Companies use futures contracts (i.e., derivative instru-ments) to manage exposure to various risks, such as inter-est rate risk, foreign exchange risk, acquisition of invento-ry or capital equipment price risk, and credit risk. Because

of the great variety of these types of contracts, “instruments” gen-erally refer to any such contracts that trade in markets such asthe Chicago Mercantile Exchange as well as agreements devel-oped strictly between companies. For example, one company may

wish to trade a contract payment provision calling for fixedinterest payment to another company for a variable interest pay-ment. The instrument achieves the objectives of both: One com-pany locks in a fixed cash flow and the other speculates oninterest changes. The accounting literature uses the “derivative”to further describe such contracts.

Hedge accounting generally requires that companies recog-nize derivatives as assets and liabilities and subsequently measure

Foreign Currency Forward Contracts and Cash Flow Hedging

A C C O U N T I N G & A U D I T I N Ga c c o u n t i n g

OCTOBER 2010 / THE CPA JOURNAL24

By Josef Rashty and John O'Shaughnessy

Navigating Accounting and Disclosure Requirements

them at fair value. A derivative mustqualify to be able to use hedge accounting.The alternative is to use nonhedge deriva-tive accounting, which reflects derivativefair value changes in earnings rather thanon the balance sheet. Nonhedge account-ing is generally unappealing to companiesbecause it creates volatility in earnings. Ifitems initially qualify for hedge account-ing but subsequently lose their eligibility,they must revert back to nonhedge account-ing and the unrealized gains and losses willbe reflected in current earnings.

The breadth and complexity of deriva-tive accounting have created significantchallenges for companies that use them.Many companies have failed to account forthem properly, resulting in a significantnumber of restatements. Companies mustunderstand the economics of the transac-tion from a risk management perspective,and be versed in its accounting complexi-ties. The determination that a transactionqualifies for hedge accounting is subject tointerpretation. Different conclusions can bereached as to whether a contract shouldbe accounted for as a derivative instrument.There have been many examples of com-panies restating their financial statementsbecause their initial judgment that calledfor derivative accounting subsequentlyproved to be incorrect.

Background Derivatives are financial instruments

whose value stems from fluctuations of theirunderlying assets, liabilities, interest rates,foreign currency exchange rates, or indices.Companies must recognize derivatives asassets or liabilities on the balance sheet atfair value and periodically remeasure them.If a derivative qualifies as a hedge instru-ment, it can decrease the volatility on a com-pany’s statement of operations or income.For example, if a derivative qualifies as acash flow hedge, a company can report theeffective portion of the gain or loss on thederivative instrument as a component ofother comprehensive income (loss), ratherthan on the income statement, and reclassi-fy it into earnings in the same period or peri-ods during which the hedged transactionaffects earnings.

The accounting rules for derivatives arethe most complex ever issued by FASB.The discussion below will examine theaccounting and disclosures required when

a company creates a derivative instrumentby engaging in a cash flow hedge trans-action. Before proceeding, it is necessaryto explain some of the technical conceptsbehind derivatives.

Derivative instruments represent rights orobligations and thus, should be shown asassets or liabilities. Because of the complex-ity and quick evolution of derivative instru-ments, they were not required to be report-ed in financial statements until 1998, whenFASB issued SFAS 133, Accounting forDerivative Instruments and Hedging Activities(Accounting Standards Codification [ASC]Topic 815).

FASB defines a derivative as a financialinstrument or other contract with the fol-lowing characteristics (ASC 815-10-15-83):

(a) It has (1) one or more underlyingsand (2) one or more notional amountsor payment provisions or both. Thoseterms determine the amount of the set-tlement or settlements, and, in somecases, whether or not a settlement isrequired. (b) It requires no initial netinvestment or an initial net investmentthat is smaller than would be requiredfor other types of contracts that wouldbe expected to have a similar responseto changes in market factors. (c) Itsterms require or permit net settlement, itcan readily be settled net by a meansoutside the contract, or it provides fordelivery of an asset that puts the recip-ient in a position not substantially dif-ferent from net settlement.Generally Accepted Accounting

Principles (GAAP) requires that if a hedgetransaction meets the criteria that permitthe use of hedge accounting, an entity mayelect to designate a derivative as one of thefollowing hedges:! Fair value—a hedge of the exposure tochanges in the fair value of a recognizedasset or liability or of an unrecognized firmcommitment that are attributable to a par-ticular risk. ! Cash flow—a hedge of the exposure tovariability in the cash flows of a recog-nized asset or liability, or of a forecastedtransaction.! Net investment—a hedge of the foreigncurrency exposure of a net investment ina foreign operation.

