Risk management accounting is one of the most debated and controversial topic amongst recent accounting thinkers. This is so because of the increased use of derivatives to manage complex financial transactions. The accounting profession was thrown apart for many years before its starts catching up with the activities of financial engineers. Financial engineers are those finance professionals whose duties include the manipulation of financial processes in order to come up with innovative products. These financial products have been accused by many to be the prime cause of the incessant modern financial crisis.
For many years, derivatives were treated as off-balance-sheet items, meaning that one cannot determine the value of those financial instruments by looking at the statement of financial position.
MEANING OF RISK MANAGEMENT ACCOUNTING
Risk management accounting is the phrase used to describe the process of accounting for financial instruments. According to IAS32 and IAS39, a financial instrument is any contract that gives rise to both a financial asset of one enterprise and a financial liability or equity instrument of another enterprise. You won’t be out of order if you define risk accounting as accounting for financial instruments. As at the time of this writing, four accounting standards at the international level have been issued. They are: IAS 32 Financial Instruments: presentation, IAS 39 Financial Instruments: Recognition and Measurement, IFRS 7 Financial Instruments: Disclosure, and IFRS 9 Financial Instruments.
The main source of the numerous problems encountered in the area of risk management accounting as evidenced by the constantly changing accounting standards issued on it is the fact that the most widely used and acceptable application of derivatives which is hedging breeds complexity in accounting.
Hedging by nature generates cash losses and gains while the transactions which they are designed to protect only generates paper gains and losses. This is a huge incubator of confusion and inconsistency in financial reporting as derivative gains and losses are realised in the income statements whereas, the losses and gains arising from the transactions they are meant to cover are not realized until sometimes in the future. This is paradoxical in the sense that, a hedge, which is designed to reduce volatility in reporting, is now the chief culprit that causes volatility.
One way of solving the complexity identified above is to use hedge accounting. A hedge accounting is a scientific approach of accounting for derivatives transactions in such a way that gains and losses on the derivatives are directly bonded to gains and losses on the instruments being hedged. This is to say that hedge accounting permits the firm to defer the gains and losses on the derivative to a future date when the hedge is completed. For example, a company that holds shares and hedges its future sale with derivative will not recognise whatever gain or loss made from the derivative until the shares are eventually sold. Notwithstanding solving the hedge problem with the introduction of hedging accounting, there are still situations where companies abuse the use of hedge accounting. The most common scenario is when companies use hedge accounting to report a non contractual situation.
There are three hedging relationships in hedging accounting rules. Those rules are:
FAIR VALUE HEDGE RELATIONSHIP RULE: a fair value hedge is a transaction in which a business entity hedges the market value of a position in an asset or liability. This is to say that fair value hedge is a form of protection from exposures arising from changes in the fair value of recognised assets and liabilities or any unrecognised commitment that could affect net income. Under this rule, any gain or losses arising after re-measurement is recorded in current earnings.
CASH FLOW HEDGE RELATIONSHIP RULE: this is a process of hedging the risk of future cash flow with a derivative. This is to say that what a company hedges against is the exposure to variability in future cash flows. A traditional example is when a firm takes up cash flow hedge when it plans to borrow in the future. For a transaction to qualify as cash flow hedge, every details of the transaction must be documented from the unset.
NET INVESTMENT HEDGE RELATIONSHIP RULE: this simply means hedging your foreign investments from exposure. The position of the relevant accounting standard is to recognise gains or losses directly in other comprehensive income in such a way that it matches against the gain or loss on the hedged investment.
SPECULATIVE HEDGE RELATIONSHIP RULE: any trade that does not qualify to be categorised under any other headings should be classed as speculation and treated accordingly. This means that derivatives are marked to market and losses or gains are taken to the current period without adjusting any other account.
Risk management accounting or accounting for financial instrument is a problematic area in accounting that constantly changes in line with prevailing situations in both the business and political arena. For you to be relevantly informed on this topic, you need to keep consuming all the documents that are released on it. You might as well be reading this article ages after its contents are no longer relevant. Do yourself a great favour by looking around this blog for other relevant contents.