A derivative is a contract whose value is derived from movements in an underlying variable. For example, a stock option contract derives its value from changes in the price of the underlying stock; as the price of the stock fluctuates, so too does the price of the related option.
There is extensive accounting guidance for derivatives and hedging. The FASB initially attempted to summarize accounting and reporting rules for derivative instruments in 1988 with the issuance of SFAS 133. At the same time, the FASB created a task force known as the Derivatives Implementation Group (DIG) to address questions from practitioners on applying the newly issued guidance. Despite the publication of nearly 500 pages of interpretive guidance, many practitioners continued to struggle with implementing the guidance, as it was often ambiguous and difficult to apply to certain instruments. The FASB continues to analyze, deliberate, and refine the guidance with the intention of providing a principles-based framework.
Rather than providing narrow implementation issues specific to ASC 815, the following summarizes certain high-level matters faced by practitioners as they navigate derivatives and hedging.
Characteristics of a derivative
In order to apply proper accounting, it is important to understand what a derivative is. Both ASC 815 and IFRS 9 provide a characteristics-based definition of a derivative. There are three characteristics, all of which must be present in order to qualify for accounting treatment of a derivative. The characteristics to meet the definition of a derivative under ASC 815 are summarized in the image below:
Under IFRS, the characteristics that define a derivative are different. See our summary of ASC 815 vs IFRS 9 differences below.
Even if an instrument possesses all three of these characteristics, there still may be circumstances where ASC 815 would not apply. There are many specific scope exceptions for certain instruments that require consideration of accounting guidance outside of ASC 815, including:
- Regular-way security trades
- Normal purchases and normal sales
- Certain insurance contracts
- Certain financial guarantee contracts
- Certain contracts that are not traded on an exchange
- Derivative instruments that serve as impediments to sales accounting
- Instruments in life insurance
- Certain investment contracts
- Certain loan commitments
- Certain interest-only strips and principal-only strips
- Certain contracts involving an entity’s own equity
- Residual value guarantees
- Certain registration payment arrangements
Our course, Derivatives: Characteristics and Scope Exceptions, walks through the considerations you need in order to understand how to properly evaluate an instrument as within scope or outside the scope of ASC 815. This course also walks through the three basic types of derivative instruments: options, swaps, and forwards and futures. Each of these structures addresses specific risks that an entity may wish to manage or otherwise use for speculation purposes.
Designing a risk management policy
An entity’s risk management policy is similar to a very strategic game of whac-a-mole. Sometimes, entities use derivative instruments as a risk management tool. However, it is important for an entity to understand the potential financial and nonfinancial risks that create financial statement volatility. If a risk is managed in isolation, it could result in financial statement volatility.
Let’s use foreign currency as an example. An entity may have the risk of financial statement volatility because it operates in multiple foreign jurisdictions. Would it be proper to use a derivative instrument and reduce the risk of reporting currency fluctuations in earnings for the most volatile currency? Before entering into an agreement, an entity should first analyze the remaining currencies to determine if there are any natural hedges in place with existing operations. That is, are there currencies that negatively correlate to that most volatile currency? If an entity ignores these natural hedges, it could end up with a greater amount of financial statement volatility.
It is important to carefully consider an entity’s inherent financial risks when designing a risk management policy in order to determine whether derivative instruments will effectively mitigate some of these exposures.
The goal of hedging is to create a situation where the combination of the hedged item and the derivative instrument ensures a predictable outcome during the hedging period. That outcome is either in the form of maintaining fair value (fair value hedge), achieving predictable cash flows (cash flow hedge), or mitigating changes in the value of a net investment in a foreign operation (net investment hedge).
Fair value hedging model
Entities use a fair value hedge when there is an exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment that is attributable to a particular risk and could affect profit or loss. Examples of these exposures include interest receipts or payments based on fixed interest rates, the fixed nature of costs of assets already purchased, or the fixed price related to the purchase of goods under a binding agreement for a specified price at a specified future date.
