Derivatives and hedging

Area 2: Technical Accounting and Reporting (35-45%)

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Topics

Derivative classification and measurement
Hedge accounting (ASC 815)
Fair value and cash flow hedges

Lessons

Derivatives and Hedging

Study Frameworks

Derivative and Hedge Accounting (ASC 815)

Hedge Accounting Framework

Fair Value Hedge

Hedges FV of recognized asset/liability or firm commitment

Both derivative and hedged item → Earnings

Example: Swap on fixed-rate debt

Cash Flow Hedge

Hedges variability of future cash flows

Effective portion → OCI; reclassify to earnings when hedged item affects earnings

Ineffective portion → Earnings immediately

Example: Swap on variable-rate debt

Net Investment Hedge

Hedges FX exposure of foreign subsidiary

Effective portion → CTA in OCI

No Designation (Speculation)

All fair value changes → Earnings

Default treatment for all derivatives

Hedge Type Classification

Is the hedge protecting against changes in fair value of a recognized asset/liability or firm commitment?

Yes

Fair value hedge — derivative and hedged item both marked to earnings

Is the hedge protecting against variability in expected future cash flows?

Yes

Cash flow hedge — effective portion to OCI, reclassify when hedged item affects earnings

Is the hedge protecting a net investment in a foreign operation?

Yes

Net investment hedge — effective portion to CTA in OCI

Not a hedge designation — derivative changes go to earnings (speculation)

Hedge Accounting Summary (ASC 815)

Feature	Fair Value Hedge	Cash Flow Hedge	Net Investment Hedge
What is hedged	FV of asset/liability or firm commitment	Variability of future cash flows	FX exposure of foreign subsidiary
Derivative gain/loss	Earnings	OCI (effective), Earnings (ineffective)	CTA in OCI
Hedged item treatment	Adjusted to FV through earnings	No adjustment until reclassification	Translation in CTA
Common example	Swap on fixed-rate debt	Swap on variable-rate debt	Forward on foreign subsidiary equity

COFFeeCash flow hedge → OCI, Fair value hedge → Full earnings

Where derivative gains/losses go: Cash flow hedges park the effective portion in OCI; fair value hedges send everything to earnings.

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