Accounting For Derivatives and Hedging Activities

The Financial Accounting
and Auditing Collection

Scott Showalter and Jan Williams, Editors
Accounting
for Derivatives
and Hedging
Activities
Frank J. Beil
www.businessexpertpress.com
Accounting for
Derivatives and
Hedging Activities
Accounting for
Derivatives and
Hedging Activities
Frank J. Beil
Accounting for Derivatives and Hedging Activities
Copyright Ó Business Expert Press, LLC, 2013.
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system, or transmitted in any form or by any
means—electronic, mechanical, photocopy, recording, or any other
except for brief quotations, not to exceed 400 words, without the
prior permission of the publisher.
First published in 2013 by

Business Expert Press, LLC
222 East 46th Street, New York, NY 10017
ISBN-13: 978-1-60649-590-2 (paperback)

ISBN-13: 978-1-60649-591-9 (e-book)
Business Expert Press Financial Accounting and Auditing collection
Collection ISSN: 2151-2795 (print)

Collection ISSN: 2151-2817 (electronic)
Cover and interior design by Exeter Premedia Services Private Ltd.,

Chennai, India
First edition: 2013
10 9 8 7 6 5 4 3 2 1
Printed in the United States of America.

Abstract
Derivatives, and derivatives used to hedge financial and operating func-
tions, are designed to allow managers of firms to manage effectively the
downside risk of their financial and operating strategies. They also can
be very useful tools that allow managers and executives to accurately
predict financial and operational performance and manage the invest-
ment communities’ “expectations” regarding overall firm performance.
Derivatives and hedges, however, if not properly designed in con-
junction with the firm’s risk management strategy, can be potentially
disastrous for the firm. The ongoing financial turmoil in markets can be
partially explained by company managers and executives not under-
standing the potential financial statement impact when derivative mar-
kets move in a particular direction for longer periods of time than
anticipated by firms.
This book is designed for managers and executives to be a compre-
hensive yet accessible resource for understanding the impact of derivative
and hedge accounting on a company’s reporting of financial statements.
The book’s primary purpose is to demystify derivatives and provide prac-
tical advice and counsel on how to use them to manage more effectively
the operational and financial risks to the firm. When used properly, deri-
vatives are an extremely effective tool that managers and executives can
use to reduce uncertainty regarding the future.
Keywords
derivatives, hedges, hedging, financial instruments, foreign currency,
hedge effectiveness, cash flows, fair value, forwards, options, futures,
swaps, interest rate derivatives
Contents
Examples Index ..................................................................................... ix
Chapter 1 Financial Reporting Implications..........................................1

Chapter 2 Hedge Criteria and Hedge Effectiveness.............................29
Chapter 3 Accounting for Fair Value Hedges......................................45
Chapter 4 Cash Flow Hedges..............................................................69
Chapter 5 Foreign Currency Hedges...................................................93
Chapter 6 Presentation and Disclosure..............................................121

Appendix 1 Scope Issues ...................................................................133
Appendix 2 Embedded Derivatives ...................................................139
Notes .................................................................................................145
Index .................................................................................................147
Examples Index
Chapter 1 Financial Reporting Implications......................................1
Fair Value Hedge of an Equipment Purchase
in Foreign Currency....................................................................16
Cash Flow Hedge of a Materials Purchase Using
a Futures Contract ......................................................................21
Illustrating Fair Value Measurements Using
an Interest Rate Swap..................................................................25
Chapter 2 Hedge Criteria and Hedge Effectiveness.........................29

Fair Value Hedge of a Commodity Using a Forward Contract .......31
Illustrating Dollar-Offset Analysis in Determining Effectiveness .....42
Chapter 3 Fair Value Hedges............................................................45

Fair Value Hedge of Fixed-rate Debt Using an Interest
Rate Swap—The Perfect Hedge ..................................................47
Fair Value Hedge of Commodity Inventory Using
Futures Contracts........................................................................55
Fair Value Hedge of a Firm Commitment Using
a Forward Contract .....................................................................62
Chapter 4 Cash Flow Hedges ...........................................................69

Illustration of Measuring Hedge Effectiveness
for a Cash Flow Hedge ...............................................................73
Cash Flow Hedge of Fixed-rate Debt using
an Interest Rate Swap..................................................................78
Cash Flow Hedge of a Forecasted Purchase Using
a Futures Contract ......................................................................83
Accounting for a Forecasted Transaction That Becomes
a Firm Commitment...................................................................88
x EXAMPLES INDEX
Chapter 5 Accounting for Foreign Currency Transactions

and Hedging Activities ......................................................................93
Accounting for Foreign Currency Transactions ...............................94
Forward Exchange Contract to Hedge a Firm Commitment
to Pay Foreign Currency ..........................................................101
Use of Foreign Currency Options to Hedge Forecasted
Foreign Sales .............................................................................107
Use of a Forward-Exchange Contract to Hedge a Net
Investment in a Foreign Subsidiary ...........................................114
CHAPTER 1
Financial Reporting
Implications
About This Chapter
Derivative instruments are very useful risk management tools that can be
used by companies to effectively manage the financial and operating risks
that all firms face in uncertain business environments. The deployment of
these financial instruments, when used properly, will allow managers to
more accurately predict their financial and operating performance and bet-
ter manage the investment communities “expectations” regarding overall
firm performance. Derivative instruments are very effective at hedging
price or market risk, interest rate risk, and foreign exchange risk.
Our focus in this chapter is to gain an understanding of the accounting
implications on the company’s financial statements when using derivatives
as hedging instruments as part of the company’s risk management strategy.
Throughout this chapter and the remaining chapters, we will focus on
managing the following risks: market price movements, interest rate move-
ments, foreign exchange movements, and credit quality. By gaining a clear
perspective of which risk we are managing (price, interest rate, foreign
exchange, credit), we will be better able to use derivatives to hedge away
a major share of our potential downside risk.
This book is written from the standpoint of operating and financial
managers using derivatives as part of an overall risk management strategy.
The book is not about using derivatives for speculative purposes as part of
an investment strategy. It is designed to be a practical guide to the tools and
techniques companies use as part of an overall risk management strategy.
2 ACCOUNTING FOR DERIVATIVES AND HEDGING ACTIVITIES
Accounting Mechanics
Accounting guidance for derivatives follows three fundamental principles.
1. Derivative instruments represent rights (assets) or obligations (liabil-

ities) that meet the definitions of assets—expected future cash inflows
or liabilities—expected future cash outflows and these assets and lia-
bilities are reported in the financial statements.
2. Fair value is the most relevant measure for financial instruments and
the only relevant measure of derivative instruments.
3. Special accounting for items designated as being hedged is provided
only for qualifying transactions. The most important criterion for
qualification for the special accounting treatment for hedging trans-
actions is for the derivative instrument to be highly effective in off-
setting fair value changes in the hedged item.
One of the complexities in recognizing a derivative instruments impact

on the financial statements is in identifying what constitutes a derivative in
accounting guidance. The accounting standard setter’s definition of a
derivative instrument essentially says that almost any financial transaction
could be considered a derivative. Their definition of a derivative is any
financial instrument that contains the following characteristics.1
1. The contract contains an underlying variable, interest rate index,

commodity price, exchange rate, or any other variable, including the
occurrence or nonoccurrence of a specified event. If the occurrence or
nonoccurrence of a specified event causes variability in the cash flows to
either party to the contract, then under this criterion we would poten-
tially have a derivative. The contract contains a notional amount or a
payment provision, or both, such as the fixed number of currency
units, shares, pounds, or any other unit specified in the contract. The
interaction between the underlying variable and the notional amount
determines the amount of settlement, and in some cases whether or
not settlement is required.
2. The contract contains no initial net investment or an initial net invest-
ment that is smaller than would be required of other types of contracts
FINANCIAL REPORTING IMPLICATIONS 3
that would be expected to have a similar response to changes in

market factors. For example, an option to purchase a share of com-
mon stock is valued at far less than purchasing the share at market
price.
3. The contract requires or permits net settlement, and can be readily set-
tled net by means outside the contract, for example trade out of the
option above prior to purchasing the underlying shares. Or, the con-
tract provides for delivery of an asset that puts the recipient in a posi-
tion not substantially different from net settlement, that is, taking
delivery of a commodity as a result of a futures contract or being able
to net settle the derivative instrument for cash.
The definition of a derivative instrument above needs to be applied

to every financial or commodity contract that the company enters into in
order to determine if the contract contains any embedded or freestand-
ing derivatives. (Appendix II covers embedded derivatives, the chapters
deal with what in accounting are called freestanding derivatives.) This
lack of clarity from the standard setters in their definition of what types
of financial instruments constitute a derivative instrument makes even
identifying whether or not you have a derivative difficult. In my view,
the two most important considerations in determining the presence of a
derivative in a financial contract are: (a) is there a mechanism contained
in the terms and conditions of the contract by which the cash flows
could vary on either side of the contract, and (b) are the cash flows to
be paid/received determined by multiplying the contractual mechanism
that changes the amount to be paid times the notional? (In Appendix I,
we will be delving much deeper into the types of financial contracts that
require derivative accounting and those contracts that are scoped out of
the accounting guidance.)
The following contracts will be used to illustrate the three-step pro-
cess above that companies need to apply in making the determination as
to whether or not their financial contracts constitute a freestanding
derivative contract. The chart also serves as an introduction to common
derivative instruments that companies use to hedge financial or opera-
tional risks.
4
Contract Underlying and notional component No or smaller initial net investment Permits/requires net settlement Derivative contract?
Interest rate swap Payment amount is based on the difference No amounts are exchanged that relate to The amount paid to either party to the Yes
between the contractual rate and the current the principal (notional) amount contract is the difference between the
rate X notional amount for both the company amounts owed or due
and the counterparty
Forward contract to Value of the contract depends on the change Since the underlying price at inception It depends on whether or not the agricultural Yes, if a traded commodity
buy or sell an in price X quantity (notional). of the contract has not changed there commodity is a traded product. If that is the and no if could not be net
agricultural product would be no initial investment. case then, yes it would be readily convertible settled because of a lack of a
(bushels of wheat) to cash. If the commodity is not traded and market mechanism that
there is no way to net settle the contract, it could potentially turn the
would not be readily convertible to cash. commodity into cash.
Futures contract to Payment amount based on the difference The margin requirement for futures is Since futures markets are only traded on Yes
purchase a commodity between the contract price and the current collateral not an investment in the exchanges, even if physical delivery is made
price of the commodity X the notional contract the company would have the option to net
contractual amount settle.
Foreign currency swap Payment is based on the difference between Even when the parties to the contract The underlying currencies would normally be Generally yes
the stated exchange rate and the current exchange their respective currencies readily convertible to cash. If one of the
exchange rate X the notional amount for upfront, the net amount is the difference currencies is not exchangeable, then this
each party to the contract between the assets exchanged, not the condition not met.
notional amount.
Option on a public Contract value is the difference between the Even if the option when purchased is in Even if contractual would require settlement Yes
company stock price stated in the contract (exercise price) the money it would offer a much larger in shares, since publicly traded be readily
and the market price X number of shares potential return. (Smaller than convertible to cash
ACCOUNTING FOR DERIVATIVES AND HEDGING ACTIVITIES
(notional). purchasing the underlying equity

securities.
Common Types of Derivative Instruments

Accounting for derivatives guidance is one of the most complex accounting
standards ever written by the Financial Accounting Standards Board
(FASB). There are literally thousands of possible derivative instruments
and hedging strategies that companies could employ to manage their finan-
cial and operating risk. (Risk is being defined as “the probability of an
uncertain outcome.”) Investment banks and commercial banks are in the
business of responding to their client needs to manage operating and finan-
cial risks. Since most firms have unique needs in managing their business
and financial risks, banks will tailor a risk-management strategy around a
company’s specific needs. This translates to new derivatives being
“invented” almost every day. For our purposes, in order for your compa-
nies to better understand the economic impact of derivative instruments
and its related hedge accounting on the financial statements, this book will
concentrate on the most common types of derivative instruments used in
practice by companies. The four derivative transactions that are most use-
ful to companies in deploying their risk management strategies are:
. Swaps, including
Interest rate swaps
Foreign exchange swaps
Pricing interest rate swaps
. Forward Contracts
. Futures Contracts
. Option Contracts
These contracts will be explained in the following sections and exam-

ples will be used to illustrate the mathematical mechanics of each of these
contractual arrangements.
Swaps
A swap is a contractual agreement in which two parties agree to swap

(exchange) a series of cash flows at prearranged intervals for a specified
period of time. The payments to be paid or received are calculated by apply-
ing an agreed-upon formula (normally a benchmark interest rate) on an
agreed-upon principal amount. Because the principal is used only to
calculate the agreed-upon cash flows to be transferred between the parties,

the principal amount for derivative contracts is called the notional. Swaps
are constructed to exchange between the parties to the contract the cash
flows generated by the existing financial contracts. Given the broad defini-
tion of a swap, any financial contract with cash flows attached can be
swapped. The only requirement is that each party to the contract feels they
are better off when engaging in the swap than they would be by not entering
into a swap transaction. The movement of the underlying benchmark inter-
est (in the United States there are only two benchmark interest rates: the
London Interbank Offer Rate (LIBOR) or the prime rate for credit-worthy
customer rate over the term of the swap when multiplied times the notional
(principal) amount agreed to by each party to the swap agreement will place
one party in a net pay position and the other parties in a net receive position
for the contractual cash flows depending upon the movement of the bench-
mark interest rate (Recently, accounting guidance was changed to allow
companies to use the Federal Forward Funds Rate instead of LIBOR.). To
simplify accounting, the only cash transferred to either party in a swap is the
amount of the net pay computed for each reporting period of the swap.
(Accounting guidance requires a derivative instrument be marked to market
every three months or on each financial reporting date.)
An interest rate swap is a contractual agreement between parties in
which each party agrees to make periodic interest payments to the other
party for the term of the derivative arrangement. The payments by each
party to the contract are determined by the agreed-upon notional and an
agreed-upon interest rate, based on a benchmark rate. To facilitate interest
rate swaps between parties, the benchmark rate is usually adjusted adding
percentage points of interest to the benchmark rate.
The most common type of interest rate swap is when the company has
fixed rate debt in the balance sheet (fixed rate payments of interest) and
wishes to exchange it for variable (floating) rate debt payments. In this case,
the company pays fixed rate interest payments and receives variable rate
interest payments from the counterparty. This swap is called a “plain
vanilla” interest rate swap. The swap of interest payments will alter the
amounts appearing on the financial statements for each party to the deriv-
ative arrangement due to the movement of the variable rate debt payments.
To simplify the payments between the parties, only the net payment is
made to the party that owes the other party after netting out fixed rate
payments and variable rate payments. On a pay fixed, receive variable swap
arrangement, if the variable rate is greater than the fixed rate for the report-
ing period under measurement, then the receive variable would get the net
amount of variable rate times the notional over the fixed rate paid.
Manufacturers and retailers can typically access variable rate debt mar-
kets more cheaply than accessing fixed income markets. However, their
financing needs would generally demand fixed rate funding, because that
is what financial institutions prefer. On the other hand, financial institu-
tions may prefer variable rate funding and have access to low-cost fixed rate
funds. By combining each party’s relative advantage, each party to an inter-
est rate swap can accomplish its objective to have access to funds at a lower
rate than either could achieve on its own.
Interest rate swaps are the most common swaps used by companies to
manage their risk exposure to changing interest rates. The primary issue to
resolve when contemplating this type of swap is that the future variable
interest rates are unknown at the time of the swap. However, participants
in swaps markets possess a wealth of information, both historical and for-
ward looking for “benchmark” interest rates such as LIBOR and the U.S.
prime rate set by large money center banks that cover a wide range of
maturities. In the United States as well as in Europe and Asia, there are
deep and liquid markets for government and corporate bonds that are rated
based on their risk characteristics (generally based on their ability to pay the
debt when due).
Note: Accounting standards setters on July 17, 2013, approved use of the
Overnight Index Swap (OIS) in valuing interest rate derivatives in addition
to LIBOR and the Prime rate as benchmark interest rates. The OIS is called
the Federal Funds Effective Swap Rate (FFESR).
Armed with this information a company can construct a “forward yield

curve” representing the relationship between the debts yield to maturity
(YTM) and the time to maturity. The predicted cash flows of interest can
then be discounted in order to determine the Net Present Value (NPV) of
the cash flows paid or to be received. At the inception of the swap, the
present values of the fixed payments and the present value of the variable
payments will net out to zero because the underlying variable interest rates
for the transaction have not changed. Over the term of the swap, changes
in variable interest rates will cause one party to the swap to be a net payer or
a net receiver of cash.
The following example illustrates the mathematics and the economics
used for valuing an interest rate swap. Company borrows $10,000,000 from
a commercial bank. The debt is a three-year variable rate loan with interest
paid every six months based on LIBOR plus 1% (100 basis points). The
company was concerned with carrying variable rate debt because they
expected interest rates to rise. Commercial bank then proposed a swap that
would commit the company to pay a fixed interest of 9.75% on the
notional principle of $10,000,000. In return, the company would receive
a payment of LIBOR plus 1% on the same notional amount in order to
pay its variable rate debt on the variable rate debt from the bank. The
following analysis is a valuation of the interest rate swap from the perspec-
tive of the company. The company is trying to determine if they are “better
off” by entering into the swap transaction.2
For the variable rate loan the forecasted costs are:
Variable Rate Loan Payments
Forecasted Forecasted variable Forecasted
Time LIBOR (%) rate to be paid (%) payments ($)
Inception 8.00 9.00 450,000
6 months 8.50 9.50 475,000
12 months 9.00 10.00 500,000
18 months 9.25 10.25 512,500
24 months 9.40 10.40 520,000
30 months 8.50 9.50 475,000
Note: Forecasted LIBOR (derived from a yield curve supplied by commer-

cial bank) plus the agreed-upon additional 1% will equal the forecasted
variable rate to be paid. The forecasted payments column is the notional
amount of $10,000,000 times forecasted variable rate to be paid divided
by 2 (semiannual interest payments).
For the fixed rate payment on the swap to counterparty the calculation is
$10,000,000 9.75%/2 = $487,500. This amount will be the same at
every semiannual “payment” date.
Economic Value for Company to Enter the Swap
In the table, parentheses means the forecasted payments made to commer-

cial bank for the original debt are less than the fixed rate payments that the
company is theoretically making for the swap. (Only the net amount
would be paid to commercial bank or received from the bank for the swap
agreement.)
Also, the present value calculation is: net cash flows/1.075t.
Net Present Value of an Interest Rate Swap

Present value
Time Net cash flows ($) Discount rate (%) of cash flows ($)
Today (37,500) 9.75 (37,500)
6 months (12,500) 9.75 (11,931.85)
12 months 12,500 9.75 11,389.52
18 months 25,000 9.75 21,743.69
24 months 32,500 9.75 26,982.01
30 months (12,500) 9.75 (9,906.01)
Total 9.75 777.36
Since the swap value to the company has a positive net present value, the
company should enter into the swap.
Foreign exchange swaps allow companies to better manage foreign cur-
rency exchange risk. (Risk of the U.S. dollar strengthening or weakening
against the foreign-currency-denominated transaction.) For these types of
derivative instruments the main consideration is the exchange rate at which
the currencies will be swapped when entering into the swap and at the
settlement date of the swap. For example, a U.S. company has just signed
a contract with a French company to supply machinery. The U.S. com-
pany needs to purchase some additional inputs in France in order to com-
plete the machinery before shipping to your customer. The contractual
terms of the arrangement are that your company will not be receiving pay-
ment from the French company for 90 days after delivery. Your situation is
that you need euros now, but won’t be paid in euros for 90 days. A foreign
exchange swap can be set up so that you borrow euros now and pay them
back in 90 days. The payments would be based on a known currency swap
rate, say dollars to euros, and a known notional amount (amount needed to
purchase the additional inputs).
Forward Contracts
Forward contracts are arrangements between a buyer and seller (parties to

the contract) for delivery of a specified amount of a specific asset at a
specified future date. The party that is obligated to take delivery of the
specific asset (normally a commodity) takes the long position; the party
that sells the commodity asset is said to take the short position. The sep-
aration of the trade date and the delivery date allows the parties to the
contract to agree on quantities to be delivered and most importantly the
forward price. Instead of settling the contract at the spot price as of
the date of delivery of the commodity, the buyer (long position) locks in
the price of the asset. This has the effect of changing a variable price to a
fixed price for the buyer. Forward contracts are essentially customized
futures contracts. The next section contains detailed information on how
futures markets work and in particular the pricing mechanisms used to
value standardized commodity assets. The principal difference between
a forward contract and a futures contract is that futures contracts are
almost always swapped and the buyer (long position) does not take deliv-
ery of the commodity asset. In forward contracts, the buyer almost always
takes delivery of the commodity asset.
Futures Contracts
Futures contracts are actively traded on regulated exchanges in order to

produce a more accurate pricing mechanism for the commodity asset. The
contracts are standardized as to quantity and price. Their primary purpose
is to accommodate buyers and sellers who wish to lock in prices they will
pay or sell (receive) for a commodity asset. For example, a cereal company
has needs for 10,000,000 (notional amount) bushels of wheat to produce
its product. The company is fearful about rising prices and wishes to lock
in the price per bushel now for delivery in 90 days. The company then
purchases 10,000,000 bushels of wheat at the forward (future) price for
delivery in 90 days. Since this derivative transaction is done on an
exchange the company has to establish a margin account equal to 5%

(percentages may vary) of the notional times the future price. The margin
account on the exchange will record, on a daily basis, the status of the
value of the futures contract. If the value decreases by greater than 5%,
the party in the long position would be required to advance cash funds to
insure exchange liquidity. The margin account is closed out by the
exchange on settlement date and each party then, depending on their
position, pays or receives cash.
Option Contracts
An option contract gives its owner the right, but not the obligation, to
trade assets according to its contractual terms. Financial options are a
financial contract with a seller (called the writer of the option) and a buyer
(called the option holder). The seller has the right to receive an upfront
cash payment from the buyer. In return for cash paid, the option holder
has the right to require the writer of the option to perform under the con-
tract. The cash received by the writer from the holder is compensation for
any obligations the holder may be required to perform.
An option can be either a call option or a put option. A call option gives
the buyer the right to purchase an asset from the writer of the option at a
specified price over a specified period of time. If the price movements are
not favorable for the holder of the option, then they would let the option
expire. A put option gives the holder of the option the right to sell an asset
to the writer of the option at a specified price over a specified period of
time. There are also differences between American options and European
options. American options can be exercised at any time by the holder over
the specified term. European options are exercised on the last day of the
period of time specified in the contract.
The valuation of options is based on the Black Sholes Merton (BSM)
model. Any Excel-based software will allow you to determine the value of a
written option as of the date the option is written. Briefly, a call or put
option is in the money when the underlying asset that can be bought (call)
or sold (put) is greater than the original price of the option. The option
holder, theoretically, has no limit to the upside, and is protected on the
downside by the cost of purchasing the written option.
Option values are determined using a mathematical formula (Excel-

based software produces a value after you input the variables). The valua-
tion of the option is based on the interplay between the following variables.
Exercise (strike) price: Price at which the holder of the option can
acquire the underlying asset (for American options, exercise at any
time over the life of the option contract, and for European options,
at the end of the contractual term).
Current stock price: Value of a call or put option will depend on the
market price of the underlying asset when the option is written.
Maturity: The longer the contractual term of the option, the more
likely there could be large swings (in the money or out of the
money) in the value of the underlying asset
Interest rates: Options are valued generally at the risk-free rate over the
term of the contractual agreement with the holder
Volatility: This is the most important factor in determining option
valuation. This variable is a measure of how likely the underlying
asset will move in or out of money. The determination of option
value depends largely on a statistical measure (volatility) of how
much the price of the underlying asset can change in one year. For
example, let’s assume the underlying asset value is $40 and the asset
has experienced volatility of 30% for over the previous 12 months.
(Volatility is usually calculated over a 12-month period) Mathemat-
ically, this means that the underlying asset price has a 67% chance
of fluctuating in price from $52 to $38. (Calculation is just taking
the $40 30% and adding or subtracting the $12 to the $40). The
BSM model then takes this mathematical change in the price for
each trading day over the number of days contained in the options
contract. It is the principal driver of option valuation.
Hedge Accounting
Hedge accounting is a special accounting treatment for the hedged item,
existing asset or liability, firm commitment or expected future cash inflows
or outflows, and the derivative instrument (forward contracts, interest rate
swaps, etc.). Qualifying for the hedge designation allows the company to
manage its risk exposure by using changes in the fair value of the hedged
item that will likely offset the fair value adjustment (mark-to-market
accounting) that is required on the derivative instrument. The accounting
impact is to record the increase/decrease in the fair value of the hedged
item, which is offset by recording the increase/decrease in the derivative
instrument in the same reporting period.
The result of attaching a derivative to the hedged item is that compa-
nies that are actively managing their risk exposures may find it useful that
the derivative instrument’s and the hedged item’s changes in fair value are
both reflected in the financial statements in the same period under mea-
surement for reporting financial statement results. Because this accounting
treatment defers recognition of gains and losses on derivatives, there are
numerous restrictions at inception of the hedge and over the life of the
hedge in order for companies to qualify for this desired accounting treat-
ment. These criteria will receive detailed attention in Chapter 2 “Hedge
Criteria and Effectiveness.”
Accounting guidance allows for three types of hedges to be used in a
managing price (market) risk, interest rate risk, and foreign exchange risk.
The hedge types are:
Fair Value Hedges are hedges of an existing asset, liability, or firm commit-
ment. The fair value hedge is a hedge of an exposure to changes in fair
value of a particular risk of the hedged item. For example, to hedge price
(market) risk related to a commodity, a company may use futures contracts
to lock in the price. The effect of entering into a futures contract for the
commodity is to transform the fixed cash flows expected from the asset,
liability, or firm commitment into variable cash flows. A firm commitment
can be defined as follows.3
An agreement with an unrelated party, binding on both parties and

usually legally enforceable, with the following characteristics:
a. The agreement specifies all significant terms, including the quantity to

be exchanged, the fixed price, and the timing of the transaction. The
fixed price may be expressed as a specified amount of an entity’s func-
tional currency or of a foreign currency. It may also be expressed as a
specified interest rate or specified effective yield. The binding provisions
of an agreement are regarded to include those legal rights and obligations

codified in the laws to which such an agreement is subject. A price that
varies with the market price of the item that is the subject of the firm
commitment cannot qualify as a fixed price. For example, a price that is
specified in terms of ounces of gold would not be a fixed price if the
market price of the item to be purchased or sold under the firm com-
mitment varied with the price of gold.
b. The agreement includes a disincentive for nonperformance that is
sufficiently large to make performance probable. In the legal jurisdic-
tion that governs the agreement, the existence of statutory rights to
pursue remedies for default equivalent to the damages suffered by the
no defaulting party, in and of itself, represents a sufficiently large dis-
incentive for nonperformance to make performance probable for pur-
poses of applying the definition of a firm commitment.
Fair value hedges will be discussed extensively in Chapter 2 “Hedge

