1.3 Overview of Three Hedge Accounting Models

ASC 815-20

35-1 Paragraph 815-10-35-2 states that the accounting for subsequent changes in the fair value (that is, gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, if so, on the reason for holding it. Specifically, subsequent gains and losses on derivative instruments shall be accounted for as follows:

No hedging designation. Paragraph 815-10-35-2 requires that the gain or loss on a derivative instrument not designated as a hedging instrument be recognized currently in earnings.
Fair value hedge. The gain or loss on a derivative instrument designated and qualifying as a fair value hedging instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk shall be recognized currently in earnings in the same accounting period, as provided in paragraphs 815-25-35-1 through 35-6. If an entity excludes a portion of the hedging instrument from the assessment of hedge effectiveness in accordance with paragraph 815-20-25-82, the initial value of the excluded component shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument with any difference between the change in fair value of the excluded component and amounts recognized in earnings under that systematic and rational method recognized in other comprehensive income in accordance with paragraph 815-20-25-83A. An entity also may elect to recognize the excluded component of the gain or loss currently in earnings in accordance with paragraph 815-20-25-83B. The gain or loss on the hedging derivative or nonderivative instrument in a hedge of a foreign-currency-denominated firm commitment and the offsetting loss or gain on the hedged firm commitment shall be recognized currently in earnings in the same accounting period. The gain or loss on the hedging derivative instrument in a hedge of an available-for-sale debt security and the offsetting loss or gain on the hedged available-for-sale debt security shall be recognized currently in earnings in the same accounting period.
Cash flow hedge. The gain or loss on a derivative instrument designated and qualifying as a cash flow hedging instrument shall be reported as a component of other comprehensive income (outside earnings) and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings, as provided in paragraphs 815-30-35-3 and 815-30-35-38 through 35-41. If an entity excludes a portion of the hedging instrument from the assessment of hedge effectiveness in accordance with paragraph 815-20-25-82, the initial value of the excluded component shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument with any difference between the change in fair value of the excluded component and amounts recognized in earnings under that systematic and rational method recognized in other comprehensive income in accordance with paragraph 815-20-25-83A. An entity also may elect to recognize the excluded component of the gain or loss currently in earnings in accordance with paragraph 815-20-25-83B. The gain or loss on the hedging derivative instrument in a hedge of a forecasted foreign-currency-denominated transaction shall be reported as a component of other comprehensive income (outside earnings) and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings, as provided in paragraph 815-20-25-65.
Net investment hedge. The gain or loss on the hedging derivative or nonderivative hedging instrument in a hedge of a net investment in a foreign operation shall be reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment, as provided in paragraph 815-20-25-66. If an entity excludes a portion of the hedging instrument from the assessment of hedge effectiveness in accordance with paragraphs 815-35-35-5 through 35-5B, the initial value of the excluded component shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument. Any difference between the change in fair value of the excluded component and the amounts recognized in earnings under that systematic and rational method shall be recognized in the same manner as a translation adjustment (that is, reported in the cumulative translation adjustment section of other comprehensive income) in accordance with paragraph 815-35-35-5A. An entity also may elect to recognize the excluded component of the gain or loss currently in earnings in accordance with paragraph 815-35-35-5B.

ASC 815 provides three categories of hedge accounting, each with its own accounting and reporting requirements: (1) hedges of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment (fair value hedges), (2) hedges of the exposure to variable cash flows of an existing asset or liability or a forecasted transaction (cash flow hedges), and (3) hedges of the foreign currency exposure of a net investment in a foreign operation (net investment hedges).

1.3.1 Fair Value Hedges

As indicated in ASC 815-35-20, a fair value hedge is a “hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk.” To be eligible for designation as a hedged item, the exposure to changes in the fair value attributable to the hedged risk must have the potential to affect reported earnings. Examples of eligible hedged exposures may include fixed-interest-rate assets or liabilities, inventory on hand, foreign-currency-denominated assets or liabilities, a portion of a closed portfolio of prepayable financial assets (or one or more beneficial interests secured by a portfolio of prepayable financial instruments), or a fixed-price firm commitment.

Generally speaking, an entity with a fair value hedge that meets all of the hedging criteria in ASC 815 would record the change in the hedging instrument’s fair value in current-period earnings. It would also adjust the hedged item’s carrying amount by the amount of the change in the hedged item’s fair value that is attributable to the risk being hedged. The adjustment to the hedged item’s carrying amount would also be recorded in current-period earnings. For fair value hedges, both the change in the hedging instrument’s fair value and the change in the hedged item’s carrying amount are presented in the same income statement line item and should be related to the item and risk being hedged. As a result of applying hedge accounting in a qualifying fair value hedging relationship, an entity accelerates the income statement recognition of the impact of changes on the hedged item that are attributable to the hedged risk. Accordingly, the entity recognizes the changes in the same period as the changes in the derivative’s fair value.

Timing of Income Statement Impact — Effect of Hedge Accounting

See Chapter 3 for a more thorough discussion of fair value hedging.

1.3.2 Cash Flow Hedges

As indicated in ASC 815-30-20, a cash flow hedge is a “hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk.” To be eligible for designation as a hedged item in a cash flow hedge, the exposure to changes in the cash flows attributable to the hedged risk must have the potential to affect reported earnings. Examples of eligible hedged exposures may include variable-interest-rate assets or liabilities, foreign-currency-denominated assets or liabilities, forecasted purchases and sales, and forecasted issuances of debt. The objective of a cash flow hedge is to use a derivative to reduce or eliminate the variability of the cash flows related to a hedged item or transaction.

Generally speaking, an entity with a cash flow hedge that meets all of the hedging criteria of ASC 815 would record the change in the hedging instrument’s fair value in OCI. Amounts are reclassified out of AOCI into earnings as the hedged item affects earnings. Those amounts are also presented in the same income statement line item in which the earnings effect of the hedged item is presented. As a result of applying hedge accounting in a qualifying cash flow hedging relationship, an entity defers the income statement recognition of changes in the derivative’s fair value. Accordingly, the entity recognizes the changes in the same period in which the hedged item affects earnings.

Timing of Income Statement Impact — Effect of Hedge Accounting

See Chapter 4 for a more thorough discussion of cash flow hedging.

1.3.3 Net Investment Hedges

A net investment hedge is a hedge of the foreign currency exposure of a net investment in a foreign operation. Even though the translation of a net investment in a foreign operation is recognized as part of the currency translation adjustment in OCI, there is a potential earnings risk upon disposition of that investment in the foreign operation. Accordingly, the foreign currency exposure in a net investment in a foreign operation is a hedgeable risk.

Generally speaking, an entity with a net investment hedge that meets all of the hedging criteria of ASC 815 would record the change in the hedging instrument’s fair value in the CTA portion of OCI.

See Chapter 5 for a more thorough discussion of net investment hedging.

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