Hedge Accounting
An accounting method that allows gains and losses on a hedging instrument to be recognized in the same period as the risk being hedged, reducing earnings volatility.
What is Hedge Accounting?
Hedge accounting is a special accounting treatment that aligns the timing of gains and losses on a hedging instrument (such as a derivative) with the gains and losses on the underlying hedged item. Without hedge accounting, derivatives are marked to market each period, creating income statement volatility that may not reflect the underlying economic risk management strategy. Under GAAP (ASC 815), a company can designate a hedging relationship and apply hedge accounting if strict documentation and effectiveness requirements are met. The three main hedge types are fair value hedges (protecting against changes in asset or liability fair value), cash flow hedges (protecting against variable cash flow exposure), and net investment hedges (protecting against foreign currency exposure on overseas operations).
Example
An airline enters into fuel futures contracts to lock in the price of jet fuel for the next six months. The airline designates these contracts as cash flow hedges under ASC 815. While fuel prices rise during the period — increasing the airline's expected fuel costs — the gain on the futures contracts is deferred in other comprehensive income and reclassified to fuel expense when the actual fuel purchases occur. This treatment avoids the earnings volatility that would result from reporting derivative gains before the hedged expense is recognized.