Criteria and Hedge Effectiveness,” Chapter 3 “Accounting for Fair Value
Hedges,” and Chapter 5 “Accounting for Foreign Currency Hedges.”
Cash Flow Hedges are hedges of the company’s exposure to the vari-
ability in expected future cash flows of recognized assets, liabilities, or
unrecognized forecasted transactions. Cash flow hedges fix the price
(amount) of what would normally be variable expected cash flows. Cash
flow hedges are used to hedge forecasted transactions. Forecasted transac-
tions are defined as
a transaction that is expected to occur for which there is no firm

commitment. Because no transaction or event has yet occurred and
the transaction or event when it occurs will be at the prevailing
market price, a forecasted transaction does not give an entity any
present rights to future benefits or a present obligation for future
sacrifices.4
Cash flow hedges will be discussed extensively in Chapter 2, Chapter 4,

and Chapter 5.
Hedges of net investments in foreign subsidiaries hedge the translation
(when a foreign company’s financial statements are combined with the
parent company’s financial statements) and transaction exposures due to

changes in foreign exchange rates. A hedge of the net investment in foreign
subsidiaries is essentially a hedge of the change in the foreign company’s
net assets (assets minus liabilities) due to changes in the foreign currency
against the U.S. dollar. This is the only hedge permitted in which the
underlying is not an existing asset, liability, firm commitment, or expected
cash flows to purchase or sell an asset or incur a liability. Net investment
hedges will be discussed extensively in Chapter 5.
Overview: Fair Value Hedge Accounting
A fair value hedge is used to turn fixed cash flows into variable cash flows.
For example, a company has fixed rate debt and wants to have variable rate
exposure for interest expense payments because it believes that interest
rates are trending downward. The company would use an interest rate
swap and receive variable rate payments from the counterparty. The com-
pany has now substituted its fixed payments to the debt holders for variable
payments from the counterparty since the variable rate payments are val-
ued by the market at each payment date at their fair value. The company
has locked in the amount of debt it would pay without incurring a loss on
the debt. (Variable rate debt for each reporting date is reported at fair
value.) This is the case because any gain or loss on the debt that needs to
be recorded is offset by the derivative (interest rate swap) recording an off-
setting gain or loss depending on the movement of interest rates. So, the
company has executed a fair value hedge of an existing liability and greatly
reduced income statement volatility for its interest payments.
The accounting treatment of a hedged transaction that is designated as
a fair value hedge is to use mark-to-market (fair value) accounting for the
derivative instrument with recognition of gain or loss in the income state-
ment when the derivative moves in or out of the money. (In the money
would be an asset and out of the money would be a liability.) For the
hedged item, the accounting treatment is to record changes in fair value
from inception of the hedge as gain or loss when the recognized asset, lia-
bility, or firm commitment moves in or out of the money. The recognized
asset, liability, or firm commitment moves in or out of the money (in the
money would represent a gain, while out of the money would represent a
liability) when on a reporting date it would cost more to purchase, for

example, inventory that has had a price increase, which would result in a
loss. This occurs because under derivative accounting the hedged item
(inventory) is assumed to be “purchased” on the reporting date. However,
the forward contract to purchase inventory would be in the money, and the
loss on inventory purchase would be offset by the gain on the derivative
instrument. The derivative instrument is in the money because it would
allow the company to exercise the derivative and purchase inventory at less
than its market price.
To illustrate the accounting and financial statement implications for a
fair value hedge, assume the following. The examples used in this chapter
are designed to demonstrate the core principles for a fair value and cash
flow hedge. When we get the respective chapter for fair value hedges, we
will add all the bells and whistles that can complicate accounting for hedg-
ing activities. Our purpose in this chapter is to understand the mathematics
and financial statement impacts in general of using hedge accounting as
part of your overall risk management strategy.
Fair Value Hedge of an Equipment Purchase in Foreign Currency
On, December 1, 20X1, a company enters into a contract with a foreign

supplier to purchase equipment (a firm commitment) at a fixed price
denominated in a foreign currency, of 200,000 Foreign Currencies (FCs).
Management believes the dollar ($) will weaken against the FC and decides
to enter into a contract to buy the FC forward contract by matching the
delivery date at a fixed price, which will lock in the exchange rate at today’s
exchange rate. The equipment will be delivered in 90 days and payment is
due on delivery. Payment date is February 28, 20X2. The company then
locks in the forward rate of FC 1.00 = $0.66.5
Additional Information:
Spot rates represent the dollar equivalences that are in effect for that day.
That is the price the company would pay to acquire the equipment on that
day. The forward rates represent the value of the derivative for the length of
time remaining until settlement. The spot and forward rate converge on
the settlement date. (Note: Foreign Currency derivatives and hedges will
be discussed extensively in Chapter 5.)
Note: Throughout the book, I will use the terms “in the money” and “out
of money” for both the derivative instrument (in this case, the forward
contract) which is valued using the change in forward rates from December
1, 20X1 to December 31, 20X1 (which is a reporting date) and from
December 31, X1 to February 28, 20X2, which is the settlement date and
the hedged item. The hedged item (firm commitment) is also valued using
the changing forward rates.
In the following table, the derivative instrument (forward contract) on

December 31, 20X1, goes in the money because you contracted at incep-
tion at FC 1 = $0.66 and you could close out the position at the reporting
date at FC 1 = $0.68 resulting in a gain of $4,000. (Notional of FC
200,000 times ($0.68 – $0.66). The offset account of the gain on hedge
is the asset account futures contract. The asset account represents that the
derivative instrument is in the money.
Now, let’s examine the firm commitment. Since we are also valuing the
firm commitment to purchase machinery at the forward rate, the mathemat-
ics works the same way. Accounting guidance assumes that I hypothetically
purchase the machinery on the reporting date and on the settlement date
using FC. The math is that we would hypothetically purchase the machinery
at FC 200,000 $0.68 = $136,000 which is $4,000 greater than the for-
ward price on December 31, X1 of FC 200,000 $0.66 = $132,000. The
hypothetical extra cash flow outlay to acquire the asset is recorded as a loss on
hedge with the balance sheet offset account a firm commitment liability.
The liability account for the hedged item represents the commitment to
purchase being out of money.
Spot and Forward Rates for the Forward Contract

Forward rates
Date Spot rates for 2/28/20X2
December 1, X1 FC 1.00 = $0.65 FC 1.00 = $0.66
December 31, X1 FC 1.00 = $0.66 FC 1.00 = $0.68
February 28, X2 FC 1.00 = $0.69 FC 1:00 = $0.69
Note: $ refers to U.S. dollars
Note: Spot rates and forward rates always converge on settlement date of
the hedged transaction.
The following illustrates the financial statement effects.
Assets = Liabilities + Stockholder’s equity

+ Gain on hedge
– Loss on hedge
December 1, 20X1: Company purchases the 90-day forward contract to

hedge its firm commitment to purchase machinery
No value of the forward contract at inception because the underlying var-

iable that values the derivative has not moved (forward price)
December 31, 20X1:

Company reports the
change in fair value
of the derivative
instrument and the
firm commitment
assets = Liabilities + Stockholder’s equity
+ Forward contract + Gain on Hedge
+ 4,000 + 4,000
Assets = Liabilities + Shareholder’s equity

+ Firm commitment – Loss on Hedge
+ 4,000 – 4,000
Note: The computation is $200,000 (.68 – .66) = $4,000. The fair

value comparison is forward to forward rates. The forward contract is
recorded as an asset and the firm commitment is recorded as a liability.
Together, they offset each other and produce no net effect on reported net
income. It is this pairing of the derivative instrument and the hedged item
and recording their respective changes in fair value that is distinctive to
accounting for derivatives.
The fair value hedge of the firm commitment on December 31, 20X1, is
considered out of the money (liability) when compared to the spot
exchange price on December 1, 20X1. The derivative instrument is, how-
ever, considered in the money (asset).The financial statement affects will
net to zero because the gain and loss are offset as well as the recording of an
asset and an equal liability.
February 28, 20X1: Record the fair value change of the derivative instru-
ment and the firm commitment and purchase the equipment

+ Forward contract + Gain on hedge
+ 2,000 + 2,000

+ Firm commitment – Loss on hedge
+ 2,000 – 2,000
To record the fair value of the firm commitment and the forward contract
and recognize gain or loss on the hedge. The computation is $200,000
(.68 – .69) = 2,000

+ Equipment – Firm commitment
+ 132,000 – 6,000
Contract liabilities
+ 138,000
To record the equipment purchase at the forward price on December 1,

X1 for settlement at February 28, X2 at FC 200,000 $0.66 =
$132,000 and to remove the firm commitment liability from the accounts
upon settlement and to record the contract liability at FC 200,000 $.69
= $138,000.

– Forward contract – Contract liabilities
– 6,000 – 138,000
– Cash
– 132,000

– Contract liabilities
– 138,000
To pay the contract liability of 138,000 after writing off the contractual
asset of 6,000 and paying cash of 132,000.
Note: The forward contract is in the money by $6,000. We settle the con-
tract and receive the $6,000. The firm commitment is out of the money by
$6,000. The company pays the $138,000 to acquire the machinery, but
writes-off the liability account (firm commitment) resulting in a recording
balance of the equipment of $132,000.
This is an effective illustration in demonstrating how hedge accounting

works. The company wanted to purchase equipment without bearing for-
eign exchange risk. By entering into a forward contract at inception of the
contract the company locks in FC 1.00 = $.66 200,000 assuring that the
equipment is recorded at that amount and the cash paid is equal to that
amount.
Overview of Cash Flow Hedges
A cash flow hedge is used to turn variable-expected payments into fixed

payments. To demonstrate a cash flow hedge, assume the company has
a variable rate debt, which exposes the company to interest rate risk if inter-
est rates on the payments rise. The company would use an interest rate
swap where the company pays a fixed rate on its interest payments to coun-
terparty and receives variable rate interest payments. The company would
be substituting the fixed rate paid to the counterparty for the floating rate
required to be paid to debt holders. (Cash flow hedges will be covered
extensively in Chapter 4)
A cash flow hedge is a hedge of a forecasted transaction that is likely to
occur in the future. Since the forecasted transaction has not occurred, the
accounting treatment in the financial statements is different because we are
not “attaching” the derivative to a recognized asset, liability, or firm commit-
ment. Instead, we are hedging the amount of cash to be paid or received on
the settlement date of the derivative instrument. While the derivative is
required to be recorded at fair value, there will be no offsetting entries to other
assets, liabilities, or firm commitments to offset the derivative instrument
changes in fair value form going in (asset) or out of the money (liability).
The accounting guidance for cash flow hedges, until settlement date,
calls for the use of a Shareholder’s Equity account called Other Compre-
hensive Income (OCI) as the offset account for the derivative instrument.
This accounting treatment for cash flow hedges has the hypothetical effect
of offsetting the asset or liability recording of the derivative instrument

with the opposite entry to shareholder’s equity using the OCI account.
This accounting treatment has the effect of rendering the financial state-
ment effect of the hedge as nearly offsetting on the balance sheet and no
effect on the income statement until the hedge is settled by the company.
Cash Flow Hedge by Using a Futures Contract to Hedge

a Raw Materials Purchase
For example, a company enters into a 90-day contract, on December 1,

20X1, to purchase raw materials by entering into a futures contract in
order to lock in the price of the raw materials at the inception of the hedged
transaction. The contract price is $8 per pound and the contract states we
will take delivery of 100,000 pounds on February 28, 20X2. The spot price
(the price we could purchase the raw materials inventory) is $7.80 on
December 31, 20X1, and $8.30 on February 28, 20X2. The financial
statement impact would be as follows.
On December 31, 20X1, we would recognize that the derivative instru-
ment is out of the money by ($7.80 – $8.00) 100,000 = $20,000). The
derivative is out of the money because we could purchase the raw materials
inventory at a market price that is less than the contract price.
On February 28, 20X2, we would recognize that the derivative instru-
ment is in the money by ($8.30 – $8.00) 100,000 = $30,000) and
purchase the materials at $8 a pound.
The financial statement effects for a cash flow hedge are illustrated
below.

+ OCI – Deferred gain
– OCI – Deferred loss
December 31, 20X1: Recognize the derivative at fair value (market price)

+ Contract liability – OCI
+ 20,000 – 20,000
Note that the liability amounts and the stockholder’s equity amounts offset
and net to -0-.
February 28, 20X1: Recognize the derivative at fair value and settle the cash
flow hedge.

+ Derivative Asset – Contract liabilities + OCI
+ 30,000 20,000 + 50,000
Note: The change in fair value of the derivative instrument is $8.30 –

$8.00, which is the price change December 31, 20X1, and February 28,
20X2. The recording of the now in-the-money derivative asset is at $30,000
in the company’s financial statements. However, since the derivative’s change
in fair value was $50,000 (from a liability of $20,000 to an asset of $30,000
are offset entry to OCI which is $50,000. This has the financial statement
effect of reporting the derivative asset at $30,000 with the offset to and a
balance of $30,000 in shareholder’s equity via the OCI account of $30,000.
Purchase Inventory at the Market (Spot) Price

+ Inventory
+ 830,000
– Cash
– 830,000
Note: Commodities are normally purchased at the spot price. We purchase

the inventory and pay cash.
Receive Cash for Derivative Being in the Money

+ Cash
+ 30,000
– Derivative asset
– 30,000
Note: We settle the derivative instrument and receive cash from the futures
market. Since this was a cash flow hedge, we protect our payment of cash
for inventory, by netting out the $830,000 paid for inventory with the
$30,000 received from settling the in-the-money derivative instrument.
Lock in at $8 per pound, successful.
Remove OCI Account from Stockholders,

Equity and Adjust Inventory

– Inventory – OCI
– 30,000 – 30,000
Note: The shareholder’s equity account remains on the balance sheet until
we settle the hedged transaction. Here is where the hedging transactions
“hedged item” comes into play. Since the arrangement was done to protect
the inventory purchase, we eliminate the OCI balance against the inven-
tory account. Also, note that when the inventory is sold, our recording of
cost of goods sold will be $30,000 less than it would be if we did not hedge.
Our objective in this hedge was to lock in the inventory price of $8.00 a
pound. The purchase of inventory at the market price of $8.30 per pound
was offset by the derivative instrument going in the money by $.30 per
pound. We receive the $30,000 cash from settling the contract, which
reduces our net cash flow cost of the inventory to $800,000. In addition,
we remove the OCI amount of $30,000 on the balance sheet by decreasing
inventory to $800,000. Mission accomplished.
Net investment hedges of foreign operations are designed to hedge the
company’s exposure to foreign exchange risk. For example, financial state-
ments of foreign-owned companies are translated into the reporting cur-
rency (U.S.$) as of the reporting date, say fiscal year-end. Since the
transactions that comprise the financial statements involve transactions
that occurred previously, they would be recorded at the exchange rate that
existed when those transactions were settled. The report date exchange will
be different than the amounts that were recorded during the year. This
exposes the company to exchange rate risk. Companies would hedge the
expected differences in exchange rates that occurred on settlement date and

exchange rates expected at fiscal year-end, to get a more favorable gain or
loss in their stockholders equity.
Accounting Measurements Used for Derivatives
Derivatives are required to be reported at fair value. Accounting guidance

defines fair value as “the price that would be received to sell the asset or
paid to transfer the liability in an orderly transaction between market par-
ticipants at the measurement date.”6 Accountants use a hierarchy of market
inputs to determine the appropriate fair value measurement to be used to
value the derivative.
The fair value hierarchy is as follows:
Level 1: Price Quantity, unadjusted; market inputs for identical

assets or liabilities (since derivative valuation until settlement can
fluctuate, this would generally not be an appropriate valuation
metric).
Level 2: Price Quantity, adjusted; market inputs for similar assets
and liabilities OR extrapolations of current market activity that is
expected to continue in the future. For example, forward and com-
modity yield curves can be constructed from historical data about
price movement or interest rate movements.
Level 3: Unobservable inputs that the company uses to proxy what it
believes market participants would use in valuing assets or liabili-
ties. For example, interest rate swaps are not traded on an exchange
that would then require that their valuation be a discounted cash
flow computation depending on the length of time of the swap and
the underlying benchmark interest rate used to value the derivative,
with an assumption as to the shape of the yield curve for the bench-
mark rate (i.e., predicting interest rate changes over the term of the
hedged transaction). This valuation technique is generally called
mark-to-model accounting.
When valuing derivatives, we generally use a mark-to-model meth-

odology in determining the financial statement effects when accounting
for derivative instruments and hedging activities. The accounting guid-

ance for derivatives requires the use of fair value measurements. Appli-
cation of fair value measurements will be used in the numerous
illustrations in the book for fair value, cash flow, and foreign currency
hedges. This approach to illustrating mark-to-model accounting (fair
value) by using specific hedging strategies to achieve the firms risk man-
agement strategy should be highly effective in demonstrating the fair
value techniques used in accounting for derivative instruments and
hedging activities.
To better illustrate the valuation concepts and demonstrate the
accounting for derivatives, we will walk through the computations for an
interest rate swap.
Fair Value Measurement for an Interest Rate Swap
On January 1, X1, a Finance Company enters into a 3-year receive-fixed,

pay-variable (floating) interest rate swap. The fixed rate is at 7% and the
notional is $10,000,000. The variable rate resets annually on 12/31 for the
next year’s rate. The company has $10,000,000 of debt on the balance
sheet that pays $7.5% to debt holders.7 You are given the following
information:
Rate of upcoming year Fair value Change in fair value

01/01/X1 7% — —
12/31/X1 6% 180,000 180,000
12/31/X2 5% 190,000 10,000
12/31/X3 — (190,000)
The fair values given above are calculated as the sum of the present value
of expected future cash flows. For example: ($10,000,000 (7%–6%)
2) / (1.06^2) = $180,000. Note that we assume at 12/31/X1 when the
variable rate resets to 6%, we assume it will stay at that rate for 20X2 and
20X3.
Since we assume in this example that the yield curve is flat meaning the
6% interest rate reset is used to value payments for X2 and X3, we would
have a level 3 measurement.
Financial Statement Template

+ Gain on swap
– Loss on swap
1/01/X1—Inception of the Swap
No accounting impact because the interest rate swap agreement is entered

into at market value.
12/31/X1—Mark the Swap to Fair Value

+ Interest rate swap + Gain on swap
+ 180,000 + 180,000
Fair value the swap at two payments of $100,000 discounted at 6%. The
computation is $10,000,000 (notional) (7%–6%). The swap goes in the
money because you are paying in year 2 and expected to pay in year 3,
$100,000 less in interest expense payments.
12–31/X1—Cash Receipt of the Swap and Record Interest Expense

@ 7.5%

+ Cash + Interest expense
+ 100,000 + 100,000

– Cash – Interest expense
– 750,000 750,000
The impact on the financial statements as of the end of the year for Finance
is to record the gain on the swap of $180,000 and then record the
cash payment received from the counterparty computed as $10,000,000
(7% – 6% = $100,000, which would be taken against the interest
expense recorded as $10,000,000 7.5%. (The entry above in Stock-
holder’s Equity is a reduction of the interest expense to be recorded by the
company.)
12/31/X2—Fair Value the Swap

+ Interest rate swap + Gain on swap
+ 10,000 + 10,000
Fair value the swap based on one remaining payment of $200,000 dis-
scounted at 5%. The change in fair value for the swap asset is now
$190,000.
12/31/X2—Cash Receipt of the Swap and Record Interest Expense

+ 200,000 + 200,000

– 750,000 750,000
Payment to be received is $10,000,000 (7% – 5%) = $200,000 from the

counterparty to the swap. Note that this has the effect of reducing net
interest expense by $200,000 due to the movement in interest rates. Also,
note the swap asset is now at $190,000.
12/31/X3—Fair Value the Swap

– Interest rate swap – Loss on swap
– 190,000 190,000
Remove interest rate swap asset from the Finance Company’s financial
statements. Since we were in the money on our interest payments the com-
pany would record a loss on swap to remove the asset from its records.
In this chapter, we have examined the foundational principles of
accounting for derivative instruments as well as the valuation of derivatives.
The following chapters will first start with exploring hedge effectiveness and
doing a deeper dive into fair value, cash flow, and foreign currency hedges.
CHAPTER 2
Hedge Criteria
and Effectiveness
About This Chapter
Hedge documentation is necessary at the inception of the hedged transac-
tion to qualify for the favorable accounting treatment allowed by account-
ing guidance for hedge transactions. The favorable treatment is that the
hedging gains and losses from the derivative instrument appear in the
income statement at the same time as fair value changes to the hedged item
are recorded in the financial statements. It is this symmetry of recording
offsetting gains or losses on the derivative instrument with gains or losses
from the hedged item (existing asset, liability, firm commitment, or fore-
casted cash flows that are probable of occurring) that makes hedge account-
ing attractive as a way to manage the volatility of the company’s financial
statements.
The documentation requirements are very detailed and if not followed
precisely will disqualify the financial transaction from qualifying for special
hedge accounting. This chapter will discuss the specific hedging documen-
tation requirements at inception of the hedge and calculating the ongoing
effectiveness of the hedge. The chapter will be organized as follows.
. Formal designation and documentation at inception

. Eligibility of hedged items and transactions
. Eligibility of hedging instruments
. Hedge effectiveness
Formal Designation and Documentation at Inception

Hedge documentation for all hedges, fair value, cash flow, or net invest-
ment in foreign operations is required at inception to document the
following.1
. Nature of the hedging relationship, including what is the hedging

instrument and what is the hedged item.
. Nature of the risk being hedged—includes market (price) risk,
interest rate risk, or foreign currency risk.
. The company’s risk management strategy, for example, hedge
inventory purchase price increases of a commodity, lock in sales
price of commodity, and converting a fixed rate financial instrument
to a floating (variable) rate.
. The method that will be used to retrospectively and prospectively
assess the hedging instrument’s effectiveness in offsetting the
exposure to changes in the hedged item’s fair value (if a fair value
hedge) or hedged transaction’s variability in cash flows (if a cash flow
hedge) is attributable to the hedged risk. There shall be a reasonable
basis for how the entity plans to assess the hedging instrument’s
effectiveness.
. The method used to measure hedge ineffectiveness.
Additional documentation for a fair value hedge of a firm commit-

ment is a description of a reasonable method for recognizing in earnings
the asset or liability representing the gain or loss on the hedged firm com-
mitment. For example, if the firm commitment was for the purchase
of equipment, then documentation of how the gain or loss will be depre-
ciated and charged to the income statement over the useful life of the
equipment.
Cash flow hedges of a forecasted transaction also require additional
documentation.
1. The date on or period within which the forecasted transaction is

expected to occur.
2. The specific nature of asset or liability involved (if any).
3. Either of the following:
a. The expected currency amount for hedges of foreign currency
exchange risk, that is, specification of the exact amount of foreign
currency being hedged
b. The quantity of the forecasted transaction for hedges of other
risks, that is, specification of the physical quantity—the number
HEDGE CRITERIA AND EFFECTIVENESS 31
of items or units of measure—encompassed by the hedged fore-

casted transaction.
4. The current price of a forecasted transaction shall be identified to
satisfy the criterion for offsetting cash flows.
5. The hedged forecasted transaction shall be described with sufficient
specificity so that when a transaction occurs, it is clear whether that
transaction is or is not the hedged transaction. Thus, a forecasted
transaction could be identified as the sale of either the first 15,000
units of a specific product sold during a specified three-month period
or the first 5,000 units of a specific product sold in each of the three
specific months, but it could not be identified as the sale of the last
15,000 units of that product sold during a three-month period
(because the last 15,000 units cannot be identified when they occur,
but only when the period has ended).
The following illustrates the formal hedge documentation require-

ments for a fair value hedge of a commodity using a forward contract.2
Jewelry is a manufacturer of gold rings and necklaces. On July 1,

20X1, Jewelry enters into a commitment to purchase 1,000 troy
ounces of gold on December 31, 20X1, in New York, at the cur-
rent forward rate of $310/troy ounce. Jewelry enters into the com-
mitment because its supplier requires a fixed-price contract.
However, it would prefer to pay the market price at the time of
delivery and record the gold inventory at whatever the market price
will be on December 31, 20X1.
Therefore, on July 1, 20X1, Jewelry enters into a six-month
forward contract to sell 1,000 troy ounces of gold on December
31, 20X1, in New York, at the current forward rate of $310/troy
ounce. Thus, the forward contract essentially unlocks the commit-
ment. The forward contract requires net cash settlement on
December 31, 20X1, and has a fair value of zero at inception. Jewelry
and the derivative counterparty are of comparable creditworthiness
and the initial CVA is negligible. Jewelry’s formal documentation of
the hedging relationship, prepared on the date the hedge is entered
into, is as follows:
Table 2.1. Formal Hedge Designation Documentation

Risk mana- The objective of the hedge is to protect the fair value of the firm
gement objec- commitment from changes in the market price of gold. Changes in the
tive and nature fair value of the forward contract are expected to be—highly effective in
of the risk offsetting changes in the overall fair value of the entire firm
being hedged. commitment.
Date of July 1, 20X1
designation
Hedging Forward contract to sell 1,000 troy ounces of gold in New York on
instrument December 31, 20X1, for $310/troy ounce.
Hedged item Firm commitment to buy 1,000 troy ounces of gold in New York on
December 31, 20X1, for $310/troy ounce. The firm commitment
qualifies for the normal purchase exception.
How hedge Hedge effectiveness (both prospective and retrospective) will be
effectiveness assessed based on a comparison of the overall changes in fair value of the
will forward contract (that is, based on changes in the December 31,
be assessed 20X1, forward price) and changes in the fair value of the firm
commitment to purchase gold (also based on changes in the New York
forward price), as expressed by a cumulative dollar-offset ratio. The
company will assess effectiveness based on changes in the forward price.
At inception, because the critical terms of the forward contract and
firm commitment coincide (such as dates, quantities, delivery location,
and underlying commodity), the company expects the hedge to be
highly effective against changes in the overall fair value of the firm
commitment. However, changes in the credit risk of both
counterparties in the fair value measurement of the forward contract
and of the hedger in the fair value measurement of the firm commitment
(the hedged item) will likely cause some ineffectiveness to the hedging
relationship that needs to be considered. The hedge meets the criteria
for a fair value hedge of a firm commitment.
How hedge Ineffectiveness will be measured on an ongoing basis by comparing the
ineffectiveness change in the fair value of the firm commitment and the change in the
will be fair value of the forward and any difference will be reflected in earnings
measured as ineffectiveness.
Eligibility of Hedged Items and Transactions

Fair Value Hedges
A company may designate a derivative instrument as hedging the exposure

to changes in the fair value of an asset or liability (market or price risk) or
an identified portion of the asset or liability. An asset or liability is eligible
for designation as hedged items in a fair value hedge of the following criteria
are met.3
1. The hedged item is specifically identified as either all or a specific

portion of a recognized asset or liability or of an unrecognized firm
commitment.
2. The hedged item is a single asset or liability (or a specific portion
thereof) or is a portfolio of similar assets or a portfolio of similar lia-
bilities (or a specific portion thereof), in which circumstance:
a. If similar assets or similar liabilities are aggregated and hedged as
a portfolio, the individual assets or individual liabilities shall
share the risk exposure for which they are designated as being
hedged. The change in fair value attributable to the hedged risk
for each individual item in a hedged portfolio shall be expected to
respond in a generally proportionate manner to the overall
change in fair value of the aggregate portfolio attributable to the
hedged risk.
b. If the hedged item is a specific portion of an asset or liability (or of
a portfolio of similar assets or a portfolio of similar liabilities), the
hedged item is one of the following:
i. A percentage of the entire asset or liability (or of the entire
portfolio). An entity shall not express the hedged item as mul-
tiple percentages of a recognized asset or liability and then ret-
roactively determine the hedged item based on an independent
matrix of those multiple percentages and the actual scenario
that occurred during the period for which hedge effectiveness
is being assessed.
ii. One or more selected contractual cash flows, including one or
more individual interest payments during a selected portion of
the term of a debt instrument (such as the portion of the asset
or liability representing the present value of the interest pay-
ments in the first two years of a four-year debt instrument).
iii. The residual value in a lessor’s net investment in a direct
financing or sales-type lease.
3. The hedged item presents an exposure to changes in fair value attrib-
utable to the hedged risk that could affect reported earnings. The
reference to affecting reported earnings does not apply to an entity
that does not report earnings as a separate caption in a statement of
financial performance, such as a not-for-profit entity (NFP).
4. If the hedged item is all or a portion of a debt security (or a portfolio

of similar debt securities) that is classified as held to maturity in
accordance with accounting guidance, the designated risk being
hedged is the risk of changes in its fair value attributable to credit risk
or foreign exchange risk, or both. If the hedged item is an option com-
ponent of a held-to-maturity security that permits its prepayment,
the designated risk being hedged is the risk of changes in the entire
fair value of that option component. If the hedged item is other than
an option component of a held-to-maturity security that permits its
prepayment, the designated hedged risk also shall not be the risk of
changes in its overall fair value.
5. If the hedged item is a nonfinancial asset or liability (other than a
recognized loan servicing right or a nonfinancial firm commitment
with financial components), the designated risk being hedged is the
risk of changes in the fair value of the entire hedged asset or liability
(reflecting its actual location if a physical asset).That is, the price risk
of a similar asset in a different location or of a major ingredient shall
not be the hedged risk. Thus, in hedging the exposure to changes in
the fair value of gasoline, an entity may not designate the risk of
changes in the price of crude oil as the risk being hedged for purposes
of determining effectiveness of the fair value hedge of gasoline.
6. If the hedged item is a financial asset or liability, a recognized loan
servicing right, or a nonfinancial firm commitment with financial
components, the designated risk being hedged is any of the
following:
a. The risk of changes in the overall fair value of the entire hedged
item.
b. The risk of changes in its fair value attributable to changes in the
designated benchmark interest rate (referred to as interest rate
risk).
c. The risk of changes in its fair value attributable to changes in the
related foreign currency exchange rates (referred to as foreign
exchange risk).
d. The risk of changes in its fair value attributable to both of the
following (referred to as credit risk):
i. Changes in the obligor’s creditworthiness.