An underlying or a hedged item (ASC815-10-15-88) is a variable within a deriva-tive instrument that, along with either a

notional amount or a payment provision,determines the settlement amount. Anotional amount (ASC 815-10-15-92) isthe number of currency units specified ina derivative contract, and it determinesthe settlement amount under a derivativeinstrument. In summary, the settlement ofa derivative instrument is determined bythe interaction of the notional amount andthe underlying.

Companies must recognize derivativeinstruments as assets or liabilities in theirstatement of financial position at fair valueand remeasure their fair values in subse-quent periods.

Futures and forwards are contracts tobuy or sell a defined amount of a specif-ic underlying asset at a specified priceagreed to at origination, with delivery andsettlement at a specified future date.Companies use foreign currency forwardcontracts to hedge against changes in cur-rency exchange rates of an existing assetor liability, a firm commitment, or a fore-casted transaction. Cash flow hedges, onthe other hand, protect against the riskthat variable prices, costs, rates, or termswill make future cash flows uncertain.

A cash flow hedge is a hedge of the vari-able cash flow of an anticipated or fore-casted transaction that will probably occur,but the amount of which has not been fixedat the time of initiation of the hedgetransaction. Forecasted transactions mustbe probable future transactions that do notmeet the definition of a firm commitmentunder GAAP. Forecasted transactions can be contractually established or merelyprobable because of a company’s past orexpected business practices. In other words,unlike firm commitment transactions, eithersome terms of the transaction are variableor the transaction itself is not contractual-ly certain. An example of this type of trans-action is illustrated below.

Effectiveness. A transaction must beeffective to qualify for hedge accountingunder ASC 815. Hedge effectiveness refersto the extent that the changes in the fairvalue of hedging instrument offset thechanges in the fair value of the hedged item(the underlying). Although there is no spe-cific guidance to determine that a hedgeis highly effective, FASB staff has statedinformally that in order for a hedge to behighly effective, the cumulative change inthe value of the derivative instrument

25OCTOBER 2010 / THE CPA JOURNAL

OCTOBER 2010 / THE CPA JOURNAL26

expressed as a ratio of the cumulativechange in the fair value of the hedged item(the underlying) must fall within therange of 80% to 120%.

If the hedge is highly effective, thenthe treatment of the difference in thechanges in fair value of the derivativeinstrument and the hedged item (the under-lying) depends upon the type of hedge. Forexample, for derivative instruments thatqualify as cash flow hedges, the effectiveportion of the gain or loss on the deriva-tive instrument is reported as a compo-nent of other comprehensive income (loss)and is reclassified into earnings in the sameperiod or periods during which the hedgedforecasted transaction affects earnings.Therefore, an entity can eliminate volatil-ity by using hedge accounting. If, howev-er, the derivative does not qualify as ahedging instrument by being highly inef-fective, any difference between the changein the value of the derivative and thehedged item (i.e., the ineffective portion)will be reflected in the income statement.

There are two methods under GAAP tocalculate the effectiveness of a cash flowhedge: the spot and forward price meth-ods. Use of the spot price method excludesthe time value and will result in morevolatile earnings, because changes to thefair value of the hedging instrument thatrelate to the difference between the spotand forward prices will be recognized inthe income statement. Use of the forwardmethod, while more complex, may resultin less earnings volatility than the spot pricemethod, because the difference betweenspot and forward prices are recognized inother comprehensive income.

While GAAP permits entities to excludeall or a part of the hedging instrument’stime value from the assessment of hedgeeffectiveness, no other components of again or loss on the designated hedge instru-

ment may be excluded from the effective-ness assessment. When entities exclude thetime value for the effectiveness testing pur-poses, the excluded time value will bereflected in the income statement.

