ASC 815: Accounting for Derivatives and Hedging

Accounting Standards Codification (ASC) Topic 815 is the U.S. Generally Accepted Accounting Principles (GAAP) standard for derivatives and hedging activities. Issued by the Financial Accounting Standards Board (FASB), it establishes a standardized framework for how companies recognize, measure, and disclose these complex financial instruments. The guidance increases transparency in financial reporting, allowing investors and other stakeholders to better understand a company’s use of derivatives and its strategies for managing financial risks.

ASC 815 mandates that all derivative instruments are recorded on the balance sheet at their fair value, reflecting the rights and obligations associated with these contracts. This uniform approach prevents the wide variations in accounting that existed before its implementation and promotes consistency across different organizations.

Identifying a Derivative Instrument

To be classified as a derivative under ASC 815, a contract must exhibit three specific characteristics.

• The instrument’s value is derived from an underlying variable in conjunction with a notional amount or a payment provision. An underlying can be a specified interest rate, security price, or commodity price, while a notional amount is a number of currency units or shares specified in the contract.
• The contract requires no initial net investment or a smaller initial net investment than would be required for other types of contracts expected to have a similar response to changes in market factors. Many derivative contracts, such as interest rate swaps, require no upfront payment.
• The contract’s terms require or permit net settlement. This means the contract can be settled by a net payment of cash or another asset, or if it provides for delivery of an asset that is readily convertible to cash.

A significant exception to this definition is the Normal Purchases and Normal Sales (NPNS) scope exception. This allows a company to avoid derivative accounting for certain contracts to buy or sell non-financial items, like commodities, if the contract is for quantities expected to be used or sold by the company in the normal course of business. To qualify, the contract must be for the physical delivery of the goods, and the company must have a practice of settling such contracts by taking delivery.

Accounting for Non-Hedge Derivatives

When a financial instrument meets the definition of a derivative but is not designated as part of a formal hedging relationship, its accounting is straightforward. These non-hedge derivatives must be recognized on the balance sheet as either assets or liabilities at their fair value. All changes in the derivative’s fair value from one reporting period to the next are recognized immediately in current earnings.

This means any gains or losses from market value fluctuations will directly impact the company’s net income for that period. For companies that use derivatives for speculative purposes or for economic hedges that do not qualify for special hedge accounting, this treatment can lead to significant fluctuations in reported earnings.

Applying Hedge Accounting

Fair Value Hedges

A fair value hedge is used to protect against changes in the fair value of a recognized asset or liability, or an unrecognized firm commitment. Common examples include using an interest rate swap to hedge the fair value of fixed-rate debt. The accounting for a fair value hedge is designed to create a matching effect in the income statement.

The gain or loss on the hedging instrument is recognized in current earnings, and the offsetting loss or gain on the hedged item attributable to the hedged risk is also recognized in current earnings. For instance, if a company hedges fixed-rate debt, the debt’s carrying value is adjusted each period, minimizing the net impact on earnings.

Cash Flow Hedges

A cash flow hedge is designed to offset the risk of variability in expected future cash flows. These hedges are used for forecasted transactions, such as the anticipated purchase of raw materials or the expected sale of goods in a foreign currency. The accounting for a cash flow hedge differs significantly from a fair value hedge.

The effective portion of the gain or loss on the hedging derivative is initially recorded in Other Comprehensive Income (OCI), a separate component of shareholders’ equity. This amount is deferred in OCI and is only reclassified into earnings in the same period the hedged forecasted transaction affects earnings. For example, gains on a forward contract hedging a future foreign currency sale are held in OCI until the sale occurs, at which point the amount is released to the income statement to offset the impact of the currency rate on revenue. Any ineffective portion of the hedge’s gain or loss is recognized immediately in earnings.

Net Investment Hedges

A net investment hedge is used to manage the foreign currency exposure of a company’s net investment in a foreign operation. When a U.S. parent company has a subsidiary with a different functional currency, the consolidated financial statements are exposed to risk from exchange rate fluctuations. The accounting for a net investment hedge is similar to that of a cash flow hedge.

The gain or loss on the hedging instrument, which can be a derivative or a non-derivative instrument like foreign currency-denominated debt, is reported in OCI. This gain or loss directly offsets the translation gains or losses arising from the foreign operation itself. The amounts remain in OCI until the foreign operation is sold or substantially liquidated, at which point they are reclassified to the income statement.

Required Documentation and Disclosures

Formal Documentation

To qualify for hedge accounting, an entity must prepare formal documentation at the inception of the hedging relationship. This documentation is a prerequisite and must clearly identify the specific hedging instrument and the hedged item or transaction. It must also articulate the entity’s risk management objective and strategy for undertaking the hedge.

The documentation must specify the nature of the risk being hedged, such as interest rate risk or foreign currency risk. Furthermore, it must detail the method the company will use to assess the hedge’s effectiveness, and this assessment must be performed at the start of the hedge and on an ongoing basis.

Financial Statement Disclosures

Beyond initial documentation, ASC 815 mandates extensive disclosures in the footnotes to the financial statements. These disclosures are both qualitative and quantitative in nature. Qualitative disclosures describe the entity’s objectives and strategies for using derivative instruments, explaining why it enters into these contracts and what risks it is managing.

Quantitative disclosures provide specific data, requiring companies to disclose the location and fair values of derivative instruments on their balance sheets in a tabular format. Companies must also disclose the location and amounts of the gains and losses reported in the income statement and in OCI. These disclosures help analysts assess the effectiveness of the company’s hedging programs and their impact on earnings and equity.

Embedded Derivatives

An embedded derivative is a component within a larger, non-derivative host contract, such as a bond or a lease. ASC 815 requires companies to analyze contracts for such features, as they may need to be accounted for separately from the host contract through a process called bifurcation. Bifurcation is required if three criteria are met:

• The economic characteristics and risks of the embedded derivative are not “clearly and closely related” to those of the host contract. For example, an equity conversion option in a standard debt instrument would not be considered clearly and closely related.
• The hybrid instrument—the combined host contract and embedded derivative—is not remeasured at fair value with changes in fair value reported in earnings under other applicable GAAP.
• A separate, standalone instrument with the same terms as the embedded feature would meet the definition of a derivative.

If all three criteria are satisfied, the embedded derivative must be bifurcated and accounted for as a separate instrument. This means it is measured at fair value, with changes in fair value recognized in current earnings. The host contract is then accounted for based on the GAAP that would apply to it as if the embedded derivative never existed.