Accounting for Derivatives

Overview

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 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.

For speculative purposes, derivative gains or losses must be marked-to-market and gains or losses are recorded 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 would be 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 recorded in current income, while the effective portion is initially posted to “other comprehensive income” and later re-classified to income in the same time frame in which the forecasted cash flow affects earnings. Importantly, as of this writing, 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; but this asymmetric provision is under consideration and is subject to change.

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, requiring effective hedge results to be consolidated with the translation adjustment in other comprehensive income. Any excess of hedge results relative to the risk being hedged would be recorded in earnings.