ii. Changes in the spread over the benchmark interest rate with
respect to the hedged item’s credit sector at inception of the
hedge.
Cash Flow Hedges
A company may designate a derivative instrument as hedging the exposure

to variability in expected future cash flows that is attributable to a particular
risk. That exposure may be associated with either of the following:4
1. An existing recognized asset or liability (such as all or certain future

interest payments on variable-rate debt).
2. A forecasted transaction (such as a forecasted purchase or sale).
A forecasted transaction is eligible for designation as a hedged transac-

tion in a cash flow hedge if all of the following additional criteria are met:
a. The forecasted transaction is specifically identified as either of the

following:
i. A single transaction.
ii. A group of individual transactions that share the same risk exposure
for which they are designated as being hedged. A forecasted pur-
chase and a forecasted sale shall not both be included in the same
group of individual transactions that constitute the hedged
transaction.
b. The occurrence of the forecasted transaction is probable.
c. The forecasted transaction meets both of the following conditions:
i. It is a transaction with a party external to the reporting entity.
ii. It presents an exposure to variations in cash flows for the hedged risk
that could affect reported earnings.
d. The forecasted transaction is not the acquisition of an asset or incur-
rence of a liability that will subsequently be remeasured with changes
in fair value attributable to the hedged risk reported currently in
earnings.
e. If the forecasted transaction relates to a recognized asset or liability, the

asset or liability is not remeasured with changes in fair value attribut-
able to the hedged risk reported currently in earnings.
f. If the variable cash flows of the forecasted transaction relate to a debt
security that is classified as held to maturity under Topic 320 : the risk
being hedged is the risk of changes in its cash flows attributable to any
of the following risks:
i. Credit risk.
ii. Foreign exchange risk.
g. The forecasted transaction does not involve a business combination.
h. The forecasted transaction is not a transaction (such as a forecasted
purchase, sale, or dividend) involving either of the following:
i. A parent entity’s interests in consolidated subsidiaries.
ii. An entity’s own equity instruments.
i. If the hedged transaction is the forecasted purchase or sale of a nonfi-
nancial asset, the designated risk being hedged is either of the following:
i. The risk of changes in the functional-currency-equivalent cash flows
attributable to changes in the related foreign currency exchange
rates.
ii. The risk of changes in the cash flows relating to all changes in the
purchase price or sales price of the asset reflecting its actual location
if a physical asset (regardless of whether that price and the related
cash flows are stated in the entity’s functional currency or a foreign
currency), not the risk of changes in the cash flows relating to the
purchase or sale of a similar asset in a different location or of a major
ingredient. Thus, for example, in hedging the exposure to changes
in the cash flows relating to the purchase of its bronze bar inventory,
an entity may not designate the risk of changes in the cash flows
relating to purchasing the copper component in bronze as the
risk being hedged for purposes of assessing offset and hedge
effectiveness.
j. If the hedged transaction is the forecasted purchase or sale of a financial
asset or liability (or the interest payments on that financial asset or
liability) or the variable cash inflow or outflow of an existing financial
asset or liability, the designated risk being hedged is any of the
following:
i. The risk of overall changes in the hedged cash flows related to the
asset or liability, such as those relating to all changes in the purchase
price or sales price (regardless of whether that price and the related
cash flows are stated in the entity’s functional currency or a foreign
currency).
ii. The risk of changes in its cash flows attributable to changes in the
designated benchmark interest rate (referred to as interest rate risk).
iii. The risk of changes in the functional-currency-equivalent cash flows
attributable to changes in the related foreign currency exchange
rates (referred to as foreign exchange risk).
iv. The risk of changes in its cash flows attributable to all of the fol-
lowing (referred to as credit risk):
aa. Default.
bb. Changes in the obligor’s creditworthiness.
cc. Changes in the spread over the benchmark interest rate with
respect to the related financial asset’s or liability’s credit sector
at inception of the hedge.
Qualifying Cash Flow Hedges
A cash flow hedge involves forecasted transactions. In order to qualify, the

forecasted transaction has to have a reasonably high level of probability of
occurring. The following accounting guidance will assist your company in
making the determination if you have achieved the threshold guidance for
probable.
1. Effect of counterparty creditworthiness on probability. An entity

using a cash flow hedge shall assess the creditworthiness of the coun-
terparty to the hedged forecasted transaction in determining whether
the forecasted transaction is probable, particularly if the hedged
transaction involves payments pursuant to a contractual obligation
of the counterparty.
2. Probability of forecasted acquisition of a marketable security. To
qualify for cash flow hedge accounting for an option designated as
a hedge of the forecasted acquisition of a marketable security, an
entity must be able to establish at the inception of the hedging rela-
tionship that the acquisition of the marketable security is probable,
without regard to the means of acquiring it. In documenting the

hedging relationship, the entity shall specify the date on or period
within which the forecasted acquisition of the security will occur.
The evaluation of whether the forecasted acquisition of a marketable
security is probable of occurring shall be independent of the terms
and nature of the derivative instrument designated as the hedging
instrument. Specifically, in determining whether an option desig-
nated as a hedge of the forecasted acquisition of a marketable security
may qualify for cash flow hedge accounting, the probability of the
forecasted transaction being consummated shall be evaluated without
consideration of whether the option designated as the hedging instru-
ment has an intrinsic value other than zero.
3. Uncertainty of timing within a range. For forecasted transactions
whose timing involves some uncertainty within a range, that range
could be documented as the originally specified time period if the
hedged forecasted transaction is described with sufficient specificity
so that when a transaction occurs, it is clear whether that transaction
is or is not the hedged transaction. As long as it remains probable that
a forecasted transaction will occur by the end of the originally spec-
ified time period, cash flow hedge accounting for that hedging rela-
tionship would continue.
4. Importance of timing in both documentation and hedge effectiveness.
5. The term probable requires a significantly greater likelihood of occur-
rence than the phrase more likely than not.
6. The cash flow hedging model does not require that it be probable
that any variability in the hedged transaction will actually occur—
that is, in a cash flow hedge, the variability in future cash flows must
be a possibility, but not necessarily a probability. However, the hedg-
ing derivative must be highly effective in achieving offsetting cash
flows whenever that variability in future interest does occur.
Foreign Currency and Net Investment Hedge
Exposure to a foreign currency exists only in relation to a specific operating

unit’s designated currency cash flows. Therefore, exposure to foreign cur-
rency risk shall be assessed at the unit level. Unit level in this case means a
foreign operation that makes its operating and financing decisions based on
the local currency in the country or countries in which it operates. If that is
the case, then the reporting currency, say U.S.$ is the reporting currency
and the local currency is what is called the functional currency. The foreign
operating unit then has exposure to foreign currency risk (local currency
being converted to reporting currency) ($) if it enters into a transaction (or
has an exposure) denominated in the local currency that is different from
the company’s reported currency ($).
Due to accounting requirement for remeasurement of assets and liabil-
ities denominated in a foreign currency into the unit’s reporting currency,
changes in exchange rates for those currencies will give rise to exchange
gains or losses, which results in direct foreign currency exposure for the
unit. The functional currency concepts of translating a local (functional)
currency into a company’s reporting currency are relevant if the foreign
currency exposure being hedged relates to any of the following:5
1. An unrecognized foreign-currency-denominated firm commitment.

2. A recognized foreign-currency-denominated asset or liability.
3. A foreign-currency-denominated forecasted transaction.
4. The forecasted functional-currency-equivalent cash flows associated
with a recognized asset or liability.
5. A net investment in a foreign operation.
If the hedged item is denominated in a foreign currency, an entity may

designate any of the following types of hedges of foreign currency exposure:
1. A fair value hedge of an unrecognized firm commitment or a recog-

nized asset or liability (including an available-for-sale security).5
2. A cash flow hedge of any of the following:
a. A forecasted transaction.
b. An unrecognized firm commitment.
c. The forecasted functional-currency-equivalent cash flows associ-
ated with a recognized asset or liability.
d. A forecasted intra-entity transaction.
3. A hedge of a net investment in a foreign operation.
Accounting guidance that permits a recognized foreign-currency-

denominated asset or liability to be the hedged item in a fair value or cash
flow hedge of foreign currency exposure also pertains to a recognized
foreign-currency-denominated receivable or payable that results from a
hedged forecasted foreign-currency-denominated sale or purchase on
credit. Specifically, an entity may choose to designate either of the
following:6
1. A single cash flow hedge that encompasses the variability of functional

currency cash flows attributable to foreign exchange risk related to the
settlement of the foreign-currency-denominated receivable or payable
resulting from a forecasted sale or purchase on credit.
2. Both of the following separate hedges:
a. A cash flow hedge of the variability of functional currency cash
flows attributable to foreign exchange risk related to a forecasted
foreign-currency-denominated sale or purchase on credit.
b. A foreign currency fair value hedge of the resulting recognized
foreign-currency-denominated receivable or payable.
Assessing Hedge Effectiveness

In order for a company to qualify for the special accounting for hedges that
defers the gain on the derivative instrument and the hedged item so that
they are recorded on the financial statements in the same reporting period,
the derivative used must be “highly effective” in offsetting changes in fair
value or cash flows on the risk being hedged.7 The difficulty for companies
is that accounting standard setters do not define what is meant by highly
effective. Fortunately, accounting practice has developed meaningful guid-
ance to assist companies in qualifying for hedge accounting. High effec-
tiveness testing compares the change in the fair value of the derivative
instrument as scaled by the change in the fair value of the hedged item.
Accounting guidance has accepted that if the change in the fair value of the
derivative when compared to the change in the fair value of the hedged
item results in a ratio of between 80% and 125% then the hedge is deemed
highly effective at inception. This calculation would be computed at each
company reporting date to ensure continued high effectiveness. The hedge
effectiveness test always puts the change in the fair value of the derivative in
the numerator and the change in fair value of the hedged item always in the
denominator.
For example, assume we write a forward contract on inventory in order
to protect the company from price increases (market risk) when we need to
purchase the inventory. The value of the inventory is $100 at the time we
write the forward contract. Assume the inventory spot price increases to
$108 and the fair value change in the derivative is $10. Working the highly
effective test, we get $10/$8 = 125%. Now, let’s reverse the changes to the
derivative and the hedged item inventory. The inventory increases by
$10 and the fair value change in the derivative is $8. Now, the calculation
is $8/$10 = 80%.
Accounting guidance requires that the hedging instrument must be
highly effective both at the inception of the hedge and on an ongoing
basis over the life of the hedge. It further requires that effectiveness
tests be performed whenever financial statements or earnings are
reported, at least every three months. In addition, accounting guidance
requires that the hedge effectiveness assessments be done both prospec-
tively (inception of the hedging arrangement) and retrospectively (look
back over the life of the hedge in determining that the highly effective
criteria is met).
Companies can select the methodology used to measure hedge effec-
tiveness. The most common approach is to use the dollar-offset approach.
This approach measures the change in fair value of the derivative instru-
ment (fair value hedge) or changes in the present value of cash flows (cash
flow hedge) against the change in the fair value of the hedged item (fair
value hedge) or changes in the present value of cash flows of the hedged
item (cash flow hedge).
The dollar-offset method can be used in performing the prospective
and retrospective evaluation. The dollar-offset method is the only method
that can be used in recognizing hedge ineffectiveness in the income
statement. In addition to documenting the dollar-offset method as the
measurement device that will be used to determine hedging effectiveness;
companies must also choose whether effectiveness evaluation will be done
for each reporting period (discrete) or over the life of the derivative instru-
ment (cumulative).
The following example illustrates an application of the dollar-offset

analysis for determining hedge effectives at inception and subsequent to
inception. When reviewing the example, note the difference in qualifying
for hedge accounting between documenting at inception the measure
based on discrete or cumulative differences between the hedged item and
the hedging instrument.8
Companies can also use regression analysis in assessing hedge effective-
ness. Regression analysis is based on the mathematical equation Y = a + b(x).
In accounting for derivatives, the equation would translate to: Y being the
independent variable (derivative instrument) and X being the dependent
variable. We are trying to determine how much of the change in Y is
explained by the change in X, with b being the notional. For example,
let’s assume that Y is a futures contract to purchase inventory. Assuming that
b is equal to zero, and then X is the change in what it would cost the com-
pany to purchase inventory at the spot price on a reporting date. We would
take the notional (bushels of wheat) and multiply that by the spot price on
the reporting date. We would then compare that amount to the notional
times the forward rate on the reporting date and determine if the change in
Y (derivative instrument) is correlated closely to the change in spot rate
within the 80% to 120% in determining effectiveness However, since com-
panies must use dollar-offset analysis in making their accounting entries for
their financial statements that is the methodology that is employed through-
out this book. Companies that want to use regression analysis for hedge effec-
tives testing are advised to purchase a detailed book on statistical analysis.
Table 2.2. Assessing Hedge Effectiveness Table

Hedged Discrete Cumulative
End of Derivative* Change Item Change (%) (%)
Inception 0 0 0 0
Quart. 1 50 50 (50) (50) 100 100
Quart. 2 105 55 (107) (57) 96 98
Quart. 3 129 24 (120) (13) 185 108
Quart. 4 115 (14) (116) 4 350 99
*Represents either the change in the fair value or the change in the present value of the
expected future cash flows of the hedged item.
The Special Case of Interest Rate Swaps

Accounting guidance for interest rate swaps when determining effective-
ness of the derivative instrument in offsetting fair value changes to the debt
allows a company to assume perfect effectiveness provided:9
1. The notional amount of the swap matches the principal amount of

the interest-bearing debt.
2. The fair value of the swap at inception is zero.
3. The formula for computing net settlements under the interest-rate
swap is the same for each net settlement. This means that the fixed
rate is the same throughout the term of the swap and debt and the
variable rate is based on the same index (U.S. LIBOR) and includes
the same constant adjustment or no adjustment.
4. The interest-bearing debt is not prepayable. (This is the requirement
that is the most difficult to adhere to because holders of debt value
the prepayment option depending on the movement of interest rates
in capital markets.)
5. The expiration date of the swap matches the maturity date of the
interest-bearing debt.
6. There is no floor or ceiling on the variable interest rate of the swap.
7. The interval between repricings of the variable interest rate in the
swap is frequent enough to justify an assumption that the variable
payment is at a market rate. This requirement in practice has gener-
ally come to mean 3 to 6 months.
This effectiveness test assessment for interest-rate swaps is termed the

critical terms match. The use of this methodology for determining perfect
effectiveness for the derivative instrument and the hedged item can be used
for any hedging transaction at the inception of the hedge. In other words,
when the critical terms match with the derivative instrument and the
hedged item matches at inception of the hedge, the hedge would be
deemed highly effective. For other than interest rate swaps, however, it still
requires an effectiveness assessment over the life of the hedge.
The accounting rules for these initial and ongoing assessments are
listed below for fair value and cash flow hedges.10
If a fair value hedge or a cash flow hedge initially qualifies for hedge
accounting, the company would continue to assess whether the
hedge meets the effectiveness test and also would measure any inef-
fectiveness during the hedge period. If the hedge fails the effective-
ness test at any time (that is, if the entity does not expect the hedge
to be highly effective at achieving offsetting changes in fair values
or cash flows), the hedge ceases to qualify for hedge accounting. At
least quarterly, the hedging entity shall determine whether the
hedging relationship has been highly effective in having achieved
offsetting changes in fair value or cash flows through the date of the
periodic assessment. That assessment can be based on regression or
other statistical analysis of past changes in fair values or cash flows
as well as on other relevant information.
If an entity elects at the inception of a hedging relationship to
use the same regression analysis approach for both prospective con-
siderations and retrospective evaluations of assessing effectiveness,
then during the term of that hedging relationship both the follow-
ing conditions shall be met:
1. Those regression analysis calculations shall generally incorporate

the same number of data points.
2. That entity must periodically update its regression analysis (or
other statistical analysis).
Electing to use a regression or other statistical analysis approach

instead of a dollar-offset approach to perform retrospective evalua-
tions of assessing hedge effectiveness may affect the ability of an
entity to apply hedge accounting for the current assessment period.
CHAPTER 3
Accounting for Fair

Value Hedges
About This Chapter
Fair value hedges are used to hedge price risk on existing assets, liabilities,
and firm commitments. Companies that use a fair value hedge want to
manage the price risk of the change in fair value of the hedged item. Deriv-
ative instruments are useful in unlocking price risk due to the changing
market conditions that will impact the value of the existing asset, liability,
or firm commitment.
Accounting for fair value hedges results in recording in the financial
statements the fair value of the derivative instrument for each reporting
period and the changes in the fair value of the hedged item. These offset-
ting amounts, provided the hedge is highly effective, are recorded on the
balance sheet with the offset amounts being recorded in the income
statement.
Given the complexity of accounting for derivatives and to facilitate
understanding of the economic impacts on the company’s financial state-
ment, this chapter will include three comprehensive examples of fair value
hedges. These examples are designed to also illustrate the extensive docu-
mentation required for hedging activities as well as their impact on the
financial statements.
Accounting Mechanics
Accounting guidance requires that companies recognize in the income
statement for each reporting period (with the offset entry on the balance
sheet) the changes in fair value of the derivative instrument as they occur
for each reporting date (quarterly), as gains and losses from the derivative
instrument that are used to hedge price risk. In addition, changes in the fair
value of the existing asset, liability, or firm commitment are also recorded
in the income statement as an adjustment to the carrying amount of the
hedged item.
This adjustment of existing assets, liabilities, or a firm commitment
that are designated as the hedged item is one of the more dramatic features
of accounting for derivatives. Once a derivative is used to unlock the price
risk for the hedged item in a fair value hedge, then accounting guidance for
the hedged item is overridden and the changes in fair value are recorded in
the balance sheet and in the income statement. For example, a Company
wants to protect the carrying value of future purchases of inventory in
order to protect itself from decreasing gross margins (sales minus cost of
sales). The Company enters into a firm commitment to purchase inventory
in three months and simultaneously purchases a forward contract to pur-
chase inventory in three-months for the same notional amount as the firm
commitment at the three month forward price. If the forward price rises
above the amount of the forward contractual price, the derivative is in the
money and recorded as an asset with the offset being a gain on hedging.
For the firm commitment, since the fair value change would be to purchase
the inventory at the new forward price, the company would record a loss
on the firm commitment and record a liability.
These adjustments to the carrying value of the hedged item in a fair
value hedge must be accounted for as any other adjustment of the carrying
amount of an asset or liability. Using the aforementioned example, when
the inventory is acquired by the company, the firm commitment (which
could be an asset or a liability) would be included in the cost of the inven-
tory and in the company’s cost of sales computation similar to any other
adjustment to the cost of the inventory.
The remainder of the chapter explores the economics, accounting, and
documentation requirements for three common types of hedges. These
hedges will involve: (a) an interest rate swap in which we are “protecting”
the fair value of the existing debt, (b) using a futures contract to hedge the
fair value of an existing asset inventory, and (c) hedging a firm commit-
ment to purchase inventory by using forward contracts.
Because of the complexity of accounting for derivatives, the economic
and accounting impacts on a company’s financial statements are best
ACCOUNTING FOR FAIR VALUE HEDGES 47
understood by working systematically through comprehensive illustrations.

For our purposes, I have chosen the most common derivative instruments
(swaps, futures, and forward contracts) that are used to hedge an existing
asset, liability, or firm commitment. All of the illustrations follow a format
that allows for an examination for of each of the hedging transactions as a
fully developed example that will serve as a standalone document, for that
particular type of hedge. The format deployed for fair value hedges, cash
flow hedges (Chapter 4), and foreign currency hedges (Chapter 5) is as
follows:
1. Description of the hedge transaction, including the company’s risk

management strategy.
2. Narrative about the hedging transaction that includes all relevant
requirements for companies in adhering to the accounting guidance
rules for hedge documentation.
a. Risk Management Strategy
b. Hedging instrument
c. Hedged item
d. Assessing hedge effectiveness
3. Detailed accounting treatment of the hedge over the contractual term
on the company’s financial statements, including extensive explana-
tions of the both the mathematics as well as accounting.
4. Detailed tables of the financial statement impacts of the hedges over
the contractual term of the hedging arrangement.
Fair Value Hedge of Fixed-Rate Debt Using an Interest Rate Swap1
1. Description of the Hedge Transaction
On June 30, 20X1, a Manufacturing Company (Company) borrows

$10,000,000 of three-year 7.5% fixed-rate debt. The debt is due at matu-
rity and contains no prepayment option. Company, at the same time,
enters into a three-year interest rate swap with a Finance Company to con-
vert the debt’s fixed rate to a variable (or floating) rate.
Under the terms of the swap, the Company receives interest at a fixed
rate of 7.5% and agrees to pay interest at a variable rate equal to six-month
U.S. London Interbank Offer Rate (LIBOR), based on the notional
amount of $10,000,000. Both the debt and the swap require that pay-
ments be made or received on December 31 and June 30.
Note: For illustrative purposes, we will only account for the two
semiannual interest periods for this interest rate swap. For an inter-
est rate swap in which the critical terms match, accounting guid-
ance allows companies to treat the hedge as a perfect hedge. The
entries then for the remaining life of the swap will perfectly offset
in earnings.
The six-month U.S. LIBOR rate on each reset date determines

the variable portion of the interest rate swap for the following six-
month period. The Company designates the swap as a fair value hedge of
the fixed rate debt, with changes in fair value that are due to changes in the
benchmark rate which is U.S. LIBOR being the specific risk that is being
hedged.
2. Hedge Documentation

The objective of entering into the hedge is to protect the debt due
to changes in fair value due to changes in the benchmark interest
rate. Changes in the fair value of the swap are expected to be per-
fectly effective in offsetting changes in the fair value of the debt
attributable to changes in the U.S. LIBOR swap rate, the desig-
nated benchmark interest rate.
b. Hedging Instrument
$10,000,000 notional amount, receive fixed at 7.5% and pay var-
iable at U.S. LIBOR, dated June 30, 20X1, with semi annual pay-
ments due on December 31 and June 30 ending on June 30,
20X4.
c. Hedged Item
$10,000,000 three-year note payable on June 30, 20X4
d. Assessing Hedge Effectiveness

Because the critical terms of the hedging instrument and the
hedged item match (i.e., principal and notional, reset dates and
interest payment dates, and maturity of the note payable and of
the swap), the hedge will be considered to be perfectly effective
against changes in the fair value of the debt due to changes in the
benchmark interest rate (U.S. LIBOR) over its term. The hedge is
constructed as a perfect hedge, so there will be no need to assess the
ineffectiveness over the term of the hedge. (Accounting guidance
only allows no ongoing assessment of hedging effectiveness for
interest rate swaps in which the critical terms match between the
derivative instrument and the hedged item.)
Accounting guidance to qualify as a perfect hedge for an interest rate

swap requires that companies perform the following steps.1
. Determine the difference between the fixed rate to be received on

the swap and the fixed rate to be paid on the debt.
. Combine the difference with the variable rate to be paid on the
swap.
. Compute and recognize interest expense using the combined-rate
and fixed-rate debt’s principal amount. For the interest-rate swap
hedge above, the table would be as follows.
(Note: For illustration purposes, we will only use the December 30,
20X1 and the June 30, 20X2 interest payments.)
Table 3.1. Framework for Determining Interest Expense

(a) (b)
Difference Variable (c) Sum of (d) Debt’s (e) Semiannual
Semiannual between rate on the (a) + (b) principal interest expense
period ending fixed rates1 swap (%) (%) amount ($) (c) (d)/2 ($)
12/30/X1 0.00% 6.00 6.00 10,000,000 300,000
06/30/X2 0.00% 7.00 7.00 10,000,000 350,000
1
Note for (a) the computation is 7.5% on debt on notes payable and 7.50% on receive fixed from
counterparty.
. Determine the fair value of the interest rate swap.
Table 3.2. Fair value of the Derivative Instrument

Six-month
U.S. LIBOR Swap fair value Debt
Date rate1 (%) asset (liability)2 ($) fair value ($)
06/30X1 6.00 -0-3 (10,000,000)
12/31/x1 7.00 (323,000) (9,677,000)
06/30/X2 5.5 55,000 (10,055,000)
1
All rate changes take place on the date indicated.
2
These fair values are assumed to be subsequent to the net swap settlements for the period, and were
obtained by dealer quotes.
3
Swap has zero value at inception because the underlying U.S. LIBOR has not changed. It is the
change in the underlying that puts the swap in the money (asset) or out of the money (liability).
. Adjust the carrying amount of the swap to its fair value in the
financial statements as well as the carrying amount of the note
payable by an offsetting amount at each payment date and reporting
date for the financial statements.
3. Accounting Treatment of the Hedging Instrument and the

Hedged Item over the Contractual Term of the Hedge
The following financial statement analysis will illustrate all the accounting
entries of the debt and the derivative instrument up to June 30, 20X2.
Table 2.3. Financial Statement Template

+ revenue (gain)
– expense (loss)
June 30, 20X1

To record the issuance of debt

+ Cash + Debt
+ 10,000,000 + 10,000,000
December 31, 20X1

To record the semiannual interest expense on the principal at the fixed rate
of 7.5%

– 375,000 – 375,000
Note: Companies that are doing an interest rate swaps, will, of course, still
make interest payments to their debt holders. The derivative instrument is
designed to mitigate the impact of interest rate risk on the fair value of the
debt. The contractual relationship between the company (receive fixed—
pay variable) and the counterparty (receive variable—pay fixed) will deter-
mine the amount to be net settled and will therefore determine the net
interest expense to be recorded by the company.
To record the change in the fair value of the derivative instrument at the
end of 1st reporting period.

+ Swap contract – Loss on hedge
+ 323,000 – 323,000
Note that U.S. LIBOR resets to 7%, which causes the derivative to go out
of the money and will be recorded as a liability with the offset entry a loss
on hedge account income statement.
To record change in the debt’s fair value that is attributable to changes in

interest rates at the end of 1st reporting period for changes in U.S. LIBOR
from 6 to 7%.

