Derivative accounting
/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.