Chapter 1 — Overview
Chapter 1 — Overview
1.1 Objective of Hedge Accounting
An entity is exposed to risks. The more complex its operations are,
the more risks it is exposed to. An entity that uses a commodity in its operations
is exposed to the risk that the commodity’s price will increase (i.e., commodity
price risk), which would increase its production costs. That same entity may fund
some of its operations by borrowing money under debt arrangements in which interest
rates are adjusted periodically (i.e., variable-rate debt). As a result, the entity
would also be exposed to the risk of higher interest rates on its debt (i.e.,
interest rate risk), which would increase its interest expense. If the entity has
global operations, it would also be exposed to changes in foreign currency exchange
rates.
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.
1.2 History of Hedge Accounting Guidance
Before the FASB’s issuance of Statement 133 in June 1998, the existing guidance on derivatives and hedging activities (provided first by the AICPA and later by the FASB) applied to specific transactions or groups of transactions. FASB Statement 133 established comprehensive accounting and reporting requirements for derivatives (as defined in the standard) and qualifying hedging activities. Derivatives within the scope of FASB Statement 133 were required to be (1) recognized on the balance sheet as assets or liabilities and (2) measured at fair value in each reporting period. FASB Statement 133 indicated that the accounting for
changes in a derivative’s fair value would depend on whether that derivative was
designated and qualified as the hedging instrument in a hedging relationship that
satisfied the criteria to qualify for hedge accounting and the accounting and
reporting requirements for such accounting.
Concurrently with the issuance of Statement 133, the FASB established the Derivatives Implementation Group (DIG) to help it develop guidance on matters associated with an entity’s implementation of FASB Statement 133. The DIG
did not vote on issues or reach consensuses; rather, the FASB chairman identified
resolutions on the basis of the discussions of each issue. The FASB staff then
documented tentative conclusions and made them available for public comment. Once
those conclusions were formally cleared by the Board, they became part of a FASB
staff implementation guide composed of DIG Issues. The DIG met bimonthly from
mid-1998 through March 2001.
In addition to addressing DIG Issues, the FASB issued several amendments to Statement 133, and the EITF deliberated some issues associated with
derivatives and hedging. When the FASB Accounting Standards Codification (the
“Codification”) was released in 2009, ASC 815 became the primary home of the
collective guidance.
In August 2017, the FASB issued ASU 2017-12, which amended the hedge
accounting recognition and presentation requirements in ASC 815. The Board’s
objectives in issuing the ASU were to (1) improve the transparency and
understandability of information conveyed to financial statement users about an
entity’s risk management activities by better aligning the entity’s financial
reporting for hedging relationships with those risk management activities and (2)
reduce the complexity of hedge accounting and simplify its application by
preparers.
ASU 2017-12 is now effective for all entities; see Section 7.2 for a summary of key changes to the
hedge accounting recognition and presentation requirements in ASC 815.
Industry groups, accounting firms, standard setters, and regulators
continue to discuss issues raised related to the implementation of ASU 2017-12. On
the basis of several meetings in 2018 and 2019 regarding these implementation
issues, the FASB posted certain interpretations on its Web site. In addition, in
April 2019, the FASB issued ASU 2019-04, which included amendments to ASC 815 related to
hedge accounting. ASU 2019-04 is now effective for all entities.
As discussed further in Chapter 8, the FASB also established a
reference rate reform project to address concerns about accounting consequences that
could result from the global markets’ anticipated transition away from LIBOR and
other interbank offered rates to alternative reference rates. The first phase of the
reference rate reform project resulted in the October 2018 issuance of
ASU
2018-16, which amended ASC 815 to add the “Secured Overnight
Financing Rate (SOFR) Overnight Index Swap (OIS) Rate” as a fifth U.S. benchmark
interest rate. ASU 2018-16 is now effective for all entities.
Further, in March 2020 the FASB issued ASU 2020-04, which added a new Codification
topic, ASC 848, to provide temporary, optional expedients related to contract
modification accounting and hedge accounting. In December 2022, the FASB issued
ASU 2022-06 to defer the sunset
date of ASC 848 until December 31, 2024. ASU 2022-06 became effective upon issuance
(see Section 8.2 for
more information about the ASU).
ASU 2017-12 added the “last-of-layer” method to ASC 815 (see
Section 3.2.1.4),
which enables an entity to apply fair value hedging to closed portfolios of
prepayable financial assets without having to consider prepayment risk or credit
risk when measuring those assets. In March 2022, the FASB issued ASU 2022-01, which expands the current
single-layer model to allow multiple-layer hedges of a single closed portfolio of
financial assets under this method. The last-of-layer method is renamed the
“portfolio layer method” to reflect this change. See Chapter 9 for further discussion of ASU
2022-01.
Changing Lanes
In addition to the ASUs discussed above, in November 2019,
the FASB issued a proposed ASU of Codification improvements to hedge
accounting. The proposed ASU considered the following potential improvements
to hedge accounting guidance in ASC 815:
- Change in hedged risk in a cash flow hedge.
- Designation of contractually specified components in cash flow hedges of nonfinancial forecasted transactions.
- Use of the term prepayable under the shortcut method.
- Use of foreign-currency-denominated debt instrument as hedging instrument and hedged item.
In June 2021, the Board issued an invitation to comment to request feedback on how to
refine its broader standard-setting agenda. On the basis of feedback
received, the FASB decided to include the following issues in the project scope:
- Application of shared risk assessment in cash flow hedges of loan portfolios.
- Use of net written options as hedging instruments.
The staff is currently working to respond to comments received from
stakeholders related to the 2019 proposed ASU and hopes to resolve the
issues during 2024.
See Appendix
A for a comparison of the hedge accounting guidance in U.S. GAAP with
that in IFRS Accounting Standards.
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.