How are hedging gains and losses treated?

Answer 1

TREATMENT OF HEDGING GAINS AND LOSSES

U.S. GAAP and IFRS allow firms to choose whether to designate a particular derivative as a hedge, and therefore eligible for hedge accounting. Firms remeasure derivatives not designated as a hedge to fair value at every balance sheet date and include changes in fair value in net income. For a derivative designated as a hedge, firms must further designate it as hedging the risk of a change in fair value (fair value hedges) or a change in cash flows (cash flow hedges). The accounting for fair value hedges and cash flows hedges is similar under U.S. GAAP and IFRS. For fair values hedges, U.S. GAAP and IFRS require firms to remeasure both the hedged item and the related derivative instrument (the hedging instrument) to fair value each period and to recognize gains and losses from changes in the fair value of both in net income. If the hedge is fully effective, the gain (loss) on the derivative will precisely offset the loss (gain) on the asset or liability hedged. The net effect on earnings is zero. If the hedge is not fully effective, the net gain or loss increases or decreases earnings to the degree the offset is incomplete. For cash flow hedges, U.S. GAAP and IFRS require firms to remeasure the derivative instrument (the hedging instrument) to fair value each period but to include gains and losses from changes in fair values in other comprehensive income each period to the extent the hedging instrument is "highly effective" in neutralizing the risk of the hedged item. Firms must include the ineffective portion in net income currently. At the end of the period, the firm closes the Other Comprehensive Income account to the balance sheet account for Accumulated Other Comprehensive Income. The firm removes the amount in Accumulated Other Comprehensive Income related to a particular hedging instrument and transfers it to net income either periodically during the life of the hedging instrument or at the time of settlement, depending on the type of derivative instrument used as a hedge.

The matching convention provides both the basis for hedge accounting, as well as the logic for the treating gains and losses from changes in fair value of fair value hedges differently from cash flow hedges. In a fair value hedge of a recognized asset or liability, both the hedged asset (or liability) and its related derivative (hedging instrument) appear on the balance sheet. Remeasuring both the hedged asset (or liability) and its related derivative to fair value each period and including the gain or loss on the hedged asset (or liability) and the loss or gain on the derivative in net income results in a net gain or loss that indicates the effectiveness of the hedge in neutralizing the risk. If the hedge is completely effective, there is a zero net effect on income (the gain or loss on the hedged item exactly offsets the loss or gain on the hedging instrument). In a cash flow hedge of a forecasted transaction, the hedged cash flow commitment does not appear on the balance sheet but the derivative instrument does appear. Recognizing a gain or loss on the derivative instrument in net income each period but not recognizing the loss or gain on the anticipated transaction each period results in poor matching. Application of the matching convention results in classifying the gain or loss on the derivative instrument in other comprehensive income until the forecasted transaction occurs, at which time net income will include the gain or loss.