Hedge Accounting versus no Hedge Accounting for Cash Flow Hedges

Abstract

US-GAAP as well as IAS (IFRS) specify 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, 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 analyzes corporate incentives to use hedge accounting rules for cash flow hedges. We find that in a two period LEN-type agency model with a risk averse principal and a risk averse agent, it almost always benefits the principal not to use hedge accounting even though it is useful to hedge. The result stems from the fact that hedge accounting concentrates risk in the second period while no hedge accounting spreads risk over both periods. Spreading risk gives rise to a more efficient risk sharing between the agent and the principal as two compensation rates are available for that purpose compared to only one in a hedge accounting setting.