GAAP vs. Hedge economics - Week 3

September 26, 2022

I can’t tell you how many times that the accounting/finance team would report a month-end loss for Risk Management and I’d have to explain to everyone why it wasn’t exactly true. The month end risk position for a company likely would be a summary of all derivative positions or other fixed positions that would involve a month-over-month calculation called “marked-to-market.” If say your net derivative position had more longs than shorts, and the market from last month to this month declined significantly, then your department would post a financial loss. All eyes would be on you in the board room to explain the loss.

This is very frustrating for a couple of reasons. First, the accounting principles used to derive the financial loss often leaves out the market value of the offsetting physical positions. That’s because unless the company qualified for and adopted strict hedge accounting standards, the physical side of any hedge may be treated differently. So between the time a hedge position was put in place and it settled, the changes in the value of the derivative each month would hit the P&L (called unrealized gains/losses), but the offsetting change in the value of the physical would only take place when the contract expired and the product was manufactured, sold, or taken out of inventory.

So, two lessons here. First, work with your accounting/finance department to educate them about the principles of hedging and the life cycle of the hedge. Second, create a “bridge” each month that dissects all the derivatives into different categories (i.e. forward contracted milk, cheese, butter, etc.), and line them up with the physical side. Otherwise, there may be months down the road when the market takes a big turn and you’ll have a lot of “explaining” to do.