There are two key concepts in the accounting for derivatives. The first is that ongoing changes in the fair value of derivatives not used in hedging arrangements are generally recognized in earnings at once. The second is that ongoing changes in the fair value of derivatives and the hedged items with which they are paired may be parked in other comprehensive income for a period of time, thereby removing them from the basic earnings reported by a business.
The essential accounting for a derivative instrument is outlined in the following bullet points:
- Initial recognition. When it is first acquired, recognize a derivative instrument in the balance sheet as an asset or liability at its fair value.
- Subsequent recognition (hedging relationship). Recognize all subsequent changes in the fair value of the derivative (known as marked to market). If the instrument has been paired with a hedged item, then recognize these fair value changes in other comprehensive income.
- Subsequent recognition (ineffective portion). Recognize all subsequent changes in the fair value of the derivative. If the instrument has been paired with a hedged item but the hedge is not effective, then recognize these fair value changes in earnings.
- Subsequent recognition (speculation). Recognize in earnings all subsequent changes in the fair value of the derivative. Speculative activities imply that a derivative has not been paired with a hedged item.
The following additional rules apply to the accounting for derivative instruments when specific types of investments are being hedged:
- Held-to-maturity investments. This is a debt instrument for which there is a commitment to hold the investment until its maturity date. When such an investment is being hedged, there may be a change in the fair value of the paired forward contract or purchased option. If so, only recognize a loss in earnings when there is an other-than-temporary decline in the hedging instrument’s fair value.
- Trading securities. This can be either a debt or equity security, for which there is an intent to sell in the short term for a profit. When this investment is being hedged, recognize any changes in the fair value of the paired forward contract or purchased option in earnings.
- Available-for-sale securities. This can be either a debt or equity security that does not fall into the held-to-maturity or trading classifications. When such an investment is being hedged, there may be a change in the fair value of the paired forward contract or purchased option. If so, only recognize a loss in earnings when there is an other-than-temporary decline in the hedging instrument’s fair value. If the change is temporary, record it in other comprehensive income.
