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Accounting for Hedge Transactions

Historically, companies have been required to disclose hedge contracts, but not record them in financial statements. However, this has changed with the adoption of the Financial Accounting Standards Board (FASB) Statement No. 133¹ (and its associated amendment, Statement No. 138).

We do not believe these new accounting standards should significantly alter a company's approach to hedging.²  It is important for companies to consider hedging strategies based upon their specific business plan and economic outlook. For most companies, the economic protection provided by a well-designed hedging strategy should far outweigh the inconvenience created by the new accounting standards.

Hedge transactions fall into three categories and accounting treatment varies by type:

• Cash flow hedges
• Fair value hedges
• Net investment in a foreign operation hedges

Cash Flow Hedge

A cash flow hedge is a hedging relationship in which the variability of the hedged item's cash flow is offset by the cash flows of the hedging instrument. In addition, the hedged item is a forecasted transaction or balance sheet item with variable cash flows.

• The remaining market value of the derivative contract is reported on the balance sheet in Other Comprehensive Income (OCI)
• Ineffective gain or loss is recorded in earnings
• Cash flow hedge treatment is typical for the use of floating to fixed interest rate swaps in conjunction with variable rate loans

Fair Value Hedge

A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset, or liability, or of an unrecognized firm commitment attributable to a particular risk. In addition:

• The hedged item is exposed to price risk
• For a highly effective hedge there must be offsetting fair value changes for the hedged item and the hedging instrument
• Changes in fair value of the hedged item and the hedging instrument are recorded in earnings
• Fair value hedge treatment is typical when hedging fixed rate debt with a matching fixed to floating rate swap

Net Investment in a Foreign Operation Hedge

Relatively unchanged from FAS 52, FAS 133 calls for the changes in fair value of the hedge instrument to be consolidated with the translation adjustment in other comprehensive income with the difference between the total hedge results and the translation adjustment flowing through earnings. This statement:

• Includes hedges of cash flow, fair value, and net investments in foreign operations
• Permits the limited use of non derivative instruments
• Expands hedge accounting, particularly for forecasted transactions and tandem currency hedges

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•FAS133.com

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