– Debt + Gain on hedge
– 323,000 + 323,000
Note: Since the critical terms of the debt and the derivative instrument as
regards notional of the derivative and principal of the debt and maturity
date and settlement date of the derivative match the interest-rate swap is
considered in accounting guidance to be a perfect hedge. The decrease in
the debt account is offset by a gain on hedge which will offset the loss on
the hedge recorded for the swap. The financial statement effects will net
out to zero. The income statement records the loss on hedge and the gain
on hedge in the same account and the swap contract liability is offset by the
decrease in the debt by the same amount. There is no net change in the
income statement or on the liability section of the balance sheet. This is
because the swap contract liability amount that will increase current liabil-
ities is offset by decrease in the debt account by the same amount.
To record the settlement of the semiannual swap amount receivable at
7.5%, minus the amount payable at U.S. LIBOR at 6%.

+ 75,000 + 75,000
Note: Company pays variable at 6% resulting in net interest expense of

$75,000 ($375,000 – $300,000) and is entitled to receive fixed interest
payments of $375,000. Since all interest rate swap payments are net set-
tled, the company records the $75,000 and reduces the interest expense
account on the income statement.
When working through the mathematics of the impact on the financial
statements of the hedge transaction, remember that we compute the fair
value of the debt and the derivative instrument based on the reset amounts
on the reset date (7% on December 31, 20X1). The amount of net interest
expense recorded by the company is computed using the interest rate at the
beginning of the reporting period (6% U.S. LIBOR on June 30,
20X1, compared to receive fixed at 7.5%).
June 30, 20X2

To record interest expense at the semiannual interest expense on the debt
principal at 7.5%.

– 375,000 – 375,000
To record the change in the debt’s fair value that is attributable to changes
in interest rates at the end of the 2nd reporting period incorporating the
change in U.S. LIBOR from 7 to 5.5%.

+ Debt – Loss on hedge
+ 378,000 – 378,000
Note: The debt will have a balance of $1,055,000 on the balance sheet.
To record the change in fair value of the swap contract at the end of the
company’s 2nd reporting period resulting in changes in U.S. LIBOR.

+ Swap contract + Gain on hedge
+ 378,000 + 378,000
Note: The swap contract at the end of reporting period 1 was a liability.
However, the movement of interest rates below the original U.S. LIBOR
of 6% puts the derivative in the money. Also, the swap contract has moved
from a liability balance to an asset balance of $55,000 on the balance sheet
(–$323,000 – $378,000).
To record the net settled payment at 7.5% less U.S. LIBOR at 7%.

+ 25,000 + 25,000

+ Interest expense
+ 25,000
Note: Derivative instrument is net settled resulting in net interest expense

being $350,000 ($375,000 − $25,000)
4. Financial Statement Impacts over the Contractual Term
Note: The following table summarizes the financial statement impacts of

accounting for the interest rate swap. The format of the analysis follows
the illustration of accounting entries that impact the financial statements
that we have used earlier. Balance sheet values represent cumulative
amounts.
Financial Statement Effects

Date/Accounts Shareholder’s
balance sheet + Asset = Liabilities + equity
June 30, 20X1
Cash + 10,000,000
Debt + 10,000,000
December 31, 20X1
Cash + 9,700,000
Swap contract + 323,000
Debt + 9,677,000
Retained earnings (Interest expense) – 300,000
June 30, 20X2
Cash + 9,350,000
Swap contract + 55,000
Debt + 10,055,000
Retained earnings (Interest expense) – 650,000
Dates/Accounts income statement
December 31, 20X1
Interest expense – 300,000
June 30, 20X1
Interest expense – 350,000
Total impact on the income statement – 650,000
The interest rate swap example illustrates the use of a derivative instrument
that “attaches” itself to an existing liability. The next illustration will use an
existing asset and deploy the use of a futures contract to hedge the fair value
of inventory. Normally, for hedges of existing assets using futures con-
tracts, there would normally be some ineffectiveness between the derivative
instrument and the hedged item. This occurs because the forward (futures)
price is determined by the spot price (price at which you could purchase
the commodity and take possession), which tends to change daily. On
futures markets there is a mathematical equivalence between the spot rate
and the futures rate. The spot rate, for any particular trading day, times 1 +
rt = future price. The formula is: the spot rate is multiplied by 1 the risk-
free rate, with t representing the time to expiration of the futures contract.
Therefore, after inception the spot rate can move with will change the
futures rate over the life of the contractual arrangement.
In addition, futures contracts for commodities may contain basis

adjustments for location, transportation, and storage costs.
The following example is designed to illustrate the documentation and
the financial statement impacts of a fair value hedge of commodity inventory
using futures contracts.
On October 1, X1, Montana Mining Company has 10,000,000 pounds of

copper inventory on hand at an average cost of $0.65 per pound. To pro-
tect the inventory from a decline in copper prices, the company hedges its
position by selling 400 copper contracts on the Chicago futures exchange
for commodities. The exchange requires that each copper contract be for
25,000 pounds so the company sells 400 contracts at the futures price of
$0.93 per pound for delivery in February 20, X2. This delivery date coin-
cides with the company’s expected physical sale of the copper.
The company is hedging changes in the fair value of its copper inven-
tory order to protect its gross margins (sales minus its inventory cost when
sold). The margin deposit (explained as follows) for each copper contract is
$700. The spot price of copper on October 1, X1, is $0.91. The spot price
on December 31, 20X1, is $0.89 and the futures price on that date is
$0.91.
On February 20, X2, the Company closes out its futures contract by
entering into an offsetting contract in which it agrees to buy 400 February
copper contracts at $0.92 per pound. (On settlement date, the spot and
futures will converge to the same $0.92 per pound.)
The Company sells the copper in the open market on February 20,
X2, at $0.92 per pound.
Note: Margin deposits for futures contracts are necessary as the exchange
guarantees that both sides will deliver under the contractual arrangement.
In addition, futures contracts generally require cash payments from the
party out of the money to the party who is in the money for all trading
days. The amount is kept in the margin account of the company during the
life of the hedge to insure sufficient cash is available should the derivative
instrument go out of the money which would require a cash transfer of
cash to a counterparty. Payments to the futures exchange for margin
accounts when executing a derivative contract creates an asset for the com-
pany, normally called futures contracts. All subsequent changes in the
derivative instrument (futures contract) are entered into the futures con-
tract account. On the settlement date of the derivative instrument, the
futures account will be paid in cash by the exchange when there is an asset
balance or be paid in cash to the exchange when there is a liability balance.
The following table summarizes the spot and futures price for the report-
ing and settlement dates of the derivative instrument and the hedged
item.
Chicago Exchange Copper Prices

Date Spot Futures
October 1, X1 $0.91 $0.93
December 31, X1 $0.89 $0.91
February 20, X2 $0.92 $0.92
Risk Management Strategy

In order to protect the fair value of the inventory from price declines on
the sale of the copper the company enters into a futures contract on the
Chicago exchange by selling 400 copper contracts at $0.93 for delivery
on February 20, X2, to match the expected sale of the copper. The
company is hedging its commodity price exposure for the entire hedged
asset (copper inventory), which also reflects the locational, transportation,
and storage cost differences between Montana and Chicago (basis adjust-
ments to the spot and futures price of copper on the different exchanges).
Since, the Company is hedging the risk of changes in the existing asset
inventory the company is using a fair value hedge. The Company expects
that locational, transportation, and storage differences will represent some
ineffectiveness in the hedge that will be recognized currently in earnings.
The Company, however, expects the correlation between Montana spot
and futures prices on copper and the spot and futures prices in Chicago to
be highly effective in offsetting changes in fair value of the copper inven-
tory located in Montana. Past historical evidence between the copper
inventories, spot and futures prices in Montana have shown a high corre-
lation with the spot and futures prices in Chicago over similar historical
periods.
Hedging Instrument
Company sells 400 copper contracts, 25,000 pounds per contract, on the
Chicago exchange, on October 1, X1, at $.93 per pound, for delivery on
February 20, X2, which will be the same date the Company at the physical
sale of the copper.
Hedged Item
Copper inventory, 10,000,000 pounds purchased at an average cost
of $.65.

The Company has historical data of the high correlation between the Mon-
tana market for copper and the Chicago market for copper. The company
expects that the correlation will continue over the life of the hedge. The
changes in fair value of futures contracts related to changes in the spot price
of copper inventory on the Chicago exchange are expected to be highly
effective in offsetting future changes in the fair value of copper inventory
located in Montana.
The company will use changes in the fair value of the copper inventory
attributable to changes in the spot price on the Chicago exchange. The com-
pany has determined that the hedging relationship will be highly effective at
inception and over the life of the hedge at offsetting changes in fair value of
the copper inventory attributable to the changes in the sport price of copper.
The company documents the following hedge-effectiveness analysis.
Determining hedge effectiveness

Chicago exchange Inventory Effectiveness ratio
Date copper (gain) loss (gain) loss for the period
12/31/X1 $(200,000)1 $220,0002 0.91
2/20/X2 300,0003 (310,000)3 0.91
1
10,000,000 ($.89 – $.91)
2
Company estimates the change of the fair value of inventory in Montana by starting with the
Chicago exchange price change and adjusting for transportation and storage costs.
3
10,000,000 ($.92 – $.89)
Note: The analysis here indicates the effectiveness ratio is in an acceptable

range of 80–120% of the derivative instrument’s change in fair value when
compared to the existing asset’s (copper inventory) fair value, and therefore
qualifies for under accounting standards for special hedge accounting treat-
ment (200,000 / 220,000 = 91%). In addition, the ongoing hedge effec-
tiveness analysis will use the change in the spot rate over the term of hedge
in determining hedge effectiveness.
Note: the hedged item (inventory) fair value changes that will be
recorded in the financial statements will be based on changes in the spot
rate. The derivative instrument (futures contract) fair value changes that
will be recorded in the financial statements will be based on changes in
the futures rate.
The hedge effectiveness assessment is done on a spot-to-spot basis because

the Company is hedging the fair value risk and an inventory price
decrease. However, accounting guidance would require that the derivative
instrument’s fair value be based on changes in the futures price. This is
because the fair value of the derivative instrument (futures contract) is
determined by changes in the future rates of copper inventory.
Accounting for the Fair Value Hedge of Inventory

+ Revenue (gain)
– Expense (loss)
October 1, X11
To record the margin deposit on 400 copper contracts
+ Future contracts
+ 280000
– Cash
– 280000
At the inception of the hedging contract neither the derivative instrument

nor the copper inventory has moved in or out of the money, because the
underlying spot or futures rates have not moved.
Note: the futures contract account is an asset at inception that will be

increased (asset) or decreased (decrease asset or the account becomes a lia-
bility) depending on whether the derivative instrument goes in the money
(increase), which will be a payment to the company or out of the money
(decrease). At the end of the arrangement, we will write off the futures
contract account and collect or pay cash.
December 31, X1
To record gain on the derivative instrument with the offset entry to the
futures contract account:

+ Future contract + Gain on hedge
+ 200,000 + 200,000

+ Gain on hedge
+ 200,000
Note: The mathematics of the gain on futures contract is computed using

the February futures price and is illustrated in the following table.
February copper futures price on October 1, X1 $0.93
February copper futures price on December 31, X1 0.91
Gain per pound 0.02
Notional amount in pounds 10,000,000
Gain on futures contracts on December 31, X2 $200,000
To record the loss on hedge activity for the existing asset (inventory):

– Copper inventory – Loss on hedge
– 220,000 – 220,000
Note: The loss of hedge includes the $200,000 computed as 10,000,000

($.91 – $.89) = $200,000. In addition, the $20,000 represents locational
and transportation costs. The ineffectiveness portion of the hedge ($20,000)
would go directly to the income statement.
February 20, X2
To record the loss on hedge activity of the derivative instrument:
Assets = Liabilities + Stockholders Equity

– Future contract – Loss on hedge
– 100,000 – 100,000
Note: The mathematics of the gain on futures contract is computed using

the February futures price and is illustrated in the following table. February
20, X2 is the settlement date.
Calculating Gain on the Futures Contract

February copper futures price on December 31, X1 $0.91
February copper futures price on February 20, X2 $0.92
Gain per pound $0.01
Notional amount in pounds 10,000,000
Gain on futures contracts on February 20, X2 $100,000
To record the gain on hedge for the existing asset (inventory):

+ Copper inventory + Gain on hedge
+ 310,000 + 310,000
Note: The gain is the computation of 10,000,000 ($0.92 – $0.89) =

$300,000 plus an additional gain of $10,000 due to locational and trans-
portation adjustments.
To record the settlement of the futures contract and record the receipt of
cash:

+ Cash
+ 380,000
– Futures contract
– 380,000
Note: The futures contact computation is ($280,000 + $200,000) –

$100,000 = $380,000
To record the sale of the 400 copper inventory:

+ Cash + Revenue from sales
+ 9,200,000 + 9,200,000
– Copper inventory – Expense from cost of sales
– 6,590,000 – 6,590,000
Note: The cash amount above is based on 10,000,000 pounds

($0.92 spot rate on February 20, X2). The copper inventory amount is
the agreement to purchase 400 February contracts at the spot price of
$0.92 per pound.
The cost of sales and the copper inventory accounts result from:
Original cost of copper $6,500,000
Adjustment at December 31, X1 – 220,000
Adjustment at February 20, X2 + 100,000
Ending value $6,590,000
Financial Statement Impact: Balance Sheet

Date/Accounts Assets = Liabilities + Shareholder’s equity
October 1, X1
Cash – 280,000
Inventory 6,500,000
Futures contract + 280,000
Retained earnings – 6,500,000
December 31, X1
Cash – 280,000
Inventory + 6,280,000
Futures contract + 480,000
February 20, X2
Cash + 9,300,000
Note: The inventory balance on December 31, X1, is the result of the change
in fair value of the hedged item from October 1, X1 ($220,000). The cash
balance of $9,300,000 is the result of selling the copper inventory contracts
at the spot price of $0.92 and receiving cash from the settlement of the
futures contracts. The futures contracts, original cost was $280,000 and
they were sold for $380,000 resulting in a cash of $100,000.
Financial Statement Impact: Income Statement

Shareholder’s
equity
+ Gain
Dates/Accounts Assets = Liabilities + – Loss
December 31, X1
Loss on hedge $–200,000
Gain on hedge + 220,000
Total + 20,000
February 20, X2
Loss on hedge – 100,000
Gain on hedge + 310,000
Gross margin on + 2,610,0001

Sale of inventory
Total + 2,820,000
Cumulative income $+2,800,000

statement impact
Note: 1The gross margin is calculated as $9,200,000 sale price at February 20, X2, minus
$6,590,000, which is the net carrying value of inventory on the same date.
Note: by entering into the futures contract the Company locked in a gross
profit of $2,800,000, which represents the $0.93 less the $0.65 cost of the
inventory on the 10,000,000 pounds of copper. Mission accomplished.
For our final comprehensive illustration in this chapter, we will demon-

strate a fair value hedge of a firm commitment using a forward contract.
Silver Company (Company) is a manufacturer of silver jewelry. On July
1, X1, the Company enters into a firm commitment to purchase 1,000 troy
ounces of silver on December 31, X1, at the current forward rate of
$310 per troy ounce. The company enters into the firm commitment
because its supplier requires a fixed price contract. However, the company
would prefer to pay the market price at the time of delivery and record the
silver inventory at whatever the market price will be on December 31, X1.
In order to accomplish their objective, the company enters into a six-
month forward contract to sell 1,000 troy ounces of silver at the current
forward rate of $310 per troy ounce. By entering into the forward contract,
the company unlocks the firm commitment. The forward contract requires
net cash settlement of December 31, X1, and has a fair value of zero at
inception because the underlying forward rates and the firm commitment
prices are equal at the inception of the forward contract.

The objective of the hedge is to protect the fair value of the firm commit-
ment from changes in the market value of silver. The forward contract to
sell 1,000 troy ounces of silver at the forward price of $310 per troy ounce
on December 31, X1 is expected to be highly effective in offsetting changes
in the fair value of the firm-hedged item. The firm commitment requires
the company to purchase 1,000 troy ounces of silver at the forward price of
$310 per troy ounce on December 31, X1. The company expects the for-
ward price of silver over the life of the forward to decline and wants to
purchase silver ounces at the market price on December 31, X1. (In this
illustration, the firm commitment is not the derivative, but is instead the
hedged item.)
Hedging Instrument
Six-month forward contract to sell 1,000 troy ounces of silver at $310 per
troy ounce entered into on July 1, X1, with a settlement date of December
31, X1.
Hedged Item
Firm commitment to purchase 1,000 troy ounces of silver at the current
forward rate of $310 per troy ounce on December 31, X1. The firm com-
mitment does not qualify as a derivative in this arrangement.

Hedge effectiveness both, at inception and over the life of the hedge, will
be assessed based on the overall changes in the fair value of the contract,
based on changes in the December 31, X1, forward price and changes in
the fair value of the firm commitment, which is also based on changes in
the forward price. The company will use the cumulative dollar-offset
method to hedge effectiveness of the derivative instrument (forward con-
tract to sell) and the firm commitment to buy 1,000 troy ounces of silver.
At inception and over the life of the hedge since the critical terms of the
firm commitment and the forward contract match such as dates, quanti-
ties, and the underlying commodity, the company expects the forward con-
tract to be highly effective in offsetting changes in the overall fair value of
the firm commitment. Any ineffectiveness from changes in the spot price
for the required reporting periods and the December 31, X1, forward price
will be reflected in the net income. The company prepares the following
hedge effectiveness table in order to illustrate hedge effectiveness.
Note: The effectiveness documentation at the inception of the hedge and

its ongoing effectiveness, in order to qualify for hedge accounting, would
normally be done by using historical information about the offsetting
changes in fair value between the derivative instrument and the hedged
item. For our purposes, we are using a hypothetical example that mirrors
the accounting for the hedging arrangement.
In practice, a company would gather evidence of the historical move-

ment of prices of the derivative instrument based on changes in the
underlying and changes in the fair value of the hedged item for a fair
value hedge over an equivalent term of the hedge. The company would
then create a “hypothetical” derivative that would mirror previous fair
value changes in the derivative instruction and determine the degree of
correlation in the changes to the fair value of the existing asset, liability,
or firm commitment.
Hedge effectiveness documentation is performed to determine at
inception if the derivative instrument and the hedged item’s fair value
changes are effective in offsetting fair value changes at the 80 to 125% level
in order to make a determination as to whether or not the company qua-
lifies for hedge accounting. The examples here treat the forecasted move-
ment of the underlying, interest rates, futures prices, and forward prices,
currency prices in order to demonstrate both the effectiveness of the hedge
as well as the accounting and the impact on a company’s financial
statements.
Hedge Effectiveness Computations

Fair value Fair value
Forward price of forward of firm
Spot for settlement on contract— commitment— Effectiveness
Date price December 31, X1 asset liability ratio
July 1, X1 $300 $310 – – –
1
September 30, X1 292 297 12,808 12,808 100%
December 31, X1 285 285 25,0002 25,000 100%
1
The fair value of the forward contract on September 30 is ($310 – 297) 1000 ounces = $13,000.
Since forward contracts are not exchange traded, accounting guidance would require the use of a
discount rate from inception to the reporting period. Assuming a 6% discount, then $13,000/
(1+.015) =$12,808. (The 6% discount would be divided by 4 to determine the 1.5%.)
2
The fair value of the forward contract for December 31 is ($310 – 285) 1000 ounces = $25,000.
Since this is the settlement date there would be no discount applied to the amount.
Note: The forward contract and the firm commitment are both valued
using the forward rate and since the critical terms match there is no inef-
fectiveness in the hedge. In practice, similar to the copper inventory hedge
there may be locational, transportation, or storage costs of a commodity
that would result in some ineffectiveness between the hedged item and the
derivative instrument when using a forward contract (this would be the
case for a commodity that required physical delivery). However, in this
hedge since we are hedging a firm commitment there are none of those
costs. We will merely swap out the contracts on settlement date and buy
the commodity at the spot price on the settlement date of delivery.
This illustration is principally designed to demonstrate the financial state-
ment effects of hedging a firm commitment.
Accounting for the Fair Value Hedge

of a Firm Commitment
+ Gain on hedge
– Loss on hedge
July 1, X1
No financial statement effect on July 1, X1, because neither the firm com-
mitment nor the forward contract has moved in or out of the money based
on changes in the forward rates.
Note: Forward contracts generally do not require any upfront payments sim-
ilar to what was illustrated in the previous example for futures contracts,
which are exchange driver transactions. A forward contract is generally
between a party and a counterparty and does not require the payment/
receipt of cash in a margin account.
Forward contracts, however, in the contractual terms between the parties
in the transaction must include terms and conditions of the transaction
that provide each party with a high level of reasonable assurance that each
party will perform the contractual specifications. This is normally done by
inserting penalty clauses for each party to the contract that are significant
enough to assure each party performs under the contract.
The exception of not recording the financial statement impacts at
inception of the contract occurs when the party and counterparty employ
a 3rd party intermediary who arranges the forward contract for a fee. When
that occurs, normally one party would pay the intermediary and record an
asset for the payment made to the intermediary.
September 30, X1
To record the changes in fair value of the forward contract (derivative
instrument) and the firm commitment (hedged item):

+ 12,808 + 12,808
Note: Forward contract is in the money because the forward price for
December 31, X1, has decreased from $310 in July 1, X1, to $297 in
September 30, X1. Since the contract “could” be net settled for $310 per
ounce, we record a gain on hedge for the derivative instrument. The gain is
discounted at 6% annual percentage rate (APR) for the 3 months.
To record changes in fair value of the firm commitment:

+ Firm commitment – Loss on Hedge
+ 12,808 – 12,808
Note: The fair value change in the firm commitment is a liability because
the accounting guidance for the fair value hedge mandates a loss on the
existing asset when there is a gain on the derivative instrument (forward

contract). In addition, the company is required to have a fixed price purchase
of silver at the forward July 1, X1 price for December 31, X1. The hedge
accounting is matching the two parallel forward prices on the firm com-
mitment and the forward contract in order to enable the company to pur-
chase the silver inventory at the spot price on December 31, X1.
December 31, X1
To record the change in fair value of the forward contract:

+ 12,192 + 12,192
Note: The forward contract adds $12,192 in order to arrive at a balance

sheet amount of $25,000 for the forward contract account. The $25,000 is
arrived at by comparing the December 31, X1 forward value of $310 for
the July 1, X1 forward December 31, X1 value and comparing it to the
forward (and spot price) value on December 31, X1 of $285.
To record change in fair value for the firm commitment:

+ Firm commitment – Loss on hedge
+ 12,192 – 12,192
Note: The firm commitment computation of loss of hedge is the same as

the computation for the derivative instrument (forward contract).
To record settlement of the forward contract:

+ Cash
+ 25,000
– Forward contract
– 25,000
Note: Company cash settles the forward contract and removes the contract
asset from its books. The $25,000 in cash results from the movement of
the forward price from $310 – $285) 1,000 ounces. The company now
has $25,000 in cash from the movement of the forward prices to offset its
cash purchase of the silver inventory for the firm commitment of $310 X
1,000 ounces = $310,000. This hedge places the company’s cash flow for
the hedge at $310,000 – $25,000 = $285,000. The company has therefore
been able to purchase silver inventory at the market price, which was the
risk management strategy they were pursuing.
To record the purchase of 1,000 ounces of silver at the contractual price for
the firm commitment:

+ Silver inventory
+ 310,000
– Cash
– 310,000
Note: For the firm commitment, company settles the contract by purchas-
ing its silver inventory at the contract rate of $310.
To remove the firm commitment from the balance sheet and reduce the
silver inventory account:

– Silver inventory – Firm commitment
– 25,000 – 25,000
Note: The Company’s firm commitment account mirrors the changes to

the forward contract. The logic of the accounting for a firm commitment
(or existing asset or liability) in a fair value hedge should now be clarified.
The firm commitment liability is written off against the inventory account
reducing its balance to $285,000. The company’s risk management strat-
egy of protecting itself from paying the forward price on July 1, X1, for
December forward rates has been accomplished.
CHAPTER 4
Cash Flow Hedges

About This Chapter
Cash flow hedges are designed to lock in variable (floating) future expected
cash flows of an anticipated or forecasted transaction. To review, fair value
hedges convert fixed cash flows on an existing asset, liability, or firm com-
mitment to variable cash flows and protect the hedged item’s fair value. For
cash flow hedges the opposite is true; the company takes inherently variable
forecasted cash flows and converts them to fixed cash flows. Cash flow
hedges are designed as a hedge of the variable cash flows from a forecasted
transaction that is expected to occur in the future.
This chapter will discuss the use of cash flow hedges that companies
can use to manage their risk exposure given the relative uncertainty of fore-
casting operating and financial transactions that will change future cash
flows for the company. Derivative instruments used in cash flow hedges
can reduce the uncertainty, for companies, of the amount of cash to be
received or paid for operating and financial transactions.
The chapter will conclude with three comprehensive examples that will
illustrate the economics and financial statement impacts of cash flow
hedges.
Forecasted (Anticipated) Transactions

Forecasted transactions are eligible for cash flow hedge accounting, while
firm commitments are only eligible for fair value hedge accounting.
Accounting guidance defines forecasted transactions as probable future
transactions that do not meet the definition of a firm commitment (which
are only permissible for fair value hedges). Forecasted transactions can be
contractually established or merely probable because of a company‘s past or
expected business practices. As discussed previously, for a contract to meet
the definition of a firm commitment, all of its relevant terms must be con-
tractually fixed (e.g., price, quantity, timing, interest, or exchange rate) and
the performance must be contractually required. On the other hand, in a
forecasted transaction, either some term of the transaction is variable or the
transaction is not contractually certain. Therefore, the distinguishing char-
acteristic between a forecasted transaction and a firm commitment is the
certainty and enforceability of the terms of the transaction.1
Because hedging a firm commitment and hedging a forecasted trans-
action give rise to different risk exposures, companies will need to deploy
different risk management derivative instruments to accomplish their risk
management strategies for the forecasted cash flows. For example, when
hedging a firm commitment the company’s goal is to unlock the fixed price
position and pay the variable (market) price. For the hedge of a forecasted
transaction the company would use derivative instruments to “fix” the
amount of cash flows paid or received.
As discussed in Chapter 2, hedge documentation is vital in qualifying
for hedge accounting. This documentation can be particularly perplexing
for forecasted transactions. The difficulty is in meeting the standard
setter’s guidance that the transaction is probable of occurring. Account-
ing guidance for derivatives would indicate that the standard setters inter-
pret probable at a high level, normally greater than or equal to a 75%
probability of occurring. Useful guidelines when documenting the hedge
include:
. Be very specific as to the date, or the period within which, the

forecasted transaction will occur
. Try to be as specific as possible concerning the nature of the asset or
liability from which the future cash flows will be derived
. Nail down the expected currency or the physical quantity to be
delivered or purchased from the forecasted transaction
Accounting for Cash Flow Hedges

The effective portion of the gain or loss on a derivative instrument desig-
nated as a cash flow hedge is reported in other comprehensive income, and
the ineffective portion is reported in earnings. The derivative instrument is
CASH FLOW HEDGES 71
carried at fair value of the balance sheet. However, unlike fair value hedges,
since the hedged item is a forecasted transaction there is no existing asset,
liability, or firm on which to “wash” out the transaction from the income
statement. Cash flow hedge accounting will record the offset fair value
change in the derivative instrument in a shareholder’s equity account called
Other Comprehensive Income (OCI). It is this arbitrary accounting that
makes cash flow hedge accounting difficult to understand. Until the hedge
is settled it is difficult for the company to determine the hedge effectiveness
as shown of the financial statements over the contractual term of the hedge.
Amounts in other comprehensive income (OCI) shall be reclassified
into earnings in the same period or periods during which the hedged
forecasted transaction affects earnings (e.g., when a forecasted sale actually
occurs). If the hedged transaction results in the acquisition of an asset or
the incurrence of a liability, the gains and losses in accumulated other com-
prehensive income shall be reclassified into earnings in the same period or
periods during which the asset acquired or liability incurred affects earnings
(such as in the periods that depreciation expense, interest expense, or cost
of sales is recognized).
This requirement, for recording interest expense over the term of the
debt or recording depreciation expense over the useful life of the equip-
ment purchases mandates that companies carefully track the hedge trans-
action over its entire contractual life, including the life of the “hedged
item”. For example, if your cash flow hedge results in a purchase of
machinery with a 10-year life the related OCI account in shareholder
equity will be released to earnings over a 10-year period of time. This
requirement substantially increases the documentation for companies
using cash flow hedge derivatives.

