Derivative accounting
/What is a Derivative?
A derivative is a contract whose value is based on the performance of an underlying asset, index, or rate. Common underlying assets include stocks, bonds, commodities, currencies, interest rates, or market indexes. Derivatives are used for hedging risk, speculation, or gaining access to otherwise hard-to-trade assets or markets. Their value fluctuates with changes in the price or level of the underlying asset, allowing investors to manage financial exposure or potentially profit from market movements without directly owning the asset itself.
Examples of Derivatives
The main types of derivatives are as follows:
Futures. Futures are standardized contracts that obligate the buyer to purchase, and the seller to deliver, a specific asset at a predetermined price on a set future date. These contracts are traded on organized exchanges, which helps reduce counterparty risk. Futures are commonly used by investors to hedge against price fluctuations in commodities, currencies, or financial instruments.
Options. Options give the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specific price before or on a particular expiration date. Because the holder isn't obligated to act, options provide flexibility and are often used for hedging or speculative strategies. The seller of the option, however, assumes the obligation if the buyer chooses to exercise the contract.
Forwards. Forwards are customized contracts between two parties to buy or sell an asset at a specific price on a future date. Unlike futures, forwards are traded over-the-counter (OTC), making them more flexible but also subject to higher counterparty risk. They are commonly used in currency and commodity markets to hedge against future price movements.
Swaps. Swaps are contracts in which two parties agree to exchange cash flows or financial instruments over a period of time. The most common type is an interest rate swap, where fixed-rate and floating-rate payments are exchanged to manage exposure to interest rate fluctuations. Swaps can also involve currencies, commodities, or other financial variables and are typically used for hedging or adjusting the structure of liabilities.
What is the Accounting for Derivatives?
A derivative is a financial instrument whose value changes in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. There are two key concepts in the accounting for derivatives. The first is that ongoing changes in the fair value of derivatives not used in hedging arrangements are generally recognized in earnings at once. The second is that ongoing changes in the fair value of derivatives and the hedged items with which they are paired may be parked in other comprehensive income for a period of time, thereby removing them from the basic earnings reported by a business.
The essential accounting for a derivative instrument is outlined in the following bullet points:
Initial recognition. When it is first acquired, recognize a derivative instrument in the balance sheet as an asset or liability at its fair value.
Subsequent recognition (hedging relationship). Recognize all subsequent changes in the fair value of the derivative (known as marked to market). If the instrument has been paired with a hedged item, then recognize these fair value changes in other comprehensive income.
Subsequent recognition (ineffective portion). Recognize all subsequent changes in the fair value of the derivative. If the instrument has been paired with a hedged item but the hedge is not effective, then recognize these fair value changes in earnings.
Subsequent recognition (speculation). Recognize in earnings all subsequent changes in the fair value of the derivative. Speculative activities imply that a derivative has not been paired with a hedged item.
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Additional Accounting Rules
The following additional rules apply to the accounting for derivative instruments when specific types of investments are being hedged:
Held-to-maturity investments. A held-to-maturity investment is a debt instrument for which there is a commitment to hold the investment until its maturity date. When such an investment is being hedged, there may be a change in the fair value of the paired forward contract or purchased option. If so, only recognize a loss in earnings when there is an other-than-temporary decline in the hedging instrument’s fair value.
Trading securities. A trading security can be either a debt or equity security, for which there is an intent to sell in the short term for a profit. When this investment is being hedged, recognize any changes in the fair value of the paired forward contract or purchased option in earnings.
Available-for-sale securities. An available-for-sale security is a security that does not fall into the held-to-maturity or trading classifications. When such an investment is being hedged, there may be a change in the fair value of the paired forward contract or purchased option. If so, only recognize a loss in earnings when there is an other-than-temporary decline in the hedging instrument’s fair value. If the change is temporary, record it in other comprehensive income.
Example of Derivative Accounting
Suture Corporation pays $1 million for an investment that is denominated in pounds. Suture’s treasurer enters into a hedging transaction that is also denominated in pounds, and which is designed to be a hedge of the investment. One year later, Suture experiences a loss of $12,000 on the investment and a $9,000 gain on the hedging instrument. The full $9,000 gain on the hedging instrument is considered effective, so only the difference between the investment and its hedge - $3,000 – is recorded as a loss in earnings.