Companies frequently use derivatives to hedge their risk exposures.
Under U.S. GAAP there are three classes of exposures to derivatives hedging activities which require specific accounting treatment in a company’s financial reporting:
- Exposure to changes in the value of assets and liabilities or a company commitment.
- This is also called a fair value hedge.
- The change in market value of the derivative is recognized on the income statement for the accounting period.
- The effective portion of the hedging instrument is first reported as part of OCI.
- This portion is later transferred to the income statement once the business transaction has taken place.
- The ineffective portion of the hedge is immediately recognized on the income statement. This portion can be thought of as the derivative’s tracking error or the change in the value of the derivative which did not mirror the change to the underlying investment’s value.
- The gain or loss on the derivative security is reported as a component of OCI as part of the cumulative translation adjustment.