With businesses in the UK exporting £875.2bn and importing £908bn worth of services or goods last year, different currencies and exchange rates affect many companies’ cash flow. In this guide, we answer the common question – what is hedge accounting?

Running a business means dealing with costs that can change fast. This is especially the case if you work with overseas suppliers or have loans with variable interest rates. 

If your cash flow depends on currency exchange or interest rate movements, even small changes can hit your profits hard. This is particularly the case at a time when, according to government statistics, 22% of UK exports go to the US – a country where the president has now started imposing tariffs too.

And this is where hedge accounting could come in for some businesses. It could help you navigate those ups and downs smoothly, keeping your financial reporting in line with what’s really happening in the business.

What is hedge accounting?

Hedge accounting links a hedging tool, such as a forward contract or interest rate swap, to a specific risk your business faces.

It alters how your business records profit and loss (P&L) with input from those tools to provide a more accurate picture of the organisation’s financial position.

Instead of showing big swings in your profit and loss when markets move, hedge accounting smooths the impact. That can make your accounts more stable and easier to understand.

But what is a cash flow hedge exactly? It protects you from changes in future cash payments or receipts.

For example, if you’re a UK business buying stock in US dollars, a weaker pound could make that stock more expensive. 

Use of a cash flow hedge helps you lock in a rate now to avoid surprises later.

When you use hedge accounting for a cash flow hedge, any changes in the value of your hedge go into a special reserve first, as opposed to directly into your profit and loss.

Changes in their mark-to-market values can go on the balance sheet in the equity section under other comprehensive income (OCI) until you recognise it on the income statement.

As a result, your reporting remains steady until the payment actually happens. Find out more about annual accounts preparation.

We have also written about creating a statement of financial position.

Hedge accounting in practice

Let’s break down what the process usually looks like:

  • Identify the risk: For example, it could be a future payment in a different currency.
  • Set up the hedge: Make use of a tool like a forward contract to fix the rate.
  • Link the hedge to the transaction: Clearly document how the two connect.
  • Test its effectiveness: Demonstrate how the hedge is likely to offset the risk.
  • Apply hedge accounting rules: Record the hedge in your accounts based on what it’s protecting.

This process means your accounts show the hedge and the risk it covers at the same time. That makes your results more accurate and avoids big accounting swings.

Hedge accounting in action

Imagine you run a small, creative business in East London and need to pay a €50,000 invoice in three months. You have checked the current exchange rate, and right now that’ll cost around £43,000.

But what if the pound were to fall prior to making the payment? You decide to lock in the exchange rate with a forward contract.

Without hedge accounting, if the contract’s value changes, your profit and loss will show a gain or loss right away – even though you haven’t paid the invoice yet. With hedge accounting, that movement sits in a reserve until the invoice is paid.

Your books show a steady picture that matches the real cost. No sudden hits or boosts to your profits that distort your records.

Find out more about trade receivables and trade debtors.

Pros and cons of hedge accounting for small businesses

Hedge accounting offers several upsides. It helps keep your profit and loss from jumping around when markets shift, which makes your reports more stable.

It also makes cash flow planning easier and ensures your accounts reflect what’s really happening in the business.

There are downsides too. It requires extra admin and careful documentation, and you’ll need to test that the hedge is working properly.

Pros of hedge accounting

  • Hedge accounting reduces profit and loss volatility that comes from fluctuations in the fair value of derivatives. It matches the timing of gains and losses on the hedge with the hedged item, which gives a clearer picture of financial performance.
  • Investors and analysts can get a more accurate view of how well a business manages its financial risks.

Cons of hedge accounting

  • It adds complexity to financial reporting and demands strict documentation and ongoing effectiveness testing. Businesses need to invest time and resources to meet the technical and compliance requirements.
  • If a hedge becomes ineffective, the business must unwind the accounting treatment, which can create unexpected hits to earnings.

For smaller businesses with occasional foreign payments, it might not be worth the extra effort.

Do SMEs need to use hedge accounting?

Hedge accounting helps small businesses take control of financial risk. It keeps your reporting steady, avoids shocks, and gives a clearer view of how you’re doing.

But it won’t be a requirement for all SMEs. If your foreign payments are small or rare, you might just want to manage the risk with a simple contract.

However, if you regularly deal in other currencies, have large payments due, or need to show reliable reports to banks or investors, hedge accounting could help.

And if your business does import goods from abroad, read our recent guide – what is postponed VAT accounting?

Get advice before you hedge

Hedge accounting follows detailed rules such as IFRS 9, so you need to document everything properly and test your hedges regularly, making sure they still work.

That’s why it helps to speak to an accountant who can guide you through the options, help with the setup or paperwork and keep your business on the right track.

Here at Accountants East London, we help businesses of all sizes with a wide range of accountancy services.

For a free, no-obligation chat about how we can help you manage risk and protect your profits, please contact us.