In order to qualify for hedge accounting, the hedge relationship must be
expected to be highly effective at inception and on an ongoing basis
throughout the term of the hedging relationship. However, determining
the extent to which a cash flow hedge is ineffective is more complicated
than in a fair value hedge where both the derivative and the hedged item
are adjusted for changes in fair value (with respect to the hedged risk)
through earnings. This complication develops because the “hedged item” is

anticipated or forecast cash flows which may diverge from the changes in
the fair value of the derivative instrument because of changing economic
conditions of the forecasted transaction.
Cash flow hedges use the same effectiveness methodologies as used by
fair value hedges. Most common is the dollar-offset approach whereby the
change in the derivative instrument is compared to the change in the
hedged item. Hedged transactions will qualify for the special hedge
accounting when the changes between the two values are in the 80% to
125% effectiveness range. The major difference in determining hedge
effectiveness is the calculation of the fair value change in the forecasted
expected future cash flows. The preferred measurement methodology in
determining the “hedged item” side of the formula in performing effective-
ness tests is to determine the expected present value of future cash flows for
the hedged transaction.
Hedges of cash flow exposures often involve a component of the total
cash flow that is the source of its variability. Considering the source of
variability in a hedged cash flow is one of the first steps in assessing inef-
fectiveness of a cash flow hedge. For example, if the hedged forecasted
transaction is the variable interest payment on a debt obligation whose
contractual terms provide for the payment of interest at the prime interest
rate plus a fixed spread, changes in the prime interest rate are the only
source of variability of the forecasted cash flow.
In situations where the variability of the hedged cash flow is solely
attributable to changes in an interest rate index, ineffectiveness may be
assessed solely by considering the effectiveness of the derivative in offsetting
changes resulting from changes in the index. As a result, when the desig-
nated derivative is based on the same interest rate index as the cause of the
variability of the hedged cash flow, and the other terms of the exposure and
the derivative match, then we have a “perfect hedge. However, unlike the
exception in the fair value hedge that ongoing effectiveness need not be
assessed, for cash flow hedges ineffectiveness after hedge inception must
always be assessed to determine any ineffectiveness. This assessment is
done because any ineffectiveness goes directly to earnings while the highly
effective portion of the hedge goes to an OCI account in the shareholder’s
equity.
CASH FLOW HEDGES 73
Similar to a fair value hedge when the critical terms match for the deriv-
ative instrument and the “hedged item” (forecasted cash flows) then at
inception the company can assume that the hedge will be highly effective
(changes in the derivative fair value will offset changes in fair value of the
forecasted transaction). Critical terms would consist of the timing of the
transaction, quantities of a commodity, and delivery dates. However, since
the critical terms of the forecasted transaction can change as to timing and
amounts, companies need to carefully monitor the critical terms match on
an ongoing basis in determining any ineffectiveness which would be
charged to earnings in the period under measurement which for derivative
instruments is every three months.
Forecasted transactions may be based on the company’s historical expe-
rience, say of revenue projections for a particular region. At inception, the
company could design a derivative instrument that matched their revenue
expectations. However, generally as the settlement date gets closer the esti-
mates of revenue are likely to change causing ineffectiveness in the hedging
relationship.
Because the hedged item is forecasted cash flows, accounting guidance
limits the amount that is recorded in OCI. The cash flow hedging model
requires that companies determine if the change in fair value of the deriv-
ative instrument as compared to the change in fair value of the forecasted
future cash flows represents an “underhedge” or an “overhedge”. An
“underhedge” occurs when the cumulative change in the fair value of the
derivative instrument is equal to or less than necessary to offset the cumu-
lative change in expected future cash flows of the hedged item. When this
is the case the entire change in the fair value of the derivative is recorded in
OCI, and there is no ineffectiveness in earnings. However, if the cumula-
tive change in the fair value of the derivative instrument is greater than the
cumulative change in the fair value of expected future cash flows, then the
amount in excess is changed to earnings with the remainder going to OCI
in shareholder’s equity.
The following example on Measuring Hedge Effectiveness1 will be
used to illustrate how to apply the accounting guidance for effectiveness
measures for cash flow hedges. Company has designated the overall change
in cash flows related to the forecasted transaction as the hedged risk. How-
ever, because of differences between the derivative instrument and the
hedged item, some ineffectiveness is expected to occur. The example will

first construct a table demonstrating the hedge effectiveness assessment,
then provides the accounting impact on the financial statements, and
finally provide a detailed examination of the OCI account on the balance
sheet.
Measuring Hedge Effectiveness
Reading the Table
A—Fair value change in the derivative during the period with

decreases in fair value shown by using (parentheses)
B—Cumulative change in the fair value of the derivative
C—Present value of expected future cash flows from the hedged trans-
action for the period with decreases shown by (parentheses)
D—Cumulative change in the present value of the expected future
cash flows
E—Lesser of the two cumulative changes
F—Adjustment made to OCI
Computations represented by the table:
1. Determine the change in the fair value of the derivative and the change
in the present values of the hedged transaction. (columns A & C)
2. Determine the cumulative changes in the fair value of the derivative
and the cumulative changes in the present values of the cash flows of
the hedged transaction. (columns B&B)
3. Determine the lesser of the absolute values of the two accounts in
#2 above. (column E)
Measuring Hedge Effectiveness

Period A B C D E F
1 $100 $100 $(96) $(96) $96 $96
2 94 194 (101) (197) 194 98
3 (162) 32 160 (37) 32 (162)
4 (101) (69) 103 66 (66) (98)
5 30 (39) (32) 34 (34) 32
CASH FLOW HEDGES 75
4. Determine the change during the period to adjust OCI to include the
amount equal to the portion of the derivative increase (decrease)
attributable to the lesser of the absolute value (column F)
5. Adjust the derivative to reflect its change in the fair value and adjust
OCI by the amount determined by #4 above. Balance the accounting
entry, if necessary, with an adjustment to earnings.
The following financial statement effects template walks you through the
accounting for the five periods presented. Note that the account
shareholder’s equity is a balance sheet account that offsets the cumulative
change in the fair value of the derivative. The analysis below will include
gain and loss accounts in shareholder’s equity. Entries to these accounts
will appear on the income statement.

Assets = Liabilities + Shareholder’s equity (OCI)
+ Gain on derivative
– Loss on derivative
Period 1: Adjust the derivative to fair value and the OCI by the calculated
amount (column F) in Measuring Hedge Effectiveness

+ Derivative instrument + OCI 96
+ 100 + Gain on derivative
+4
amount (column F) in table on Measuring Hedge Effectiveness

+ Derivative instrument + OCI
+ 94 + 98
–4

+ Derivative instrument – OCI
+ 162 – 162

+ Derivative instrument – OCI
+ 101 – 98
– 3
+ Derivative instrument + OCI
+ 30 + 32
–2
Cash flow hedges, until settlement date, have their primary effect on the
balance sheet. The following roll-forward schedule illustrates the impact in
the shareholder’s equity account OCI over the 5 periods.
Accumulated OCI (+ increases balance and – decreases balance)
Roll-Forward Schedule for Fair Value Changes in the Derivative

Instrument
Beginning Change in Ending
Period balance fair value Reclassification balance
1 $– $+96 $– $+96
2 +96 +94 +4 +194
3 +194 –162 – +32
4 +32 –98 – –66
5 –66 +30 –2 –34
Caution the following explanation for the changes in the balance sheet
account OCI will take some time to go through. The easiest way to
CASH FLOW HEDGES 77
understand the changes is to correlate the OCI changes to the financial

statement effects template found above.
The reclassification column relates to reclassifications between earnings
and other comprehensive income. In Period 2, the +$4 in that column
relates to the prior period’s derivative gain that was previously recognized
in earnings. That amount is reclassified to other comprehensive income in
Period 2 because the cumulative gain on the derivative is less than the
amount necessary to offset the cumulative change in the present value of
expected future cash flows on the hedged transaction. In Period 5, the
–$2 in the reclassification column relates to the derivative loss that was
recognized in other comprehensive income in a prior period. At the end
of Period 4, the derivative’s cumulative loss of $69 was greater in absolute
terms than the $66 increase in the present value of expected future cash
flows on the hedged transaction. That +$3 excess had been recognized in
earnings during Period 4.
In Period 5, the value of the derivative increased (and reduced the
cumulative loss) by $30. The present value of the expected future cash
flows on the hedged transaction decreased (and reduced the cumulative
gain) by $32. The gain on the derivative in Period 5 was –$2 smaller, in
absolute terms, than the decrease in the present value of the expected
future cash flows on the hedged transaction. Consequently, the entire gain
on the derivative is recognized in other comprehensive income. In addi-
tion, in absolute terms, the –$3 cumulative excess of the loss on the deriv-
ative over the increase in the present value of the expected future cash flows
on the hedged transaction (which had previously been recognized in earn-
ings) increased to $5. As a result, $2 is reclassified from other comprehen-
sive income to earnings so that the $5 cumulative excess has been
recognized in earnings.
The remainder of this chapter will illustrate four of the more common
cash flow hedges used by companies to hedge their forecasted future cash
flow needs. The four hedges are:
1. Use of an interest rate swap to hedge variable rate debt payments; this
is the same example as the first illustration for fair value hedges
(Chapter 3) which will enable us to compare and contrast the two
hedge treatments for identical risk management strategies.
2. Use of options to hedge an anticipated purchase of inventory; this

will be our first detailed look at how options are used in a
company’s risk management strategy.
3. Use of a commodity swap to hedge anticipated sales of crude oil; this
hedge; as well as the hedge in #2, continue our emphasis on using
derivative instruments on buying and selling inventory.
4. A forecasted transaction that becomes a firm commitment and then
an existing asset of the company; this all in one hedge links the fair
value hedge accounting for a firm commitment with the anticipated
purchase of inventory (forecasted transaction) and then adds the
accounting for when the firm commitment becomes an existing asset.
Cash Flow Hedge of Fixed-Rate Debt Using an Interest Rate Swap
Description of the Hedge Transaction

On June 30, 20X1, a Manufacturing Company (Company) borrows
$10,000,000 of three-year 7.5% fixed-rate debt. The debt is due at matu-
rity and contains no prepayment option. The Company, at the same time,
enters into a three-year interest rate swap with a Finance Company to con-
vert the debt’s fixed rate to a variable (or floating) rate.
Under the terms of the swap, the Company receives interest at a fixed
rate of 7.5% and agrees to pay interest at a variable rate equal to six-month
U.S. LIBOR, based on the notional amount of $10,000,000. Both the
debt and the swap require that payments be made or received on Decem-
ber 31 and June 30.
Note: For illustrative purposes, we will only account for the two semiannual
interest periods for this interest rate swap. For an interest rate swap in which
the critical terms match, accounting guidance allows companies to treat the
hedge as a perfect hedge. The entries for the remaining life of the swap for
the changes in the derivative instrument and the hedged item will perfectly
offset in earnings.
The six-month U.S. LIBOR rate on each reset date determines the variable
portion of the interest rate swap for the following six-month period. The
Company designates the swap as a cash-flow hedge, which will hedge the
exposure to variability in the cash flows of the variable-rate debt, with
CASH FLOW HEDGES 79
changes in cash flows that are due the changes in the six-month LIBOR the
specific risk being hedged.
Hedge Documentation
The objective of entering into the hedge is to fix its cash flows associated
with the risk of variability in the six-month U.S. LIBOR. In order to meet
its risk management objective, the Company has decided to enter into the
interest rate swap described below for the same notional amount and
period of the $10,000,000 million debt entered into on June 30, X1. It
is expected that this swap will fix the cash flows associated with the fore-
casting interest payments on the entire notional amount of the debt. The
company is hedging its interest rate risk.
$10,000,000 notional amount, pay fixed at 7.5% and receive variable at

U.S. LIBOR, dated June 30, 20X1, with semi annual payments due on
December 31, X1 and June 30, X2 and ending on June 30, 20X4.
c. Hedged Item
Forecasted interest payments on notional of $10,000,000 debt entered

into on June 30, X1, and ending on June 30, X4. Reset dates for December
31, X1 and June 30, X2 determine the interest rates to be paid. These reset
rates will be determined by U.S. LIBOR. The six-month U.S. LIBOR
variable rate on the reset date determines the variable interest amount for
the following six-month period.
The Company has determined that the critical terms match for the deriv-
ative instrument and the hedged item and is, therefore, assuming no inef-
fectiveness at inception and over the term of the interest rate swap. Since
there is no ineffectiveness all changes in the fair value of the interest rate
swap will be recorded in OCI in the shareholder’s equity.
Accounting Guidance to qualify as a perfect hedge for an interest rate

swap requires that companies perform the following steps:
. Determine the difference between the variable rate to be received on

the swap and the variable rate to be paid on the debt.
. Combine the difference with the fixed rate to be paid on the swap.
. Compute and recognize interest expense using the combined rate
and variable-rate debt’s principal amount. For the interest-rate swap
hedge above, the table would be as follows in the
company’s determination of interest expense.
Note: For illustration purposes, we will only use the December 30, X1 and
the June 30, X2 semiannual interest payment dates.
Calculation of Interest Expense

(e)
(a) Difference Semiannual
between (b) Fixed (d) Principal interest
variable rate on (c) Sum amount Expense
Date rates the swap (a) + (b) of debt ((c) (d))/2
12/31/X1 0.00% 7.5% 7.5% $10 Million $375,000
6/30/X2 0.00% 7.5% 7.5% $10 Million $375,000
. Determine the fair value of the interest rate swap. The table below
indicates the interest rate swaps fair value for December 31, X1 and
June 30, X2.
Swap fair value

Six-month U.S. + Asset
Date LIBOR rate – Liability
6/30/X1 6.00% Zero value at inception
12/31/X1 7.00% $+323,000
Obtained from dealer quotes
06/30/X2 5.50% $–55,000
Obtained from dealer quotes
. The last step in the process is to adjust the carrying amount of the
swap and adjust OCI by an offsetting amount.
CASH FLOW HEDGES 81
The following accounting entries will demonstrate the financial statement

impacts of a cash flow hedge on the variability of interest payments.

+ OCI
– Interest Expense
June 30, X1
To record the issuance of debt

+ Cash + Debt
+ 10,000,000 + 10,000,000
Note: the swap asset/liability has zero value at inception because the under-
lying value driver (U.S. LIBOR) has not changed
December 31, X1
To record semiannual interest on the debt a 6.00% annual percentage rate
(APR):

– 300,000 – 300,000
Calculation is $10,000,000 (6%/2) = $300,000
To record settlement of the semiannual swap payment at 7.5% less the

amount receivable at 6% U.S. LIBOR, as an adjustment to interest
expense:

– 75,000 – 75,000
Calculation is $10,000,000 × (7.5% – 6%)/2 = $75,000
To record the change in fair value of the interest rate swap with the offset
amount to OCI:

+ Swap contract + OCI
+ 323,000 + 323,000
Amount is taken from the table above and is the result from a dealer quote.
Note: For cash flow hedges, there is no income statement component

(unless there is some hedge ineffectiveness) until settlement of the
hedge for the derivative instrument. In the accounting entry above the
asset swap contract will be offset by the change in the OCI account in
shareholders equity. There is, however, an income statement effect on
interest expense. The company records its variable rate payment of
interest expense at 6% times the notional amount and also pays an addi-
tional $75,000 to counterparty, which is calculated as notional (7.5%
–6%)/2.
The attractiveness of a using a cash flow hedge on the variability of pay-

ments set by the benchmark rate (in this case U.S. LIBOR) is that the
variable interest amounts are fixed (known with certainty) over the term
of the swap.
June 30, X2
To record the interest payment to debt holders at the 7% variable rate:
Assets = Liabilities + Stockholder’s Equity

– 350,000 – 350,000
Calculation is $10,000,000 (7%/2) = $350,000
To record the payment of semiannual interest at 7.5%, less amount receiv-

able of 7% as an adjustment to interest expense:

– 25,000 – 25,000
To record change in fair value of the swap contract from dealer quote:
CASH FLOW HEDGES 83

– Swap Contract – OCI
– 378,000 – 378,000
Note: The derivative instrument (swap contract) will continue to be

recorded at its fair value of the balance sheet over the term of the swap agree-
ment with the offset being to OCI in shareholders equity. The change in fair
value of the derivative instrument should be thought of as a gain (in the
money) or as a loss (out of the money). However, the gain or loss amount
is an adjustment to the OCI in shareholders equity until the hedge is settled.
In the accounting entries above for interest expense, the amounts accu-
mulated in OCI are “indirectly” recognized as periodic settlements of the
swap in interest expense at each reset date. At the end of the term of the swap,
the OCI account will go to zero and the cumulative adjustments to interest
expense will have been indirectly charged to earnings. It is this arbitrary
accounting that can cause difficulty in determining hedge effectiveness by
examining the impacts of the balance sheet. Compare this accounting to a
fair value hedge where we can closely track the changes of the derivative
instrument and the hedged item fair value changes on the balance sheet.
For our next comprehensive illustration, we will examine the financial
statement effects of a cash flow hedge of a forecasted purchase. What makes
this an interesting hedge is that we will use one commodity to hedge a
different commodity.
Cash Flow Hedge of a Forecasted Purchase Using

a Futures Contract
On January 1, X1, the Company, a large airline company, forecasts the pur-
chase of 84 million gallons of jet fuel in six months. The company is con-
cerned that jet fuel prices will rise over the coming months, so it enters into
2,000 long (purchase) contracts for purchase of 42,000 gallons per contract
of heating oil futures. Each contract of heating oil is for $0.4649/gallon with
settlement date on June 30, X1. We will assume that no premium was
required to enter into the contracts and that any interest earned or expensed
is ignored. These exceptions will allow us to focus on the hedged transaction.
The Company’s risk management strategy is to hedge its exposure the

price risk due to adverse changes in jet fuel prices. The Company expects
some ineffectiveness in the hedged transaction because it is hedging heating
oil futures contracts against the expected rise in the jet fuel prices over the
term of the hedge. The Company has accepted the basis risk (changes in
price between two different commodities), but still expects the hedged
transaction to be highly effective.
The Company prepares the following analysis for the period ending
March 31, X1, and for June 30, X1, as a basis for determining hedge effec-
tiveness and the potential financial statement effects.
Analysis to determine fair value as of March 31, X1
6/30/X1 6/30/X1 Expected
Heating oil cash flows of jet
Period Ending 3/31/X1 futures contracts fuel purchases
Futures price—end of period $0.4726 $0.4759
Futures price—beginning of period 0.4649 0.4688
Change in price over since 1/1/X1 0.0077 0.0071
Gallons hedged under contract 84,000,000 84,000,000
Change in fair value—gain (loss) $646,800
Change in expected $(596,400)
cash flows—gain (loss)
Note: Using the cumulative dollar-offset method in determining hedge

effectiveness, we get ($646,800/$596,400) = 108%. This amount is within
the 80% to 125% and the hedge is considered highly effective.
Analysis to determine fair value as of June 30, X1
Heating oil cash flow on jet
Period ending 6/30/X1 futures contracts fuel purchase
Spot and futures price at end of period $0.4768 $0.4810
Futures price at beginning 0.4726 0.4759
of period 3/31/X1
Change in price per gallon 0.0042 0.0051
Gallons hedged 84,000,000 84,000,000
Change in fair value—gain (loss) $352,800
(Continued)
CASH FLOW HEDGES 85

Heating oil cash flow on jet
Period ending 6/30/X1 futures contracts fuel purchase
Change in expected cash $(428,400)
flows—gain (loss)
Cumulative change in fair value/expected $999,600 $(1,024,800)
cash flows over the term of the hedge
Note: Cumulative dollar offset is ($999,600/1,024,800) = 98%
The objective of the hedge is to reduce the variability of the expected cash
flows of the forecasted purchase of jet fuel on June 30, X1. Changes in the
fair values of heating oil futures are expected to be highly effective at off-
setting changes in the expected future cash flows of jet fuel due to changes
in price.
Hedging Instrument
2,000 long (purchase) for June 30, X1, for heating oil futures contracts at
$0.4649 per gallon. Each contract is 42,000 gallons.
Hedged Item
Forecasted purchase of 84,000,000 million gallons of jet fuel on the same

date the heating oil futures contract matures on June 30, X1.
Based on performing a regression analysis using past six-month periods of

time the Company determined that there is a high correlation between the
price of heating oil and the price of jet fuel. Based on that determination,
the company concluded that the correlation will continue in the future and
deemed the hedge to be highly effective as of the inception of the hedge on
Jan 1, X1. On an ongoing basis in determining hedge effectiveness, the
Company will use the cumulative dollar-offset method. The Company will
compare the estimated cash flows on the heating oil futures contracts with
the expected cash flows on the jet fuel contracts. Both the derivative instru-
ment and the hedged item (forecasted cash flows) will be based on the
forward prices. Ongoing effectiveness analysis will be updated on March
30, X1, and June 30, X1. (see above)
The following transactions will now illustrate the financial statement
effects of the hedged transaction.

Assets = Liabilities + +Stockholder’s Equity
+ OCI
+ Income from hedge ineffective
– Expense for hedge ineffectiveness
Jan 1, X1
No entry required because the futures contact has zero value at inception
March 31, X2
To record the changes in fair value of the futures contracts and the change
in forecasted expected cash flows.

+ Future contract + OCI
+ 646,800 + 596,400
+ Expense
+ 50,400
Note: The change in fair value of the futures contract is recorded as an asset
based on the analysis of fair value as of March 31, X1. The offset account
OCI is limited to the amount of the changes in expected future cash flows
(hedged item). The remainder would be recorded as an expense due to
hedge ineffectiveness.
In cash flow hedge, the amount of the “overhedge” ($646,800 – $596,400)

= $50,400 is recognized in earnings normally as other expense. In the
“underhedge” (in this case the change in the expected future cash flows
would be greater than the change in the derivative instrument), the change
in fair value of the derivative would be recognized entirely with an equal
offset amount to OCI.
CASH FLOW HEDGES 87
June 30, X1
To record the change in fair value of the futures contracts and the change
in expected cash flows from purchase of jet fuel:

+ Futures contracts + OCI
+ 352,800 + 403,200
– Expense
– 50,400
Note: The asset account futures contract is now valued at $999,600 as is

the OCI account. The calculation for the OCI account is ($596,400 +
$403,200) = $699,600. Also, note the income and expense from hedge
ineffectiveness offset each other by the settlement date.
To record the settlement of the futures contract:

+ Cash
+ 996,600
– Futures contract
– 999,600
To record the purchase of jet fuel:

+ Jet fuel inventory
+ 40,404,000
– Cash
– 40,404,000
Note: the 84,000,000 gallons of jet fuel are purchased at the spot price on
June 30, X1, which is $0.4810
To record the use of the jet fuel used in the following period (entry would
be made on September 30, X1):

– Jet fuel inventory – Air fuel expense
– 40,400,000 – 39,404,400
– OCI
– 999,600
Note: The balance in the OCI account is written off to earnings when the
company uses the inventory. The amount written off then reduces the
aircraft fuel expense. Think of a credit balance in OCI as a deferred gain.
Analysis
The financial statement impact of the hedged transaction was to lock in the
price of the 84,000,000 gallons of jet fuel at $0.4691 ($39,404,000/
84,000,000) instead of the spot price of $0.4810. The hedge wasn’t perfectly
effective, however, resulting in ($1,024,800 –999,600) going to earnings.
The final illustration in this chapter of a cash flow hedge will be:
Accounting for a Forecasted Transaction That Becomes

a Firm Commitment
On November 1, X1, a company which produces a bread-based product,

determines that it needs 100,000 bushels of wheat in the last week of Feb-
ruary, X2.
The company enters into a March 20, X2, forward contract (20,000
bushels per contract) to purchase wheat at $3.00 per bushel. The company
designates the forward contracts as a hedge of forecasted cash flow pur-
chases of inventory of 100,000 bushels of wheat on February 25, X2.
On December 31, X2, the company issues a purchase order to buy
100,000 bushels of wheat at $2.80 per bushel, to be delivered on February
25, X2. The company closes out its forward contracts purchased on
November 1, X1 on February 25, 20X2.
The designated risk being hedged is risk of changes in cash flows relating to all
the changes in the purchase price of the wheat inventory. This is cash-flow
hedge of a forecasted transaction from the period November 1, X1 to
December 31, X2. At that date, the company enters into a firm commitment
to purchase 100,000 bushels of wheat at $2.80, which is a fair value hedge.
Hedging Instrument
On November 1, X1, the company enters into forward contracts to by

100,000 bushels of wheat at $3.00 per bushel. The company designates
CASH FLOW HEDGES 89
the forward contracts as a hedge on forecasted wheat inventory purchases

on February 25, X2.
Hedged Item
From the period November 1, X1 to the period February 24, X2 the com-
pany is hedging its exposure to the variability of cash flows for the
100,000 bushels of wheat inventory needed on Feb 25, X2.
On December 31, X1, the company enters into a firm commitment to
purchase 100,000 bushels of wheat at $2.80 per bushel.
After cash flow hedge accounting has been discontinued of December 31,
X1, for the forecasted transaction, the forward contracts can be redesignated as
fair value hedge. However, in a fair value hedge we are turning fixed cash flows
into variable cash flows and the forward contract is a fixed price. The forward
contracts do not represent a fair value hedge of the firm commitment. We could
however get a fair value hedge on the firm commitment if we sell an equivalent
number of forward contracts on wheat inventory.
The company will assess hedge effectiveness based on the changes in

forward prices. The company expects the forward price changes on the
forward contracts to be highly effective when compared to expected future
cash flows for the purchase of bushels of wheat.
Note: The forward contract can be net settled at any time because of
the ready market for bushels of wheat contracts that are convertible into
cash.
Changes in the fair value of the contracts during the term of the hedge(s)
December 31, X1 February 25, X2

Forward price at beginning of period $3.00 $2.80
Forward price at end of period 2.80 3.10
Change in price, per bushel (0.20) 0.30
Bushels under contract 100,000 100,000
Change in fair value of contracts—gain (loss) $20,000 $30,000
The financial statement effects and related explanations are as follows:

+ OCI
+ Gain on hedge
– Loss on hedge
+ Gain on forward contract
– Cost of sales
November 1, X1
No entry is recorded because the forward contract has zero value at inception.
December 31, X1
To record the change in fair value of the forward contract and the offsetting
entry to OCI

– Forward contract – OCI
– 20,000 – 20,000
Note: Forward contract is a liability with an amount of $20,000 with the same
amount recorded in OCI representing a deferred loss. The amount in the OCI
account will stay on the financial statements until we purchase the inventory.
Feb 24, X2
To record the change in fair value of the forward contracts:

+ Forward contracts + Gain on forward contracts
+ 30,000 + 30,000
Note: The cash flow hedge expired on December 31, X1 and the remain-
ing term of the forward contracts did not qualify as a hedge of the firm
commitment. The forward contract is recorded as a gain to earnings.
To net settle the forward contracts:

+ Cash
+ 10,000
– Forward contracts
– 10,000
CASH FLOW HEDGES 91
Note: The company settles the forward contracts for cash. The amount is
the net of the $20,000 deferred loss in OCI and the $30,000 gain on
forward contract.
To record the purchase of wheat inventory:

+ Wheat inventory
+ 280,000
– Cash
– 280,000
Note: Inventory is purchased at the firm commitment price of $2.80 per

bushel X 100,000 bushels.
To record write off of OCI when the cereal products are sold:

+ OCI
+ of sales
– 20,000
CHAPTER 5
Foreign Currency Hedges

About This Chapter
Foreign currency derivatives and hedging activities continues to illustrate
the previous accounting guidance for fair value and cash flows hedges for
companies that conduct business in more than one currency. The account-
ing guidance for derivative and hedge accounting on how to account for
foreign currency transactions is limited to:
. Continuing to permit hedge accounting for the type of hedge items

(e.g., net investments and firm commitments) and hedging
instruments (e.g., derivatives and nonderivatives) that were
previously permitted under accounting guidance for foreign
currency transactions and financial reporting
. Increasing the consistency of hedge accounting guidance for foreign
currency hedges and other types of hedges by broadening the scope
of foreign currency hedges that are eligible for hedge accounting
(endnote ASC 830)
The previous illustrations on accounting for fair value and cash flow
hedges will be applied to foreign currency hedges, including the hedge of a
net investment in a foreign subsidiary. This chapter will focus on any dif-
ferences of what derivative instruments qualify as hedges of a company’s
price (market) risk due to changes in exchange rates between currencies. As
usual we will use comprehensive illustrations to demonstrate the account-
ing and documentation requirements for foreign currency hedges. Special
attention will be devoted to hedging the net investment of a foreign-
controlled subsidiary.
Foreign Currency Hedges

Accounting guidance permits three major exceptions to the general prin-
ciples to accounting for derivative instruments and hedging activities from
our previous discussions in chapter 1. These exceptions are:
1. A nonderivative financial instrument denominated in a foreign cur-

rency to be designated as a hedge of a firm commitment (fair value
hedge).
2. A derivative or nonderivative financial instrument denominated in a
foreign currency to be designated as a hedge of foreign currency
exposure of a net investment in a foreign operation.
3. A recognized foreign-currency-denominated asset or liability for
which a transaction gain or loss in recognized in earnings to be the
hedged item in a fair value or cash flow hedge.
Accounting for Foreign Currency Transactions

The complexity of accounting for foreign currency transactions is that
accounting standard setters, both U.S. GAAP and IFRS, had derivative and
hedging guidance in place for foreign currency transactions that were not
superseded by the issuance of the present accounting guidance for deriva-
tive instruments and hedging activities. This complicates the understand-
ing of the derivative instruments, impact on financial statements by
requiring adherence to two sets of reasonably complicated accounting stan-
dards. Let’s proceed with an explanation of accounting for foreign currency
transactions and then dive into placing a hedge around the existing asset,
liability, firm commitment, or forecasted future cash flows.
A foreign currency transaction is a transaction between (for our pur-
poses) U.S. companies and foreign suppliers or customers in which the
transaction is denominated in a foreign currency measured on the finan-
cial statements in dollars ($). In essence, every foreign currency transac-
tion is two transactions; 1) operating transaction; and 2) financing
transaction. The operating transaction component is normally the buy-
ing and selling of products or services. The operating portion does not
result in a gain or loss due to price risk caused by the movement of the
dollar against the foreign exchange currency. There will, however, be a
FOREIGN CURRENCY HEDGES 95
transaction gain or loss due to changes in the currencies that are recorded
as a finance gain or loss.
Foreign currency rates are determined by comparing the price of one
country’s currency (U.S. dollar) with what that currency can purchase in
foreign currency units (FC). The rates can be expressed directly—amount
of currency needed to acquire one unit of foreign currency or indirectly—
amount of foreign currency that can be acquired per unit of domestic cur-
rency. For example, at present (exchange rates change every business day)
the Great Britain Pound (GBP) is trading at $1: GPB 1.50272. To deter-
mine the United States Dollar (USD) we would divide the value of the
GPB into 1 USD and arrive at $0.66546. This translates to the USD is
worth $0.66546 when compared to the GPB.
Currency rates of foreign countries when compared to the USD are
generally floating rates. That is, based on the particular relative economic
conditions for that country (or the European Union which has the Euro)
their currency floats against the dollar. China is the exception as they peg
their currency to be relatively constant against the dollar as a component of
governmental policy. These floating exchange rates against the USD causes
the financial gain or loss when companys get paid in foreign currencies
(FC) for sales made or when making purchases of goods and services that
occur on a date other than the operating transaction date. This is what is
meant by the strengthening of the USD or the weakness of the USD when
compared to FCs. For example, if the GPB goes to 1.6025 as measured
against the USD, the USD equivalent would be $0.62. The dollar weak-
ened against the GBP. This is the risk of foreign currency transactions, the
FC strengthens against the dollar, making the USD less valuable or the
USD rises against the FC making the FC less valuable. The management
of these risks, by using derivative instruments, depends on whether the
company is receiving assets (cash) or paying off liabilities.
When companies are receiving assets they would prefer that the foreign
currency strengthen against the dollar. Since foreign currency (FC) busi-
ness transactions are settled in the local foreign currency then remeasured
to U.S. dollars, the rising FC will be worth more dollars and result in an
exchange gain being recorded. When the company is paying liabilities, it
wants the opposite, the USD rising against the FC. In that case, the USD
buys more FCs to settle the transaction.
The accounting framework used account for import and export trans-
actions is as follows:
1. Restate foreign currency invoice price into U.S. dollars using the
appropriate foreign exchange spot rate.
2. Record an exchange gain or loss that causes the dollar amounts to
differ from the original transaction.
3. If the transaction is not settled at a balance sheet reporting date (nor-
mally quarterly) record an exchange gain or loss by adjusting the
receivable or payable to its dollar equivalent using the spot rate on
the balance sheet reporting date.
The following examples1 will illustrate the accounting for foreign cur-
rency transactions.
On October 16, X1, a Retailer purchased sweaters at an invoice price of
17,000 New Zealand dollars (NZ$) from a New Zealand manufacturer. The
exchange rate was $.0.62: NZ$. Payment was due on December 16, X1.
+ Exchange gain
– Exchange loss
To record the purchase of sweater inventory on October 16

+ Inventory + Accounts payable
+ 10,540 + 10,540
Note: The calculation is NZ$ 17,000 X $0.62 = $10,540. The transaction

is denominated in NZ$, but measured in USD. The accounts payable will
be settled in NZ$ based on their $ equivalent on the settlement date.
On December 16, the Retailer purchases 17,000 NZ$ at an exchange rate

of $0.63: NZ$ and transmits to manufacturers bank in New Zealand.

+ Accounts payable – Exchange loss
+ 710 – 710
Note: Accounts payable amount is now NZ$17,000 X $0.63 = $17,710,

which is $710 greater than the amount recorded on October 16.

+ Foreign Currency
+ 10,710
– Cash
– 710,000

– Foreign currency – Accounts payable
– 10,710 – 10,710
Note: The strengthening of the NZ$ against the USD and the company is a
liability position caused by the foreign currency loss. Also, note that the
inventory account, the operating aspect of the transaction, is not changed
due to currency changes, instead the balance sheet account is changed.
The following illustration will involve accounting for a sale and making the
adjustment on the balance sheet reporting date.
On November 20, X1, the Retailer sold wool coats to a Canadian com-
pany for 9,800 Canadian dollars (C$) when the spot exchange rate was
$0.95: C$. Payment was due on January 20, X2. The company’s fiscal year
ended on December 31, X1. The exchange rate on December 31, X1, was
$0.985: C$ and the exchange rate on January 20, X2 was $.995: C$.

+ Exchange gain
– Exchange loss
+ Revenue
To record the sale wool coats to a Canadian company on November 20:

+ Accounts receivable + Revenue
+ 9,310 + 9,310
Calculations to derive the asset and revenue amounts recorded are 9,800C
$ $0.95 =$9,310
January 31 entry to record the appropriate adjustment on the financial

statements:

+ Accounts receivable + Exchange gain
+ 343 + 343
Calculations to derive increased asset value at the reporting date are C$

(9,800 x $0.985) – 9,310 = $343. The USD weakened against the C$
leading the foreign currency buying more dollars.
On January 20, X2, the company received payment from the Canadian com-
pany at the spot rate of $0.995, and exchanged the Canadian currency for
USD, after adjustment for the movement of the C$ against the USD.
To record changes due to a strengthened C$:

+ 98 + 98
To record the collection of the account receivable from the Canadian

company:

+ Foreign currency
+ 9,751
– Accounts receivable
– 9,751
To record the exchange of C$ to USD:

+ Cash
+ 9,751
– Foreign currency
– 9,751
Note: The foreign currency strengthened against the USD, resulting in the
foreign currency buying more dollars.
The illustrations above demonstrate the exchange (price) risk that compa-
nies have to take when selling and purchasing products and services in
international markets. The company challenge in managing the price risk
is two-fold: (a) Will the USD rise or fall against the particular foreign cur-
rency in which the company has economic transactions? and (b) Is the
company in a net asset position or a net liability position with regard to
its current operations? The combination of the company’s perspective of
the answers to the two questions above will determine its risk management
strategy. Derivative instruments that can be used as hedges of the financial
risk (each foreign currency transaction has an operating and financial risk)
can be a very effective way for companies to manage those risks. The fol-
lowing simplified example will illustrate the accounting for a hedge of
exposed assets using a forwards sale contract.
The Retailer sold goods for 2,000 GBP to a British customer on Oct 1,
X1, when the spot rate was $2.10: GBP. Payment in pounds is due on
March 1, X2. On the same date as the operating transaction was entered
into, Retailer enters into a forward sale contract to deliver 2,000 GBP on
March 1, X2, at a forward rate of $2.11/GBP.

+ Revenue
+ Exchange gain
– Exchange loss
Retailer records the sale of goods to the British Customer on October 1:

+ Accounts receivable + Revenue
+ 4,200 + 4,200
Calculation to record revenue is $2.10 2,000 = $4,200
Note: No entry is required for the forward contract since its fair value is
zero because the contract price and the forward price are the same at con-
tract inception. When the forward price moves over the life of the hedge,
then a gain or loss will be recorded.
Retailer records a year-end adjustment for both the changes in the spot rate
(financial component of the sales transaction) and an adjustment for the
changes in the forward rate on the derivative instrument. On December
31, X1, the spot rate for GBP has moved to $2.15/GBP and the forward
rate for delivery is now $2.16/GBP.
To record the changing value of exchange spot rates on the financial
statements:

+ Accounts receivables + Exchange gain
+ 100 + 100
Calculation is ($2.15 – $2.10) 2,000 = $100
To record the change in fair value of the forward contract:

+ Forward contract – Exchange loss
+ 100 – 100
Calculation is ($2.16 – $2.11) 2,000 = 100
On March 1, X2, the British customer pays the Retailer and the company
settles the forward contract. The spot rate and the forward rate have con-
verged to $2.18/GBP.
To record the changing value of the exchange spot rates on the finan-
cial statements:

+ 60 + 60
Calculation is ($2.18 – $2.15) 2,000 = $60
To record the changing fair value of the derivative instrument:

+ Forward contract – Exchange loss
+ 40 – 40

– Exchange loss
– 40
Calculation is ($2.18 – $2.16) 2,000 = $40
To record payment to the British customer on March 1, X2:

+ Foreign currency
+ 4,360
– Accounts receivable
– 4,360
Calculation is $4,200 + $100 +$60 = $4,360
To record the delivery of the foreign currency and settlement of the for-
ward contract on March 1, X1:

+ Cash – Forward contract
+ 4,220 – 140
– Foreign c
urrency
– 4,360
Analysis: the company receives foreign currency (GBP) based on the for-
ward contract of 2,000 $2.11 = $4,220 and closed out the forward con-
tract liability account and the foreign currency account.
The remainder of this chapter will demonstrate through compre-
hensive illustrations the most popular foreign currency hedges used by
companies.2
Use of a Forward Exchange Contract to Hedge a Firm

Commitment to Pay Foreign Currency
A U.S. company enters into a firm commitment with a foreign supplier on

September 30, X1, to purchase equipment for foreign currency (FC)
10,000,000. The equipment is deliverable on March 31, X2, and is pay-
able on June 30, X2. In order to hedge the commitment to pay foreign
currency of 10,000,000, the company enters into a forward exchange con-

tract on September 30, X1, to receive FC 10,000,000 on June 30, X2 at an
exchange rate of FC1=U.S.$0.72.
The company assesses hedge effectiveness based on the measurement of
the difference between changes in the value of the forward exchange con-
tract and the USD equivalent of the firm commitment. Since both of the
fair value changes are calculated based on changes in the forward rates from
inception to June 30, X2, the company determines there will be no hedge
ineffectiveness.
Foreign Currency (FC)/U.S. Exchange Rates

Date Spot rates Forward rates for June 30, X2
September 30,X1 FC 1 = $0.65 FC 1 = $0.72
December 31, X1 FC 1 = $0.66 FC 1 = $0.71
March 31, X2 FC 1 = $0.69 FC 1 = $0.71
June 30, X2 FC 1 = $0.70 Spot and forward rates converge
As the basis for determining the impact on the financial statements over the
term of the hedging relationship the company prepares the following fair
value analysis assuming zero hedge ineffectiveness. The fair value analysis is
based on changes in the forward rates for both the derivative instrument
(forward contract) and the firm commitment discounted at 6.00% to
determine the net present value.
Fair value of Change in fair

forward contract value of forward
Date discounted at 6.00% contract gain (loss)
September 30, X1 $– $–
*
December 31, X1 (97,066) (97,066)
**
March 31, X2 (98,522) (1,456)
***
June 30, X2 (200,000) (101,478)
Total ($200,000)
*[FC 10,000,000 (0.71 –0.72)/[1.06/4)]^2 = (97,066)

**[FC 10,000,000 (0.71 –0.72)]/1.06/4 = 98,522
***[FC 10,000,000 (0.70 –0.72)] = 200,000
Hedge Documentation

The objective of the transaction is to hedge the changes in the fair value of
the equipment purchase (fair value hedge) firm commitment attributable
to changes in foreign currency forward rates between the foreign currency
(FC) and the USD. The company entered into a forward contract to pur-
chase FC 10,000,000 on September 30, XI, to receive FC 10,000,000 on
June 30, X2 to reduce the risk in the variability of foreign currency
exchange rates.
A forward contract to buy FC 10,000,000 at an exchange rate of FC 1 = U.
S. $0.72 on June 30, X2.
c. Hedged Item
The firm commitment to purchase equipment from foreign supplier at
foreign currency 10,000,000 on March 30, X2.

The company has performed a critical terms assessment of the derivative
instrument and the hedged item and concluded that the changes in fair
value attributable to the changes in foreign currency and the USD are
expected to be completely offset by the forward contract. The company
will perform ongoing effectiveness tests by verifying and documenting that
the critical terms of the firm commitment and the forward contract (deriv-
ative instrument) match.
The company documented that the critical terms match was as follows.
. The critical terms of the forward and the hedged transaction (firm
commitment) are identical; same notional, same date, and same
currency.
. The fair value of the forward contract at inception is zero. No
amounts were paid or received and were entered into at market rates.
. Effectiveness will be based on changes in the forward rate. (ASC
815-20-25-84 (a) (b) (c))
The following illustrates the financial statement impact over the term of
the derivative instrument as well as the firm commitment.

+ Foreign exchange gain
– Foreign exchange loss
September 30, X1
No impact on financial statements as the forward contract has zero value at
inception
December 31,X1
To record the change in fair value of the forward exchange contract

+ Forward contract payable – Foreign exchange loss
+ 97,066 – 97,066
Note: fair value changes are taken from the fair value table above.
To record change in the fair value of the firm commitment that is due to
changes in the exchange rate:

+ Firm commitment + Foreign exchange gain
+ 97,066 + 97,066
Note: for a fair value hedge if the derivative instrument (forward contract)
goes out of the money then the accounting rules require that the firm com-
mitment offset the liability recorded that is equal to the loss on foreign
exchange, be offset by a gain on foreign exchange with the offset being to
an asset account firm commitment.
March 31, X2
To record the change in fair value of the forward exchange contract

+ 1,456 – 1,456
Note: the amount recorded on March 31 increase the balance sheet

account forward contract payable to $98,522
To record the change in fair value of the firm commitment due to changes
in foreign exchange rates:

+ Firm commitment + Foreign exchange gain
+ 1,456 + 1,456
Note: the amount recorded on March 31 for the asset account firm com-
mitment will now be equal to the account balance for the forward contract
payable.
To record receipt of the equipment on March 31, X2 at the forward con-

tract rate established by the hedging transaction:

+ Equipment + Equipment payable
+ 6,998,522 + 6,900,000
– Firm commitment
– 98,522
Note: the equipment is recorded at the spot price on March 31, X2, of
$0.69 FC 10,000,000 = $6,900,000. The firm commitment asset is
written off at its carrying value of $98,522. The equipment then is
recorded at the combination of the two amounts. Also, note that the equip-
ment will not be placed in service until the payment date of June 30, X2, so
no depreciation would be recorded on June 30, X2.
June 30, X2
To recognize the change in fair value of the forward contract:

+101,478 – 101,478
Note: The company has a natural hedge on the derivative instrument since
it settled the firm commitment hedge transaction on March 31, X2. The
foreign-currency-denominated payable is remeasured to the company’s
reporting currency (USD) using the reporting period and changes in the
spot rate. For the remainder of the transaction (converting FC to cash to
pay the account payable) the change in fair value of the forward contract
consists of these components:
1. Change in the spot rate

2. Interest on opening fair value
3. Change is spot/forward differential
This will cause some recorded income statement mismatch in the for-
ward contract the accounts payable owned due to the implicit interest cost
of the forward. In the journal entry above, I assumed $98, 522 (6.00%/
4) = $1,478.
To recognize the transaction loss on the foreign currency account payable:

+ Accounts payable – Foreign exchange loss
+ 100,000 – 100,000
Note: the change in the fair value of accounts payable is based solely on the
changes in spot rates. FC 10,000,000 ($0.69 – $0.70) = $100,000
To record settlement of the forward contract and the accounts payable:

– Cash – Forward contract payable
– 7,200,000 – 200,000
– Accounts payable
– 7,000,000
Note: Settlement of the forward contract at FC 10,000,000 $0.72 =

$7,200,000. Accounts payable is FC 10,000,000 $0.70 (spot price) =
$7,000,000. The forward contract payable is written off when the deriva-
tive instrument is settled.
Analysis of the Hedged Transaction
The firm commitment was recorded $6,998,522, which consisted of the

accounts payable at the spot price of $0.69 FC 10,000,000 plus the fair
value of the firm commitment. If the company which was very close to the
accounts payable of $7,000,000 that was recorded. In addition, gains and
losses on the firm commitment were offset, with just a small amount of earn-
ings mismatch when we settled the forward contract. However, the move-
ment of forward rates caused a $200,000 loss on the derivative instrument.
For the next illustration, let’s examine a cash flow using foreign-
currency option.
Use of Foreign-Currency Options to Hedge Forecasted Foreign Sales
Company is a U.S. reporting company with sales to foreign customers. The

company’s sales are denominated in foreign currencies (FC) but do not
meet the accounting guidance for classification as a firm commitment. The
company forecasts that as of September 30, X1, foreign currency sales of
FC 10,000,000 will occur in 6 months on March 31, X2. The company
has historical experience with its customers that the sales are probable of
occurring. The company’s risk management policy uses foreign currency
put options to hedge the exchange (price) risk when selling to foreign cus-
tomers. Because this is a hedge of a forecasted transaction, the company
will designate as a cash flow hedge of forecasted sales.
The contractual terms and conditions of the foreign currency put are as follows:
Contract items Put option contract terms

Contract amount FC 10,000,000
Trade date September 30, X1
Expiration date March 31, X2
Foreign currency exercise rate (price) FC 1 = $0.50
Spot rate FC 1 = $0.50
Premium $20,000
The premium paid for the option represents the time value only.
Option premiums generally represent the time value only when purchased
because the interaction between the foreign currency exercise rate of FC 1 =
$0.50 and the spot rate of FC 1 = $0.50 has not moved. The difference in
the spot rate from September 30, X1 and March 31, X2 will put the option
in the money (spot rate rises above the exercise rate) or out of the money
(spot rate falls below the exercise rate). This movement between the two
rates is called the intrinsic value of the option. The foreign-currency put
option is designated as hedge of the company’s forecasted cash flows, and
the company expects the hedge to be perfectly effective because the critical
terms of the derivative instrument match the hedged item (forecasted
future cash flows from sales). The company will assess hedge effectiveness
at inception and over the life of the hedge on the basis of changes in the
options intrinsic value—amount of positive value for the difference
between the option’s spot exchange rate and the exercise exchange rate.
Changes in the time value (premium of $20,000) will not be hedged and
will instead be written off to earnings over the term of the contract.
The objective of the hedged transaction is to eliminate the currency (price)

risk associated with the forecasted foreign-currency denominated sales for
the company which is a USD reporting currency due to changes in the
FC:USD exchange rate. The derivative instrument purchase takes place on
September 30, X1.
Hedging Instrument
This is a cash flow hedge in which the hedging instrument is a purchased
put option to sell FC 10,000,000 with an exercise price of FC 1: $0.50
USD. The risk exposure being hedged is the variability of the future
expected cash flows attributable to a specific change is exchange rates.
Hedged Item
The foreign exchange put option is designated as a foreign currency cash
flow hedge of FC 10,000,000 of forecasted foreign currency sales on March
31, X2. The company has determined that the forecasted transaction is prob-
able of occurring based on historical transactions of a similar nature and will
update this assessment for each reporting period of the hedged transaction.

The company assessed the critical terms of the derivative instrument and
the hedged item (forecasted cash flows) and found a match such that
changes in the put options intrinsic value will completely offset the changes
in the forecasted cash flows based on changes in the spot rate. The com-
pany used the following accounting guidance in determining whether the
critical terms of the derivative instrument and the hedged item matched in
concluding hedging effectiveness.
. The critical terms of the hedged item and the option are identical as
notional, cash flow date, and currency.
. The option was at the money at inception of the hedged transaction.
. Effectiveness will be assessed based on the intrinsic value of the
option. The change in the option’s intrinsic value will completely
offset the change in the expected cash flows based on changes in the
spot rate.
The company will assess the critical terms of the hedged transaction to
determine if there are any changes that would cause some ineffectiveness.
The company will record in other comprehensive income (OCI) changes
in the derivative instrument that are effective in offsetting changes in the
forecasted cash flows due to changes in the spot rate over the term of the
hedged transaction. Any change in the critical terms that cause hedging
ineffectiveness between the derivative instrument and the hedged transac-
tion will be recorded in earnings.
Prior to recording the financial statement effects of the hedged trans-
action, we will examine the valuation of the derivative instrument (put
option) over the term of the hedged transaction.
Valuation of the Derivative Instrument

FC/U.S. $
March Contract 9/30/X1 12/31/X1 3/31/X2
Contract rate 2.00 2.00 2.00
Spot rate 2.00 2.10 2.30
Given the information above, we then perform a fair value analysis that will
become the basis for recording the financial statement effects and deter-
mining hedge effectiveness.
Fair Value Analysis of Derivative Instrument

Date Time Value Intrinsic Value Total Value
9/30/X1 $20,000 $— $20,000
1
12/31/X1 9,000 238,095 247,095
3/31/X1 —— 652,1742 652,174
(FC 10,000,000/2.00 = $5,000,000) less (FC 10,000,000/2.10) =

$4,761,905 which equals $238,095.
Taking the same $5,000,000 contract rate, we subtract the sport rate of
(FC 10,000,000/2.30 = $4,347,826) = $414,079. This is the amount of
the increase in intrinsic value for the March 31, X2 reporting period. In the
table above, the $414,079 is added to the $238,095 to produce the
reported asset value of $652,174.
Note that the time value goes to zero on settlement date. The decreas-
ing value in time value component of the put option will go directly to
earnings. However, since we are hedging the forecasted cash flows with the
changes in spot rates (intrinsic value) of the derivative instrument, this
produces no hedge ineffectiveness.
The following transaction history is an analysis of the financial statement
effects of the hedged transaction.

