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 analyzes corporate incentives for hedge accounting if accounting income is used for performance measurement. We consider a two period LEN-type agency model with a risk averse principal and agent. In a first best setting we find that the principal is indifferent between applying hedge accounting rules and not to do so. In a second best setting the results depend on how the firm's overall risk exposure is allocated over periods. If first period risk exposure is relatively low either hedge accounting or no hedge accounting is preferred. For an intermediate first period risk exposure we find that it is optimal not to use hedge accounting rules even though it is optimal to hedge. Given the first period risk exposure is sufficiently high, hedge accounting is beneficial.