Derivatives accounting is a set of accounting principles applied to certain business transactions. The principles primarily apply to items that are either embedded as part of a larger contract or financial instrument used for hedging activities. The rules that apply in derivatives accounting include changing fair value to match the market when designated as hedging exposure, recognizing variable cash flows from derivatives, and derivatives designated as hedging exposure for foreign currency. The purpose of derivatives accounting is to accurately value the item for financial reporting. Changing the fair value of derivatives may be a necessary gain or loss against earnings.
A fair value hedge occurs when a company designates derivatives that recognize changes in the fair value of an asset, liability, or firm commitment. Gains and losses from these derivatives must go against earnings in change periods and should offset with hedged items, meaning the company has properly or improperly mitigated the risk inherent in a business transaction. The result is that a company shows the extent of how a hedge made in a contract or financial instrument was ineffective in offsetting an item’s fair value. Companies typically want to offset gains and losses to have a zero net effect on earnings.
The second classification under derivatives accounting occurs when forecasting a variable cash flow. Companies must report the effective portion from the gains or losses associated with the derivatives. Gains or losses often go under other comprehensive income, keeping it outside of actual operating earnings. The company must reclassify gains and losses, however, when forecasted transactions actually affect earnings. The ineffective portion — the gain or the loss — must then go against earnings, similar to the first derivatives accounting scenario.
Foreign currency derivatives have a different accounting treatment. Gains or losses must go into a company’s comprehensive income account. This treatment is for a net investment in a foreign operation using foreign currency. Companies should treat these investments as unrecognized firm commitments, otherwise known as available-for-sale securities. Cash flow hedges in derivatives accounting must have a designation that places foreign currency exposure against others in foreign currency transactions.
Accounting for derivatives and the various hedging situations are difficult and complex processes. Companies should always seek outside for a professional accountant to ensure they follow all proper rules. Fair market value accounting rules are important in these transactions. Overstating the value of derivatives can lead to misstated financial statements. This leads to poor or ineffective decisions from internal or external stakeholders.