ACCA P2 考官文章HEDGE ACCOUNTING(Part 1)

The article explains the basic principlesof hedging and the current accounting regulations as set out in IAS 39, FinancialInstruments: Recognition and Measurement(IAS 39). The article concludes byconsidering the weaknesses of IAS 39 and how those weaknesses are addressed bythe proposed changes issued by the IASB in September 2012.

BASIC PRINCIPLES OF HEDGING

Are you risk adverse? I think I am. Forexample, as a property owner I have an insurance policy to protect me from therisk of incurring a loss if my house were to burn down. Companies will face manyrisks and if they seek to cover these risks then they are said to be hedging.Hedging therefore is a risk management process whereby risk adverse companiesfirstly identify and quantify that they have a risk and secondly seek to coverthat risk.

THE HEDGED ITEM

Risks come in many forms for companies. Forexample there is a risk that the fair value of assets and liabilities that theyhold might increase or decrease, that in future the price of the goods they buyor sell might change, that interest rates on their borrowings or deposits mightchange, and that foreign exchange rates may move. A hedged item is defined asan item that exposes the entity to risk of changes in fair value or future cashflows and is designated as being hedged.

THE HEDGING INSTRUMENT

In order to protect themselves from losseson hedged items companies enter into contracts to cover any loss arising. Thesecontracts often not only eliminate the risk but also eliminate any potentialgain. These contracts are termed the hedging instrument. A hedging instrumentis defined as a contract whose fair value or cash flows are expected to offsetchanges in the fair value or cash flows of a designated hedged item. Hedginginstruments are normally a type of financial instrument known as a derivative.

I have written about the accounting forfinancial instruments (see 'Related links'). To recap, a financial instrumentis a contract that gives rise to a financial asset of one entity and afinancial liability or equity instrument of another entity. A derivative is socalled because its value changes in response to the change in an underlyingvariable such as an interest rate, a commodity, a security price, or an index.Derivatives often require no initial investment, or one that is smaller thanwould be required for a contract with similar response to changes in marketfactors; and are settled at a future date.

An example of a derivative is a forwardcontract. Forward contracts are contracts to purchase or sell a specificquantity of something, eg a commodity, or a foreign currency at a specifiedprice determined at the outset, with delivery or settlement at a specifiedfuture date. For example a farmer may enter into a forward contract with asupermarket to sell in 12 months a specific amount of crop at a certainprice. In this way the producer (the farmer) is protected from the risk offalling prices, and the consumer (the supermarket) is protected from the riskof rising prices. It therefore provides certainty.

Another example of a derivative is afutures contract. These contracts are similar to forwards but whereas forwardcontracts are individually tailored, futures are generic and are tradable in amarket. Futures are generally settled through an offsetting (reversing) trade,whereas forwards are generally settled by the actual delivery of the underlyingitem or cash settlement.

If a derivative is held by a company and itis not designated as a hedging instrument then it is deemed to be held forspeculation, ie for trading purposes. All derivatives must be recognised atfair value on the statement of financial of position - this is sometimesreferred as being 'marked to market'. As the value of derivatives can be veryunstable and so can generate large gains and losses in a short period,derivatives cannot be carried at historic cost (which is often nil anyway) asthis would result in large gains and losses being unreported. If the derivativeis not designated as a hedging instrument then any gains or losses arising arerecognised in the statement of profit of loss. This is fair enough as therightful place for trading profits and losses is the statement of profit orloss.

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