Derivative accounting is established in FASB Statement No.133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities, as amended by FAS 137, FAS 138, FAS 149 and FAS 155.  Upon issuing FAS 133, the FASB established the Derivatives Implementation Group (DIG) for the specific purpose of addressing the many implementation issues that arose. All of these standards have since been supeceded and replaced by The Accounting Standards Codification, primarily by ASC 815.

Derivative accounting can be broken down into two broad categories, hedge accounting and non-hedge accounting.  Hedge accounting deals with accounting for derivatives that are entered into as a hedging strategy.  These are generally intended to mitigate a market risk such as interest rate fluctuations, foreign exchange rates and commodity price movements. Hedge accounting is available under FAS 133 only if certain strict criteria are met at inception and, in some cases, through the life of the derivative instrument.The purpose of hedge accounting is to relate the gains and losses arising from changes in fair value of the derivative with the related gains and losses of the hedged transactions.  While the derivatives must be carried at fair value at any given reporting date, the gains and losses from changes in fair value may potentially be offset against the gains and losses arising from the hedged transaction thereby minimizing the overall impact of hedge and the hedged transaction on a company’s income statement.

Derivatives not qualifying for hedge accounting fall into the non-hedge accounting category. Any gains or losses arising from changes in fair value of the derivative must be fully reported in current income. Such changes in fair value may potentially have a significant impact on a company’s report income or loss. Derivatives captured by non-hedge accounting fall into one of two types, either freestanding derivatives or embedded derivatives.  Freestanding derivatives are instruments that in their entirety meet the definition of a derivative set forth in paragraph 6 of FAS 133. Embedded derivatives are features or provisions within a host contract that meet specific criteria, namely, 1) the feature or provision meets the FAS133 definition, 2) the feature or provision would be accounted for as a derivative were it freestanding and 3) the host contract is not a derivative in its entirety (i.e., a derivative can not contain embedded derivatives).  The specifics of non-hedge accounting applicable to freestanding and embedded derivatives is addressed in the Non-Hedge Accounting page.

Why You Should Care

Hedge accounting has the very desirable effect of mitigating the impact of market price fluctuations on the reported income of a company.  However, the ability to use hedge accounting is highly restricted in that specific criteria must be met at inception and throughout the contractual term of the derivative.  Meeting the qualifications must be documented in writing at the time the derivative is entered into (Note: Effective in 2015, new simplified rules are available for interest rate swap agreements).  This may not be done after the fact.  Additionally, continuous documentation of the effectiveness of the hedging strategy must be maintained.  Fail to meet the documentation requirements and hedge accounting is no longer an option.

Auditors are no longer permitted to assist their clients in the identification or proper accounting treatment of any transaction. Hedge accounting and non-hedge accounting are particularly complex technical areas.  Companies face potential internal control failures for improperly accounting for derivatives, a potentially critical problem for public companies which frequently must restate previously filed financial statements as a result.