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.