In order to maintain the advantages ofhedge accounting treatment, an entity mustcomply with rigorous GAAP documenta-tion requirements for its hedging transac-tions. This must be performed at the incep-tion of the hedging relationship and on anongoing basis (at least quarterly). Theassessment must include an evaluation ofwhether the relationship between thederivative instrument and the hedged item(the underlying) is considered highly effec-tive. In the absence of such documentation,an instrument might not qualify for hedgeaccounting.

ExampleEntity S is the wholly owned sub-

sidiary of Entity A and is primarilyengaged in research and development activ-ities. The revenues of Entity S have beenconsistently equal to 20% of its totalexpenses—Entity A finances the remain-ing 80% of S’s expenditures. The func-tional currency of Entity A is its localcurrency unit (LCU). The functional cur-rency of Entity A is the U.S. dollar (USD).

The results of operations of Entity A aresubject to foreign currency exchange fluc-tuation due to changes in the exchange valueof LCU to USD; Entity A, however, has anatural hedge for 20% of Entity S’s expen-ditures. Therefore, Entity A enters into atwo-period forward contract for a cash flowhedge to purchase 20,000 LCU forapproximately 83% of S’s 24,000 LCUexpenditures for two periods (10,000 LCUper period).

The objective of the cash flow hedge isto cover the exposure to variability in thecash flows of a forecasted intercompany

liability (ASC 815-35-55-2). The follow-ing table reflects the monthly statement ofoperations of Entity S:Revenues 2,000 LCUExpenditures 12,000Net loss 10,000 LCU

In this illustration, the hedged item (theunderlying) is the exchange rate or theexchange rate index, and the notional amountis the fixed number of currency units (20,000LCU) which is the payment provision for thesettlement of derivative instrument.

According to ASC 830, ForeignCurrency Matters, companies should reflectthe foreign currency fluctuation on theintercompany accounts that are not hedgedor are de-designated (i.e., discontinued asa hedge) (ASC 830-20). Furthermore, theyshould use average rates or other approx-imations to reflect the foreign currencytranslation of revenues and expenses (ASC830-55-10, 11). This provision affects thede-designated hedges and is reflected inperiods 2 and 3 of this example.

Exhibit 1 reflects the conversion ratesbetween USD and LCU for four periods:In period 0, Entity A initiates its hedge doc-umentation for a hedge contract for two10,000 LCU, representing a two-period for-ward contract. It must be noted that thatinitiation of a hedge contract is notreflected in the financial statements butrequires footnote disclosures.

For the sake of simplicity, this exampleignores the calculation and presentationof present value. Assume also that averagerates are the same as spot rates. A discus-sion of fair value adjustments will followbelow. Furthermore, assume that Entity Auses the spot exchange rates to test thehedge effectiveness and therefore excludesthe time value. As a result, the foreignexchange (FX) gain and loss due to timevalue (TV) is reflected in the income state-ment. Furthermore, the effect of taxes onthe financial results is ignored.

Period 1The following journal entry recognizes

change in the fair value of forward contract:Cash flow hedge asset (des.)1 $400FX gain (loss) (excl. TV)2 $200

OCI (loss)3 $6001. 20,000 LCU (2 ! 10,000) ! ($1.12 " $1.10 forward rates) = $4002. Foreign exchange is the differencebetween 1 and 3

Periods Spot Rate Forward Rate Forward Points Average RatePeriod 0 $1.12 $1.10 $0.02 $1.12Period 1 $1.15 $1.12 $0.03 $1.15Period 2 $1.18 $1.16 $0.02 $1.18Period 3 $1.22 $1.17 $0.05 –

EXHIBIT 1Forward Fair Value Rates

OCTOBER 2010 / THE CPA JOURNAL28

3. 20,000 LCU ! ($1.15 " $1.12 spotrates) = $600

The following journal entry reflects theend of the period 1 designated hedge trans-action:Expenditures1 $11,200OCI (loss)2 $300

Intercompany liability3 $11,5001. 10,000 LCU ! $1.12 = $11,2002. 10,000 LCU ! ($1.15 " $1.12 spotrates) = $3003. 10,000 LCU ! $1.15 = $11,500

This journal entry reflects that Entity Ahas been able to eliminate the impact offoreign currency fluctuation through othercomprehensive income (loss).

