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Economic risk and GAAP

A hedge can do its economic job and still look uneven in the financial statements. Economic risk is the change in value. Accounting risk is which line of the statements shows that change, and whether the offsetting sides even use the same measurement.

This page names the words a reader will meet. It does not prepare a journal entry, and it does not say that any particular hedge has qualified for hedge accounting.

01

Two scores for one hedge

Suppose a hedge gains $2 million in economic value over the quarter. The assets and liabilities it was meant to protect may have lost about $2 million of economic value. On an economic scorecard the two lines offset.

The financial statements may not show that pair. One side might be carried at fair value, so the loss appears now. The other side might be carried at amortized cost, so its economic loss does not appear as a market mark. The hedge gain might land in earnings, or in other comprehensive income, or be deferred. A reader who looks only at earnings can see volatility that the economic surplus did not have. A reader who looks only at economic surplus can miss a volatility that earnings did have.

A $2 million economic gain is not automatically a $2 million earnings lineThe left column is economic value. The right column is the financial statements. The same hedge can move one without an equal move in the other.A $2 million economic gain is not automatically a $2 million earnings lineTeaching sketchEconomic valueHedge +$2 millionThe position is worth moreFinancial statementsEarnings and OCImay not show +$2 million
Economic risk is the change in value. Accounting risk is where that change shows up: earnings, OCI, or neither, depending on the measurement. This sketch does not record a journal entry.

02

The words, one clause each

  • Fair value is a current exit price. The carrying amount moves when the market moves.
  • Amortized cost spreads an asset or liability toward its maturity value. A market move does not automatically reprice the carrying amount.
  • OCI, other comprehensive income, is a statement of changes that are not all inside net income.
  • AOCI, accumulated other comprehensive income, is the running total of those OCI amounts inside equity.
  • Earnings volatility is how much net income jumps around from period to period.
  • An accounting mismatch is two sides of one economic hedge measured on different bases, so the statements do not show the offset.
  • A fair-value hedge is an accounting designation aimed at a change in fair value. A cash-flow hedge is a designation aimed at a future cash flow. Designation is a formal choice with tests. This page does not perform those tests.
  • Hedge effectiveness, in the accounting sense, is whether the hedge offset the designated risk closely enough for that designation. Economic effectiveness is whether surplus was protected. They can disagree.

03

How to use the split

When you read the hedging page, the $60,000 per basis point is an economic measure. When you read a financial statement, ask which of those dollars are in earnings, which are in OCI, and which are not marked at all. An economically tidy receive-fixed swap can still add earnings volatility if the liability it hedges is not marked the same way.

The shock lab reports the economic surplus only. It does not split that surplus into earnings and OCI.