Hedging Strategies and Accounting
Over the last a hundred years, hedging has gained increased dominance in the world of finance and accounting. This is because it allows businesses to reduce the risks that arise from uncertainties in the market. Though introduced to protect farmers against the risk that their produce might go bad or sell at unfavourable prices, hedging is currently used in all sectors from mining to financial services. However, accounting for hedges is fraught with complex regulations that make reporting inherently difficult. Bearing these facts, this paper intends to discuss the various hedging practices that can be used by a business dealing in agricultural products. Additionally, suggestions are made on how accounting for operating income should be done according to the accounting standards used globally.
Hedging is the practice of investing in an asset so as to offset the risk that arises from adverse price movements in the open market. Hedging involves one party making the offer to buy a commodity at a particular date, at a particular price. In a hedging contract, there are two positions that are taken by each party. The seller often assumes the short position as he is the one offering to deliver the commodity while the buyer takes the long position as he undertakes to receive the commodity. This creates a contract that is known as a future contract. Because it is based on another asset, a future contract is classified as a derivative and it can be sold by either party in the futures market. The value of the future contract is based on daily movements in the cash market.
Thomson Foods has several hedging strategies at its disposal. One of them is going long in the futures market. This position means that Thomson Foods undertakes to buy a commodity at a future date as stated in the contract. Most future exchange boards would require that Thomson Foods deposits a certain sum of money in its account with the board. This is the initial margin and it is calculated as a percentage of the contract’s value. The amount is refunded to the company once the contract matures, plus any profit or losses that have been made. For example, if the contract is worth ten thousand dollars, the margin is calculated as five hundred dollars if the margin is stated as five per cent. This is the investment the company makes in the futures market.
Once the company obtains the contract, it can sell it in the market depending on the advantages it affords. For instance, the contract’s value can appreciate to twelve thousand dollars. From an investment of five hundred dollars, Thomson Foods would have made a net profit of one thousand, five hundred dollars. The amount that would be given to the company would be two thousand, five hundred dollars which include the margin deposited earlier. However, the company will still need to buy farm produce from farmers. This occurs in the cash market where both the company and the farmer meet. Should the price of produce be higher than expected, Thomson Foods will have covered this loss by the gains made in the futures market, thus completing the circle.
An alternative strategy would be to go short in the futures market. In the scenario described above, Thomson Foods has the option of selling the contract to another party in the market. From this position, Thomson Foods is going short. This strategy is suitable if the company expects that there will be a decline in the price of the commodity in question. For example, the company could anticipate that the in the next two months the price of wheat will drop from ten dollars per unit to eight dollars. Therefore, it sells its contract at ten dollars per unit. When the price drops to eight dollars, Thomson Foods repurchases the contract, thus making a profit of two dollars per unit. The accounting treatment of the loss would be the same as described earlier.
The situations described above qualify to be classified as naked futures contracts. However, Thomson Foods have a third alternative which is using spreads to further reduce its risk position. This strategy has two alternatives, which are the calendar spread and inter-market spread. Calendar spread refers to a strategy whereby Thomson Foods buys two contracts where one obliges it to buy a commodity, while the other one obliges it to sell a commodity. Both contracts must be at the same price, but the trick is to have the liquidation date set on different dates thus its name.
A spread in different commodities is referred to as an inter-market spread. For Thomson Foods, this could be through buying a long contract in wheat and at the same time buying a long contract in beef products. The contracts mature at the same time and this allows the company to cover the loss made in one contract with the gains made in the alternative contract. The final strategy is whereby Thomson Foods buys futures contract in different futures exchange markets. This is referred to as an inter-exchange spread. For example, the company could buy contracts in the exchange in Japan and another one in the United States.
Apart from using the futures market, Thomson Foods can use the options market to protect its interests. An option is a contract that gives one party the right, but not the obligation to either buy or sell a commodity while obligating the other party to sell or buy the commodity. There are two types of options and these are the put option and the call option. Put options give the holder the right to sell an asset at a specific date at the strike price. On the other hand, a call option gives the holder the right to buy an asset. Buyers of either a put or call option are not obligated to exercise their rights. However, sellers of either option are obligated to honor the contract should the buyer exercise his right.
When Thomson Foods buys a call option for the supply of beef, it hopes that the price of beef will increase before the contract expires. This is because the company will exercise its right to buy beef as stated in the contract and thus save money. When it buys a put option, Thomson Foods hopes that the price of beef will drop significantly. When this happens, the company will sell beef at a higher price as stated in the option contract. That way, the company, is covered from drastic changes in the market price of beef.
From the situations described above, Thomson Foods’ hedge in the futures and options market is regarded as cash flow hedges. This is because the main goal is to protect the company from fluctuations in market prices that would have a negative effect on its cash flows. According to accounting standards, the gains made from a cash flow hedge are categorized under other comprehensive income until the transaction occurs (Bloom & Cenker, 2008). When the contract matures, Thomson Foods will transfer the gains made to the income statement. The accounting practices for hedges are controlled by IAS 39 (Financial Instruments) which is being replaced by IFRS 9 (Financial Instruments). In the US, the practice is guided by Statement No. 133 (Accounting for Derivative Instruments and Hedging Activities).
The current financial and business world is one ridden by risks. Therefore, it is imperative that companies learn how to reduce their risks through engaging in hedging practices. As discussed above, one of the ways of doing this is through participating in the futures market. The investor can take a long position where he undertakes to buy a commodity at a specific price in the future. On the other hand, a short position in the market enables the company to sell a commodity at a specified price in the future. Another market available to the company is the options market. In this market, the company undertakes the right to buy or sell its commodities at a specified price in the future. To account for these hedging practices, the derivative asset is recognized at cost while the gains and losses are recognized under other comprehensive incomes in the income statement.
Bloom, R., & Cenker, W. J. (2008, October 1). Derivatives and Hedging: Accounting vs. Taxation. Retrieved May 24, 2014, from American Institute of Cetrified Public Accountants: http://www.journalofaccountancy.com/Issues/2008/Oct/Derivatives_and_Hedging_Accounting_vs_Taxation.htm