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.
1. 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. 10,000
Cash Cr. 10,000
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. 2,500
Unrealized Holding Gain or Loss—Equity Cr. 2,500
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 Loss—Income Dr. 500
Security Fair Value Adjustment (AFS) Cr. 500
What journal entry would Hayward record on Dec. 31, 2009, to recognize the increase in value of the put option?
Put Option Dr. 500
Unrealized Holding Gain or Loss—Income Cr. 500
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 25,000
Unrealized Holding Gain or Loss—Equity 25,000
([$1,575 - $1,550] x 1,000 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. 1,575,000
Cash Cr. 1,575,000
At the same time, Allied makes final settlement on the futures contract and records the following entry.
Cash Dr. 25,000
Futures contract Cr. ($1,575,000-$1,550,000) 25,000
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.
As a accountant, for recording and accounting treatment transactions relating to hedge, you will divide transaction on basis of two type of hedge.
1. 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. 10,000
Cash Cr. 10,000
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. 2,500
Unrealized Holding Gain or Loss—Equity Cr. 2,500
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 Loss—Income Dr. 500
Security Fair Value Adjustment (AFS) Cr. 500
What journal entry would Hayward record on Dec. 31, 2009, to recognize the increase in value of the put option?
Put Option Dr. 500
Unrealized Holding Gain or Loss—Income Cr. 500
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 25,000
Unrealized Holding Gain or Loss—Equity 25,000
([$1,575 - $1,550] x 1,000 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. 1,575,000
Cash Cr. 1,575,000
At the same time, Allied makes final settlement on the futures contract and records the following entry.
Cash Dr. 25,000
Futures contract Cr. ($1,575,000-$1,550,000) 25,000
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.
Pretty informative. Can you show samples about how hedge accounting is practiced today?
ReplyDeleteits very nice artical give me some more knowldge notes on hedge fund accounting as i m working in hedge fund so it will help to clear my basics
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ReplyDeleteyou have explained hedge accounting in easy way Please write about swap currency swap, interest swap
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regards
Very helpfull
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