Chapter 6 — Presentation and Disclosures

6.3 Income Statement

6.3.1 Qualifying Hedging Relationships

ASC 815-20

45-1A For qualifying fair value and cash flow hedges, an entity shall present both of the following in earnings in the same income statement line item that is used to present the earnings effect of the hedged item:

The change in the fair value of the hedging instrument that is included in the assessment of hedge effectiveness
Amounts excluded from the assessment of hedge effectiveness in accordance with paragraphs 815-20-25-83A through 25-83B.

See paragraphs 815-20-55-79W through 55-79AD for related implementation guidance.

As discussed in Section 3.1, gains and losses on the derivative and the hedged item that are attributable to the hedged risk in a qualifying fair value hedging relationship are recognized in earnings and presented in the same income statement line item, which should be related to the risk being hedged. As discussed in Section 4.1, changes in fair value attributable to components of the hedging instrument that are included in the assessment of hedge effectiveness in a qualifying cash flow hedging relationship are recorded in OCI. The changes in fair value that are recorded in OCI are reclassified from AOCI into earnings when the hedged item affects earnings and presented in earnings in the same line item as the earnings effect of the hedged item.

In accordance with ASC 815, if the results of a qualifying hedging relationship are recognized in earnings, they generally must be recognized in the income statement line item related to the risk being hedged. For example, an entity that is hedging interest payments on outstanding debt with an interest rate swap should recognize any related gains and losses in interest expense. There are a few exceptions to this rule, which are discussed in the next sections.

Chapters 3, 4, and 5 provide detailed examples, many of which illustrate the income statement classification of gains and losses related to qualifying hedging relationships.

6.3.1.1 Forecasted Transaction Will Probably Not Occur

ASC 815-20

45-1B For cash flow hedges in which the hedged forecasted transaction is probable of not occurring in accordance with paragraph 815-30-40-5, this Subtopic provides no guidance on the required income statement classification of amounts reclassified from accumulated other comprehensive income to earnings.

If the hedged item is a forecasted transaction and it becomes probable that the transaction will not occur within two months of the originally specified time period, amounts are generally reclassified out of AOCI (see Section 4.1.5.2). ASC 815 is silent on the income statement classification of such amounts in this circumstance. We believe that an entity should exercise judgment in deciding where to report amounts that are reclassified out of AOCI into earnings when it becomes probable that a forecasted transaction will not occur within two months of the originally specified time frame. The entity should disclose where such amounts are reported and consistently apply any policy that it develops. Even though the FASB decided not to require such amounts to be recognized in the same line item in which the earnings effect of the forecasted transaction would have been reported, entities are not precluded from deciding to do so.

6.3.1.2 Excluded Components of Net Investment Hedge

ASC 815-20

45-1C For qualifying net investment hedges, an entity shall present in the same income statement line item that is used to present the earnings effect of the hedged net investment those amounts reclassified from accumulated other comprehensive income to earnings. This Subtopic provides no guidance on the required income statement classification of amounts excluded from the assessment of effectiveness in net investment hedges.

As discussed in Section 5.4.2.1.1.1.2, ASC 815-35 is silent on the income statement classification of amounts related to excluded components of the derivative that are recognized in earnings in connection with a hedging relationship in which the spot method is used. We believe that the FASB intended to allow entities to continue the practice they had used before the issuance of Statement 133. In many cases, entities had viewed the “cost or income” of derivatives related to foreign currency hedging as a financing cost, so they had recognized such amounts, whether positive or negative, in interest expense. For many entities, the decision to recognize such costs in interest expense was also driven by the fact that they may also have issued foreign-currency-denominated debt to finance the foreign operations. We believe that an entity should establish a reasonable, consistently applied income statement classification policy and disclose that policy in its financial statements.

6.3.1.3 Hedging on an After-Tax Basis

ASC 815-20-25-3(b)(2)(vi) allows an entity to hedge foreign currency risks on an after-tax basis. If an entity uses an after-tax hedging strategy for cash flow or net investment hedges, the portion of the gain or loss on the hedging instrument that exceeds the loss or gain, respectively, on the hedged item should be included as an offset to the related tax effects in the period in which such effects are recognized (see Section 5.1.3).

