
When a financial asset or financial liability is recognized initially, it is measured at its fair value plus transaction costs. After initial recognition the value of financial assets fluctuates permanently. At financial statement date the value of financial assets needs to be measured again.
For this purpose of measuring a financial asset, IAS 39 divides financial assets into four categories and defines the relevant measuring method:
Category:
measured at:
Held-for-Trading
fair value through profit or loss
Held-to-Maturity
amortized cost using the effective interest method
Loans and Receivables
amortized cost using the effective interest method
Available-for-Sale
fair value not recognized in profit or loss
Derivates as a particular financial instrument are generally categorized as Held-for-Trading.
The necessity of regulations for hedge accounting derives from the different valuation methods for the distinct categories of financial instruments according to IAS 39 (so called "mixed model").
Considering an entity buying an underlying item of the category Held-to-Maturity for example and a derivate as a hedge instrument which belongs to the Held-for-Trading category by definition, fluctuation would change the fair value of both, the hedged item and the hedging instrument itself. From a purely economic perspective, the entity would not face a gain or loss at all, since the opposite performances of the hedged item and the hedging instrument would compensate each other. However, on the balance sheet the underlying would be measured at amortized cost whereas the derivative would be measured at fair value through profit and loss. This would finally result in imbalanced reporting because the fluctuation of the value of the hedge instrument will be shown in the profit and losses but not the fluctuation of the value of the hedged item which is measured at amortized costs.
Therefore in 2005 an additional regulation was introduced into IAS 39 which defines that designated hedging relationships between a hedging instrument and a hedged item can be treated as one single financial instrument.
Hedging relationships are of two types:
fair value hedge: a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment (e. g. loans, securities, bonds or liabilities with a fix interest rate), or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss.
cash flow hedge: a hedge of the exposure to variability in cash flows (e. g. loans, securities, bonds or liabilities with a variable interest rate) that
is attributable to a particular risk associated with a recognized asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction and
could affect profit or loss.
A fair value hedge shall be accounted for as follows:
the gain or loss from remeasuring the hedging instrument at fair value (for a derivative hedging instrument) shall be recognized in profit or loss; and
the gain or loss on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized in profit or loss. This applies if the hedged item is otherwise measured at cost.
Recognition of the gain or loss attributable to the hedged risk in profit or loss applies if the hedged item is an available-for-sale financial asset.
A cash flow hedge shall be accounted for as follows:
the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge shall be recognized directly in equity through the statement of changes in equity; and
the ineffective portion of the gain or loss on the hedging instrument shall be recognized in profit or loss.
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 the large swings are balanced out (Hedge).
The most important benefit of hedge accounting for the reporting entity is that investors and creditor get a more transparent view of the risks that are included in the financials of the company. A higher credibility of the financial report often leads to better credit ratings which became even more important after Basel II which made the credit rating process mandatory for the assignment of loans (Zingel 26.06.2009). The efficiency of hedging and hedge accounting is ultimately affecting the financial performance of a company because a better credit rating results in less financing costs.
1.4 HGB
In contrast to the international accounting standards, which aim at supplying a large amount of information relevant for decision making to a wide group of users, reporting according to HGB has a focus on creditor protection and the principle of caution.
The fundamental problem of hedge accounting in connection with a financial statement according to HGB arises from the conflict between the "Grundsätze ordnungsgemäßer Buchführung" (GoB) and the treatment of hedged item and hedging instrument as a single financial instrument.
The German HGB does not include any regulations on accounting any derivative instruments.
According to § 252 Abs. 1 Nr. 3 HGB and § 246 Abs. 2 HGB the individual assets and liabilities have to be valued separately (principle of individual valuation). The principle consequently prohibits the offsetting of different positions of the balance sheet. It therefore contributes to the principle of caution in the way that risks of losses caused by individual assets are disclosed.
In § 252 Abs. 1 Nr. 4 HGB the principle is stated that the financial situation of the reporting entity shall not be presented too optimistically. The principle of imparity and the principle of realization can be derived from this paragraph. Those two principles have an impact especially on the profit and loss calculation: in contrast to gains, losses are recognized through depreciation already when they emerge not only when they are realized. The intention of the lawmaker is, to enable the reporting entity to reduce the dividend by the expected loss (anticipation of losses). As a result funds are held back which later will be required to offset subsequent losses. Furthermore the principle of imparity is the basis for the establishment of reserves for uncertain liabilities and expected losses from pending transactions (§249 Abs. 1 S.1 HGB) and for the valuation of assets at a lower current value (principle of the lowest value § 253 Abs. 2 S.3 HGB).
Finally it must be stated that according to HGB pending transactions (e. g. swaps, options, etc.) are regarded as off-balance sheet items.
