Hedge accounting incentives for cash flow hedges of forecasted transactions

Abstract

US GAAP as well as IAS (IFRS) contain specific accounting regulations for hedging activities. Basically the hedge accounting rules ensure that an offsetting gain or loss from a hedging instrument affects earnings in the same period as the gain or loss from the hedged item. However, due to the way hedge accounting rules are set up, their application turns out to be an option rather than an obligation for firms. Recognizing this fact, the paper analyses corporate incentives for hedge accounting in the presence of a moral hazard problem. We consider a two-period LEN-type agency model with a risk averse agent and a risk neutral principal. The principal decides upon hedging and motivates effort through an incentive contract based on accounting income. We find that in such a setting the principal strictly prefers hedging as opposed to no hedging. Whether he prefers hedge accounting or not depends on how the firm's overall risk exposure is allocated over periods. If risk exposures differ largely over periods the principal prefers hedge accounting. Otherwise no hedge accounting is preferred.