Rebalancing can be achieved by:
- Increasing the volume of the hedged item
- Increasing the volume of the hedging instrument
- Decreasing the volume of the hedged item
- Decreasing the volume of the hedging instrument
Decreasing the volume of the hedging instrument or hedged item does not mean that the respective transactions or items no longer exist or are no longer expected to occur. As demonstrated in the example below, rebalancing only changes what is designated in the particular hedging relationship.
In the example above, the entity no longer needs to hold this portion of the derivative any longer for hedging purposes and could, therefore, close it out. As mentioned, the entity could have also rebalanced by designating more WTI exposure (assuming that the higher level of exposure is highly probable of occurring). In that case, there would not be any immediate accounting entries; the entity would simply designate more WTI exposure. The same would be true when rebalancing by increasing the volume of hedging instrument, in which case the entity would simply designate additional volume of hedging instrument (provided, of course, it is available).
Even though the standard allows for adjustments to either the quantity of hedging instrument or the quantity of the hedged item, when rebalancing, entities should consider that adjusting the hedged item will be operationally more complex than adjusting the hedging instrument because of the need to track the history of different quantities that were designated during the term of the hedging relationship.
For example, if a quantity of 10 tonnes of a hedged item were added to increase the quantity of hedged item and later deducted to decrease it, those 10 tonnes would have been part of the hedged item for only a part of the life of the hedging relationship. However, any cash flow hedge adjustment would still, in part, relate to that quantity. This can get more complex in situations in which the hedging relationship needs frequent rebalancing, if not all hedged transactions occur at the same time, or in conjunction with the cost formulae used for the measurement of the cost of inventory.
In addition, adjusting the hedged item might suggest the entity is using an accounting driven approach to hedge accounting, because risk management would normally adjust the quantity of the designated hedging instruments when rebalancing since the hedged exposure is the ‘given’ and drives what hedges are needed.