Period 2Entity A de-designates (or simply discon-

tinues) the 10,000 LCU derivative at theend of period 1 and settles the derivative inperiod 3. The following journal entry recog-nizes change in the fair value of the de-des-ignated portion of the forward contract:Cash flow hedge asset (de-designated)1(R) $400

Other income (exp.)1(R) $4001. 10,000 LCU ! ($1.16 " $1.12 forwardrates) = $400(R) Will be reversed at time of settlement

The following journal entry reflects theimpact of ASC 830, Foreign CurrencyMatters, on the 10,000 LCU de-designat-ed hedge at the end of period 2:Other income (exp.) 1(R) $300

Intercompany liability 1(R) $300

1. 10,000 LCU ! ($1.18 " $1.15) = $300(R) Will be reversed at time of settlement

The following journal entry recognizeschange in the fair value of the designatedportion of the forward contract:Cash flow hedge asset (des.)1 $400

FX gain or loss (excluded TV)2 $100OCI (loss)3 $300

1. 10,000 LCU ! ($1.16 " $1.12 forwardrates) = $4002. Difference between 1 and 33. 10,000 LCU ! ($1.18 " $1.15 spotrates) = $300

The following journal entry reflects the endof period 2 designated hedge transaction:Expenditures1 $11,200OCI (loss)2 $ 600

Intercompany liability3 $11,8001. 10,000 LCU ! $1.12 = $11,2002. 10,000 LCU ! ($1.18 " $1.12) = $6003. 10,000 LCU ! $1.18 = $11,800

Period 3The following two sets of entries will be

reversed upon the hedge settlement. First, Entity A de-designates an additional

10,000 LCU derivative at the end of period 2 and settles the total amount of thederivative in period 3. The following jour-nal entry recognizes the change in the fairvalue of the de-designated forward contract:Cash flow hedge asset (de-designated) 1(R) $200

Other income (expense) 1(R) $2001. 20,000 LCU ! ($1.17 " $1.16 forwardrates) = $200

(R) Will be reversed at time of settlementSecond, the following entry reflects the

impact of ASC 830, Foreign CurrencyMatters, on the 20,000 LCU de-designat-ed hedge at the end of period 3:Other income (exp.) 1(R) $800

Intercompany liability1(R) $8001. 20,000 LCU ! ($1.18 " $1.22) = $800(R) Will be reversed at time of settlement

Exhibit 2 reflects a partial presentationof Entity A’s income statement subsequentto its engagement in hedging activities andprior to settlement for its intercompany bal-ance during each period.

As shown in Exhibit 2, Entity A hasbeen able to accomplish the following:! It has stabilized its expenses and itsgross loss.! It has been able to project and achieveits cash flow objectives.

Clearly, A is better off financially as aresult of the derivative transaction, but thatwas not the objective. The goal was to pro-vide visibility on the projection of cash andexpenses, and Entity A was able to achievethis goal.

Entity A has not been able to achievethe following:! The FX loss (excluded time value) didnot get reflected in other comprehensiveincome and expenses because Entity Achose to exclude the time value from theassessment of hedge effectiveness. As dis-cussed above, such an election results inmore earnings volatility.! There was a gap between the time ofthe hedge settlement and the date of occur-rence of transaction, and as a result,Entity A has not been able to achieve thefollowing:

! The intercompany balance is adjust-ed in every period for foreign curren-cy translation under ASC 830, and the amount is reflected in the incomestatement.! The cash flow hedge assets, whichwere created during the hedge period,are adjusted for fluctuations in forwardrates, and the amount is reflected in thestatement of operations.As a result of the two factors above,

the amount of net loss has fluctuatedfrom one period to the next; nevertheless,all of these adjustments are reversedwhen the hedge transaction is settled.

