Derivatives are financial devices that “derive” their value from other financial instruments. Examples of derivatives are futures contracts, forward contracts, interest rate swaps and put options.
Derivatives may be freestanding or embedded in a host contract that is itself not a derivative. The combination of a host contract and an embedded derivative is a hybrid instrument.
A common example of an embedded derivative is the conversion feature of convertible debt. It represents a call option on the issuer’s stock.
The pronouncement of ASC 815 addresses the accounting for derivative instruments including certain derivative instruments embedded in other contracts, and hedging activities.
- Derivative instruments that meet the definition of assets and liabilities should be reported in the financial statements.
- Fair value is the only relevant measure for derivative instruments.
Types of Derivative Instruments:
- Fair value hedges of assets, liabilities & commitments.
- Cash flow hedges.
- Foreign currency hedges.
Gains or Losses on Derivative Instruments:
- Fair Value Hedges: Gains or losses on fair value hedges are recognized in current earnings.
- Cash Flow Hedges: Gains or losses on cash flow hedges are reported as a component of comprehensive income because the gain or loss on the hedged item will not occur until a future period. The other comprehensive income will be reclassified to income when the gain or loss on the transaction is recognized in earnings.
- Foreign Currency Hedges:
- Gains or losses on hedged firm commitments are recognized currently.
- Gains or losses on hedged assets and liabilities are recognized currently.
- Gains or losses on hedges of available-for-sale securities are recognized currently.
- Gains or losses on hedges of forecasted foreign-currency-denominated transactions are reported as a component of comprehensive income and reclassified to earnings when the transaction is complete. These hedges are considered cash flow hedges.
- Gains or losses on hedging of a net investment in a foreign operation are reported in comprehensive income as part of the translation adjustment.
Embedded derivatives must be accounted for separately from the related host contract if the following conditions are met:
- The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics of the host.
- The hybrid instrument is not remeasured at fair value under otherwise applicable GAAP, with changes in fair value reported in earnings as they occur.
- A freestanding instrument with the same terms as the embedded derivative would be subject to the requirements of ASC 815.
If an embedded derivative is accounted for separately, the host contract is accounted for based on the accounting standards that are applicable to instruments of its type. The separated derivative should be accounted for under ASC 815. If separating the two instruments is impossible, the entire contract must be measured at fair value, with gains and losses recognized in earnings. It may not be designated as a hedging instrument because non derivatives usually do not qualify as hedging instruments.
FASB Definition of Derivative Instruments
A derivative instrument is a financial instrument or other contract with all three of the following characteristics:
- It has: (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.
- It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Its terms require or permit net settlement. It can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
Definitions of Underlying, Notional Amount, and Payment Provisions:
- An underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable. An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.
- A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in the contract. The settlement of a derivative instrument with a notional amount is determined by interaction of that notional amount with the underlying. The interaction may be simple multiplication, or it may involve a formula with leverage factors or other constants.
- A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner.
The above article should act as the guidelines in your preparation for Derivatives in the FAR CPA Exam. Hope this helps. If you have any queries, feel free to comment in the section below. Happy Learning!
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