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Accounting for Fair Value Hedges

Publication Date :

13 Oct, 2018

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Accounting for Fair Value Hedge Example

Company Fair has an asset with a current fair value of $ 2000, and the management is concerned that the fair value of the hedge will go down to $ 1900. This will result in a loss to the company.

To offset this loss, the company enters into an offsetting position through a derivative contract, which also has a fair value of $ 2000. Since this is an offsetting position, its fair value will move in the opposite direction as that of the hedged item.

At the time of the closure of books, the following scenarios are possible:

Case #1 - Decrease in the fair value of the hedged item and a simultaneous increase in the fair value of the offsetting hedged instrument

Sl. No.	Position on reporting date	Value of Hedged Item	Gain / Loss on Hedged Item	Value of Hedged Instrument	Gain / Loss on Hedged Instrument	Net Gain / Loss
1	Net Loss	$ 1,920.00	($80.00)	$ 2,060.00	$60.00	($20.00)
2	Net Gain	$ 1,970.00	($30.00)	$ 2,040.00	$40.00	$10.00
3	No Loss / No Gain	$ 1,950.00	($50.00)	$ 2,050.00	$50.00	Neither loss nor gain

Case #2 - Increase in the fair value of the hedged item and a simultaneous decrease in the fair value of the offsetting hedged instrument

Sl. No.	Position on reporting date	Value of Hedged Item	Gain / Loss on Hedged Item	Value of Hedged Instrument	Gain / Loss on Hedged Instrument	Net Gain / Loss
4	Net Loss	$ 2,040.00	$ 40.00	$ 1,950.00	($50.00)	($10.00)
5	Net Gain	$ 2,050.00	$ 50.00	$ 1,970.00	($30.00)	$20.00
6	No Loss / No Gain	$ 2,050.00	$ 50.00	$ 1,950.00	($50.00)	Neither loss nor gain

Accounting for Fair Value Hedges - Journal Entries

	What will be Debited?	What will be Credited?
In the case of the Hedged Item
a) Loss on the hedging item on the reporting date	Debit the loss to Loss on the Hedged Item A/c This will have an effect on the Profit & Loss A/c and reduce the profit of the company.	Credit the Hedged item. Since this is an asset, the value of the asset will go down, and this will affect the Financial Position i.e., Balance Sheet of the company.
b) Gain on the hedging item on the reporting date	Debit the Hedged item. Since this is an asset, the value of the asset will go up, and this will affect the Financial Position i.e., Balance Sheet of the company.	Credit the gain to Gain on the Hedged Item A/c This will have an effect on the Profit & Loss A/c and increase the profit of the company.
In the case of the Hedging Instrument
a) Loss on the hedging instrument on the reporting date	Debit the loss to Loss on the Hedged Instrument A/c This will have an effect on the Profit & Loss A/c and reduce the profit of the company.	Credit the Hedged Instrument. Since this is an asset, the value of the asset will go down, and this will affect the Financial Position i.e., Balance Sheet of the company
b) Gain on the hedging instrument on the reporting date	Credit the Hedged item. Since this is an asset, the value of the asset will go up, and this will affect the Financial Position, i.e., Balance Sheet of the company.	Credit the gain to Gain on the Hedged Instrument A/c This will have an effect on the Profit & Loss A/c and increase the profit of the company.
Net effect of both the Hedging Item and the Hedging Instrument
Net loss on the date of reporting	Net loss will decrease the overall profit of the company.	Net reduction in the Net Assets of the company
Net gain on the date of reporting	Net increase in the Net Assets of the company	Net gain will increase the overall profit of the company.