Hedge Accounting

Hedge accounting is an accounting approach in which derivative transactions that are defined as hedges are associated with a specific existing exposure so that the changes in value of the derivative are recognised in a company’s profit and loss account at the same time as the hedged item.

Fair-value hedging is used for hedging assets and liabilities. Cash flow hedging is used to hedge cash flows arising from transactions such as the sale of a company’s products.

In order to benefit from hedge accounting treatment, certain recognised accounting standards have to be met and the process must be adequately documented. In particular, the hedges have to meet effectiveness tests. When currency forwards are used, the spot component of the forward price is generally considered to be ‘effective’ hedging while the forward points are considered ‘ineffective’ and therefore directly impact a company’s profit and loss account.