Explain the accounting for derivative instruments

Answer 1

DERIVATIVE INSTRUMENTS

Firms often acquire derivative instruments to hedge interest rate, exchange rate, commodity price, and other risks. U.S. GAAP and IFRS classify derivatives into three categories:

1 . Fair value hedges of a recognized asset or liability or of an unrecognized firm commitment.
2 . Cash flow hedges of an existing asset or liability or of a forecasted transaction.
3 . Nonhedging derivative.

Firms must designate each derivative as a hedging instrument, or else accounting views the derivative as a nonhedging instrument. Furthermore, firms must designate each hedging instrument as either a fair value hedge or a cash flow hedge. The following summarizes the accounting for each of these three categories of derivatives:

1 . Fair value hedges: remeasure both the hedged item and the derivative to fair value each
period and recognize any unrealized gains and losses in net income.

2 . Cash flow hedges: remeasure the derivative to fair value each period and include the
unrealized gain or loss in other comprehensive income to the extent that the derivative
instrument is effective in neutralizing risk. When the firm settles the hedged item, transfer
the previously unrealized gain or loss from other comprehensive income to net income.

3 . Nonhedging derivatives: remeasure the derivative to fair value each period and include
the unrealized gain or loss in net income.

Firms can apply the fair value option to derivatives. Under the fair value option, the principal
change in accounting for derivatives relates to cash flow hedges. Changes in the fair value of cash flow hedges affect net income as they occur instead of initially affecting other comprehensive income.