Business organizations use derivative instruments to control their exposure to multiple risks – interest rate/foreign exchange/price/credit risks.
Before the release of the derivatives and hedging guidelines, the accounting standards had not succeeded in staying with the functions of the derivatives sector since organizations need not record derivative instruments on the balance sheet.
Negative opinion encompassing mega derivative revenue loss increased public anxiety. Therefore, the Financial Accounting Standards Board (FASB) established a detailed accounting framework for derivative instruments/hedges.
Primary principles of accounting for derivatives and hedging activities:
- Derivative instruments reflect rights/obligations that cater to the interpretations of assets/liabilities and must be documented in financial statements.
- The fair value is the optimal measure for financial instruments.
- Derivative instruments must be calculated based on the fair value.
- Only assets/liabilities must be incorporated as part of the financial statements.
If a derivative instrument caters to a specific hedge accounting benchmark, an organization can delegate the instrument as one of the hedges:
- Fair value hedge: A hedge of the exposure to changes in the fair value.
- Cash flow hedge: A hedge of the exposure to variability in the cash flows.
- Foreign currency hedge: A hedge of the foreign currency exposure in a foreign operation.
The bottlenecks related to accounting for derivatives and hedging functions
Establishing Human Resources with Expertise
Accounting for derivatives and hedging functions consist of the application of the various needs that an organization must accomplish to be eligible for hedge accounting. Organizations must comprehend the economics of transactions in terms of a risk management outlook.
Preparing Hedge Documentation
The appliance of hedge accounting needs comprehensive documentation. An organization must record at the time of a hedging relationship the risk management goals along with the strategy for commencing derivative transaction to be eligible for hedge accounting.
Cross Functional Coordination
Assessing derivatives at fair value and identifying transformations in earnings could result in fluctuations in an organization’s accounting outcome. Hence, organizations must apply hedge accounting.
Determining Embedded Derivatives
The need to document specific embedded derivatives distinctly was initially meant for the purpose of compliance. The application of embedded derivatives to specific critical financial instruments is complex.
Derivatives are of various kinds and have different uses. Derivatives assist in safeguarding the organization from unexpected contingencies – difficult foreign-exchange movements, unanticipated increments in input costs. However, derivatives always have a cost associated with it even if the result is positive.