It should also be noted that if the hedgehad failed the effectiveness test, then the

Description1 Period 1 Period 2 Period 3Revenues $ 2,300 $ 2,360 $ 0Expenses not hedged $ 2,300 $ 2,360 $ 0Expenses hedged $11,200 $11,200 $ 0Gross loss $11,200 $11,200 $ 0FX gain (loss) (excluding time value) ($ 200) $ 100 $ 0Other income (expense) – $ 400 $ 200Other expense, ASC 830 – ($ 300) ($ 800)Net loss $11,400 $11,000 $ 6001. Average LCU rates for the conversion of revenues and expenses for period 1and period 2 are $1.15 and $1.18, respectively. The intercompany debt would besettled at $1.17 in period 3.

EXHIBIT 2Effect of Hedging on the Income Statement

OCTOBER 2010 / THE CPA JOURNAL 29

amount in other comprehensive incomewould have been reclassified into theincome statement.

The following journal entry reflects thesettlement of the derivative:Intercompany liability $23,300

Other income (exp.) 1 $ 500Cash flow hedge assets (des.)2$ 800Cash1 $22,000

1. 20,000 ! ($0.02 forward points atperiod 0 + $100 [excluding TV FX loss])2. $400 in period 1 + $400 in period 23. 20,000 LCU ! $1.10 = $22,000

Exhibit 3 shows the balance of thehedge-related accounts at the end of eachperiod presented.

Despite some volatility during theinterim periods, Entity A achieved itsobjective of recording its expenses at thespot rate of $1.12 and its obligations atthe forward rate of $1.10 (the prevailingrates at the initiation of the hedge transac-tion). The difference between the two rates(the forward points) is reflected in theincome statement.

Fair Value Measurement FASB’s objective is for companies to

estimate the fair value of derivatives sep-arately from the fair value of the non-derivative portions of the contract.Generally, the fair value of derivativeinstruments in a loss position should notbe offset against the fair value of deriva-tive instruments in a gain position (ASC815-10-45-4).

FASB allows a company to measure thefair value of its financial assets and liabil-ities based on one or more of the follow-ing valuation techniques:! Market approach, which uses pricesand other relevant information generatedby market transactions involving identicalor comparable assets or liabilities (ASC820-10-35-29); ! Cost approach, which is the amountrequired to replace the service capacity ofan asset (i.e., replacement cost) (ASC 820-10-35-34); or! Income approach, in which futureamounts are converted into a single pre-sent amount based on market expectations,including present value techniques, optionpricing, and excess earnings models(ASC 820-10-35-32).

Furthermore, FASB has established athree-tier fair value hierarchy that priori-tizes the inputs used in measuring fair valueas follows: ! Level 1, observable inputs such asquoted prices in active markets (ASC 820-10-35-40);! Level 2, inputs other than quoted pricesin active markets, observable either directlyor indirectly (ASC 820-10-35-47); and! Level 3, unobservable inputs for whichthere are little or no market data that requirethe reporting entity to develop its ownassumptions (ASC 820-10-35-52).

In practice, most companies use the“income approach” and Level 2 inputs tovalue their derivatives. GAAP defines the

income approach as one that uses valuationtechniques to convert future amounts (e.g.,cash flows or earnings) to a single presentamount (discounted). Those valuation tech-niques include the following: present valuetechniques; option-pricing models (whichincorporate present value techniques), suchas the Black-Scholes-Merton formula (aclosed-form model) and a binomial model (alattice model); and the multiperiod excessearnings method, which is used to measurethe fair value of certain intangible assets.

GAAP requires that the fair market valueof the financial assets be reflected in thefinancial statements. If the fair marketvalues of the cash flow hedge assets were$410 and $1,230 at the end of period 1 andperiod 2, respectively, Entity A wouldrecord the following journal entries:

Period 1Cash flow hedge asset $10

OCI (designated) $5Other income (de-designated) $5

$410 fair market value, less $400 book value

Period 2Cash flow hedge asset $20

Other income (de-designated) $20$1,230 fair market value, less $1,200 bookvalue and $10 period 1 fair market value