Under fair value hedge accounting, the hedging instrument is treated as a typical freestanding derivative. It is measured at fair value with changes in fair value recorded through the income statement. The “special treatment” occurs with the hedged item. Changes in value of the hedged item due to the risk being hedged is recorded as an adjustment to the asset or liability through the income statement in the same account line item as would normally be used for the underlying asset or liability.
Cash flow hedging model
Entities use a cash flow hedge when there is an exposure to variability in cash flows that is attributable to a particular risk associated with a recognized asset or liability or highly probable forecasted transaction and could affect profit or loss. Examples of these exposures include interest receipts or payments based on variable interest rates, or the variable nature of a future cost of assets expected to be purchased in the future.
Under cash flow hedge accounting, the “special treatment” occurs with the hedging instrument. The hedging instrument is recognized similar to other freestanding derivatives on the balance sheet at fair value. However, changes in fair value of the hedging instrument included in the assessment of effectiveness is recorded in other comprehensive income. The amounts that accumulate in other comprehensive income are reclassified to earnings in the same income statement line item that is used to present the earnings effect of the hedged item when the hedged item affects earnings. The hedged item does not have any special accounting treatment in a cash flow hedge.
Net investment hedging model
Entities use a net investment hedge when there is an exposure to changes in the fair value of an entity’s investment in a foreign operation. In accordance with ASC 830, Foreign Currency: Overview of ASC 830, investments in foreign operations are translated into a parent’s functional currency each reporting period with gains or losses recorded in the currency translation adjustment within equity.
For instruments that qualify as hedges of a net investment in a foreign operation, the entire change in fair value of a hedging instrument is recorded in accumulated other comprehensive income and reclassified into earnings when the net investment is sold or liquidated.
Qualifying for hedge accounting
Hedging aligns the economic impact of a derivative instrument with the accounting. However, in order to achieve this result, an entity must “earn” this right. There are four key elements to achieve hedge accounting:
- Hedged item and hedgeable risk: ASC 815 limits the risks that are eligible for hedge accounting. Generally, hedging must be performed on a one-to-one basis. However, in some circumstances, portfolio hedging is allowed.
- Hedge instrument: In general, the hedging instrument is a derivative. However, ASC 815 does allow non-derivative instruments as a hedging instrument in limited cases.
- Hedge effectiveness: ASC 815 requires that for hedge transactions to qualify for hedge accounting, the hedging relationship must be “highly effective”. Further, it does not include a specific method for assessing effectiveness, but it does include guidelines that must be followed. This is an area that requires extensive analysis throughout the term of the derivative instrument.
- Formal documentation: In order to qualify for hedge accounting, management must formally document their hedge relationships. This documentation provides essential details and allows management to formally demonstrate that they meet the criteria to apply hedge accounting.
Our course, Hedge Accounting Qualifications, will help you understand each of these required elements so that you can evaluate whether the effort is worth it for the resulting financial statement presentation. You will also learn about the presentation and disclosure requirements should you choose to embark on a journey to employ hedging accounting to align the economics and accounting recognition of risk mitigation efforts.
Navigating instruments with embedded derivatives
Sometimes, contracts in their entirety do not meet the definition of a derivative. However, these contracts may have certain terms that impact some or all of the future cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument. It may mean that a derivative instrument exists within another contract or instrument.
An embedded derivative is defined as implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument. An embedded derivative is a component of a hybrid instrument; the other component is the host contract.
Hybrid instruments require extensive analysis to determine whether each of the components should be accounted for separately (bifurcation) or as one instrument. At issuance or acquisition, and on an ongoing basis (under U.S. GAAP), hybrid instruments should be evaluated using a three-step approach:
- Identify the host and embedded derivative of the hybrid instrument
- Determine whether or not a hybrid instrument needs to be separated
- Determine valuation of both the embedded derivative and host
To determine whether bifurcation is required, the following characteristics of a hybrid instrument need to be considered:
An embedded instrument that is bifurcated from a host contract is accounted for as a derivative unless it qualifies for a hedging relationship.