As a result the application of the abovementioned principles of the accounting standard in conjunction with hedge transactions would lead to a distorted representation of the financial situation of the accounting entity because every change in the market value of a financial instrument would cause a loss in the balance sheet although economically the outcome would be neutral.
Due to this conflict it was theoretically not possible to implement hedge accounting in the financial report according to HGB in the past.
1.5 BilMoG
On 26.03.2009 the Deutsche Bundestag passed the so called „Gesetz zur Modernisierung des Bilanzrechts" (BilMoG). The Bundesrat agreed on 03.04.2009 and the law came into force on 29.05.2009 (NWB Verlag 27.05.2010).
The main purpose of the new law was to develop the HGB into an equivalent, but easier alternative to the IAS/IFRS. One essential issue was an increase in transparency of the financial report.
To achieve those objectives
the financial reporting options were reduced and
the regulation was moderately adapted to the IAS/IFRS (Bundesverband der Deutschen Industrie 28.05.2008).
Concerning hedge accounting the BilMoG introduced the new § 254HGB which for the first time deals with accounting units.
Assets, liabilities, pending transactions and expected financial transactions with a high probability can now be combined into accounting units in order to offset negatively correlated fair value and cash flow risks.
The compensatory valuation of the accounting unit applies only for the proportion and the time period of offsetting fair value and cash flow changes.
If complementary fair value and cash flow changes do not offset each other, the principle of caution (including the principles of realization, imparity and initial costs) fully applies to each individual asset, liability or pending transaction in the accounting unit.
At every balance sheet date the effectivity of the offsetting fair value and cash flow changes have to be revaluated.
If the conditions of § 254 HGB apply, a compensatory valuation has to be carried out. The documentation of a hedge transaction is not a requirement for the establishment of accounting units. If the effectiviity of the hedge cannot be valuated until the balance sheet date, the caution principle applies and it has to be assumed that no effective accounting unit exists.
Literaturverzeichnis
Bundesverband der Deutschen Industrie (28.05.2008): Der neue Entwurf zum Bilanzrechtsmodernisierungsgesetz (BilMoG). Die wichtigsten Auswirkungen für Handels- und Steuerbilanz. Bundesverband der Deutschen Industrie. Online verfügbar unter http://www.bdi.eu/download_content/Publikation_Der_neue_Entwurf_zum_Bilanzrechtsmodernisierungsgesetz.pdf, zuletzt geprüft am 27.05.2010.
Bunea-Bontas, Cristina; Bacovia, George (2009): Basic Principles of Hedge Accounting, zuletzt aktualisiert am 17.05.2010, zuletzt geprüft am 30.05.2010.
Bilanzunwirksame Geschäfte - Forderungen, Verbindlichkeiten, Entstehen, Finanzderivaten, Handel, Preisentwicklung - Beteiligungen geschlossene Fonds. Deutsche Bank. Online verfügbar unter http://beteiligungen-geschlosssene-fonds.de/2010/01/Bilanzunwirksame-Geschfte/, zuletzt geprüft am 21.05.2010.
Finanz-Lexikon.de: Hedge Accounting (2010). Online verfügbar unter http://www.finanz-lexikon.de/hedge%20accounting_2965.html, zuletzt aktualisiert am 20.05.2010, zuletzt geprüft am 20.05.2010.
Hausin, Manuel; Hemmingsson, Christoffer; Johansson, Jesper (2008): How to hedge disclosures. IFRS 7 and Hedge Accounting - A first stocktaking. Master Thesis. Betreut von Pernilla Lundqvistq und Jan Marton. Göteborg. VID Göteborgs Universitet, Business Administration. Online verfügbar unter http://gupea.ub.gu.se/dspace/bitstream/2077/10191/1/07-08-59M.pdf, zuletzt geprüft am 30.05.2010.
Hedge. Online verfügbar unter http://www.investopedia.com/terms/h/hedge.asp, zuletzt geprüft am 20.05.2010.
NWB Verlag (Hg.) (2010): Bilanzrechtsmodernisierungsgesetz (BilMoG). Online verfügbar unter http://www2.nwb.de/portal/content/ir/beitraege/beitrag_831296.aspx, zuletzt aktualisiert am 27.05.2010, zuletzt geprüft am 27.05.2010.
Wikipedia (2010): Anschaffungswertprinzip. Online verfügbar unter http://de.wikipedia.org/wiki/Anschaffungswertprinzip, zuletzt aktualisiert am 05.02.2010, zuletzt geprüft am 27.05.2010.
Zingel, H. (2009): International Financial Reporting Standards. Online verfügbar unter http://www.zingel.de/pdf/03ias.pdf, zuletzt aktualisiert am 26.06.2009, zuletzt geprüft am 19.05.2010.