– Loss on hedge
+ OCI—deferred gain
– OCI –deferred loss
+ Revenue
September 30, X1
To record the foreign currency option at the premium paid:

+ Foreign currency option
+ 20,000
– Cash
– 20,000
Note: The option is recorded as an asset when paid and represents the time
value of option. Over the term of the hedged transaction, the time value
will converge to zero, so we will write this amount off against earnings over
the term of the hedged transaction.
December 31, X1
To record the change in time value of the foreign currency option;

– Foreign currency option – Loss on hedge
– 11,000 – 11.000
Note: The computation of the time value decrease is a present value cal-
culation using the risk-free rate and the time remaining on the option. For
our purposes, they are given values.
To record the change in the intrinsic value of the option;

+ Foreign currency option + OCI
+ 238,095 + 238,095
Note: The option goes in the money and is recorded as a deferred gain in
OCI in Shareholder’s equity.
March 31, X2
To record the change in the time value of the option:

– Foreign currency option – Loss on Hedge
– 9,000 – 9,000
Note: Time value goes to zero on settlement so we remove the remaining

value from the asset account foreign currency option.
To record the change in the intrinsic value of the option:

+ Foreign currency option + OCI
+ 414,079 + 414,079
Note: Record the increase in the foreign currency option account to reflect
changes in the spot rate from 2.10 to 2.30 on March 31, X2.
To record FC 10,000,000 in sales at the current spot rate of 2.30 FC/U.S.$:

+ Cash + Revenue
+ 4,347,826 + 4,347,826
Note: The company records the sales of FC 10,000,000 and records the
U.S. dollar equivalent in revenue.
To record settlement of the derivative instrument (put option):

+ Cash
+ 652,174
+ Foreign currency option
+ 652,174
Note: The company settles the foreign currency option and receives cash
equivalent to its intrinsic value, which is the result of the spot rates moving
from 2.00 to 2.30 over the term of the hedged transaction of FC
10,000,000 as compared to the contract rate of 2.00.
To transfer the deferred gains in OCI to earnings:

– OCI
– 652,174
+ Revenue
+ 652,174
Note: The hedge was done to assure that the company received at least
$5,000,000 from its FC 10,000,000 sales. The transaction above when we
cashed out the derivative instrument for $652,174 combined with the spot
sales of $4,347,826 accomplishes our objective. The cost of the option
contract of $20,000 was the cost of predictability that assured the company
of revenue of $5,000,000.
The next two illustrations both involve hedging the net investment in a
foreign subsidiary. Subsidiary will be used to describe the relationship when a
U.S Company controls the operating and financial policies of a foreign
company. The first illustration will use a forward exchange contract and the
second illustration will use a non derivative contract to hedge the net invest-
ment in a foreign subsidiary. The use of a non-derivative contract in a hedged
transaction is one of the exceptions to accounting guidance for hedging activ-
ities that is allowed under accounting guidance for foreign operations.
Prior to illustrating a hedge of the net investment in a subsidiary some
accounting background is necessary to understand why a company would
do the hedged transaction. The risk management strategy for this type of
hedge is to protect the net carrying value (assets minus liabilities) of the
subsidiary from adverse changes in the local foreign currency that the sub-
sidiary uses during the year to record and report its changes in assets and
liabilities. The adverse effect of foreign exchange rates is magnified by the
accounting guidance that generally requires assets and liabilities to trans-
lated by the U.S. company at the spot rate for the foreign exchange equiv-
alent using the fiscal reporting date at the end of the year.
This arbitrary accounting rule mandates that companys generally use
the spot exchange rates of Foreign Currency (FC) USD in the year-end
reporting date. However, during the operating year the company has been
reporting changes based on exchange rates that were in effect when the
transactions were originated and settled. Since exchange rates fluctuate every
business day, the translation of foreign controlled companies, balance sheets
and income statements to be combined with the U.S. company would
never equal and would the accounting equation would be out of balance.
Accounting guidance then rectifies this imbalance by requiring the off-
set amount needed to balance the combined financial statements by using
an account called cumulative translation adjustment (CTA) in shareholder’s
equity. For example, if the CTA amount needed to balance the financial
statements is a credit (think gain) then the amount is added to shareholder’s
equity. If the amount needed to balance the financial statements is a debit
(think loss) the CTA is reduced by that amount. The CTA account is a
permanent balance sheet account that is carried on the financial statements
of the U.S. company until they would divest the foreign subsidiary or sell a
large enough interest in the subsidiary that the U.S. company would no
longer control the foreign subsidiary.
The risk management strategy is to protect against a large debit CTA
(loss from foreign exchange translation) because of the adverse effect on the
company’s shareholder equity amount as reported in the combined finan-

cial statements. Changes in shareholder equity from one balance sheet date
to the next are generally viewed by financial statement users as the amount
of earnings retained by the company from its earned income. The amount
retained for the current year is net income earned minus the dividends
paid. When companies are required by accounting rules to add in other
components of shareholder equity the financial analysis of the company
can be difficult to assess.
In the previous chapter on accounting for cash flow hedges, the use of
the offset account other comprehensive income (OCI) can make this the
analysis of changes in assets and liabilities from one year to the next or over
time more difficult. In my view, that is why I look at changes to OCI over
the term of the hedge as deferred gains or losses. That view does not hold
for the cumulative translation adjustment because it is a purely arbitrary
rule that allows combined financial statements to be in balance. They are
not deferred gains and losses because normally the company has no inten-
tion of realizing the CTA amounts by immediate sale of the operating sub-
sidiary. The way to mitigate the adverse changes or to smooth out changes
to the reported amount of a foreign subsidiary on the U.S. company’s
financial statements is to engage in hedges of the net investment (assets
minus liabilities). Since assets minus liabilities is equal to shareholder
equity you are hedging the adverse change in arbitrary changes to share-
holder equity not due to income earned and dividends paid.
Use of a Forward-Exchange Contract to Hedge a Net Investment

in a Foreign Subsidiary
A U.S. Company has a net investment of FC 50,000,000 in a foreign

subsidiary. On October 1, X1, the company enters into a six-month for-
ward contract to sell FC 50,000,000 at FC 1 = $1.70, when the spot rate is
FC 1 = $1.72 to hedge its entire net investment in foreign subsidiary of FC
50,000,000 as of the beginning of the reporting year.
The company will measure effectiveness based on the changes in the
forward rates and on the beginning balance of the net investment in foreign
subsidiary at the beginning of the hedging period. This will allow the com-
pany to record all changes in the fair value of the derivative instrument
(forward contract) to be reported in the cumulative translation adjustment

(CTA) account in shareholder’s equity. The company documents that the
notional of the forward contract and the hedged item match and the cur-
rency of the forward matches the currency of the foreign subsidiary.
Exchange Rates
Date Spot Forward
October 1, X1 FC 1 = $1.72 FC 1 = $1.70
December 31, X1 FC 1 = $1.65 FC 1 = $1.63
March 31, X2 FC 1 = $1.60 FC 1 = $1.60
We can take the hypothesized changes in exchange rates and construct our
fair value analysis of the derivative instrument and the hedged item.
Fair Value Analysis of Derivative Instrument and Hedged Item
Change in fair value Change in fair value
of forward contract of net investment due
(discount rate to changes in the spot
Date used is 8%) rate ( ) represents liability
October 1, X1 $— $—
December 31, X1 3,431,3731 (3,500,000)3
March 31, X2 1,586,627 (2,500,000)
2
Cumulative $5,000,000 ($6,000,000)4
1
Fair value change on December 31, X1, is calculated as [FC 50,000,000 X (1.70 – 1.63)] /[1 +(.08/4)] =
$3,431,627. Note: the change in the derivative instrument is calculated using the change in forward rates.
2
The $5,000,000 is derived from the calculation FC 50,000,000 X (1.70 – 1.60). The change in fair
value for March 31, X2, is the difference between the cumulative total and the December 31,
X1, change in fair value.
3
The $3,500,000 is derived from the calculation FC 50,000,000 X (1.72 – 1.65). Note the changes
in the net investment account are computed using the changes in the spot rate, and with no
discount attached.
4
The $6,000,000 is derived from the calculation FC 50,000,000 X (1.72 – 1.60). The
$2,500,000 fair value change is the difference between the cumulative change in fair and the
change in fair value of the hedged item on December 31, X1.
Hedge Documentation
The objective of the hedged transaction is to hedge the net investment in

foreign subsidiary of the company, against adverse changes in exchange
rates. The Company uses the USD for reporting while the foreign subsid-
iary uses FC in their financial reporting. The hedge is to protect the net
investment (Shareholder’s equity) from movements of the FC when trans-
lated into the reporting currency U.S. dollar.
Hedging Instrument
Company will use a forward contract to sell FC 50,000,000 at FC 1 = U.S.

$ 1.70. The derivative instrument is entered into on October 1, X1, and
will be settled on March 31, X2.
Hedged Item
The foreign forward exchange contract is designated as a hedge of the net

investment of the foreign subsidiary’s beginning balance of FC 50,000,000
on October 1, X2.
Hedge effectiveness will be assessed at the inception of the hedged term

and over the term of the hedged transaction. Effectiveness will be based on
overall changes in the fair value of the foreign forward contract. The fair
value changes will be based on changes in the forward rate. The critical
terms of the hedged transaction including notional, currency, and under-
lying for the forward contract match the same critical terms of the net
investment in foreign subsidiary as of October 1, X1. As a result, the com-
pany expects the hedge to be highly effective.
The company will measure effectiveness of the forward contract on the
foreign exchange risk of the net investment in subsidiary by using a hypo-
thetical derivative. The changes in the value of the foreign forward contract
will be compared to changes in the hypothetic derivative, which will be
changes in the net investment in foreign subsidiary over the term of the
hedge. The net investment in foreign subsidiary will be hypothetically cal-
culated beginning at October 1, X1, and on required reporting and settle-
ment dates over the term of the hedged transaction. The hypothetical
derivatives (net investment in foreign subsidiary) changes in fair value will
use the spot rates in effect over the term of the hedged transaction.
The following transaction history of the hedged transaction will dem-

onstrate the financial statement effects.

+Cumulative Translation Adjustment (CTA)
October 1, X1
No entry at inception since the FC forward equals the contract rate
December 31, X1
To record the change in fair value of the forward contract from October 1,
X1 as a CTA:

+ Forward contract receivable + CTA
+ 3,431,473 + 3,431,473
Note: the forward contract receivable goes in the money because the forward
rate for the October contract for March settlement decreases on December
31, X1. The offset entry is to increase shareholder equity by increasing the
cumulative translation adjustment account for the same amount.
To record the change in the foreign subsidiaries assets and liabilities (net
investment in foreign subsidiary) based on changes in the spot rate from
October 1, X1 to December 31, X1:

– Net investment in foreign – CTA
subsidiary – 3,500,000
– 3,500,000
Note: The net investment decrease is calculated as per the table above based
on changes in the spot rates from October 1, X1, to December 31, X1. The
offset entry to CTA will represent some ineffectiveness due to the derivative
instrument using the forward rate to record fair value changes and the
hypothetical derivative net investment in foreign subsidiary is using the spot
rate. The net investment in foreign subsidiary is carried on the controlling
company’s books as a single-line item in their financial statements.
March 31, X2
To record the change in the fair value of the forward contract from Decem-
ber 31, X2, to the settlement date:

+ Forward contract + CTA
receivable + 1,586,627
+ 1,586,627
Note: Change in the fair value on the forward contract from inception to
the settlement date is $5,000,000.
To record the cash settlement of the forward contract:

+ Cash
+ 5,000,000
-Forward contract
Receivable
- 5,000,000
Note: The forward contract is turned into cash on the settlement date. The
$5,000,000 represents the gain from entering into the forward contract on
October 1, X1.
To record the cumulative translation adjustment:

-Net Investment in foreign subsidiary -CTA
-2,500,000 -2,500,000
Note: The forward contract went in the money by $5,000,000 while the
net investment went out of the money by $6,000,000. However, for
these types of hedges there is no ineffectiveness that goes to earnings.
From the analysis above, note that all the adjustments are made on the
balance sheet accounts of the controlling company. What appears to be
ineffectiveness will not be recorded over the term of the hedged
transaction.
Analysis
The controlling company will increase cash by $5,000,000 by settling

the forward contract. The company will also maintain the cumulative
translation adjustment account, which results in a net change of minus
$1,000,000 over the term of the hedged transactions and also carry the
net investment in foreign subsidiary account at $6,000,000 less than its
beginning balance of FC 50,000,000, which would be carried on the
company’s books at FC 50,000,000 1.72 (spot rate) = $86,000,000.
The mathematical result of the hedged transaction was to record debits
for the asset cash (forward contract receivable) and a debit net change of
$1,000,000 in the cumulative translation adjustment account, which
equals $6,000,000. This amount is offset by the decrease in the net invest-
ment in subsidiary account of $6,000,000, which would be the credit
change in the account. The total changes when translating the FC into
USD for the March 31, X2 reporting date would offset to zero. No inef-
fectiveness in the hedge.
CHAPTER 6
Presentation and Disclosure

About This Chapter
Disclosure and presentation requirements for companies that use derivative
instruments as part of their risk management strategy are an important part
of their financial reporting requirement. This chapter will present qualita-
tive and quantitative disclosures as well as the required disclosures for fair
value and cash flow hedges and the hedge of a net investment in foreign
subsidiaries. In addition, the chapter will include detailed disclosure notes
for the company’s significant accounting policies for derivative instruments
and hedging activities for all entities and for industrial/commercial entities.
Accounting guidance for derivatives disclosures makes disclosures
about the fair value of financial instruments optional for entities that meet
all of the following criteria.1
1. The company is a non-public entity

2. The company’s total net assets (asset minus liabilities) are less than
$100 million on the date of the financial statements
3. The company has no instrument that, in whole or in part, is
accounted for as a freestanding derivative.
Disclosure objectives for derivative instruments and hedging activities

are designed to assist financial statement users in understanding how deri-
vatives are used as a part of the company’s risk management strategy. These
objectives are to help the users of the company’s financial statements to:1
1. How and why a company uses derivative instruments

2. How derivative instruments and related hedging activities are
accounted for
3. And, how derivative instruments and related hedging activities affect

the company’s financial position (balance sheet), financial perfor-
mance (income statement), and cash flows (statement of cash flows).
Qualitative and Quantitative Disclosures

As described in accounting guidance, an entity that holds or issues deriv-
ative instruments (or nonderivative instruments that are designated and
qualify as hedging instruments pursuant to the standards) shall disclose,
for every annual and interim reporting period where a balance sheet and
income statement are presented, a description of the objective, context,
and strategies for issuing or holding derivatives. The purpose of these dis-
closures is to enhance the overall transparency of an entity’s derivative
transactions by helping investors and creditors understand what an entity
is trying to accomplish with its derivatives.
As discussed in accounting guidance for derivative disclosures, these qual-
itative disclosures may be more meaningful if described in the context of
an entity’s overall risk-management profile. The qualitative disclosures
require an entity to: (a) distinguish between objectives and strategies for
derivative instruments used for risk management purposes and those used
for other purposes (at a minimum based on the instruments primary under-
lying risk exposure such as interest rate risk, credit risk, etc.), and (b) distin-
guish between the accounting designations of derivative instruments (e.g.,
cash flow hedging, fair value hedging, and net investment hedging relation-
ships). For derivative instruments not designated as hedging instruments, a
description of the purpose of the derivative activity is also required.
An entity that holds or issues derivative instruments (or nonderivative
instruments that are designated and qualify as hedging instruments pur-
suant to the standards) shall disclose the following, for every annual and
interim reporting period, where a balance sheet and income statement are
presented:
a. The location and fair value amount of derivative instruments and non-
derivative instruments that are designated and qualify as hedging
instruments pursuant to recommended accounting guidance.2
PRESENTATION AND DISCLOSURE 123
1. Present fair value on a gross basis (i.e., not giving effect to netting
arrangements or collateral)
2. Segregate assets from liabilities and (a) segregate derivative instru-
ments that are qualifying and designated as hedging instruments
from those that are not; within those two categories, segregate by
type of contract, and (b) disclose the line item(s) on the balance
sheet in which the fair value amounts are included
Disclosure Requirements for Fair Value Hedges3
b. The location and amount of gains and losses related to the following:
1. Derivative instruments qualifying and designated as hedging
instruments in fair value hedges (tabular format required)
2. Related hedged items qualifying and designated in fair value
hedges
c. For derivative instruments, as well as nonderivative instruments that
may give rise to foreign currency transaction gains or losses under
accounting guidance for foreign currency transactions, which have
been designated and have qualified as fair value hedging instruments,
and for the related hedged items, an entity shall disclose:
1. The net gain or loss recognized in earnings during the reporting
period representing: (a) the amount of the hedges’ ineffectiveness
and (b) the component of the derivative instruments’ gain or loss,
if any, excluded from the assessment of hedge effectiveness.
2. The amount of net gain or loss recognized in earnings when a
hedged firm commitment no longer qualifies as a fair value hedge.
Disclosure requirements for cash flow hedges:
d. The location and amount of gains and losses by the type of contract
related to:
1. The effective portion recognized in other comprehensive income
(tabular format required)
2. The effective portion subsequently reclassified to earnings (tabular
format required)
3. The ineffective portion and the amount excluded from effective-
ness testing (tabular format required)
e. A description of the transactions or other events that will result in the

reclassification into earnings of gains and losses that are reported in
accumulated other comprehensive income.
f. The estimated net amount of the existing gains or losses at the report-
ing date that is expected to be reclassified into earnings within the next
12 months.
g. The maximum length of time over which the entity is hedging its
exposure to the variability in future cash flows for forecasted transac-
tions excluding those forecasted transactions related to the payment of
variable interest on existing financial instruments.
h. The amount of gains and losses reclassified into earnings as a result of
the discontinuance of cash flow hedges because it is probable that the
original forecasted transactions will not occur by the end of the orig-
inally specified time period or within the additional period of time
discussed in the standard.
Disclosure Requirements for Net Investment Hedges
Location and amount of gains and losses by type of contract are related to
the following:
1. The effective portion recognized in other comprehensive income

(tabular format required)
2. The effective portion subsequently reclassified to earnings (tabular
format required)
3. The ineffective portion and the amount excluded from effectiveness
testing (tabular format required)
The following two comprehensive disclosure examples are presented in two

parts. In the first part is an example of a generic disclosure note for all
companies using derivative instruments for hedging activities.4 The second
qualitative disclosure note will be the required additional exposures for
commercial or industrial companies.
Qualitative Disclosures for Derivatives Instruments

and Hedging Activities
1. All derivatives are recognized on the balance sheet at their fair value. On
the date that the Company enters into a derivative contract, it designates
the derivative as: (1) a hedge of (a) the fair value of a recognized asset or
liability or (b) an unrecognized firm commitment (a fair value hedge), (2) a
hedge of (a) a forecasted transaction or (b) the variability of cash flows that
are to be received or paid in connection with a recognized asset or liability
(a cash flow hedge), (3) a foreign-currency fair value or cash flow hedge
(a foreign currency hedge), (4) a hedge of a net investment in a foreign
operation, or (5) an instrument that is held for trading or nonhedging
purposes (a “trading” or “nonhedging” instrument).
Changes in the fair value of a derivative that is highly effective and that
is designated and qualifies as a fair value hedge, along with changes in the
fair value of the hedged asset or liability that are attributable to the hedged
risk (including changes that reflect losses or gains on firm commitments),
are recorded in current-period earnings. Changes in the fair value of a
derivative that is highly effective as and that is designated and qualifies as
a cash flow hedge, to the extent that the hedge is effective, are recorded in
other comprehensive income, until earnings are affected by the variability
of cash flows of the hedged transaction (e.g., until periodic settlements of a
variable-rate asset or liability are recorded in earnings). Any hedge ineffec-
tiveness (which represents the amount by which the changes in the fair
value of the derivative exceed the variability in the cash flows of the fore-
casted transaction) is recorded in current-period earnings.
Changes in the fair value of a derivative that is highly effective as and
that is designated and qualifies as a foreign-currency hedge is recorded in
either current-period earnings or other comprehensive income, depending
on whether the hedging relationship satisfies the criteria for a fair value or
cash flow hedge. If, however, a derivative is used as a hedge of a net invest-
ment in a foreign operation, the changes in the derivative’s fair value, to the
extent that the derivative is effective as a hedge, are recorded in the
cumulative-translation-adjustment component of other comprehensive
income. Changes in the fair value of derivative trading and nonhedging
instruments are reported in current-period earnings.
The Company occasionally purchases a financial instrument in which a
derivative instrument is “embedded.” Upon purchasing the financial
instrument, the Company assesses whether the economic characteristics of
the embedded derivative are clearly and closely related to the economic
characteristics of the remaining component of the financial instrument
(i.e., the host contract) and whether a separate, nonembedded instrument

with the same terms as the embedded instrument would meet the defini-
tion of a derivative instrument. When it is determined that (1) the embed-
ded derivative possesses economic characteristics that are not clearly and
closely related to the economic characteristics of the host contract and
(2) a separate, stand-alone instrument with the same terms would qualify
as a derivative instrument, the embedded derivative is separated from the
host contract, carried at fair value, and designated as either (1) a fair value,
cash flow, or foreign-currency hedge or (2) a trading or nonhedging deriv-
ative instrument. However, if the entire contract is measured at fair value,
with changes in fair value reported in current earnings, or if the Company
cannot reliably identify and measure the embedded derivative for purposes
of separating that derivative from its host contract, the entire contract is
carried on the balance sheet at fair value and is not designated as a hedging
instrument.
The Company formally documents all relationships between hedging
instruments and hedged items, as well as its risk-management objective and
strategy for undertaking various hedge transactions. This process includes
linking all derivatives that are designated as fair value, cash flow, or foreign-
currency hedges to (1) specific assets and liabilities on the balance sheet or
(2) specific firm commitments or forecasted transactions. The Company
also formally assesses (both at the hedge’s inception and on an ongoing
basis) whether the derivatives that are used in hedging transactions have
been highly effective in offsetting changes in the fair value or cash flows
of hedged items and whether those derivatives may be expected to remain
highly effective in future periods. When it is determined that a derivative is
not (or has ceased to be) highly effective as a hedge, the Company discon-
tinues hedge accounting prospectively, as discussed below.
The Company discontinues hedge accounting prospectively when (1)
it determines that the derivative is no longer effective in offsetting changes
in the fair value or cash flows of a hedged item (including hedged items
such as firm commitments or forecasted transactions); (2) the derivative
expires or is sold, terminated, or exercised; (3) it is no longer probable that
the forecasted transaction will occur; (4) a hedged firm commitment no
longer meets the definition of a firm commitment; or (5) management
determines that designating the derivative as a hedging instrument is no

longer appropriate or desired.
When hedge accounting is discontinued due to the Company’s deter-
mination that the derivative no longer qualifies as an effective fair value
hedge, the Company will continue to carry the derivative on the balance
sheet at its fair value but cease to adjust the hedged asset or liability for
changes in fair value. When hedge accounting is discontinued because the
hedged item no longer meets the definition of a firm commitment, the
Company will continue to carry the derivative on the balance sheet at its
fair value, removing from the balance sheet any asset or liability that was
recorded to recognize the firm commitment and recording it as a gain or
loss in current-period earnings. When the Company discontinues hedge
accounting because it is no longer probable that the forecasted transaction
will occur in the originally expected period, the gain or loss on the deriv-
ative remains in accumulated other comprehensive income and is reclassi-
fied into earnings when the forecasted transaction affects earnings.
However, if it is probable that a forecasted transaction will not occur by
the end of the originally specified time period or within an additional two-
month period of time thereafter, the gains and losses that were accumu-
lated in other comprehensive income will be recognized immediately in
earnings. In all situations in which hedge accounting is discontinued and
the derivative remains outstanding, the Company will carry the derivative
at its fair value on the balance sheet, recognizing changes in the fair value in
current-period earnings.
2. Additional footnote disclosures for commercial/industrial users of fair
value, cash flow, and net investment hedges
Fair Value Hedges
The Company enters into forward-exchange contracts to hedge the

foreign-currency exposure of its firm commitments to purchase certain
production parts from Germany and Brazil. The forward contracts that are
used in this program mature in 18 months or less, consistent with the
related purchase commitments. The Company generally hedges between
60 and 80 percent of its total firm-commitment purchase contracts.
The Company uses interest rate swaps to economically convert a por-

tion of its nonprepayable fixed-rate debt into variable-rate debt. The result-
ing cost of funds is lower than it would have been if variable-rate debt had
been issued directly. Under the interest rate swap contracts, the Company
agrees with other parties to exchange, at specified intervals, the difference
between fixed-rate and floating-rate interest amounts, which is calculated
based on an agreed-upon notional amount. The level of variable-rate debt
(after the effects of interest rate swaps have been considered) is maintained
at 35 to 50 percent of the total Company debt.
The value of the Company’s inventory of copper and aluminum raw
materials changes daily, consistent with price movements in the respective
commodities markets. The Company uses futures contracts to manage
price risks associated with this inventory and generally hedges 70 to 75 per-
cent of the inventory’s total value.
For the year ended December 31, 20X0, the Company recognized a
net gain of $XXX, (reported as [financial-statement line item caption]
in the statement of operations), which represented the ineffective por-
tion of all of the Company’s fair value hedges. All components of each
derivative’s gain or loss were included in the assessment of hedge effec-
tiveness. The Company also recognized a net gain of $XXX (reported as
[financial statement line item caption] in the statement of operations)
in relation to firm commitments that no longer qualified as fair value
hedge items. The amounts discussed above are also referenced in Foot-
note X.
Cash Flow Hedges
The Company’s direct-foreign-export sales are denominated in the

customers’ local currency. The Company purchases foreign-exchange put
options and forward-exchange contracts as hedges of anticipated sales
denominated in foreign currencies. The Company enters into these con-
tracts to protect itself against the risk that the eventual dollar-net-cash
inflows resulting from direct-foreign-export sales will be adversely affected
by changes in exchange rates. Based on the Company’s estimate of future
foreign exchange rates, it hedges 50 to 75 percent of anticipated sales for
the following 12 months.
The Company receives royalties from each of its European subsidiaries.

The Company uses foreign-currency forward-exchange contracts and swap
contracts that expire in less than 12 months to hedge against the effect that
fluctuations in exchange rates may have on forecasted intercompany roy-
alty cash flows. The Company purchases foreign-currency put options,
with contract terms that normally expire within less than six months to
hedge against the adverse effects that fluctuations in exchange rates may
have on foreign-currency-denominated trade receivables.
The Company uses interest rate swaps to economically convert a por-
tion of its variable-rate debt to fixed-rate debt. The resulting cost of funds
is lower than it would have been had fixed-rate borrowings been issued
directly. The level of fixed-rate debt, after the effects of interest rate swaps
have been considered, is maintained at 50 to 65 percent of the total Com-
pany debt.
The Company enters into long-term sales contracts at spot prices with
a number of its customers. As a hedge against possible price fluctuations in
anticipated commodity purchases (which will be necessary to fulfill the
sales contracts), the Company purchases copper and aluminum futures and
options contracts. The futures and options contracts limit the unfavorable
effect that potential price increases would have on metal purchases, and
the futures contracts likewise limit the favorable effect of potential price
declines.
For the year ended December 31, 20X0, the Company recognized a
net loss of $XXX (reported as [financial-statement line item caption] in the
statement of operations), which represented the total ineffectiveness of all
cash flow hedges. All components of each derivative’s gain or loss were
included in the assessment of hedge effectiveness. In addition, after discon-
tinuing certain of its cash flow hedges, the Company determined that it
was not probable that certain forecasted transactions would occur by the
end of the originally specified time period or within an additional two-
month period of time thereafter. Therefore, the Company reclassified a net
gain of $XXX as [financial-statement line item caption] into the statement of
operations from accumulated other comprehensive income. The amounts
discussed above are also referenced in Footnote X.
As of December 31, 20X0, $XXX of deferred net gains on derivative
instruments accumulated in other comprehensive income are expected to
be reclassified as earnings during the next 12 months. Transactions and

events that: (1) are expected to occur over the next 12 months and (2) will
necessitate reclassifying the derivative gains as earnings include (a) royalties
earned, (b) actual direct-foreign-export sales, (c) the repricing of variable-
rate debt, and (d) the sale of machinery and equipment that includes pre-
viously hedged purchases of aluminum and copper raw materials. The
maximum term over which the Company is hedging exposures to the var-
iability of cash flows (for all forecasted transactions, excluding interest pay-
ments on variable-rate debt) is 18 months. The amounts discussed above
are also referenced in Footnote X.
Hedges of Net Investments in Foreign Operations
The Company has numerous investments in foreign subsidiaries. The net

assets of these subsidiaries are exposed to volatility in currency exchange
rates. The Company uses both derivative and nonderivative financial instru-
ments to hedge this exposure and measures the ineffectiveness of such
hedges based on the change in spot foreign exchange rates. The Company
manages currency exposure related to the net assets of the Company’s Latin
American subsidiaries primarily through foreign-currency-denominated
debt agreements that the Company (the “parent company”) enters into.
Gains and losses in the parent company’s net investments in its subsidiaries
are economically offset by losses and gains in the parent company’s foreign-
currency-denominated debt obligations.
The Company also enters into foreign-currency forward-exchange con-
tracts to hedge the foreign-currency exposure of its investments in Euro-
pean and Asian subsidiaries. These agreements are in place for each
subsidiary and have contract terms of nine months to one year.
For the year ended December 31, 20X0, $XXX of net losses related to
(1) the foreign-currency-denominated debt agreements and (2) the forward
exchange contracts were included in the Company’s cumulative translation
adjustment. For the same period, $XXX of net losses was recorded in earn-
ings representing the amount of the hedges’ ineffectiveness. The amounts
discussed above are also referenced in Footnote X.
The presentation and disclosure requirements for derivative instru-
ments and hedging activities are quite extensive. Companies that use
derivatives to hedge their business risks must have extensive internal con-
trols build around the documentation and the accounting for these finan-
cial instruments.
This book is designed to equip managers and executives with an under-
standing of the complex world of derivative instruments. The focus
throughout the book is on operating managers and executives who are
responsible for managing operating and financial risks that could adversely
impact the company’s financial position. My goal is to make the account-
ing for derivatives and hedging activities understandable. In addition, the
goal of the book is have an accounting toolkit when evaluating the impacts
on the financial statements when engaging in this type of risk management
activities.
APPENDIX I
Scope Issues
About This Chapter
The accounting for derivatives model states that a derivative instrument is
any contract that contains the following three elements.
1. The contract contains an underlying variable and a notional (princi-

pal) amount that if or when an event occurs causes variability of cash
flows for one or both parties to the contract.
2. The contract has no initial net investment or an initial net invest-
ment that is smaller than other types of contracts and provides sig-
nificant leveraging of returns.
3. The contract requires or permits net settlement; there are market
mechanisms in place that would facilitate net settlement.
Because of this extremely broad definition of financial and nonfinancial

contracts that would qualify as derivatives, accounting guidance allows for
two types of exceptions: (1) Items that qualify as derivatives but are reported
on financial statements using a different accounting guidance (guidance for
a transaction is superseded by other accounting guidance) and (2) Deriva-
tives that are scoped out of the accounting guidance for derivatives. This
chapter will discuss the common exceptions to derivative accounting under
each of the two categories above.
However, it is important to note that the derivative exceptions that are
scoped out require careful documentation in meeting the exception require-
ments and the company elects not to account for them as derivatives.
Different Accounting Model
The contracts scoped out of the derivative accounting model include the
following:
134 APPENDIX I
. equity contracts issued by the company,

