What comes to mind when you hear the word derivatives? Or, how about hedge accounting?
If you feel intimidated or cringe at the thought of accounting for derivatives and hedging activities, you are not alone!
I may be dating myself a bit here, but I remember when the FASB first issued FAS 133, Accounting for Derivative Instruments and Hedging Activities back in 1998. I was working at one of the Big 4 accounting firms and it was still what I consider my early days as a CPA. I remember feeling confused with trying to understand derivatives, let alone hedge accounting. It was kind of like trying to learn a different language where just the thought of the monstrous undertaking was so overwhelming that it stopped me in my tracks.
At that time, I was able to avoid being directly responsible for auditing or accounting for these instruments since they were considered complex and thus elevated to those with more experience. But, as with many things I have tried to avoid in life, I could only hide for so long.
In the year 2000, I was offered a job to become a subject matter expert on derivatives and hedge accounting and to lead the efforts to implement the standard for a large financial institution. While I was nervous, feeling a little unqualified and to be honest, a bit scared that I may fail and let down my new employer, I knew it was a great opportunity. And if I didn’t take it, I’d probably regret it, or always wonder “what if.” So, despite my fears and apprehension, I accepted the position and the challenge of demystifying derivatives and hedging.
When I look back at that journey, I am glad that I took advantage of the opportunity. While there were definitely challenges and a fair amount of frustration with fully grasping the rules, certain concepts and application issues at times, I’ve come out on the other side not only with increased knowledge and a greater comfort level with these instruments, but I also find derivatives and hedge strategies fascinating. I probably would even admit that when hedge strategies were presented to me in my accounting policy role, I would “geek-out” with applying the accounting!
Fast forward to today…as we all know, ASC 815 is now the FASB Codification topic for derivatives and hedging. While I no longer do the actual accounting or compliance, I do get to work on creating accounting training and one of my favorite areas is derivatives and hedging.
I know that derivatives and hedge accounting (like it was for me all those years ago) tends to be an area that is still confusing, complicated, and overwhelming to accountants. When learners shy away from the topic, I tend to reassure them that when you get into the topic, it is not as complicated as we tend to make it out to be, and I often pose the question:
How do you eat an elephant?
Well, one bite at a time, of course!
And, that is a good approach to tackling accounting for derivatives and hedging.
Derivative and Hedge Accounting Training
I am excited to announce that we have recently released a four-part training series on accounting for derivatives and hedging. We break down this monstrous topic into more manageable chunks and teach you the complex lingo, concepts, and rules in a more easily understandable manner using examples, video, interactivity, and mini case questions.
In the remainder of this blog post, I am going to provide an introduction to derivatives and hedging as well as give an overview of our derivatives and hedge accounting training courses.
Accounting for Derivatives and Hedging Activity
ASC 815 requires a derivative to be recorded on the balance sheet as an asset or liability and to be measured at fair value. Changes in fair value each period are reported in earnings, unless the derivative is designated in a qualifying hedge relationship.
In order to apply the accounting, it’s important that you know what a derivative is. ASC 815 provides a characteristics-based definition of a derivative. There are three characteristics, all of which must be present in order to meet the definition of a derivative and be accounted for as such. The image below depicts a summary of the three characteristics.
Course 1 - Derivatives: Characteristics and Scope Exceptions
In our first derivative accounting training course, these three characteristics are covered in detail as understanding the characteristics-based definition is critical to applying the accounting guidance. It is important to note that there are contracts though, where the three characteristics may be met, but ASC 815 provides an exclusion from the scope of derivative accounting. Scope exceptions to the guidance are also reviewed in this course.
In addition to the characteristics and scope exceptions, the course covers the basic derivative concepts which include terminology and detailed explanations of common derivative types. Examples are provided to illustrate application of the characteristic-based definition to these common derivative instruments.
The accounting for derivatives also applies to derivatives that are embedded in other contracts. Embedded derivatives are covered in our second derivatives training course.
Course 2 - Derivatives: Embedded Derivatives
There are contracts, referred to as hybrid instruments, that do not in their entirety meet the definition of a derivative but may have terms within the overall contract that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument. The big issue with these types of contracts is determining whether it should remain as one instrument for valuation and accounting purposes or whether the embedded derivative must be accounted for separately from the host contract. The rules to make that determination are covered in depth in this second derivative eLearning course.
As mentioned above, there is special accounting treatment when a derivative is designated in a qualifying hedge accounting relationship. The accounting depends upon the type of hedging relationship. The last two courses in our series are dedicated to hedge accounting training.
Course 3 - Hedge Accounting: Introduction to Hedge Accounting
In this course you will learn the difference between economic hedging and hedge accounting, the different types of hedging strategies, and the accounting for these qualifying hedges. The three hedging strategies are:
- Fair value hedging – A fair value hedge is a hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, which are attributable to a particular risk.
- Cash flow hedging – A cash flow hedge is a hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk.
- Net investment hedging – A net investment hedge is a hedge of the foreign currency exposure of a net investment in a foreign operation.
Course 4 - Hedge Accounting: Hedge Accounting Qualification
Hedge accounting is a choice and ASC 815 mandates strict criteria that must be met in order to apply “special” hedge accounting. In this final hedge accounting course, you learn about the criteria to qualify for hedge accounting and the requirements to maintain hedge qualification to be able to continue applying the special hedge accounting.
The requirements can be categorized as follows:
- Documentation requirements
- Requirements for hedge items and the risk being hedged
- Requirements for the hedging instrument, and
- Effectiveness requirements
There is a lot to learn about derivatives, hedging, and the accounting for these transactions. And while it may at first feel daunting, our training, whether you need a specific course to hone in on a specific area or whether you need the entire 4-part derivative and hedge accounting training series, is available to break down the topic to make it more manageable and help you to build a solid foundational knowledge.
About GAAP Dynamics
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