FASB 133: Accounting for Derivatives and Hedging

The Financial Accounting Standards Board (FASB) introduced Statement 133 in 1998 to create a comprehensive standard for how companies report derivative financial instruments. Before this, guidance was fragmented and applied to specific transactions rather than providing a universal framework. The core change mandated that all derivatives be recognized on the balance sheet as assets or liabilities, measured at their current fair value to increase transparency for investors.

The principles from FASB 133 were integrated into the FASB Accounting Standards Codification (ASC) as Topic 815, Derivatives and Hedging. Since then, ASC 815 has been updated to address implementation challenges and better align accounting with the economic reality of hedging strategies. A notable amendment, Accounting Standards Update (ASU) 2017-12, was issued to reduce the complexity of applying hedge accounting and expand the scope of eligible strategies.

Core Concepts of Derivative Accounting

Under ASC 815, a financial contract is considered a derivative if it has three specific characteristics. The first is that the contract has both an “underlying” and a “notional amount.” An underlying is a variable, such as an interest rate or commodity price, that causes the derivative’s value to change. The notional amount is a specified unit of measure, like a number of shares or currency units, that is multiplied by the underlying to determine the settlement amount.

The second characteristic is that the contract requires no initial net investment or a very small one compared to other contracts that would produce a similar response to market changes. This feature distinguishes derivatives from traditional assets. For instance, a stock option allows a party to gain exposure to a stock’s price movements with a much smaller initial investment than buying the stock outright.

The final feature is that the contract’s terms allow for “net settlement,” meaning it can be settled by a net payment of cash without delivering the actual asset. For example, a party to a futures contract for oil does not typically take physical delivery of the barrels. Instead, the contract is settled by paying or receiving the net difference between the contract price and the market price of oil at a specified date.

Hedge Accounting Designations

ASC 815 allows companies to use special accounting rules, known as hedge accounting, if a derivative is used to offset specific risks. This treatment links the timing of the gain or loss recognition on the derivative with the gain or loss on the item being hedged. To qualify, a company must formally designate the derivative into one of three hedge categories: a fair value hedge, a cash flow hedge, or a net investment hedge.

Fair Value Hedge

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. For example, a company holding fixed-rate debt is exposed to the risk that if interest rates fall, the fair value of its debt will increase. To hedge this, the company could enter into an interest rate swap to receive fixed-rate payments and pay variable-rate payments.

In a qualifying fair value hedge, the gain or loss on the hedging derivative is recognized immediately in current earnings. The offsetting loss or gain on the hedged item attributable to the hedged risk is also recognized in current earnings. This simultaneous recognition prevents the income statement volatility that would otherwise occur if only the derivative’s value change was reported.

Cash Flow Hedge

A cash flow hedge is designed to offset the risk of variability in future cash flows related to an asset, liability, or a forecasted transaction. For instance, a U.S. company expecting to purchase inventory from a European supplier is exposed to the risk that the euro will strengthen against the dollar, increasing the cash outflow.

The accounting for a cash flow hedge uses Other Comprehensive Income (OCI), a separate component of shareholder equity. The effective portion of the gain or loss on the hedging instrument is initially recorded in OCI and held there until the hedged transaction affects earnings. At that point, the amount is reclassified into the income statement to offset the transaction’s impact. Any ineffective portion of the derivative’s gain or loss is recognized immediately in earnings, often in a line item like “other income/expense.”

Net Investment Hedge

A net investment hedge is used by a parent company to hedge the foreign currency exposure of its ownership stake in a foreign subsidiary. When a U.S. parent has a subsidiary in the United Kingdom, the subsidiary’s financial statements are recorded in British pounds. Fluctuations in the GBP/USD exchange rate can create volatility in the parent company’s consolidated equity when the statements are translated.

The accounting for a net investment hedge is similar to that of a cash flow hedge. The gain or loss on the hedging instrument, such as a foreign-currency-denominated debt instrument, is recorded in OCI. This amount is included as part of the cumulative translation adjustment (CTA) within OCI, directly offsetting the translation gain or loss from the net investment in the foreign operation.

Requirements for Applying Hedge Accounting

A company must meet stringent requirements outlined in ASC 815 to use hedge accounting. The two primary requirements are formal documentation and the ongoing assessment of hedge effectiveness. Failure to meet these criteria at any point means the special accounting treatment must be discontinued.

Formal, contemporaneous documentation must be prepared at the inception of the hedging relationship. This documentation must identify the company’s risk management objective and strategy for the hedge. It must also specify the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and the method the company will use to assess the hedge’s effectiveness.

The hedge must also be highly effective. This assessment has two parts: a prospective evaluation and a retrospective one. At inception, the company must expect the hedge to be highly effective in offsetting the designated risk. Throughout the life of the hedge, the company must continue to assess its effectiveness on an ongoing basis, at least quarterly. If a hedge ceases to be highly effective, hedge accounting must be terminated from that point forward.

Financial Statement Presentation and Disclosure

ASC 815 also governs how derivatives and hedging activities are presented in financial statements and detailed in the notes. The standard mandates specific presentation for derivative assets and liabilities on the balance sheet and requires extensive disclosures.

On the balance sheet, derivative assets are included with other assets, and derivative liabilities are with other liabilities. Companies must present these instruments on a gross basis, but accounting rules permit them to be offset and presented as a single net amount if certain conditions are met, such as having a master netting arrangement with the counterparty.

Beyond the primary financial statements, companies must provide extensive footnote disclosures broken down into qualitative and quantitative information. Qualitative disclosures describe the company’s objectives and strategies for using derivatives, including the risks being managed. Quantitative disclosures provide specific data, often in tables, showing the fair values of derivative instruments and their location on the balance sheet, as well as the location and amount of gains and losses recognized in the financial statements.