M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.
What is a Hedge?
I'm sure you have heard the expression 'risky businesses'. Well if you ask anyone in business they would agree, business is risky! One of the risks in business is that the value of things is always going up and down. Businesses make use of hedges to lessen the risk from declining asset values or expected cash flows. Hedges are a derivative financial instrument. Derivatives get their value from fluctuations in the value of something else. A good hedge has a value that moves in the opposite direction of the value of the asset or cash flow being hedged. In other words, when the price of an asset or cash flows go down, the price of the hedge and cash flows will go up and soften the blow to the business from falling asset values or declining cash flows.
Fair Value Hedges
Fair value hedges are hedges that reduce the risk of loss from declines in an asset's value. A fair value hedge is paired with the underlying asset it is protecting. When the value of the underlying asset falls, the value of the hedge goes up and reduces the loss in value to the asset owner. Good examples of this are futures contracts which are widely used in agriculture to protect farmers from declining market prices for the crops they grow.
Farmer Fred grows grain that he sells to the Super Cereal Company for use in their super puffs and flakes. Fred worries about the weather, pests that want to eat his crop, and grain prices in the global markets going down. The executives at the cereal company have their own set of worries, but they are the opposite of Fred's. They worry about the price of grain in global markets going up. That would mean they will have to pay more to Fred for his grain, and that might cause them to raise the prices hungry Americans pay for their breakfast cereal.
Any time two parties have an opposite interest in the price of something, such as Fred and the cereal company, a fair value hedge can protect them both from uncertainty. Both parties can also gain from price certainty. Farmer Fred can lock in a price he knows he will get from his crop. That makes it easier to plan for purchasing fertilizer and pesticides. The cereal company needs price certainty too because they have to pay their employees! Both parties are excited to enter into the fair value hedge called a forward contract.
How the Hedge Works
Farmer Fred has $24,000 worth of grain planted and growing at today's prices. So, on April 1, Fred and the cereal company agree that on Oct 1, Fred will deliver his crop to the local grain elevator and sign ownership over to Super Cereal. In return, Fred will receive $24,000 for his crop. Here is how the deal looks to Farmer Fred:
|Market value of Grain||$20,000||$24,000||$28,000|
|Cash received or paid by Farmer Fred||$4,000||$0||($4,000)|
If the market value of the crop falls to $20,000 the cereal company owes Fred the $4,000 difference to make it $24,000. But if the market value rises to $28,000, Fred will owe the food company $4,000 to bring the transaction price down to $24,000. The value of the forward contract is a contra asset on Fred's books and is equal to the amount of cash that will change hands. Since Fred will be paying or receiving cash from the cereal company, the table above is the opposite for Super Cereal.
Accounting for Fair Value Hedges
Since no cash changes hands when the forward contract is signed, no journal entries are made and the value of the contract is zero. But, an important accounting issue arises when the market price of grain changes. Fair value hedges fluctuate in value along with the underlying asset, in this case, the grain. The gain or loss in value for both must be recognized in the same period's income statement. When the price of the grain falls, and his crop is only worth $20,000 on June 30, Fred will make two journal entries:
|Loss from decline in value of crop||$4,000||Loss on decline in value is recognized|
|Grain inventory||$4,000||The credit reduces the value of the grain asset to fair market value|
|Forward contract on grain||$4,000||This sets up the forward contract as a contra asset to the grain|
|Gain on forward contract||$4,000||This recognizes the gain in value of the forward contract on the income statement.|
Overall, Fred has no net decline in income thanks to the forward contract! Similar entries will be made on Oct 1 when the contract is executed.
Derivatives are financial instruments that get their value from fluctuations in the value of something else. One type of derivative is a hedge which lessens the impact of a decline in value of an asset or cash flow. A fair value hedge reduces the risk of an asset's value declining because its own value moves in the opposite direction of the underlying asset it is protecting. The two instruments are paired on the balance sheet with the fair value hedge as a contra asset. Fluctuations in the fair value hedge and the underlying asset value must be recognized immediately on the income statement
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