Updated July 19, 2023
Definition of Accounting for Fair Value Hedges
An investment position entered by an organization to mitigate or eliminate the exposure of a change in the fair value of an asset or liability or any such item like a commitment from a risk that can impact the profit and loss account of the organization.
Explanation
Hedging an asset or liability limits its exposure to extreme changes in value, thereby actively mitigating risk. Fair value hedging applies to any item with a fixed value. The primary purpose of hedging is to mitigate the risk of loss, actively aiming to offset potential declines in asset value. By entering into a hedging position, any gains from the hedged instrument can be a positive factor in the financial statement, thereby reducing the impact on profits caused by a significant drop in the asset’s value.
Example of Accounting for Fair Value Hedges
ABC Ltd. owns an asset that has a current fair value of $1,000, and due to the current market scenario, it is forecasted that the value will fall down to $900 and result in a loss. To hedge this loss, the company enters into a derivative contract which has a value of $1,000 same value as the asset. The fair value of the derivative contract will have an opposite value since it is an offsetting position.
As expected, if the value of the asset decreases and the value of the hedging instrument increases
| Sr. No | Profit / Loss | Fair Value of Hedged Asset | Profit / Loss on Hedged Item | Value of Hedged Instrument | Profit / Loss on Hedged Instrument | Net Profit / Loss |
| 1 | Net Loss | $900.00 | -$100.00 | $1,050.00 | $50.00 | -$50.00 |
| 2 | Net Profit | $980.00 | -$20.00 | $1,030.00 | $30.00 | $10.00 |
| 3 | Break Even | $990.00 | -$10.00 | $1,010.00 | $10.00 | Break Even |
In case there is a decrease in the value of the hedging instrument and an increase in the value of the asset
| Sr. No | Profit / Loss | Fair Value of Hedged Asset | Profit / Loss on Hedged Item | Value of Hedged Instrument | Profit / Loss on Hedged Instrument | Net Profit / Loss |
| 1 | Net Loss | $1,100.00 | $100.00 | $950.00 | -$50.00 | -$50.00 |
| 2 | Net Profit | $1,050.00 | $50.00 | $970.00 | -$30.00 | $20.00 |
| 3 | Break Even | $1,050.00 | $50.00 | $950.00 | -$50.00 | Break Even |
How to Account for Fair Value Hedge?
Accounting for a fair value hedge can be performed by following the below steps:
- On the date of entry on the financial statement, the value for the asset whose value is being hedged and the instrument used for hedging needs to be determined.
- When there is any change in the fair value of the asset, record it in the financial statement.The change resulting from the hedging can be either a profit or a loss, depending on the asset’s current value for which the hedging was conducted.
- The current value of the instrument used for hedging needs to be identified. Like in the previous step, a profit or a loss must be recorded on the financial statement.
Accounting for Fair Value Hedges Journal Entries
The below entries are based on the date of reporting the entries on the financial statement.
|
Asset / Hedged Instrument |
Scenarios | Debit |
Credit |
| Asset | Value of The Asset Increases | The asset’s value increase should be debited, i.e. the Asset should be debited. Record this as an increase in the asset value, which will positively impact the financial statement. | The Gain on the Hedged Asset A/C should be credited. As a result, the gain in the value will show an increased profit. |
| Value of The Asset Decreases | The Loss on the Hedged Asset A/C should be debited. Since this is a reduction in the asset’s value, this will reduce the profit on the financial statement. | The decrease in the value of the asset should be credited i.e. the Asset should be credited. Record this as a decrease in the asset value which will negatively impact the financial statement. | |
| Hedged Instrument | Value of the Hedged Instrument Increases | The increase in the value of the hedged instrument should be debited; this gain will positively impact the financial statement. | The gain needs to be credited to the Gain on the Hedged Instrument A/C |
| Value of the Hedged Instrument Decreases | The decrease must be recorded by debiting the Loss on the Hedged Instrument A/C. Since this is a decrease in the instrument’s value, this will negatively impact the financial statement. | The hedged instrument needs to be credited |
Fair Value Hedge vs Cash Flow Hedge
- A fair value hedge is hedging against the risk of an asset’s fair value, which is expected to impact the financial statement. In contrast, a cash flow hedge aims at mitigating the risk associated with the cash flows.
- The cash flow hedge mitigates the vulnerability of a cash flow related to an asset, liability, or transaction related to a particular risk. The company formulates a cash flow hedge to minimize the risk of paying more for a raw material than expected.
Conclusion
Fair Value Hedging refers to the practice of hedging risks on the value of an asset by entering into a position that might result in an equivalent amount of stability; this, thereby, does not impact the financial statements as much as it would not have been a hedge position. Unlike a cash flow hedge, a fair value hedge mitigates the risk associated with an asset based on the fair value of the asset. The performance of the hedged instrument decides whether the hedging position entered was fruitful and practically minimized or mitigated the risk to the extent that the cost and efforts involved in entering the hedge position were worth it. Fair value hedging can result in magnified losses if the hedging instrument fails since the asset’s value is expected to fall.
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