Fair Value Hedge
Fair value hedge is an arrangement to mitigate risk of changes in fair value of a recognized asset or a liability or an unrecognized firm commitment (i.e. a promise to enter into a transaction) affecting profit or loss.
The arrangement involves shielding an existing asset or liability, called the hedged instrument, by purchasing instruments, called hedging instruments, such that the fair values of both the instruments respond oppositely to a particular risk. For example, if a company owns an inventory of cotton, it runs the risk of drop in price of cotton due good weather and excess supply, etc. However, the company can purchase a put option enabling it to sell the inventory of cotton at the specified price in case the price falls below the specified price (called the exercise price).
Fair value hedge, cash flow hedge and net investment hedge are three types of hedges recognized by accounting standards. A fair value hedge differs from a cash flow hedge in that it is aimed at compensating fair value changes of an existing asset or a liability while the cash flow hedge is designed to remove/reduce the variability of cash flows arising from a recognized asset or liability or a probable forecast transaction.
Accounting for fair value hedge depends on the hedged instrument. If the fair value changes of the hedged instrument are recognized in other comprehensive income, the fair value changes in the hedging instrument are also recognized in other comprehensive income. Similarly, if the fair value changes of the hedged instrument are taken to profit and loss, the fair value changes in hedging instrument are also recognized in profit and loss. The accounting method reflects the mechanics of the hedge, i.e. the hedging instrument compensates the balance sheet and income statement effects of the hedged instrument.
Example & Journal Entries
Tepeco, Inc. is a company engaged in commodities trading. The company recently obtained $5 million short-term borrowing which is secured by the company’s inventory of 1,000 tons of copper which it purchased at a cost of $5.2 million. The bank has obligated Tepeco, Inc. to provide additional collateral in event the value of copper inventories fall below $5 million. On 1 January 2015, Tepeco, Inc. sold the inventories forward by entering into a 12-month futures contract at price of $5,200 per ton.
On 30 June 2015, i.e. the financial year end of Tepeco, Inc., price of copper fell to $4,900 per ton.
Identify the hedged instrument and the hedging instrument and journalize the transactions.
Hedged instrument is the instrument whose fair value is shielded using the hedging strategy. In this case, it is the copper inventory held by Tepeco, Inc. Hedging instrument on the other hand is the derivative instrument which mitigates the fair value changes of hedged instrument by reversely mimicking its fair value movement.
On 30 June 2015, the fair value of copper inventories held for trading shall be adjusted as follows:
|Profit and loss||$300,000|
|Inventories ($5,200,000 - $4,900 * 1,000)||$300,000|
The loss on inventories shall be offset by corresponding gain on the forward transaction. Since the forward transaction entitles Tepeco, Inc. to sell copper at $5,200 per ton even though the market price is $4,900 per ton, it represents a $300 gain per ton, which translates into $300,000 gain on 1,000 tons. The fair value change of the hedging instrument is recognized as follows:
|Profit and loss (1,000 * ($5,200 - $4,900)||$300,000|
There shall be zero effect on the net value of inventories on Tepeco, Inc. balance sheet even though copper price fell over the period by $300 per ton. The hedging strategy saves Tepeco, Inc. from furnishing additional security to the bank in wake of the fall in fair value.