6.3.2 Economic Hedging

In an economic hedge, an entity enters into a derivative to manage a risk (e.g., interest rate, currency, credit, or commodity), but the relationship is not accounted for as a hedge under ASC 815. In such cases, either (1) the hedging relationship fails to meet the rigorous requirements for hedge accounting or (2) the hedging entity concludes that the costs of implementing hedge accounting outweigh the benefits and thus does not designate the derivative in a qualifying hedging relationship.

ASC 815 is silent on classification in the income statement of gains and losses related to derivatives that are not in qualifying hedging relationships. Consequently, there is diversity in practice regarding the presentation of such results.

In a speech at the 2003 AICPA Conference on Current SEC Developments, Gregory Faucette, a professional accounting fellow in the OCA, made extensive comments on the income statement classification of derivatives. Mr. Faucette addressed the following topics:

The classification of gains and losses on derivatives used in economic hedges in multiple income statement categories.
The inclusion of gains and losses on derivatives used in economic hedges in inappropriate financial statement captions.

With respect to the first topic, Mr. Faucette indicated that it would be inappropriate for an entity to present gains and losses on a nonhedging derivative under multiple captions in its income statement. For example, an entity should not classify separately the unrealized gains and losses on an economic derivative under the caption “risk management activities” while classifying realized gains and losses on the same derivative (e.g., periodic or final cash settlements) in a separate revenue or expense line item that may be associated with the underlying in the economic hedge. Mr. Faucette’s discussion echoed SEC staff comments made at the September 2003 AICPA SEC Regulations Committee’s joint meeting with the SEC staff. At that meeting, the staff cited the following examples:

If an insurance company purchases a derivative to economically hedge the benefits paid on equity-indexed annuity products, it should record the premium paid for the derivative, the mark-to-market adjustment, and any realized gain or loss in the same line item on the income statement, despite the fact that the derivative is an economic hedge.
If net interest expense or income (e.g., net cash payments) is periodically recognized for an interest rate swap that does not qualify for hedge accounting, it should be recorded in the same line item as any unrealized and realized gains or losses recognized for that instrument.

With respect to the second topic, at the 2003 AICPA Conference on Current SEC Developments, Mr. Faucette cited the following example of inappropriate income statement classification of the results of a derivative used as an economic hedge:

For example, a financial institution classifying in the provision for loan losses all changes in credit derivatives used as economic hedges would not seem appropriate given the importance of that line item to certain credit quality analyses.

The guidance from the SEC staff clearly addresses its views on an inappropriate classification of credit derivatives in the income statements of financial institutions. Also, it suggests that registrants should (1) carefully consider whether it is appropriate to classify the results of derivatives used as economic hedges in captions that are included in the determination of operating income and (2) document the justification for such classification.

Typically, the income statement consequences of derivatives used as economic hedges should be classified consistently with other gains and losses on financial instruments or in accordance with specialized industry practice, if any. Because many companies that are not financial institutions only incur such gains and losses infrequently, classification as other income or expense is common.

If a company classifies the income statement impact of derivatives used as economic hedges in captions that would be considered part of operating income, the factors to be considered include the following:

Is there a clear justification for the presentation that the company has chosen? Is there a clear relationship between the derivative activity and the other transactions classified in the same income statement caption?
Does the company have a documented policy for its income statement presentation and is that policy consistently followed?
Is it remote that the changes in the fair value or cash flows of the derivative could distort trends, especially in captions that are significant to users of the registrant’s financial statements?
Companies should consider significant timing differences between unrealized changes in the fair values of (1) the derivative used as an economic hedge and (2) the hedged item. For example, if cash flows on the derivative will not occur for a significant period, the unrealized changes in the derivative’s fair value easily might distort an income statement caption that includes current transactions that settle in a short period.
Has the company fully complied with the disclosure requirements of ASC 815-10-50?
Has the company considered the guidance in ASC 815-10-55-62 for physically settled derivative contracts that are not held for trading purposes?

See Section 7.3 of Deloitte’s Roadmap Derivatives for discussion of income statement geography for derivatives not held for hedging purposes (i.e., not in either qualifying hedges or economic hedges).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.