What is hedge accounting and what is it used for?

How does currency risk arise?

The exchange rate risk as such resides in the variation of the exchange ratewhen they arise as a result of this change exchange rate differences. As part of the exchange risk, the exchange rate changes. While an entity can buy the euro for 25 CZK at the beginning of the month, it can buy the euro for 25.50 CZK as part of the exchange rate movement. The opposite situation can also occur, when at the beginning of the month the entrepreneur buys the euro for 25 CZK and at the end of the month he would pay only 24 CZK for the same transaction.

Exchange rate differences occur in such transactions. As part of course development, they may arise three situations. The first situation that would be ideal is for the course to remain the same. In this case, there would be no exchange rate difference. If the exchange rate increases or decreases, an exchange rate difference appears in the accounting transactions, namely profit or loss.

Exchange rate differences in accounting

The basic rules for accounting for exchange differences are defined in the decree on the accounting law. Yes exchange rate difference occurs, it is allocated to financial expenses (account 563 – exchange loss) or in favor of financial income (account 663 – exchange gain). An exchange difference arises, for example, when a receivable or a debt is settled, when the payables and receivables are converted on the balance sheet date or, for example, when the payables and receivables are offset. Therefore, if an entity records foreign currency liabilities or assets at the balance sheet date, it is necessary to execute them conversion at the current CNB exchange rate. This also applies, for example, to bank accounts and cash registers held in foreign currencies.

If, for example, an entrepreneur issued an invoice for 1000 EUR on March 30, 2022, this invoice would be valued at the rate of 24.46 CZK/EUR. The invoice would therefore be valued at CZK 24,460 after recalculation. The invoice would be paid on April 12, 2022, when the exchange rate was set at 24.45 CZK/EUR. An amount of CZK 24,450 would be credited to the contractor’s bank account. As a result of these accounting operations, there would be an exchange difference of 10 CZK, when the entrepreneur who issued the invoice will incur an exchange loss.

Currency risk hedging

However, the entities can hedge against exchange rate risk. If the entities regularly carry out transactions in foreign currencies, it is not desirable that the differences resulting from the evolution of the exchange rates affect the costs and the income of a given period and therefore the economic result.

The most common tool used to hedge against currency risk is fixing the exchange rate. This fixing consists of the entity negotiating the exchange rate for a certain period during which it will negotiate with the bank. Due to hedge accounting, the exchange differences will be recognized in profit or loss, but the change in the fair value of the hedge reflected in equity.

If the entity uses the form hedging against currency risk, these differences resulting from these contractual relationships are recognized in the balance sheet (accounts 41 ×). The Accounting Act Decree defines when exchange rate differences in these cases are part of costs or revenues depending on the nature of the transaction. “The following items are posted to the relevant expense or income accounts exchange differences at the time of recognition of the relevant contractual relationships or in the event that the expected contractual relationship does not materialize. Active and passive according to the first sentence must meet the conditions applicable to the hedging derivative; if they no longer meet those conditions, an entity applies paragraphs 1–3 from that time. “

Czech Accounting Standard 110 – Derivatives

A derivative is understood for accounting purposes financial instrument (financial instrument means any legal event that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity) that simultaneously meets the following conditions:

  • its fair value varies according to the evolution of the interest rate, the price of the security, the price of raw materials, the exchange rate, the price index, the rating or the credit index, resp. depending on other variables (so-called underlying asset),
  • which, in comparison with other types of contracts in which a similar response to changes in market conditions is based, requires little or no initial investment,
  • which will be settled in the future, while the trading time of the transaction until its settlement is longer for him than for the spot transaction.

A hedging instrument is a hedging derivative or, in limited cases, another financial asset or liability that meets the same requirements as a hedging derivative. A non-derivative financial asset or liability can be used as a hedging instrument only for currency hedging.

The hedging instrument can then be an asset or a liability on the balance sheet, contracts recognized in the balance sheet accounts, or anticipated future transactions, or net investment in foreign currency holdings.

Entities can choose from three types of hedging derivatives, namely fair value hedges, cash flow hedges or net investment hedges.

When can entities use hedge accounting?

The conditions under which an entity may use hedge accounting are defined in Czech accounting standards. Czech accounting standard no. 009 is then devoted to derivatives as such, but for hedging applications, Czech accounting standard no. 110, intended for financial institutions, is also taken into account. The purpose of the standard is to ensure basic procedures for accounting for derivatives to ensure consistency in the use of accounting methods by the entities.

For hedge accounting to be used, derivatives must be consistent with the entity’s overall strategy from a risk management perspective. The hedging relationship must be contractually documentedincluding the definition of the hedging relationship, the risk being hedged and the other terms of the hedging relationship.

Other conditions to consider include overall effectiveness, measurability and ongoing assessment of the effectiveness of the hedging instrument. Aby mHowever, a derivative must be designated as a derivative, but must meet clearly defined conditions.

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