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Overview
Coverage
Accounting
Effectiveness
Disclosure
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Originally issued as FAS 133, the rules for accounting for derivatives and hedging transactions are found under Topic 815, 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.
For speculative purposes, derivative gains or losses must be marked-to-market and gains or losses are realized in the current period's income.
When hedging exposures associated with the price of an asset, liability, or a firm commitment, accounting for the derivative is the same as it is for speculative uses. In addition, however, the underlying exposure must also be marked-to-market due to the risk being hedged; and these results must flow through current income, as well. This treatment is called a "fair value hedge."
A hedge of an upcoming, forecasted event is a "cash flow hedge." For cash flow hedges, derivative results must be evaluated, with a determination made as to how much of the result is "effective" and how much is "ineffective." The ineffective component of the hedge results must be realized in current income, while the effective portion is initially posted to "other comprehensive income" and later re-classified as income in the same time frame in which the forecasted cash flow affects earnings. Importantly, the FASB only recognizes hedges as being ineffective for accounting purposes when the hedge effects exceed the effects of the underlying forecasted cash flow, measured on a cumulative basis.
Finally, the last category qualifying for special accounting treatment is the hedge associated with the currency exposure of a net investment in a foreign operation. Again, the hedge must be marked-to-market. This time, the treatment maintains the spirit of the current provisions of the FASB Statement 52, which require effective hedge results to be consolidated with the translation adjustment in other comprehensive income. Differences between total hedge results and the translation adjustment being hedged flow through earnings.
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