With traditional accounting, derivatives and the transactions they hedge against

Question

With traditional accounting, derivatives and the transactions they hedge against can give the appearance of increased volatility on accounting statements, due to gains and losses from the derivatives being realized on the income statement prior to the gains and losses on the hedged transactions. Hedge accounting attempts to eliminate this by allowing “the firm to defer the gains and losses on the derivative until later when the hedge is completed” (pg. 566). In other words, hedge accounting attempts to match the profit/loss from the derivative to the profit/loss from the hedged asset.

Although hedge accounting leads to greater transparency and accuracy in disclosing hedged transactions, the system may be misused if the transaction does not actually result in a hedge. I will go into this in more detail in the example to follow.

Example: a firm may plan to borrow money in the future, for which it enters into a derivative in order to hedge against an increase in interest rates. Ideally the firm would end up borrowing the money, which is when hedge accounting would come into play – the derivative gains and losses would be recognized once the final transaction (the loan) was complete. However, this also allows hedge accounting to be misused as the firm had no commitment to borrow. In other words, the firm may decide not to borrow the funds, but use hedge accounting to record the gains / losses on the derivative even though there was no hedge.

Comment pls

Explanation / Answer

Accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. a derivative may be specifically designated as.

(a) Hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment.

(b) Hedge of the exposure to variable cash flows of a forecasted transaction.

(c) Hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction.

The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative.

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