How Does Fair Value Hedge Accounting Work?

A fair value hedge is an accounting strategy that allows a company to manage the risk of changes in the value of its assets, liabilities, or certain commitments. The goal is to insulate a company’s earnings from volatility by using a financial instrument expected to move in the opposite direction of the item being protected.

This accounting treatment matches the timing of gains and losses from both the protected item and the financial instrument in the same reporting period. By applying fair value hedge accounting, a business can present a more stable and accurate picture of its financial performance, avoiding significant swings in reported income that may not reflect its true economic position.

Core Components of a Fair Value Hedge

A fair value hedge is constructed from two elements: the hedged item and the hedging instrument. The hedged item is a recognized asset, liability, or an unrecognized firm commitment exposed to fair value fluctuations. For this accounting treatment to be appropriate, the potential changes in the item’s value must be capable of affecting the company’s reported earnings.

Examples of hedged items include assets and liabilities with fixed interest rates, such as a company’s issued bonds or a loan it holds. In these cases, the risk is that a change in interest rates will alter the market value of the debt. Another example is inventory subject to price changes in the open market. A business can also hedge an unrecognized firm commitment, which is a binding agreement to buy or sell an asset at a fixed price in the future.

The hedging instrument is the tool used to counteract the identified risk, and it is typically a derivative contract. The purpose of the hedging instrument is to generate gains or losses that offset the losses or gains on the hedged item. This creates a neutralizing effect on the income statement.

Common hedging instruments include interest rate swaps, used to manage the risk of changing interest rates on debt. Forward contracts are often used to lock in a price for a future purchase or sale of a commodity or foreign currency. Options, which give the holder the right but not the obligation to buy or sell an asset at a predetermined price, can also be used to protect against unfavorable price movements.

Qualification and Documentation Requirements

To use fair value hedge accounting, a company must meet the requirements set forth by accounting standards, specifically under Accounting Standards Codification 815. A primary condition is the formal designation of the hedging relationship at its inception. This means the company must explicitly state its intention to use a specific hedging instrument to offset the risk associated with a particular hedged item.

Another qualification is the expectation that the hedge will be highly effective. This involves assessing, both at the beginning and on an ongoing basis, how well the changes in the fair value of the hedging instrument offset the changes in the fair value of the hedged item. While there is no longer a strict numerical threshold, many companies follow the principle that the change in the instrument’s value should be between 80% and 125% of the opposite change in the hedged item’s value.

Formal documentation must be completed at the start of the hedging relationship. This documentation must detail the company’s risk management objective and its strategy for the hedge. It must also clearly identify the hedging instrument, the hedged item, and the specific nature of the risk being hedged. Finally, the documentation must outline the method the company will use to assess the hedge’s effectiveness over time.

The Accounting Mechanism and Reporting

When a hedge is effective, a loss on the hedged item will be offset by a gain on the hedging instrument, or vice versa, resulting in a minimal net impact on reported profits. This matching of gains and losses in the same accounting period is what mitigates volatility on the income statement.

Consider a company that has issued $10 million of fixed-rate debt and wants to protect itself from the risk that a fall in interest rates will increase the fair value of its liability. The company enters into an interest rate swap that will increase in value if interest rates fall. If interest rates decrease, the fair value of the debt might increase by $100,000, creating an unrealized loss.

Simultaneously, the interest rate swap would increase in value by a corresponding $100,000. A journal entry would record a gain from the swap on the income statement. When combined, the $100,000 loss from the debt is offset by the $100,000 gain from the swap, resulting in a net-zero effect on earnings for that period.

On the balance sheet, the hedged item is presented at its original amount, adjusted for the gain or loss attributable to the hedged risk, which is known as a basis adjustment. The hedging instrument is also reported on the balance sheet at its fair value. On the income statement, the offsetting gains and losses are presented in the same line item to clearly show the results of the hedging activity.

Discontinuing Hedge Accounting

A company must discontinue fair value hedge accounting for several reasons. The relationship ends for accounting purposes if the hedge no longer meets the effectiveness requirements or if the company voluntarily chooses to de-designate it. Discontinuation is also required if:

• The hedging instrument is sold, terminated, or exercised.
• The hedged item, such as a specific asset or liability, is sold or settled.

Once hedge accounting is discontinued, the special treatment stops prospectively. The carrying amount of the hedged item is no longer adjusted for changes in its fair value related to the hedged risk. If the hedging instrument is still held, its changes in fair value are recorded in earnings without an offsetting adjustment.

The cumulative fair value adjustments made to the carrying amount of the hedged item during the hedge are not immediately written off. Instead, these basis adjustments are amortized into earnings over the remaining life of the hedged item, often using the effective interest method for debt. For example, if fixed-rate debt had its carrying value increased, that increase would be amortized as a reduction to interest expense over the debt’s remaining term.