. stock-based compensation awarded to employees,
. certain types of insurance contracts, and
. contracts issued that would be an impediment to sale accounting.
Equity Contracts Issued by the Company

Contracts that are issued or held by the company that are both (1) classified
in stockholders equity and (2) indexed solely to their own stock are not to
be accounted for under the derivative accounting model.1 Move to appen-
dix these contracts are exempted because accounting guidance states that
derivatives are assets and liabilities. For example, when a company issues a
call option on its own stock, the option may be exempted for derivative
accounting if it represents an equity transaction. In making this determi-
nation, a company would use the following model.
1. Evaluate any contingent provisions. Contingency provisions are not

based on (a) an observable market, other than the market for the
company’s own stock (if applicable) or an (b) observable index, other
than those calculated or measured solely by the issuer’s own operations.
2. Once the contingent event has occurred, the instruments amount is
based solely on the issuer’s stock
a. Settlement amount must be equal to the fair value of a fixed
number of equity shares and a fixed price or settlement amount.
In other words, a fixed (shares) for fixed (cash or principal amount
of a bond) comparison.
A word of caution, this is an extremely complex area of accounting. If

your company has any of these transactions, you must consult the detailed
accounting guidance and navigate carefully. A future book “Accounting for
Capital Transactions: An Issuer’s Perspective” will examine these difficult
accounting transactions in-depth.
Share-Based Compensation
Accounting for stock or options issued to employees in return for services

rendered as compensation is covered under other accounting guidance.2
APPENDIX I 135
However, when option contracts granted for employee service are modi-
fied, and the employee no longer is providing services to the company, the
derivative accounting model then would be applied to the modification.
Normal Purchases and Normal Sales
Normal purchase and normal sales3 are contracts that provide for the pur-
chase or sale of something (inventory) other than a derivative financial
instrument that will be delivered in quantities expected to be used or sold
by the company over a reasonable period of time in the normal course of
business. For example, the Company purchases forward contracts for phys-
ical delivery of 500,000 gallons of high fructose corn syrup for use in
producing beverage products. The forward contracts are staggered to be
delivered to the company at a rate of 100,000 gallons per month. In that
case, since the commodity is used in the normal course of operations (pro-
ducing beverages) and the time limit is reasonable, the forward contracts
would meet the normal sales and purchases exception and the derivative
instruments would not be accounting for as derivatives, but would instead
be accounted for as and inventory purchase. The company delivering the
high fructose corn syrup would likewise qualify for the normal sales excep-
tion and account for the forward contracts as sales when delivered.
The accounting guidance that provides an exception for normal busi-
ness activities of having to apply the complex requirements of accounting
for derivatives and hedging activities to inventory purchases or product
sales provides a great deal of relief. However, since these are derivative
instruments, the accounting guidance is very specific as to what would
qualify for the normal sales and purchases exception from derivative
accounting. In addition, the documentation for qualifying for this excep-
tion must be done at inception of each derivative contract.
To qualify for the scope exception, a contract’s terms must be consis-
tent with the terms of an entity’s normal purchases or normal sales, that is,
the quantity purchased or sold must be reasonable in relation to the
entity’s business needs. Determining whether or not the terms are consis-
tent requires judgment.
In making those judgments, an entity should consider all relevant fac-
tors, including all of the following:
136 APPENDIX I
a. The quantities provided under the contract and the entity’s need for
the related assets
b. The locations to which delivery of the items will be made
c. The period of time between entering into the contract and delivery
d. The entity’s prior practices with regard to such contracts.
Further, each of the following types of evidence should help in identi-

fying contracts that qualify as normal purchases or normal sales:
a. Past trends
b. Expected future demand
c. Other contracts for delivery of similar items
d. An entity’s and industry’s customs for acquiring and storing the related
commodities
e. An entity’s operating locations. (endnote 815-10-15-15)
In addition to the accounting guidance above the underlying (forward

rates on a forward contract to deliver a commodity) must be clearly and
closely related to the asset being sold or purchased. This analysis is specific
to the derivative contract being evaluated for the scope exception for nor-
mal sales and purchases. In other words, if the derivative contract contains
a price adjustment for either party to the contract that is not a part of either
the buyer’s and seller’s normal business practices for purchasing or selling
commodities (which are sold and purchased at market prices) and is sig-
nificant when compared to market transactions (fair value), then the excep-
tion test fails and we account for it as a derivative instrument.
For example, the clearly and closely related criteria for a forward con-
tract that is a commodity would be a clause in the contract that would
change the basis adjustment made for storage, transportation, or insurance.
Since the basis adjustment would relate directly to the underlying com-
modity, the basis adjustment would be clearly and closely related to the
physical commodity being delivered.
The documentation requirements for the normal purchases and nor-
mal sales scope exception may be applied to either (1) groups of contracts,
or (2) an individual contract. In addition, the Board has stated that an
entity may document which contracts are not designated as normal
APPENDIX I 137
purchases and normal sales (i.e., when qualifying for the normal purchases
and normal sales exceptions is normal for a company, it may be easier for
that company to document contracts that do not qualify as normal pur-
chases and normal sales). However, a company’s documentation must be
specific enough to enable a third party to determine which specific con-
tracts are designated as normal purchases and normal sales. (endnote)
The other important scope exception for a derivative instrument is one
that serves as an impediment to recording a sale (revenue) for the seller.4
A derivative instrument whose existence serves as an impediment to rec-
ognizing a related contract as a sale by one party or a purchase by the
counterparty is not subject to this accounting guidance for derivative
instruments. For example, the existence of a guarantee of the residual value
of a leased asset by the lessor may be an impediment to treating a contract
as a sales type lease, in which case the contract would be treated by the
lessor as an operating lease. Another example is the existence of a call
option enabling a transferor to repurchase transferred assets that is an
impediment to sales accounting. Such a call option on transferred financial
assets that are not readily available would prevent accounting for that trans-
fer as a sale. The consequence is that to recognize the call option would be
to count the same thing twice. The holder of the option already recognizes
in its financial statements the assets that it has the option to purchase.
(endnote 815-10-15-63)
The following financial contracts that meet the definition of what con-
stitutes a derivative are also scoped out of the accounting guidance or deriv-
ative instruments.
. Certain insurance contracts (life, health, property, casualty)

. Financial guarantee contracts
. Certain loan commitments
. Regular securities trades
This following may represent complex financial contracts that are to be

carefully analyzed before a company can conclude that the scope excep-
tions apply for that particular contract.
APPENDIX II
Embedded Derivatives
If derivatives are embedded in a financial instrument or other contract, the
base contract (i.e., excluding the embedded derivative) is referred to as the
host contract. The combination of the host contract and the embedded
derivative is referred to as the hybrid instrument. An example of a hybrid
instrument is a structured note that pays interest based on changes in the
S&P 500 Index; the component of the contract that is to adjust the interest
payments based on changes in the S&P 500 Index is the embedded deriv-
ative, and the debt instrument component of the contract that is to pay
interest without such adjustment and to repay the principal amount is the
host contract.
Certain financial instruments and other contracts that do not in their
entirety meet the definition of a derivative instrument (including prepay-
able loans, convertible bonds, insurance policies, and leases) often contain
embedded derivative instruments with implicit or explicit terms that affect
(1) some or all of the cash flows or (2) the value of other exchanges required
by the contract in a manner similar to that of a derivative instrument. The
effect of embedding a derivative instrument in a host contract is that some
or all of the cash flows or other exchanges that otherwise would be required
by the host contract (whether unconditional or contingent upon the occur-
rence of a specified event) will be modified based on an underlying (e.g., an
interest rate, a price index, or some other index) that is applied to a
notional amount (or there is a payment provision triggered by the under-
lying). It is that variability of the cash flows to be paid or received that is
calculated based on the notional amount based on the movement of the
underlying that requires the an analysis of whether the host contract con-
tains an embedded derivative that needs to be bifurcated (separated) from
the host contract.
Embedded derivatives can be difficult to identify because few host con-
tracts will use the term derivative. Companies should be aware that
140 APPENDIX II
embedding into contracts terms and conditions that vary the cash flows to
be paid or received based on an underlying variable or the occurrence or
nonoccurrence of and event may result in the identification of an embed-
ded derivative.
After a company has identified that a derivative has been embedded in
the contract, the next step is to determine if the derivative is an embedded
derivative or a freestanding derivative1. If the derivative is determined to
be freestanding, then it is required to be bifurcated (separated) from the
host and accounted for as a derivative instrument apart from the host
instrument. For example, the Company issues $10,000,000 of convert-
ible debt at 5.25% with each 1,000 of debt convertible into 50 shares of
the company’s common stock at the holder’s option. Under some
circumstances, the put option held by the holder would be bifurcated
by the issuer and the equity put option would be accounted for as a
freestanding derivative instrument and the convertible debt would be
accounting for as “straight” debt.
Therefore, although a derivative instrument may be written into the
same contract as another instrument (i.e., in a debt agreement), it is con-
sidered embedded only if it cannot be legally separated from the host con-
tract and transferred to a third party. If it cannot be separated from the host
contract it would be scoped out of the accounting guidance for derivative
instruments. In contrast, features that are written in the same contract, but
that may be legally detached and separately exercised would be considered
attached, freestanding derivatives rather than embedded derivatives by
both the writer and the holder. These freestanding derivatives would be
accounted for separately regardless of whether they meet the accounting
guidance for bifurcation.
Prior to illustrating a common example of bifurcating an embedded
derivative from the host contract, we will define a host contract and the
criteria one uses in determining whether to account for an embedded
derivative as a freestanding derivative instrument. A host contract is the
contract that would have been issued if the hybrid instrument did not con-
tain an embedded derivative (Issue straight debt instead of convertible
debt). Each embedded derivative is compared to its host contract to deter-
mine if bifurcation of the hybrid instrument (i.e., into its host contract and
embedded derivative components) would be required (accounted for as a
APPENDIX II 141
freestanding derivative). Therefore, in order to apply the embedded deriv-

ative model, it is necessary to properly define the host contract based on its
underlying economic characteristics and risks. This analysis is the key var-
iable in determining whether the embedded derivative will be bifurcated
from the host and accounting for as a freestanding derivative.
Accounting guidance states that an embedded derivative must be bifur-
cated from the host when “the economic characteristics and risks of the
embedded derivative instrument are not clearly and closely related to the
economic characteristics and risks of the host contract”.2 Said another way,
if the host contract’s change in price is due to a different market variable
than the embedded derivative then accounting guidance states that the
embedded derivative be bifurcated. For example, changes in value to debt
are due to interest rate risk, changes in equity values are due to market or
price risk.
To illustrate the financial statement impacts of one of the most com-
mon examples of how to account for an embedded derivative, we will illus-
trate the accounting for an equity-linked note. (endnote)
On January 1, 20X1, Company issues a two-year structured note with
a principal amount of $1,000,000 indexed to the stock of an unrelated
publicly traded entity (A Company). At maturity, the holder of the instru-
ment will receive the principal amount plus any appreciation or minus any
depreciation in the fair value of 10,000 shares of A Company, with changes
in fair value measured from the issuance date of the debt instrument. The
note bears a floating rate of interest. The market price of A Company
shares is as follows: $100 per share at the issuance date; $90 at December
31, 20X1, and $125 on December 31, 20X2.
Identifying the Embedded Derivative

The host contract is a debt instrument because the instrument has a stated
maturity and because the holder has none of the rights of a shareholder,
such as the ability to vote the shares and receive distributions to share-
holders. The embedded derivative is an equity-based forward contract (it pro-
vides upside and downside potential) that has as its underlying the fair value of
the stock of Alta Properties. The forward-based derivative should initially be
recorded at its fair value of $0. That is, all of the proceeds should be
142 APPENDIX II
ascribed to the debt host contract. (endnote ASC 815-15-30-4 and-30-5)

Subsequently, the debt host is accounted for as debt by Company and as a
debt security by the investors. The forward contract should be marked to
market through earnings as a freestanding derivative.
Note: The journal entries below treat the forward contract as a

separate asset or liability to emphasize that the embedded deriva-
tive and host contract are measured separately. For financial
reporting purposes, companies should combine the fair value of
the derivative with the carrying amount of the host contract. For
this illustration, we will record the financial statement effects for
the issuer of the structured note.
Issuer’s Accounting (Company)

– Loss on forward contract
Company would record the following journal entries (for brevity, the
accrual of interest is not presented below):
January 1, X1
To record the issuance of the structured note as debt:
+ Cash + 1,000,000 + Debt + Debt 1,000,000

+ Cash
+ 1,000,000

+ Debt
+ 1,000,000
Note: at inception, the entire proceeds are recorded at the amount of

the proceeds received for the issuance of the structured note. Since the
APPENDIX II 143
forward contract at inception has zero value all of the proceeds are recorded
as debt.
December 31, X1
To record the change in fair value of the forward contract [(90 – 100)
–$10,000]:
+Forward contract +100,000 +Gain on forward contract +100,000

+ Forward contract
+ 100,000

+ 100,000
Note: The computation of the forward contract fair value change is com-
puted as demonstrated above. The logic is if we paid off the debt as of this
date we would write off the debt at $1,000,000 and write off the asset
account forward contract at $100,000 and the remainder would be a
decrease in cash of $900,000. The gain on forward reduces the amount
of cash to be paid if we had paid off the debt.
December 31, 20X2

To record the change in fair value of the fair value of the forward contract
[(125 90) – $10,000]:

+ Forward contract liability
+ 350,000

– Loss of forward contract
– 350,000
Note: the fair value change of ($90 – $125) 10,000 =$350,000 has
changed the asset account to a liability account with a balance of $250,000.
144 APPENDIX II
To record settlement of the debt contract with investors:

– Cash
– 1,250,000

– Forward contract liability
– 250,000
– Debt
– 1,000,000
Note: the forward contract liability of $250,000 that is written off will
increase the amount of cash to be paid to settle the debt to $1,250,000.
The accounting for embedded derivatives, similar to accounting for deriv-

ative instruments in general, can be very complex. The intricacies involved
in even recognizing an embedded derivative and then performing the anal-
ysis of whether the embedded derivatives should be accounted for as free-
standing derivatives will depend on the terms and conditions of the
contract. A detailed discussion of the many instances of embedded deriva-
tives is beyond the scope of this book. However, that being said, any clause
embedded in a contract that could cause the amount paid or received to
vary and the amount is based on the underlying variable interacting with
the notional (principal) amount owed or received is potentially an embed-
ded derivative that would cause a company analysis to determine if the
derivative is freestanding and requires bifurcation from the host.
Notes
Chapter 1
1. Financial Accounting Standards Board (FASB), Accounting Standards
Codification (ASC), 815-10-15-83
2. Adapted for Ernst and Young. (2012). Financial Reporting Developments:
Derivative Instruments and Hedging Activities, from www.ey.com.us/
accounting link
3. FASB ASC 815-20-20 Glossary
4. FASB 815-20-20 Glossary
5. Adapted from PWC National Professional Service Group. (2012). Guide to
Accounting for Derivative Instruments and Hedging Activities from www.
cfodirect.com/guides
6. FASB ASC 820—Fair Value Measurements
7. Adapted from FASB ASC 815-10-55
Chapter 2
1. FASB ASC 815-20-25-80
2. PWC (2012)
3. FASB ASC 815-20-25-3
4. FASB ASC 815-20-25-3(d)
5. FASB ASC 815-20-25-28
6. FASB ASC 815-20-25-31
7. FASB ASC 815-20-25-75 through 81
8. PWC (2012)
9. FASB ASC 815-20-25-102 through 111 and FASB ASC 815-20-55-71
Chapter 3
1. All problems are adapted from FASB ASC 815-25-55 and from PWC (2012)
and E&Y (2011)
146 NOTES
Chapter 4
and E&Y (2011)
Chapter 5
and E&Y (2011)
Chapter 6
1. FASB ASC 815-10-50-1 through 4(d)
4. E&Y (2011)
Appendix I
1. FASB ASC 480 and FASB ASC 815-10-15-74(a)
2. FASB ASC 480 and FASB ASC 815-10-15-74(b)
3. FASB 815-25-50-1 through 5
4. E&Y (2011)
Appendix II
1. FASB ASC 815-15-25-1
2. FASB ASC 815-15-25-1
Index
A Derivatives, accounting
Accounting mechanics measurements, 24–27
fair value hedges, 45–56 Dollar-offset approach, 41–42
financial reporting implications, 2–4
E
B Embedded derivatives, 139–144
Black Sholes Merton (BSM) model, 11 identifying, 141–142
BSM model. See Black Sholes issuer’s accounting
Merton model (Company), 142–144
Equity contracts, 134–137
C contingent provisions, 134
Cash flow hedges, 14–15, 20–23, normal purchases and normal
30–31, 35–37, 69–91, 128–130 sales, 135–137
accounting for, 70–71 share-based compensation,
fixed-rate debt using interest rate 134–135
swap, 78–79 Exercise (strike) price, 12
forecasted purchase using futures
contract, 83–88 F
forecasted (anticipated) Fair value analysis, of derivative
transactions, 69–70 instrument and hedged item, 115
hedge effectiveness, 71–91 Fair value changes, roll-forward
qualifying, 37–38 schedule for, 76
using a futures contract to Fair value hedges, 13–14, 15–20, 31,
hedge, 21–23 32–35, 127–128
Credit risk, 34, 36 accounting for, 45–68
CTA. See Cumulative translation accounting mechanics, 45–56
adjustment equipment purchase in Foreign
Cumulative translation adjustment Currency, 16–20
(CTA), 113 of firm commitment, 65–68
Current stock price, 12 fixed-rate debt using interest rate
swap, 47–56
D hedged item, 57, 63
Derivative accounting model, 133–134 hedge effectiveness, 57–58, 63–64
Derivative instruments, 2, 3 hedging instrument, 57, 63
disclosure objectives for, 121–122 of inventory, 58–63
fair value of, 50 qualitative/quantitative
forward contracts, 10 disclosures, 123–124
futures contracts, 10–11 risk management strategy, 56, 63
option contracts, 11–12 Fair value hierarchy, 24–25
swaps, 5–10 FASB. See Financial Accounting
types of, 5–12 Standards Board
148 INDEX
Federal Funds Effective Swap Rate Hedge effectiveness, 40–42, 57–58,

(FFESR), 7 63–64, 71–91
FFESR. See Federal Funds Effective cash flow hedges, 71–91
Swap Rate computations, 65
Financial Accounting Standards measuring, 74–79
Board (FASB), 5 Hedge transaction, 106–107
Financial reporting implications, 1–27 description of, 47–48, 78–79
Financial statement effects, 18, 54 Hedging activities, qualitative
Financial statement impacts, 53–56 disclosures for, 124–127
Financial statement template, 26, 50 Host contract, 139
Firm commitment, 13, 88–91 Hybrid instrument, 139
Forecasted (anticipated)
transactions, 69–70, 73, 88–91 I
Foreign currency, 38–40
Interest expense, 26–27, 49
hedges, 93–119
Interest rate risk, 34
options, 107–114
Interest rates, 12
transactions, 94–119
Interest rate swaps, 6–9
Foreign currency hedges, 93–119
fair value measurement for, 25–27
forward exchange contract,
special case of, 43–44
101–107, 114–115
hedge documentation, 115–119
Foreign exchange risk, 34, 36 L
Foreign exchange swaps, 9–10 LIBOR. See London Interbank
Formal hedge designation Offer Rate
documentation, 29–32 London Interbank Offer Rate
Forward contracts, 10 (LIBOR), 6, 7
spot and forward rates, 17
Forward exchange
M
contract, 101–107, 114–115
Maturity, 12
Forward yield curve, 7
Futures contracts, 10–11
N
H Net investment hedges, 38–40,
124–131
Hedge accounting, 12–23
foreign operations, 23, 130–131
cash flow hedges, 14–15, 20–23
Net Present Value (NPV), 7, 9
fair value hedges, 13–14, 15–20
NFP. See Not-for-profit entity
Hedged items and transactions,
Not-for-profit entity (NFP), 33
eligibility of, 32–40
NPV. See Net Present Value
Hedge documentation, 29–32,
115–119
analysis, 119 O
hedged item, 48, 79, 103, 116 OCI. See Other Comprehensive
hedge effectiveness, 49–53, 79–83, Income
103–106, 116–118 OIS. See Overnight Index Swap
hedging instrument, 48, 79, Option contracts, 11–12
103, 116 Other Comprehensive Income
risk management strategy, 48, 79, (OCI), 20–21, 23, 71, 73, 114
103, 115–116 Overnight Index Swap (OIS), 7
INDEX 149
P S
Purchase inventory, market Share-based compensation, 134–135
(spot) price, 22 Shareholder’s equity
account, 23
Spot rates, 16
Q Swaps, 5–10
Qualitative/quantitative cash receipt, 26–27
disclosures, 122–123 fair value, 26, 27
fair value hedges, 123–124 inception of, 26
net investment hedges, 124–131
V
R Variable rate loan payments, 8
Risk, defined, 5 Volatility, 12
OTHER TITLES IN OUR FINANCE AND FINANCIAL
MANAGEMENT COLLECTION
• An Executive’s Guide for Moving from US GAAP to IFRS by Peter Walton

• Effective Financial Management: The Cornerstone for Success by Geoff Turner
• Financial Reporting Standards: A Decision-Making Perspective for Non-Accountants by
David Doran
• Revenue Recognition: Principles and Practices by Frank Beil
• Accounting for Derivatives and Hedging Activities by Frank Beil
ALSO IN FORTHCOMING IN THIS COLLECTION
• Accounting Fraud Maneuvering and Manipulation, Past and Present by Gary Giroux 12/
31/2013
• Accounting for Business Combinations by Frank J Beil 1/15/2014
• Accounting for Capital Transactions: An Issuer's Perspective by Frank J. Beil 5/15/2014
• The Use of Fair Value Measurements in Accounting by Frank J. Beil 7/15/2014
• Using Financial Statements: Analyzing, Forecasting, Decision-Making 8/15/2015
• International Auditing Standards in the United States: Comparing and Understanding
Standards for ISA and PCAOB by Asokan Anandarajan and Gary Kleinman 11/15/2014
Announcing the Business Expert Press Digital Library

Concise E-books Business Students
Need for Classroom and Research
This book can also be purchased in an e-book collection by your library as

• a one-time purchase,
• that is owned forever,
• allows for simultaneous readers,
• has no restrictions on printing, and
• can be downloaded as PDFs from within the library community.
Our digital library collections are a great solution to beat the rising cost of textbooks.
e-books can be loaded into their course management systems or onto student’s e-book readers.
The Business Expert Press digital libraries are very affordable, with no obligation to buy
in future years. For more information, please visit www.businessexpertpress.com/librarians.
To set up a trial in the United States, please contact Adam Chesler at adam.chesler@
businessexpertpress.com for all other regions, contact Nicole Lee at [email protected].
Accounting for Derivatives and Hedging
Activities
Frank J. Beil
Derivatives, and derivatives used to hedge financial and operating functions,
are designed to allow managers of firms to manage effectively the downside
risk of their financial and operating strategies. They also can be very useful
tools that allow managers and executives to accurately predict financial and
operational performance and manage the investment communities’ “expec-
tations” regarding overall firm performance.
But as you probably know, derivatives and hedges, if not properly designed
in conjunction with the firm’s risk management strategy, can be potentially
disastrous for the firm.
That’s where this book can help. This book will help you and other man-
agers and executives to understand the impact of derivative and hedge ac-
counting on a company’s reporting of financial statements. It will help de-
mystify derivatives and provide practical advice and counsel on how to use
them to manage more effectively the operational and financial risks to the
firm. When used properly derivatives are an extremely effective tool that
managers and executives can use to reduce uncertainty regarding the future.
But you’ll need this book to achieve that successful future.
Frank J. Beil, CPA, CGMA is a lecturer at the Carlson School of Management

at the University of Minnesota, where he teaches undergraduate and grad-
uate courses in financial statement analysis, auditing, and accounting for
mergers and acquisitions. He has worked as a director for Risk Management,
Inc., a consulting firm that offers analysis and reporting services pertain-
ing to investment strategies of companies. His clients have included Green
Mountain Energy, the Anglo-Irish Bank, Hunt Brothers Realty, and Razor, Inc.
The Financial Accounting and Auditing Collection

Scott Showalter and Jan Williams, Editors
ISBN: 978-1-60649-590-2

Accounting For Derivatives and Hedging Activities

Uploaded by

Copyright:

Available Formats

Accounting For Derivatives and Hedging Activities

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Accounting For Derivatives and Hedging Activities

Uploaded by

Copyright:

Available Formats

The Financial Accounting

and Auditing Collection

First published in 2013 by

ISBN-13: 978-1-60649-590-2 (paperback)

Business Expert Press Financial Accounting and Auditing collection

Collection ISSN: 2151-2795 (print)

Cover and interior design by Exeter Premedia Services Private Ltd.,

First edition: 2013

Printed in the United States of America.

Chapter 1 Financial Reporting Implications..........................................1

Chapter 6 Presentation and Disclosure..............................................121

Chapter 2 Hedge Criteria and Hedge Effectiveness.........................29

Chapter 3 Fair Value Hedges............................................................45

Chapter 4 Cash Flow Hedges ...........................................................69

Chapter 5 Accounting for Foreign Currency Transactions

1. Derivative instruments represent rights (assets) or obligations (liabil-

One of the complexities in recognizing a derivative instruments impact

1. The contract contains an underlying variable, interest rate index,

that would be expected to have a similar response to changes in

The deﬁnition of a derivative instrument above needs to be applied

(notional). purchasing the underlying equity

Common Types of Derivative Instruments

These contracts will be explained in the following sections and exam-

A swap is a contractual agreement in which two parties agree to swap

calculate the agreed-upon cash ﬂows to be transferred between the parties,

Armed with this information a company can construct a “forward yield

Note: Forecasted LIBOR (derived from a yield curve supplied by commer-

Economic Value for Company to Enter the Swap

In the table, parentheses means the forecasted payments made to commer-

Net Present Value of an Interest Rate Swap

Forward contracts are arrangements between a buyer and seller (parties to

Futures contracts are actively traded on regulated exchanges in order to

exchange the company has to establish a margin account equal to 5%

Option values are determined using a mathematical formula (Excel-

An agreement with an unrelated party, binding on both parties and

a. The agreement speciﬁes all signiﬁcant terms, including the quantity to

of an agreement are regarded to include those legal rights and obligations

Fair value hedges will be discussed extensively in Chapter 2 “Hedge

a transaction that is expected to occur for which there is no ﬁrm

Cash ﬂow hedges will be discussed extensively in Chapter 2, Chapter 4,

parent company’s ﬁnancial statements) and transaction exposures due to

Overview: Fair Value Hedge Accounting

liability) when on a reporting date it would cost more to purchase, for

Fair Value Hedge of an Equipment Purchase in Foreign Currency

On, December 1, 20X1, a company enters into a contract with a foreign

In the following table, the derivative instrument (forward contract) on

Spot and Forward Rates for the Forward Contract

Note: $ refers to U.S. dollars

The following illustrates the ﬁnancial statement effects.

Assets = Liabilities + Stockholder’s equity

December 1, 20X1: Company purchases the 90-day forward contract to

No value of the forward contract at inception because the underlying var-

December 31, 20X1:

Assets = Liabilities + Shareholder’s equity

Note: The computation is $200,000 (.68 – .66) = $4,000. The fair

Assets = Liabilities + Stockholder’s equity

Assets = Liabilities + Stockholder’s equity

Assets = Liabilities + Stockholder’s equity

To record the equipment purchase at the forward price on December 1,