Accounting for Derivatives

Accounting Treatments

Accounting rules pertaining to derivatives and hedging transactions were initially published as Financial Accounting Standard (FAS) No. 133. These days, those same rules can be found in the Accounting Standard Codification (ASC 815).

When FAS 133 was first issued, FASB appreciated that these rules were complex and potentially confusing; and because of that, they enlisted a panel of accounting and industry experts to serve as an advisory panel – the DIG — to offer guidance and suggestions to the Board in connection with implementation questions that arose from reporting entities. Ira Kawaller served on that panel for its duration, providing him with an insider’s view as to FASB’s concerns and intentions.

The following is intended as an overview of these rules. It is designed to highlight only the more critical features of the standard, and it may omit relevant guidance for specific situations. Before entering into any hedging transactions, readers are encouraged to contact Kawaller & Company to discuss particular circumstances.

The single inviolate accounting requirement for derivatives is that they must be marked-to-market and recorded as assets or liabilities on the balance sheet. Beyond that, the accounting treatment will depend on the intended use of the derivative and/or whether specific conditions have been satisfied. Four distinct accounting treatments are allowable:

  • Fair value accounting
  • Cash flow hedge accounting
  • Accounting for hedges of net investments in foreign operations
  • Speculative or undesignated accounting

In the first three cases (i.e., for all the hedge accounting treatments), the accounting treatments are elective, but qualifying criteria must be satisfied. Put another way, if reporting entities either choose not to apply hedge accounting, or if they fail to meet the prerequisite conditions, the undesignated derivatives accounting treatment becomes the default treatment.

Fair value hedge accounting may be applied when a derivative is used to hedge an exposure associated with the price of an asset, liability, or a firm commitment. In these situations, the derivative is marked-to-market through earnings each period. In addition, fair value accounting also requires the carrying value of the hedged item to be adjusted on the balance sheet to reflect the value change due to the risk being hedged. This value change also flows through current income, along with the derivative’s gain or loss. Thus, the earnings effects of the hedged item and the hedging derivative are both recognized in earnings coincidently, period by period.

A hedge of an upcoming, forecasted event would be a cash flow hedge. This treatment may be elected for derivatives that are used to hedge exposures that derive from highly probable, forecasts of uncertain cash flows that the company expects to face. In these instances, cash flow hedge accounting serves to defer some or all of derivative results until the periods in which the associated exposures (i.e., the uncertain forecasted cash flows being hedged) impact earnings.

The third category qualifying for special accounting treatment is the hedge associated with the currency exposure of a net investment in a foreign operation. Here, hedge accounting serves to classify derivative results in the currency translation account – the same geography on the financial statement that applies to the gains or losses that arise in connection with net investments.

Finally, when derivatives are used for speculative purposes or if they are intended as hedges but the criteria for hedge accounting are not satisfied, derivative gains or losses must simply be marked-to-market and gains or losses are recorded in the current period’s income.

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As of August 2017, the FASB released an amendment to ASC 815. Compliance with the amended standard allows for a transition period, however, with implementation required on or before fiscal years starting December 15, 2018. Thus, prior to the mandatory implementation date, different entities might follow either the earlier guidance or the amended guidance.

Key differences between the original and the amended guidance are summarized below:

1. Risk Component Hedging

    1. The original guidance required identifying the full price of any commodity exposure to serve as the risk being hedged. The amended guidance allows for defining the risk being hedged in commodity exposures as any commodity price components, but only if that component is contractually specified.
    2. Component hedging for interest rate exposures is allowed for any contractual interest rate component in a cash flow hedge – not just benchmark rates.
    3. The SIFMA Municipal Swap Rate is deemed to be a benchmark rate (along with Treasury rates, LIBOR Swap rates, and Fed Funds swap rates) for fair value hedges.

2. Fair Value Interest Rate Hedges

    1. Under the revised guidance, when calculating the basis adjustment on the hedged item, the same discount rate can be used as the one that applies for the hedging derivative. Previously, the two respective discount rates were likely to differ.
    2. The amended guidance allows for partial term hedging, where the basis adjustment of the hedged item is calculated on the basis of the horizon being hedged, as opposed to the full maturity of the longer-maturity fixed rate instrument that serves as the source of the exposure being hedged.
    3. The revision allows for greater flexibility in calculating the carrying value adjustment for fair value hedges when the hedged item is a prepayable financial instruments: Entities may now adjust the carrying value of the hedged in a way that considers only how changes in the benchmark interest rate affect a decision to settle a fixed-rate instrument before its scheduled maturity.
    4. The new rules Introduce the “last-of-layer” approach in hedges of portfolios. This new approach allows for hedging a portion of some larger portfolio, as long as a sufficient volume of the prospective hedged items remains in place. (Note: This revision does not allow for substitutions of hedged items in the population of the portfolio being hedged, without re-designation.)

3. Cash Flow and Net Investment Hedges

    1. For reporting and disclosure purposes, FASB no longer requires separate and distinct measurement and accounting for effective versus ineffective hedge results.
    2. For cash flow hedges under the amended standard, total hedge gains or losses — ineffective as well as effective — are initially recorded in other comprehensive income and subsequently reclassified to earnings coincidently with the earnings impact of the hedged item.
    3. Analogously, for net investment hedges, the entire derivative result is posted to the currency translation account (CTA).

4. Recognition and Presentation of the Effects of Hedging Instruments

    1. Hedge gains or losses must be posted to the income statement line relating to the hedged item.
    2. Although hedges must still be expected to be highly effective to qualify for hedge accounting, ineffective earnings will no longer be explicitly measured or recognized.

5. Amounts Excluded from the Assessment of Hedge Effectiveness

    1. In assessing hedge effectiveness, the allowable excluded amounts were expanded beyond forward points and option time values to allow for the exclusion of cross-currency basis spreads.
    2. Excluded hedge gains or losses must continue to be reflected in earnings, but the earnings amount can now be determined on the basis of a “systematic and rational method,” allowing for these effects to be amortized over time.

6. Hedge Effectiveness Assessment Methodologies

    1. Following an initial quantitative effectiveness assessment, if the reporting entity can verify and document that the facts and circumstances of the hedge relationship have not changed, further quantitative testing may no longer be required. The capacity to rely on “qualitative testing,” as opposed to a quantitative test, should be assessed on a hedge-by-hedge basis.
    2. The “critical terms match method,” would apply to the case where a hedging derivative matures within the same 31-day period or fiscal month in which the forecasted event(s) occurs.
    3. For publicly held companies, the deadline for performing the initial quantitative hedge effectiveness assessment (if required) has been extended to a date no later than the first quarterly effectiveness testing date. The underlying data for this test, however, would reflect applicable data as of the date of hedge inception. Private companies have been granted a more generous timing allowance, extending to the date on which the next interim (if applicable) or annual financial statements are available to be issued. Despite this more lenient requirement, effectiveness assessment must still be performed quarterly.
    4. Entities that elect the shortcut hedge accounting method that find they no longer meet the qualifying criteria may continue hedge accounting seamlessly provided an alternative effectiveness assessment methodology had been specified in the hedge documentation.