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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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ACCOUNTING CONSIDERATIONS

Global accounting standards for financial assets and liabilities now generally require derivative positions to be MtM, with resulting gains and losses forced through the income statement. However, hedge accounting allows deferring MtM flows until the hedged item hits the accounts. For example, FAS 133 hedge accounting rules define three types of hedges:

1. Fair value: recognized assets or liabilities, and unrecognized firm commitments

2. Cash flow: forecast unrecognized transactions

3. Net investment: foreign net assets.

Exposures that qualify for hedge accounting treatment include foreign currency assets and liabilities, forecast sales or costs, cash profits, including intercompany transactions, and other exposures that could affect the company’s income statement. Yet a broad range of other types of exposures do not qualify, such as undeclared dividends, foreign accounting earnings, and future M&A transactions. The following parameters have generally been deemed consistent with hedge accounting treatment:

  • Amount. At the start, the company must be able to specify the amount being hedged and the worst-case rate. Contingent instruments, such as knockout options and accrual forwards are not permitted.
  • Options. The hedge cannot be subsidized with a net sold option. The amount of options sold must be equal to or less than the amount bought. And the maturity of the short position should be shorter than the maturity of the corresponding long position.
  • Effectiveness ...

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