Period 3OCI $ 5Other income $25

Cash flow hedge asset $30

Description Period 1 Period 2 Period 3 After SettlementCash flow hedge asset (designated) $ 400 $ 800 $ 800* $ 0Cash flow hedge asset (de-designated) – $ 400 $ 600* $ 0FX gain (loss) (excluding time value) ($ 200) $ 100 ($ 100) ($ 100)Other comprehensive income $ 300 $ 0 $ 0 $ 0Intercompany liability $11,500 $23,300 $ 23,300* $ 0Expenditures $11,200 $22,400 $ 22,400 $22,400Other income – $ 400 $ 600* $ 500Other expense, ASC 830 – ($ 300) ($ 1,100)* $ 0Intercompany liability, ASC 830 – $ 300 $ 1,100* $ 0Cash – – – ($22,000)* Reversed at the time of hedge settlement

EXHIBIT 3Hedge-Related Accounts

OCTOBER 2010 / THE CPA JOURNAL30

Reversal of entries in period 1 and period2 upon settlement of the hedge

Best Practices Preparing and gathering information to

properly execute a hedge contract is a sig-nificant undertaking and requires extensivecoordination among the accounting,finance, treasury, risk management, legal,and information technology departments.Many companies have elected to outsourcethe function or use the assistance ofexpert third parties to design and imple-ment hedge operations.

Hedge accounting requires extensivedocumentation at inception. A derivativeinstrument absent such documentation willnot qualify for hedge accounting.Additionally, a hedge may also lose itsprivilege for hedge accounting if it is notfully utilized by the end of the program.There is usually a grace period of up to60 days for companies to cure the defi-ciency; otherwise, the transaction loses eli-gibility for hedge accounting treatment.Companies usually hedge between 75%and 80% of their forecasted amount tocover possible underutilization due to anyunforeseen economic circumstances.

Most companies that engage in foreigncurrency forward contracts choose to ignoretime value for the measurement of effec-tiveness (as illustrated in the exampleabove). The exclusion of time value maycreate some volatility in earnings—as it didduring the recent financial crisis—but theimpact on earnings is only temporary andcorrects itself by the end. Nevertheless, thisapproach remains popular among compa-nies that engage in foreign currency for-ward contracts, because it makes achieve-ment of the effectiveness threshold morefeasible.

From an administrative perspective,companies usually use the end-of-last-peri-od spot rate as the average for the cur-rent-period exchange rate, because an actu-al calculation of an average exchange rateis problematic and cannot be determineduntil the period is complete. Furthermore,many companies have a policy of revers-ing the prior-period journal entries and cre-ating a fresh inception-to-date journal entryeach period. The advantage of thisapproach is that any bookkeeping errorsare flushed out as part of the reversal. Thisis unlike this example above, whereby the

journal entries for each period reflectedonly the change in the economics of thatparticular period.

DisclosuresIn March 2008, FASB issued SFAS 161,

Disclosures About Derivative Instrumentsand Hedging Activities (ASC 815). Thispronouncement expanded the disclosurerequirements for derivatives and amendedSFAS 133 (ASC 815). The required addi-tional disclosures became effective forinterim periods beginning after November15, 2008. The following is a summary,taken from “Derivatives: New DisclosuresRequired,” by Barbara Apostolou andNicholas G. Apostolou, The CPA Journal,November 2008, of the disclosure provi-sions related to foreign currency forwardcontracts: ! Fundamental disclosures, such as the rea-son a company uses foreign currency for-ward contracts and how it accounts for it;! Qualitative disclosures, such as objec-tives of the hedge program, type of hedge(e.g., cash flow), and volume of transaction;! Volumetric disclosures, such as theaggregate U.S. dollar notional amount offoreign currency forward contracts held bythe company as of a specific date;! Quantitative disclosures, such as the bal-ance sheet tables, reflecting location andfair value of derivatives on gross basis, aswell as statement of operations or incometables, reflecting net gains and losses ofderivatives and segregation of derivativesdesignated or not designated as hedginginstruments. ASC 815 requires the follow-ing information to be presented in tabularformat in quarterly and annual reports:

! Designated derivative assets and lia-bilities for the current period and endof last year;! Nondesignated derivative assets andliabilities for the current period and endof last year;! Gains (losses) recognized in othercomprehensive income (loss) for theeffective portion of derivative instru-ments designated and qualified as cashflow hedges for the current and priorperiods;! Gains (losses) reclassified from othercomprehensive income (loss) to earningsto offset the actual amounts of rev-enues and expenditures for the currentand prior periods;