Our course, Embedded Derivatives, will help you understand the considerations necessary to evaluate a hybrid instrument as well as how to account for embedded derivatives. It also provides presentation and disclosure requirements.
Accounting Differences: ASC 815 vs. IFRS 9
As with many areas of accounting literature, there exist differences between U.S. GAAP and IFRS as it relates to accounting for derivatives and hedges. While the original objectives and intentions of subsequent revisions are similar, the path to these objectives are different. In general, ASC 815 includes additional guidance and considerations to analyze, whereas IFRS 9 is more principles based. The result is that some instruments are reported differently on an entity’s financial statement. Some of the key differences are:
Characteristics of a derivative
While both ASC 815 and IFRS 9 include required characteristics of a derivative instrument, there is only one common characteristic: the instrument or contract requires no initial net investment or an initial net investment that is smaller than would be required for a similar arrangement. The other two characteristics under IFRS 9 are that the value of the instrument or contract changes in response to changes in a specified underlying and that it will be settled at a future date. IFRS 9 does not require a contract or instrument to include net settlement features or to have a notional amount. This may result in classification differences of certain instruments that meet the definition of a derivative under IFRS 9 but do not possess all required characteristics under ASC 815.
Evaluating a hybrid instrument
ASC 815 requires the bifurcation evaluation of a hybrid instrument for all host arrangements, whereas under IFRS 9, this evaluation is not necessary for certain hybrid contracts with financial asset hosts. Under IFRS 9, embedded derivatives are not separated from financial assets within the scope IFRS 9. Rather, the entire hybrid contract should be assessed and measured based on the classification requirements.
Additionally, IFRS 9 only requires an entity to assess a hybrid instrument for bifurcation at inception of the contract. Subsequent reassessment under IFRS 9 is prohibited unless there is a change in the terms of the contract that significantly modifies the cash flows under the contract (in which case it is required). In contrast, ASC 815 requires evaluation both at inception as well as throughout the life of the contract, unless specific limits apply.
Accounting for hedge ineffectiveness
For a cash flow hedge under ASC 815, if an entity concludes that the hedge relationship is highly effective, the entire change of the fair value of the designated hedging instrument included in the hedge effectiveness assessment is recognized in other comprehensive income. So, even if the hedging instrument does not exactly mitigate the risk exposure from the hedged item, all changes in fair value would still be classified in other comprehensive income.
Under IFRS 9, the change in fair value of the hedging instrument is split between an effective portion and an ineffective portion. The effective portion is recognized in other comprehensive income and is subsequently held in a separate component of equity (the cash flow hedge reserve) until the underlying hedged item affects profit or loss. The ineffective portion, if any, is recognized immediately in profit or loss.
Under IFRS 9, hedges of a net investment in a foreign operation are accounted for similarly to cash flow hedges. The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge should be recognized in other comprehensive income and included with the foreign exchange differences arising on translation of the results and financial position of the foreign operation and the ineffective portion should be recognized in profit or loss.
Join the Revolution with GAAP Dynamics!
GAAP Dynamics training courses are designed to help leading accounting firms and multinational companies move beyond the training status quo. Our courses are continually updated and new courses are constantly being added, so check back often! Below are a few of our courses related to Derivatives and Hedge Accounting.
Derivatives: Characteristics and Scope Exceptions - This course covers the basic derivative instrument types and the accounting for derivatives under ASC 815, including swaps, forwards and futures, and options. This course also explores the numerous scope exceptions to applying the guidance in ASC 815.
Derivatives: Embedded Derivatives - This course introduces embedded derivatives and the accounting for embedded derivatives under ASC 815.
