The Accounting standard Codification (ASC) 815 shows the accounting of derivatives and hedging techniques. It requires the derivatives to be shown on the balance sheet as an asset or liability at their fair value. Any change in the fair value is shown under the income statement unless any hedging technique is used. The accounting technique should be aligned with the risk management strategy of the company.
Types of Hedging
There are three different types of hedging:
Fair Value Hedge: A fair value hedge is to hedge the exposure when there are changes in the fair value of the asset or liabilities, or they are exposed to a certain kind of risk which may lead to changes in their fair value.
Mitigation of risk (Fair Value Hedge): In continuation with the above example, to mitigate the risk or reduce the risk, a floating interest-bearing asset is swap with the fixed interest-bearing assets that can be used. In the fair value hedge accounting case, the derivative unlocks the floating rate asset and is protected against the asset’s fair value. Under this type of accounting, the fair value is recorded as an asset in the balance sheet, and any change in the asset value should be shown under the income statement as a hedged item.
Cash flow hedge: Cash flow hedges are used when the cash flows are uncertain and can variate, so in those scenarios, the hedging techniques are used to reduce the risk involved.
Mitigation of risk (Cash Value Hedge): In continuation with the above example, Cash flow hedges is used to mitigate the risk or lower the risk by entering into a swap transaction for the floating interest received from the asset into the cash flow, providing a fixed interest from the assets. Under the cash flow hedge accounting, the derivative is recorded at its fair value, with any changes in the value recorded under the heading Other Comprehensive Income. When the hedged item affects the earnings, any earnings recorded in the other comprehensive income statement are then recorded as part of the earnings in the income statement to set off the risk and show the asset’s value with minimum loss.
Example of Hedging and Difference between Fair value hedge & Cash flow hedge
Example: Company ABC has raised a fixed-rate debt while all the assets are based on floating interest-bearing assets. Since there will be a cash flow mismatch, it is required by the company to hedge the uncertainty or the risk of the cash flow involved. The company will have to pay a fixed amount of interest at every fixed period while it will earn based on a floating rate, leading to a short-term liquidity crunch for the company and might default in its payment. Fair value hedge vs. Cashflow hedge: A fair value hedge is used to mitigate the risk created due to fixed exposure such as fixed cost, rate, or terms and conditions. A cash flow hedge is used to mitigate the risk created due to the floating exposure.
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