A risk management strategy used in limiting or offsetting probability of loss from

fluctuations in the prices of commodities, currencies, or securities. In effect, hedging is

a transfer of risk without buying insurance policies.
Hedging employs various techniques but, basically, involves taking equal and opposite
positions in two different markets (such as cash and futures markets). Hedging is used
also in protecting one's capital against effects of inflation through investing in high-yield
financial instruments (bonds, notes, shares), real estate, or precious metals.

Hedging is thr process of entering into two simultaneous contracts of opposite nature
with corresponding terms,one in the spot or cash market, and the other in the fuLures
markeL,to offset the loss in one contract by profit in the other contract.

An investment made in order to reduce the risk of adverse price movements in a
security, by taking an offsetting position in a related security, such as an option or a
short sale.

Why is hedge accounting necessary?
Many Iinancial institutions and corporate businesses (entities) use derivative Iinancial
instruments to hedge their exposure to diIIerent risks (Ior example interest rate risk, Ioreign
exchange risk, commodity risk, etc.).
Accounting Ior derivative Iinancial instruments under International Accounting Standards is
covered by IAS39 (Financial Instrument: Recognition and Measurement).
IAS39 requires that all derivatives are marked-to-market with changes in the mark-to-market
being taken to the proIit and loss account. For many entities this would result in a signiIicant
amount oI proIit and loss volatility arising Irom the use oI derivatives.
An entity can mitigate the proIit and loss eIIect arising Irom derivatives used Ior hedging,
through an optional part oI IAS39 relating to hedge accounting.
edit] What hedge accounting options are available to an
entity?
All economic hedges aim to manage Ioreign currency exposure, meaning they are undertaken Ior
the economic aim oI reducing potential loss Irom Iluctuations in Ioreign exchange rates.
owever, not all hedges are designated Ior special accounting treatment. Accounting standards
enable hedge accounting Ior three diIIerent designated Iorex hedges:
O A cash Ilow hedge may be designated Ior a highly probable Iorecasted transaction, a Iirm
commitment (not recorded on the balance sheet), Ioreign currency cash Ilows oI a recognized
asset or liability, or a Iorecasted intercompany transaction.
O A Iair value hedge may be designated Ior a Iirm commitment (not recorded) or Ioreign
currency cash Ilows oI a recognized asset or liability.
O A net investment hedge may be designated Ior the net investment in a Ioreign operation.
The aim oI hedge accounting is to provide an oIIset to the mark-to-market movement oI the
derivative in the proIit and loss account. For a Iair value hedge this is achieved either by
marking-to-market an asset or a liability which oIIsets the P&L movement oI the derivative. For
a cashIlow hedge some oI the derivative volatility into a separate component oI the entity's
equity called the cash Ilow hedge reserve.
Where a hedge relationship is eIIective (meets the 80125 rule), most oI the mark-to-market
derivative volatility will be oIIset in the proIit and loss account.
To achieve hedge accounting requires a large amount oI compliance work involving
documenting the hedge relationship and both prospectively and retrospectively proving that the
hedge relationship is eIIective.
edit] Simple Procedure of Hedge Accounting
To know simple procedure oI hedge accounting, we should divide hedge into two parts. One is
Iair value hedge and other is cash Ilow hedge. When we have risk oI decreasing the share prices,
we take the contract oI Iair value hedge. We give option to other at current prices. II anybody
accepts and iI in Iuture, prices oI share decreases, we will get gain Irom option and will record
like general income record.
In cash Ilow hedge accounting, we do hedge Ior reducing the risk oI increasing the prices. II
prices will increases, we will have to paid same but we will receive the cash proIit Irom Iuture
contract. We also record the payment and gaining amount Irom such transactions.
Hedge accounting has been included in financial reporting subject of CA- Final. Before learning
hedge accounting with simple way, we should know about hedge or hedging. Hedge or hedging
may be any investment which is done for protecting the company from future risk. Hedge may
be used in All financial instruments and derivatives like financial futures, options and swaps. In
hedge, we also may do agreement for buying the asset in future date but at current price. We do
these type of contract because we forecast that prices in future date will increase.


As a accountant, for recording and accounting treatment transactions relating to hedge, you will
divide transaction on basis of two type of hedge.

Fair Value Hedge

Illustration: 1. Assume that on April 1, 2008, Hayward Co. purchases 100 shares of Sonoma
stock at a market price of $100 per share. Hayward does not intend to
actively trade this investment. It consequently classifies the Sonoma investment as available-for-
sale. Prepare the journal entry that Hayward makes on April 1, 2008 to record this investment.

Available-for-Sale securities Dr


Cash Cr


Illustration: 2 The value of Sonoma shares increases to $125 per share during 2008. Prepare
the journal entry that Hayward makes on December 31, 2008, to recognize the gain.

Security Fair Value Adjustment (AFS) Dr 2


Unrealized Holding Gain or LossEquity Cr 2


Illustration:3. Hayward is exposed to the risk that the price of the Sonoma stock will decline. To
hedge this risk, on January 2, 2009, Hayward purchases a put option on 100 shares of Sonoma
stock and designates the option as a fair value hedge. This put option (which expires in two
years)
gives Hayward the option to sell Sonoma shares at a price of $125. What entry is required on
January 2, 2009 to recognize the put option?

A memorandum entry only. Since the exercise price equals the current market price, no journal
entry is necessary. Because this is just option offer. So, it will go to off balance sheet.

Illustration:4 At December 31, 2009, the price of the Sonoma shares has declined to $120 per
share. Hayward records the following entry for the Sonoma investment.

Unrealized Holding Gain or LossIncome Dr


Security Fair Value Adjustment (AFS) Cr

What journal entry would Hayward record on Dec. 31, 2009, to recognize the increase in value of
the put option?


!ut Option Dr


Unrealized Holding Gain or LossIncome Cr


2 Cash Flow Hedge

Illustration: In September 2008 Allied Can Co. anticipates purchasing 1,000 metric tons of
aluminum in January 2009. Allied wants to hedge the risk that it might pay higher prices for
inventory in January 2009. Allied enters into an aluminum futures contract that gives Allied the
right and the obligation to purchase 1,000 metric tons of aluminum for $1,550 per ton. This
contract price is good until the contract expires in January 2009. The underlying for this
derivative is the price of aluminum. If the price of aluminum rises above $1,550, the value of the
futures contract to Allied increases.

Allied enters into the futures contract on September 1, 2008. Assume that the price to be paid
today for inventory to be delivered in January-the spot price-equals the contract price.

At December 31, 2008, the price for January delivery of aluminum increases to $1,575 per
metric ton. What journal entry would Allied make to record the increase in the value of the
futures contract.


Futures contract 2


Unrealized Holding Gain or LossEquity 2
([$ - $( x tons)

In January 2009, Allied purchases 1,000 metric tons of aluminum for $1,575 and makes the
following entry ($1,575 x 1,000 tons = 1,575,000).

Aluminum inventory Dr


Cash Cr

At the same time, Allied makes final settlement on the futures contract and records the following
entry.

Cash Dr 2


Futures contract Cr ($-$) 2

If you make any cash flow reserve, you can show this in liability side. If any advance amount is
given for buying the asset in future date, it will be shown in the asset side.