Hedge Accounting: Introduction to Hedge Accounting - This course is a starting point to begin learning about hedge accounting under ASC 815. You will learn:
- The difference between economic hedging and hedge accounting, including why companies would choose one strategy over the other
- The different types and accounting for hedging strategies, including fair value hedges, cash flow hedges, and net investment hedges
- The required disclosures under ASC 815 when hedge accounting is elected
Hedge Accounting: Hedge Accounting Qualifications - ASC 815 mandates strict criteria that must be met in order to apply "special" hedge accounting. In this course, you will learn the requirements to qualify for hedge accounting, and the requirements to continue to apply hedge accounting on an ongoing basis. including the formal documentation requirements and effectiveness testing.
ASC 815: Derivatives - This 2.0 CPE credit collection of two courses covers the basic derivative instrument types under ASC 815, dives into their accounting, as well as introduces embedded derivatives.
ASC 815: Derivatives and Hedge Accounting - This comprehensive course collection walks you through the accounting and reporting for ASC 815, Derivatives and Hedging, starting with freestanding derivatives. Next, you'll walk through identifying and accounting for embedded derivatives. Finally, the course concludes with two modules on hedge accounting. The first introduces you to hedge accounting and the three types of hedging strategies. The second course walks through the initial requirements to apply hedge accounting and the ongoing requirements to maintain hedge accounting. The collection of four courses is eligible for 4.0 CPE credits.
There are numerous resources available on accounting for derivatives and hedging under both ASC 815 and IFRS 9. To save you time searching, we have compiled a list of resources below to assist you in your research and quest to master derivatives and hedge accounting.
Resources from GAAP Dynamics:
We have written several blogs on a variety of derivatives and hedge accounting topics which are categorized and listed below. Click on the links to view the full blog post.
Derivatives and Hedge Accounting: An Overview of ASC 815
Does the thought of derivatives and hedge accounting feel daunting? This training program breaks down the ASC 815 requirements to help you!
ASC 815: Fair Value Hedge Versus Cash Flow Hedge
ASC 815 permits three hedge types that qualify for special hedge accounting treatment. In this post we will look at fair value and cash flow hedges.
Identifying and Accounting for Embedded Derivatives Under ASC 815
Scared of embedded derivatives? Don’t be! Using a “real-life” example, this post walks through the accounting for embedded derivatives under ASC 815.
Partial Term Hedges and Hedges of Prepayment Risk under ASC 815 after Improvements in ASU 2017-12
ASU 2017-12 makes it easier to achieve fair value hedge accounting for partial term hedges and hedges with prepayment risk.
Hedging Non-Financial Risks under ASC 815 after Improvements in ASU 2017-12
ASU 2017-12 makes it easier to achieve cash flow hedge accounting for hedges of non-financial risks.
Is it Time to Give Hedge Accounting under ASC 815 Another Try?
ASU 2017-12 offers a wide range of improvements to hedge accounting under ASC 815, aligning it more with risk management strategies and making it more operable.
Variation Margin: Accounting for Derivatives under ASC 815 (FAS 133)
An update on Dodd-Frank’s central clearing and variation margining requirement, and its impact on accounting for derivatives under ASC 815.
Time’s Running Out: Get Up to Speed on IFRS 9 Financial Instruments
Get up to speed on the requirements for classification and measurement of debt securities under IFRS 9 Financial Instruments with this post!
We publish blog posts regularly on various accounting topics and issues. If you want to stay updated by receiving an email notification as new blog posts are published, you can subscribe to our blog here: Subscribe to GAAPology
Resources From the FASB and IASB:
- FASB Codification Link – This link will take you to the authoritative guidance
- IFRS Link – This link will take you to the authoritative guidance (professional subscription required)
Resources From Accounting Firms:
The Big 4 accounting firms have informative, in-depth guides on Derivatives and Hedge Accounting. To save you time and effort in your research, we have linked to them below.
- Deloitte: Perspectives, Insights, & Analysis: Hedging (2020)
- EY: Financial Reporting Developments - Derivatives and Hedging (2020)
- KPMG: Derivatives and Hedging Handbook (2020)
- PwC: Derivatives and Hedging Guide (2020)