Describe the accounting for derivatives
ACCOUNTING FOR DERIVATIVES
A firm must recognize derivatives on its balance sheet as assets or liabilities, depending on the rights and obligations under the contract. Firms must remeasure derivatives to fair value each period. The change in fair value either increases or decreases the balance sheet carrying value of the derivative asset or liability, and also affects either (1) net income immediately (like a trading security), or (2) other comprehensive income immediately and net income later (like securities available for sale).
The income effect of a change in the fair value of a derivative depends on the purpose for which a firm acquires the derivative and whether the firm chooses to apply hedge accounting.
In both U.S. GAAP and IFRS, hedge accounting is elective; firms need not designate any derivatives as accounting hedges, regardless of the degree to which the derivatives mitigate the volatility of outcomes of other arrangements.
U.S. GAAP and IFRS require firms to classify derivatives as (1) fair value hedges, (2) cash flow hedges, or (3) not a hedging instrument. Derivatives designated as cash flow hedges or fair value hedges receive special accounting treatment. The choice between the two designations depends on the firm's general hedging strategy and its purpose in acquiring the particular derivative instrument. If a firm does not designate a particular derivative as either a fair value hedge or a cash flow hedge, authoritative guidance requires that the firm account for the derivative as if it were a trading security (U.S. GAAP) or a security at fair value through profit and loss (IFRS). Firms measure derivatives that they do not designate as hedges at fair value each period and include the resulting gain or loss in net income.
Fair Value Hedges
Derivative instruments acquired to hedge exposure to changes in the fair values of assets or liabilities are fair value hedges. Fair value hedges are either (1) hedges of a recognized asset or liability (or an identified portion of a recognized asset or liability), or (2) hedges of an unrecognized firm commitment (or an identified portion of that commitment).
Cash Flow Hedges
Derivative instruments acquired to hedge exposure to variability in cash flows are cash flow hedges. Cash flow hedges are of two general types: (1) hedges on some or all of the cash flows of a recognized asset or liability, and (2) hedges on some or all of the cash flows of forecasted transactions.
Firms might use a particular derivative either to hedge fair value or to hedge cash flows, but not both.
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