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Accounting Resources for ASC 815 and IFRS 9

ASC 815, Derivatives and Hedging provides guidance on a complex area of accounting. Derivatives are highly leveraged instruments that provide each party with exposure to an economic risk without significant upfront costs. While derivatives are mainly used by entities to mitigate risk by offsetting existing financial exposures, they can also be used by an entity for speculative purposes to (hopefully) profit from the fluctuation in value of the underlying asset from which the derivative originates.

Derivative instruments are measured at fair value each reporting period with changes in fair value reported in earnings. If the purpose of the derivative is for risk management or hedging, this measurement method may not always align with the value of the item being hedged. The result is a timing mismatch in measurement methods. While the economics do not change, there is earnings volatility until the period that the underlying asset or liability being hedged impacts earnings.

Luckily, there is a solution for this accounting mismatch: hedge accounting. The purpose of hedge accounting is to align the accounting with the economics of the risk mitigation efforts by recognizing the impact of the derivative instrument in the same period in which the underlying asset or liability being hedged affects an entity’s financial results. By aligning the economics with the financial reporting, hedge accounting reduces earnings volatility without changing the economics of the underlying transaction.

As you begin your quest to learn more about derivatives and hedge accounting, this page will serve as a guide, bringing together a compilation of accounting issues, references, and links to various content pieces, including our derivative and hedge accounting training courses.

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Welcome Video

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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. 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 adjacent image.

Under IFRS, the characteristics that define a derivative are different from U.S. GAAP. See our summary of ASC 815 versus IFRS 9 differences below.

Even if an instrument meets all three required 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:

Our course, Derivatives: Characteristics and Scope Exceptions, discusses how to evaluate if an instrument is within scope oof 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.

Hedging relationships

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). Our course, Hedge Accounting: Introduction to Hedge Accounting is the perfect starting place to help you better understanding how hedge accounting is used to reduce income statement volatility.

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. ASC 830, Foreign Currency Matters, requires investments in foreign operations to be translated into a parent’s functional currency each reporting period. Gains or losses are recorded in the currency translation adjustment within equity. To learn more about foreign currency transactions, check out our course that provides an overview of ASC 830.

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: 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: Hedge Accounting Qualification, 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.

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:

1. Identify the host and embedded derivative of the hybrid instrument
2. Determine whether or not a hybrid instrument needs to be separated
3. 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, Derivatives: 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.

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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 (but not all) 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. 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. The ineffective portion should be recognized in profit or loss.

Please note: The differences above are not the only differences between ASC 815 and IFRS 9.

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Online Learning

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 under both U.S. GAAP and IFRS: 

Derivatives: Characteristics and Scope Exceptions – This CPE-eligible, eLearning course (1.0 CPE) covers the basic derivative instrument types and the accounting for derivatives under ASC 815. It also explores the numerous scope exceptions to applying the guidance in ASC 815.

Derivatives: Embedded Derivatives – This CPE-eligible, eLearning course (1.0 CPE) provides an in-depth understanding of the accounting for embedded derivatives under ASC 815.

ASC 815: Accounting for Centrally-Cleared Derivatives – This CPE-eligible, eLearning course (1.0 CPE) provides an in-depth understanding of the accounting for embedded derivatives under ASC 815.

Hedge Accounting: Introduction to Hedge Accounting – This CPE-eligible, eLearning course (1.0 CPE) walks through hedge accounting under U.S. GAAP (ASC 815) in a way that is easily understood.

Hedge Accounting: Hedge Accounting Qualification – This CPE-eligible, eLearning course (1.0 CPE) explains 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.

Financial Instruments: Derivatives and Embedded Derivatives under IFRS 9 – This CPE-eligible, eLearning course (1.5 CPE) focuses on accounting for derivatives and embedded derivatives in accordance with IFRS 9.

Course collections

We’ve bundled eLearning courses together to provide comprehensive learning and bigger savings!

ASC 815: Derivatives – This 2.0 CPE credit collection of two courses covers the basic derivative instrument types under ASC 815 and characteristics of a derivative. In this collection you will gain an understanding of accounting and reporting considerations for derivatives and learn about embedded derivatives.

ASC 815: Derivatives and Hedge Accounting – This comprehensive eLearning course collection covers the accounting and reporting for ASC 815, Derivatives and Hedging. We begin by learning about freestanding derivatives, including characteristics of a derivative found within ASC 815 and the related exceptions. The next course discusses how to identify and account for embedded derivatives, including whether or not they need to be bifurcated. Next, we discuss hedge accounting and the three types of hedging strategies, or models, available within ASC 815. Finally, you learn about the requirements to apply hedge accounting initially and on an ongoing basis under U.S. GAAP. The collection of four courses is eligible for 4.0 CPE credits.

ASC 815: Hedge Accounting – This 2.0 CPE credit collection of two eLearning courses breaks down the rules for applying hedge accounting under ASC 815. Cash flow, fair value and net investment hedging models are explored using examples.

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Accounting Resources

We have written several blogs related to derivatives and hedge accounting. Below are some of the blogs and you can find even more on GAAPology.

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!

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.

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.

ASC 815: Hedging for Partial Term or Prepayment Risk
This post discusses two hedging strategies under ASC 815 that can be used for fair value hedges of interest rate risk: hedging a partial term and hedging instruments with prepayment risk.