! Gains (losses) reflected in earnings dueto their exclusion from assessment ofhedge effectiveness (e.g., the timevalue exclusion above), for the currentand prior periods;! Gains (losses) reclassified into earn-ings for the ineffective portion of thehedge or as a result of discontinuationof hedge program (de-designation) forthe current and prior periods. In the “Qualitative and Quantitative

Disclosures About Market Risk” section ofquarterly and annual reports, companiesmust disclose the hedge program and theeconomics of a transaction from a riskmanagement perspective. The table includ-ed in this section should reflect thenotional amount in foreign currency andits equivalent in U.S. dollars as well asthe average rate of the committed amountfor the hedge program during the period.

Companies must also disclose the fairvalue of derivative instruments and themethod of arriving at such a fair valuemeasurement in a “Fair Value Measurement”note in quarterly and annual reports.

A “Commitment and Contingencies” noteshould reflect the maximum length of timeover which a company is hedging its expo-sures. It should also state that the companyhas arrived at such amounts based on theforecast of operating expenditures and rev-enues. Companies must disclose the amountof gains and losses related to derivativeinstruments in a “Other ComprehensiveIncome or Loss” note, net of tax effects.Companies should also disclose whetherthese transactions are speculative in nature.

ASC 815 requires that when a compa-ny discloses information on derivativeinstruments in more than a single note, itshould cross-reference those sources ofinformation.

Recent DevelopmentsFASB and the International Accounting

Standards Board (IASB) are jointlyreconsidering the accounting for all finan-cial instruments, including hedge account-ing. The objective of this joint project isto improve the usefulness of financial state-ments and simplify the accounting forfinancial instruments. Despite starting ajoint project, the two boards have beenpulled in different directions by politicalforces, and as a result have reached dif-ferent conclusions.

OCTOBER 2010 / THE CPA JOURNAL 31

FASB released its highly anticipated pro-posed update on the accounting for finan-cial instruments on May 26, 2010. Amongthe proposed changes are requirements tomeasure more financial instruments at fairvalue and simplification of hedge account-ing. Comments on the exposure draft weredue by September 30, 2010; no effectivedate has been proposed.

FASB is proposing the followingchanges to modify ASC 815 hedgeaccounting, based largely on changes thatit proposed in 2008:! Replacing the notion of highly effec-tive with “reasonably effective,”! Eliminating the “short-cut method”(which was not discussed above),! Requiring that both “overhedges” as wellas “underhedges” result in ineffectiveness,! Reassessing hedges for reasonableeffectiveness qualitatively rather thanquarterly,! Prohibiting discretionary de-designationof a hedge prior to its maturity.

In contrast, the IASB published itsapproach on November 12, 2009, with therelease of International Financial ReportingStandard (IFRS) 9, Financial Instruments.IFRS 9, which reached fundamentally dif-ferent conclusions than FASB’s exposuredraft, may be adopted early but is noteffective until January 1, 2013. The IASB isconducting its project in three separate phas-es: classification and measurement, impair-ment, and hedge accounting. The IASBrecently issued guidance which requires thatmost financial instruments be measuredeither at amortized cost or at fair value,with changes in fair value recognized in theincome statement. The EuropeanCommission, however, has refused to endorse this standard pending further analysis.

As indicated, the accounting pronounce-ments surrounding the derivatives are themost complex ever issued by FASB. FASBhas acknowledged this fact and has embarkedon several projects to simplify the account-

ing for derivatives. The IASB has likewiseundertaken similar projects; however, itappears that the two standards setters areheading in different directions rather thantoward a single, converged standard, withFASB generally emphasizing more fair valueaccounting than the IASB.

The discussion above is meant to coversome basic principles and lay the ground-work for the accounting and disclosuresrequired for cash flow hedges and foreigncurrency forward contracts. The rules andprinciples of accounting for derivativeinstruments remain very complex andrequire careful application of professionaljudgment. "

Josef Rashty, CPA, is the director of com-pliance and reporting at InformaticaCorporation, Redwood City, Calif. JohnO'Shaughnessy, PhD, CPA (inactive), isa professor of accounting at San FranciscoState University, San Francisco, Calif.