One of the most powerful risk mitigation tools for companies comes in the form of derivatives. A derivative is a separate contract or financial instrument with an underlying variable, a notional amount or payment provision, no net investment, and requires net settlement. Derivatives can be designed to hedge market price risk, interest rate risk, foreign exchange risk, or credit risk. ASC 815, Derivatives and Hedging, governs the accounting for derivatives and certain nonderivative instruments used as hedges. There are three types of hedges under ASC 815:

• Fair value hedges– hedges the exposures to fair value changes of a recognized asset or liability or unrecognized firm commitment
• Cash flow hedges– hedges exposure to variable cash flows of a recognized asset or liability or forecasted transaction
• Net investment hedges– hedges foreign currency exposure of a net investment in a foreign operation

All derivatives are reported at fair value and are recorded as either an asset or liability on the balance sheet depending on the contract. Cash flows hedges receive special treatment because the changes in fair value are recognized in other comprehensive income instead of earnings. This article specifically covers cash flow hedges.

Cash flow hedges

A cash flow hedge is designed to mitigate any variability in future cash flows of an asset, liability, or forecasted transaction. The variability in cash flows can be caused by changes in prices, costs, rates, or terms that are not fixed.

In theory, the cash flow hedge would completely offset the income statement variability in a hedged transaction. As such, the change in the fair value of the derivative in a cash flow hedge would be recorded within other comprehensive income. Subsequently, the cash flow hedge would be reclassified to earnings when the hedged transaction occurs (e.g., when a forecasted sale occurs).

Hedge accounting criteria

To qualify for hedge accounting, very specific criteria need to be met. This greatly limits the use of hedge accounting. The criteria are as follows:

• Hedged risk– the hedged risk must result in exposure to variability in fair value or cash flows that impact earnings.
• Hedged item– certain assets, liabilities, firm commitments, and forecasted transactions can be hedged. Examples include variable-interest-rate debt, foreign currency-denominated assets/liabilities, forecasted sales/purchases, or forecasted debt issuances. These transactions can be a single transaction or a group of individual transactions with the same risk exposure. The hedged item must be with a third party, except in the case of foreign currency hedges. Forecasted transactions are probable, but there does not need to be a firm commitment. Items excluded from hedge accounting include equity method investments, noncontrolling interests, equity investments in subsidiaries, business combinations, and equity transactions by the company (e.g., stock issuance, treasury stock, or dividends).
• Hedging instrument– generally, only a derivative instrument qualifies as a hedging instrument. The hedging instrument can be a freestanding derivative, a proportion of a freestanding derivative, or a combination of freestanding derivatives. Components of a compound derivative, intra-entity derivatives, and written options are excluded.
• High effectiveness– the hedge relationship must be “highly effective” in offsetting changes in cash flows or fair value of the hedged transaction during the period. To be “highly effective,” the hedging instrument should offset 80%-125% of the change in fair value or cash flows of the hedged item. To assess the effectiveness, the company must compare the changes in the hedging instrument’s fair value to the changes in cash flows or fair value of the hedged item. This effectiveness assessment must be performed at the hedge’s inception and for each reporting period. The initial effectiveness test at inception should be a quantitative analysis but can be delayed until the first quarterly hedge effectiveness assessment date (up to three months). The two most common quantitative effectiveness approaches are regression analysis and the dollar offset method. Thereafter, the effectiveness test must include a prospective assessment as well as a retrospective assessment, but the company can elect whether to use a quantitative or qualitative analysis on a go-forward basis.

Qualitative assessments include the shortcut method and the critical terms match method. The shortcut method is generally used for interest rate swaps that hedge interest rate risk in debt instruments and allows the company to assume the hedging instrument is perfectly effective. To use the shortcut method, very specific criteria need to be met, and all the terms of the swap need to mirror the debt instrument. The critical terms match method is applied to forward and future contracts that hedge risks other than interest rate risk. Under the critical terms match method, the terms of the hedging instrument match the designated risk of the hedged item. As long as the hedging instrument matures within 31 days of the forecasted transaction, the critical terms match method can still be used. The company must have a formal ongoing process for determining if the terms still match under the critical terms match method.

Certain items are excluded from the assessment of hedge effectiveness. This includes the time value of options or the discount or premium of a forward contract. These items are essentially the cost of entering into the hedging instrument. The company may elect to recognize these components in earnings through an amortization approach or a mark-to-market approach.

• Formal designation and documentation– At the hedge’s inception, formal documentation of the hedging relationship, the risk management objective, and the hedging strategy is required. Hedge accounting cannot be retroactively applied. The documentation must include the following:
  1. The hedging instrument
  2. The hedged item or transaction
  3. The nature of the risk being hedged
  4. The hedging relationship
  5. The method for performing the effectiveness test, both at inception and subsequently.
  6. For forecasted transactions, the date the transaction is expected to occur, the quantity of the forecasted items, the specific nature of the assets or liabilities, the current price of the forecasted transaction
  7. The specific hedged component in a forecasted purchase or sale of a nonfinancial asset
  8. The specific hedged rate for a variable-rate financial asset or liability

Private companies may be able to apply the simplified hedge accounting approach in certain cases. Also, private companies are not required to complete the formal designation and documentation at inception for hedges that do not qualify for the simplified hedge accounting approach.

Recognition and Measurement

The hedging instrument is recorded at fair value on the balance sheet (as either an asset or liability). Subsequent changes in the fair value of the entire instrument are recorded in other comprehensive income. Assuming the hedging relationship is highly effective, no hedge ineffectiveness needs to be recognized each period. The amounts recorded in other comprehensive income are reclassed into earnings when the underlying hedged item/transaction impacts earnings. The amounts reclassed should be recorded in the same line items as the hedged item/transaction impact. The items excluded from the effectiveness assessment are recognized in earnings either on an amortization basis or mark-to-market basis.

Discontinuance of hedging relationship

Hedge accounting may need to be discontinued due to a change in circumstances, the hedge no longer meets all the hedging criteria, or the company voluntarily de-designates the hedge. When hedge accounting is discontinued, but the hedging instrument still exists, any subsequent changes in fair value are recorded in income. Amounts recorded in other comprehensive income are not reclassed to earnings unless it becomes probable that the forecasted transaction will not occur by the end of the original period or an additional two months after that.