Question 2: 25 Marks Most Firms Hedge At Least Some Of Their

Question 2 25 Marksmost Firms Hedge At Least Some Of Their Risks He

Most firms hedge at least some of their risks. Hedging can take two basic forms—namely, natural hedging and hedging by means of derivative instruments. The use of derivatives as hedges has expanded greatly in recent years. Generally, under accounting standards (IAS 39 and related U.S. standards), derivative instruments are fair-valued with any unrealized gain or loss included in net income. However, hedge accounting provides some exceptions to this rule.

Required: A firm has a large amount of long-term debt (valued on a cost basis) and decides to set up a natural hedge of this debt. However, a natural hedge can lead to excess net income volatility—that is, net income volatility greater than the actual volatility of the firm’s operations. Explain how this can happen. (5 marks) Suggest two ways that the excess net income volatility arising in part (a) can be prevented. (6 marks) IAS 39 identifies two basic types of hedge. Describe each type. For each type, explain how IAS 39 controls excess net income volatility arising from entering into the hedge. (8 marks) Use the bonus plan hypothesis of positive accounting theory to explain why a firm manager dislikes excess net income volatility. Are the policies to control excess net income volatility you described in parts (a) and (b) unethical? Explain why or why not. (6 marks)

Paper For Above instruction

Hedging plays a vital role in risk management strategies employed by firms, aiming to stabilize financial performance amid volatile markets. Understanding how different hedging methods impact net income and how accounting standards govern these practices is essential for a comprehensive grasp of corporate risk management. This paper explores the concept of natural hedging, the causes of excess net income volatility, mechanisms to mitigate this volatility, the types of hedges under IAS 39, and the ethical considerations surrounding policies to control income fluctuations.

Natural Hedging and Its Impact on Income Volatility

Natural hedging involves structuring operational activities to offset potential losses in one area with gains in another, often through matching revenue and expenses in different currencies or interest rate environments. For a firm with significant long-term debt, natural hedging might entail generating revenue in the same foreign currency or interest rate environment to offset foreign exchange or interest rate risks inherent in the debt. While this approach effectively mitigates specific risks, it can inadvertently lead to excess net income volatility. This occurs because natural hedging strategies often involve netting out positions that are not perfectly correlated or synchronized in timing and magnitude. As a result, fluctuations in exchange rates or interest rates can cause gains or losses in net income that are disproportionate to the firm's operational performance, amplifying income volatility beyond the actual business risks.

Methods to Prevent Excess Income Volatility

To minimize the excess volatility resulting from natural hedging, firms can adopt several strategies. Firstly, employing dynamic hedging techniques that adjust the hedge positions continually helps align the hedge with current market conditions, thereby reducing unanticipated income variability. Secondly, implementing hedge effectiveness testing ensures that hedges remain highly correlated with the underlying exposures, enabling better control over unrealized gains and losses. Additionally, firms might consider using derivative instruments expressly designed for hedging purposes, which, under specific accounting treatments, can be designated as hedging instruments, thus avoiding adverse effects on net income.

IAS 39 and the Two Basic Types of Hedges

IAS 39 delineates two primary types of hedging relationships: fair value hedges and cash flow hedges. A fair value hedge aims to offset the changes in the fair value of a recognized asset or liability or an unrecognized firm commitment attributable to a particular risk. This type of hedge is useful when a firm wants to hedge the exposure to changes in the fair value of existing items on its balance sheet. IAS 39 requires that gains or losses from fair value hedges and the hedged items be recognized immediately in profit or loss, which can exacerbate income volatility but ensures transparency.

In contrast, a cash flow hedge aims to offset variability in cash flows attributable to a particular risk associated with a recognized asset or liability or a forecasted transaction. This hedge type is effective in stabilizing future cash flows, such as expected sales or purchase transactions. IAS 39 mandates that for cash flow hedges, the gains or losses on the hedge are initially recognized in other comprehensive income and reclassified into profit or loss when the forecasted transaction affects earnings. This treatment reduces short-term income volatility and aligns closer with the economic reality of the hedge.

Managerial Dislike for Excess Net Income Volatility: The Bonus Plan Hypothesis

The bonus plan hypothesis of positive accounting theory suggests that managers prefer stable earnings because their compensation often depends on meeting certain financial targets. Excess net income volatility can hinder this goal by making earnings unpredictable, thereby reducing the likelihood of meeting bonus thresholds. Managers are thus motivated to implement policies that smooth earnings, even if these policies do not reflect the true economic performance of the firm, to safeguard their compensation and job security. This behavioral insight explains why managers might favor hedging and other accounting strategies that limit income fluctuations, aligning reported earnings more closely with performance targets and reducing managerial risk.

Ethical Considerations of Income Volatility Control Policies

Policies aimed at controlling excess net income volatility, such as employing hedging strategies or accounting treatments that smooth earnings, can raise ethical questions. On one hand, these practices enhance financial stability, provide transparency, and improve comparability, aligning managerial incentives with shareholder interests. On the other hand, if such policies are used to intentionally obscure true economic performance or manipulate earnings for personal gain, they could be deemed unethical. Ethically appropriate practices should focus on transparency, adhering to accounting standards, and accurately portraying the firm's financial health. If the policies serve to mitigate unintentional volatility and improve the quality of financial reporting without deceiving stakeholders, they can be considered ethically acceptable.

Conclusion

In conclusion, while natural hedging and derivative-based hedging serve as crucial tools for managing risk, they can inadvertently increase net income volatility if not carefully managed. IAS 39 provides the framework for recognizing and accounting for these hedges, aiming to balance transparency with stability, particularly through its distinctions between fair value and cash flow hedges. Managers' dislike of income volatility, motivated by positive accounting theory and bonus plans, further influences their approach to risk management and accounting policies. Ultimately, employing these strategies responsibly and ethically enhances both financial stability and stakeholder trust, provided they are transparently disclosed and aligned with ethical standards.

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