Hedge accounting is a type of accounting that is used for certain types of investments. These investments are generally more complicated than regular investments, and hedge accounting helps to prepare investors for sudden changes in the market and limit the effects of those changes. This is done by combining entries for both the opposing hedge and the security ownership to offset any opposing movements that might occur.
This type of accounting is made up of four basic parts. If you are interested in protecting your investments through a hedge strategy, knowing and understanding these parts is essential.
Four Aspects of Hedge Accounting
- Volatility- In the financial world, nothing stays the same very long. Investment markets themselves are always subject to change, as they are filled with risk, regulations, and the choices and attitudes of various investors. Volatility is often the result, which sudden, and sometimes drastic, changes to the value of instruments. This can create quite a problem for individuals who are trying to predict the value of their accounts because adjustments must constantly be made. Hedge accounting seeks to eliminate, or at least reduce, this problem by creating a more stable investment through the combination of the opposing hedge and security ownership.
- Derivative Instruments- Derivative instruments come in many forms in hedge accounting, like call and put options, forward contacts, and future contacts. These instruments are used to reduce or soften the effects volatility has on the market by giving individuals a chance to make positive changes to their account before the market is affected by risks or regulations. While the value of these derivative instruments will depend on the value of the primary investment, they must be purchase and will have a value of their own as well.
- Account Combination- When an accountant needs to deal with the instruments we mentioned above, there are three main issues he must consider first: the value of the instrument, the security for that specific instrument, and any changes to the market that could affect the instrument. To make the process of investing easier, hedge accountants take both of the first two issues, combine them together, and treat them as if they are only one issue within the treasury management. This reduces the effects of sudden changes in the market, because the combined account can only be affected by fluctuations in the market that are for both instruments and derivatives.
- Requirements- While this type of accounting allows for the combination of an investment security and any derivative instruments, the real position of both of these items must be part of the accounting financial reporting. This is one of the basic requirements of using hedge accounting and must be considered before you decide to use it.
Are you thinking of using hedge accounting to soften the frequent changes that occur in the market? Make sure you know and understand what you are doing before you take the plunge so you can protect your investment, your primary security, and your derivative instruments from the volatile world of risky and regulated investing.