1.1 Objective of Hedge Accounting

Some entities mitigate certain risks by entering into separate contracts that may meet the definition of a derivative instrument. For such circumstances, ASC 815 allows entities to use a specialized hedge accounting for qualified hedging relationships. For example, assume that Reprise manufactures tweezers and uses aluminum in its tweezer production process. To protect itself from a possible increase in the cost of the metal, Reprise may enter into financially settled futures contracts to purchase the aluminum. Because Reprise’s aluminum futures contracts are derivative contracts within the scope of ASC 815, the futures contracts are recognized on its balance sheet at fair value in each reporting period.

If hedge accounting is not applied, changes in the fair value of derivative instruments are recognized in earnings in each reporting period, which may or may not match the period in which the risks that are being hedged affect earnings. In the case of Reprise, if the price of aluminum were to increase, it would recognize gains related to the futures contracts in each reporting period over the contracts’ life. However, the cost of the aluminum needed in production would also increase and would be recognized as an increased cost of goods sold in the period in which the tweezers are ultimately sold. The objective of hedge accounting is to match the timing of the income statement recognition of the effects of the hedging instrument with the timing of the recognition of the hedged risk.

Not all derivatives will be designated as hedging instruments in qualifying hedging relationships under ASC 815. For example, an entity that owns shares of a publicly traded stock can economically hedge price changes in that stock by entering into financially settled options or forwards related to that stock. If both the hedging instrument (i.e., the derivative) and the hedged item (i.e., the stock) are recognized on the balance sheet at fair value, with changes in fair value recognized in earnings in each reporting period, no specialized accounting is needed to match the recognition of gains and losses on the derivative with the recognition of those on the stock investment. In addition, some derivatives may be entered into as economic hedges of risk but may not qualify for hedge accounting because they are related to an exposure that is not a qualifying hedge accounting exposure. Further, hedge accounting is optional, so some entities choose not to apply it to qualifying hedging relationships because they perceive that the costs of such accounting exceed its benefits. Derivatives that are used as economic hedges but are not designated in qualifying hedging relationships require special consideration for financial reporting purposes (see further discussion in Section 6.3.2). Finally, some derivatives are entered into for speculative purposes and are not part of a risk mitigation strategy.

Note that not all risk mitigation activities involve derivative instruments — for example, Reprise could have locked in its production costs by purchasing large quantities of aluminum in advance. In this case, once the aluminum inventory is acquired, there is no need for hedge accounting because the inventory is recorded at cost and there is no further income statement volatility associated with that portion of the production costs.

While the term hedging is sometimes used broadly to include any of the risk mitigation activities discussed above, this Roadmap focuses primarily on the application of hedge accounting, including the importance of the term’s usage in financial reporting (see Chapter 6). In most cases, hedge accounting involves the designation of a derivative as the hedging instrument and a hedged item that is (1) a recognized asset or liability that is not remeasured at fair value, (2) an unrecognized firm commitment, or (3) a forecasted transaction. For a comprehensive discussion of the identification, classification, measurement, and presentation and disclosure of derivative instruments, including embedded derivatives, see Deloitte’s Roadmap Derivatives.