💰Intermediate Financial Accounting II Unit 7 – Derivatives and Hedging in Accounting

What Are Derivatives?

• Financial instruments derive their value from an underlying asset, rate, or index
• Common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes
• Enable companies to manage financial risks by locking in prices or rates
• Facilitate the transfer of risk from one party to another without actually trading the underlying asset
• Require little initial investment compared to the potential gains or losses
• Settlement occurs at a future date based on changes in the underlying asset's value
• Examples include forwards, futures, options and swaps (interest rate swaps, currency swaps)
• Speculative investors use derivatives to magnify potential returns through leverage

Types of Derivatives

• Forward contracts obligate the holder to buy or sell an asset at a predetermined price on a specified future date
• Futures contracts are standardized forward contracts traded on exchanges with set quantities and settlement dates
• Options give the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a set price (strike price) by a certain date (expiration)
  • American options can be exercised anytime before expiration
  • European options can only be exercised on the expiration date
• Swaps involve two parties agreeing to exchange cash flows at specified intervals (interest rate swaps, commodity swaps, currency swaps)
• Credit derivatives transfer credit risk from one party to another (credit default swaps)
• Weather derivatives hedge against weather-related risks and are based on a specified weather index
• Equity derivatives are based on individual stocks or stock indexes (stock options, index futures)

Accounting for Derivatives

• Derivatives are initially recorded on the balance sheet at fair value
  • If fair value is not readily determinable, valuation techniques like the Black-Scholes model are used
• Subsequent changes in fair value are recognized in earnings immediately unless designated as a hedging instrument
• Derivatives with positive fair values are recorded as assets while those with negative fair values are recorded as liabilities
• Realized gains or losses upon settlement are recognized in earnings
• Unrealized gains or losses from changes in fair value flow through earnings each reporting period
• Embedded derivatives within other contracts must be accounted for separately if they are not clearly and closely related to the host contract
• Disclosure of derivative positions, purposes, and effects on financial performance is required

Hedging Basics

• Hedging uses derivatives to mitigate exposure to financial risks like changes in fair values or cash flows
• Hedged items can be recognized assets or liabilities, unrecognized firm commitments, forecasted transactions or net investments in foreign operations
• Hedging instruments are designated derivatives whose changes in fair value or cash flows are expected to offset changes in the hedged item
• Hedge effectiveness refers to the degree to which changes in the fair value or cash flows of the hedging instrument offset changes in the hedged item
  • Highly effective hedges have an offset ratio between 80% and 125%
• Economic hedges mitigate risk but don't qualify for special hedge accounting
• Speculation seeks to profit from changes in market prices without an underlying risk exposure

Hedge Accounting Methods

• Hedge accounting better aligns the timing of gain or loss recognition on the hedging instrument with the hedged item
• Fair value hedges hedge exposure to changes in the fair value of a recognized asset, liability or firm commitment
  • Gains or losses on both the hedging instrument and hedged item are recognized in earnings in the same period
• Cash flow hedges hedge exposure to variability in cash flows related to a recognized asset, liability or forecasted transaction
  • Effective portion of the gain or loss on the hedging instrument is initially reported in OCI and later reclassified to earnings when the hedged transaction affects earnings
• Net investment hedges hedge foreign currency exposure related to a net investment in a foreign operation
  • Effective portion of the gain or loss on the hedging instrument is reported in OCI as part of the cumulative translation adjustment

Fair Value vs. Cash Flow Hedges

• Fair value hedges mitigate exposure to changes in fair value while cash flow hedges address variability in future cash flows
• For fair value hedges, the hedged item is adjusted for changes in fair value attributable to the hedged risk
  • This offsets the change in fair value of the hedging instrument, minimizing earnings volatility
• Cash flow hedge accounting defers the effective portion of gains or losses on the hedging instrument in OCI until the hedged transaction occurs
  • Amounts in accumulated OCI are reclassified to earnings in the same period(s) the hedged item affects earnings
• Ineffective portions of both fair value and cash flow hedges are recognized in earnings immediately
• Hedge designations must be properly documented at inception and reassessed ongoing

Effectiveness Testing

• Prospective effectiveness testing assesses whether a hedging relationship is expected to be highly effective in the future
  • Can be done through critical terms matching, dollar-offset method, or regression analysis
• Retrospective effectiveness testing evaluates whether the hedging relationship has been highly effective to date
  • Commonly uses the dollar-offset method comparing cumulative changes in fair value or cash flows
• Shortcut method assumes perfect hedge effectiveness for certain interest rate swaps
  • Strict criteria must be met to qualify for the shortcut method
• Hypothetical derivative method compares the change in fair value of the actual derivative to that of a hypothetical derivative
• Ineffectiveness must be measured and recognized in earnings each reporting period
• If a hedge ceases to be highly effective, hedge accounting is discontinued prospectively

Disclosure Requirements

• Qualitative disclosures describe risk management strategies, objectives, and accounting policies for each type of hedge
• Quantitative disclosures present the fair values of derivative instruments and their gains or losses segregated by accounting designation (fair value, cash flow, or net investment hedge)
• Amounts of gains or losses reclassified from accumulated OCI into earnings must be disclosed by income statement line item
• For cash flow hedges, disclose the amount of ineffectiveness recognized in earnings and a description of where it is reported in the income statement
• Disclose the net gain or loss recognized in earnings for fair value and cash flow hedges that are excluded from the assessment of hedge effectiveness
• For derivatives not designated as hedging instruments, describe their purpose and disclose gains or losses by income statement line item
• Credit-risk-related contingent features of derivative instruments and the potential effect of a credit downgrade must be disclosed
• Disclose the existence and nature of credit-risk-related contingent features and circumstances that could require posting of collateral or settlement of the instrument