Financial assets

Cash and cash equivalents

Cash is simple to summarize.

Cash comprises cash on hand and cash in bank.
Companies generally hold more cash equivalents than cash.
Cash may also be restricted.

In common usage, "cash on hand" often refers to both physical currency and deposits with financial institutions. However, in an accounting context, cash on hand refers to currency.

Note: IAS 7 uses the term "cash on hand" while the ASC glossary "currency on hand." In practice, the two are synonyms.

Also note: neither IFRS nor US GAAP use the term petty cash. However, in common practice, petty cash generally refers to an amount of currency that could be stored in a desk drawer or carried in a pocket. If, on the other hand, the currency would require a safe or motorized transport, it should be referred to as cash on hand | currency on hand.

In their respective glossaries, IFRS and US GAAP use the term "demand deposits" when discussing cash held at banks or other financial institutions. However, in practice, "cash in bank" is more common.

Note: "cash in bank" may also, especially in an international context, be referred to as "bank accounts" or simply "bank." However, these border terms may also include items, such as certificates of deposit, that would fall into the cash equivalents category (below), so should be avoided if precision is required.

To earn a return, most companies invest their excess cash. When they expect to need that cash in the near term, they invest in highly liquid, short-term investments. If these have a maturity of three months or less, they are classified as cash equivalents. Otherwise, they are classified as investments, either short or long-term investments depending their maturity and/or the company’s intent.

Both IFRS and US GAAP define cash equivalents as short-term, highly liquid investments readily convertible to known amounts of cash. Interestingly, while a three months or less criteria is present in both, IAS 7 includes it in the guidance while ASC 230 the definition.

More importantly, IAS 7.7 (edited) states "...an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less..." while ASC 230 definition (edited) states: "generally, only investments with original maturities of three months or less qualify..."

IFRS does not specify how to interpret "say."

In practice, this synonym for approximately is generally understood to mean two or three business days, but certainly no more than five.

While seemingly minor, the absence of the qualifier means, for example, a promissory note with an original maturity of 93 days would qualify as a cash equivalent under IFRS but not US GAAP, where the limit is 92 days (or 90 if it were acquired on the first of January of a non-leap year).

In a seeming role reversal, the ASC uses the term original maturity without defining it. In contrast, IAS 7 does not use the term, but rather states "from the date of acquisition," which is the definition of original maturity.

IFRS and US GAAP do not specifically define restricted cash. They do, however, require its disclosure. While this does not mean it must be kept in a separate account, it would be good practice.

In ASU 2016-18, the EITF discusses its reasoning for not doing so.

In BC8 (edited) it states: The Task Force considered, but rejected, classifying changes in restricted cash or restricted cash equivalents that result from transfers between cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents on the basis of either the nature of the restriction (that is, investing activities) or the purpose for the restriction. The Task Force believes that internal transfers between cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents do not represent a cash inflow or outflow of the entity because there is no cash receipt or cash payment with a source outside of the entity that affects the sum of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents...

In BC9 (edited, emphasis added) it continues... The Task Force considered defining restricted cash; however, it ultimately decided that the issue resulting in diversity in practice is the presentation of changes in restricted cash on the statement of cash flows. The Task Force's intent is not to change practice for what an entity reports as restricted cash or restricted cash equivalents.

Reading between the lines, what the EITF seems to be saying is: we would rather not define restricted cash because, to paraphrase Supreme Court Justice Potter Stewart, "You know it when you see it."

Like US GAAP, IFRS does define restricted cash, although it does not explain why.

In US GAAP, the guidance is provided by ASC 210, so applies to cash, the balance sheet item.

In IFRS, it is provided by IAS 7, which primarily deals with the change in cash, a.k.a. cash flow.

Restricted cash is discussed in ASC 210-10-45-4.a. While much of the guidance focusses on sinking and similar funds, by analogy it would apply to any cash balance that the entity cannot use in its day-to-day operations, particularly to pay employees, suppliers or other creditors.

The existence of a restriction often implies the entity is committed to remit the cash to a particular creditor(s), so the cash would not be available to satisfy the claims of other creditor.

Note: if the creditors that have a claim to the restricted cash are creditors because the entity applied IAS 37 | ASC 450, the balancing entry would be a provision | contingent liability. This page discusses and illustrates the accounting for provisions | contingent liabilities.

Note: ASC 470-10-50-1 provides additional guidance aimed specifically at sinking funds.

Also note: while they feature prominently in IFRS guidance, ASC 210 does not specifically mention the exchange controls or other legal restrictions discussed in IAS 7.49.

While IAS 7 focuses on cash flow (the change in cash), (black letter paragraph) IAS 7.48 does address cash (the balance) stating: an entity shall disclose, together with a commentary by management, the amount of significant cash and cash equivalent balances held by the entity that are not available for use by the group.

Unfortunately, the following (grey letter) paragraph expands on this guidance by specifying these generally comprise "cash and cash equivalent balances held by a subsidiary that operates in a country where exchange controls or other legal restrictions..."

Why is that unfortunate? Because it is occasionally interested to mean that only restrictions based in law must be disclosed. Thus, for example, a restriction associated with a sinking fund would not need to be disclosed because it based in contract, not law.

However, a carful read of the paragraph reveals that it actually states (emphasis added) "Examples include cash and cash equivalent balances held by a subsidiary that operates in a country where exchange controls or other legal restrictions... This implies that other restriction, not just legal restrictions, may require disclosure.

When viewed through the lens of practice statement 2 (Making Materiality Judgements), the guidance means any material restriction, especially one that prevents an entity from using an amount of cash in regular, day-to-day operations falls into the category of restricted cash.

Note: unlike ASC 210-10-45-4.a, where sinking funds feature prominently, IFRS only mentions them in passing (in IFRS 7.18.a and IAS 32.49.d).

ASC 210-10-45-4.a (edited, emphasis added) states: ...Even though not actually set aside in special [bank] accounts, funds that are clearly to be used in the near future for the liquidation of long-term debts, payments to sinking funds, or for similar purposes shall also, under this concept, be excluded...

While, by implication, a separate accounting account not necessary either, it does make keeping track easier.

Note: IAS 7.48 does not go into similar operating detail, but the logic is comparable.

Restricted cash is usually associated with:

Pension funds
Sinking funds
Security deposits
Customer pre-payments
Compensating balances
Minimum bank balances
Mandatory deposits at central banks
Letters of credit or standby LOCs
Collateral
Escrow
Legal contingencies
Exchange controls
Capital expenditures
Etc.

While ASC 210-10-45-4.a provides blanket guidance for any "cash and claims to cash that are restricted as to withdrawal or use for other than current operations..." it mostly focuses on sinking funds implying that this form of restriction is a priority for the FASB.

While IFRS 7.48 provides guidance for "...significant cash and cash equivalent balances held by the entity that are not available for use by the group," IAS 7.49 focuses on "exchange controls or other legal restrictions."

While ASC 810-10-15-10.a.1.iii does mention foreign exchange restrictions, controls, or other governmentally imposed uncertainties, these are only discussed in the context of consolidation of foreign operations, not restricted cash balances.

Both IAS 7.50.c and ASC 210-10-45-4.a discuss cash restricted to fund expected capital expenditures.

However, as such restrictions are only based on management intent, they would not be comparable to, for example, pension funds or escrow accounts, where these funds are held by third parties and only disbursed if pre-set conditions are met.

As this distinction is important to financial statement users, material restrictions of a discretionary nature need to be reported separately in a way that makes this nature clear.

Note: while IFRS and US GAAP do not preclude restricting cash for capital expenditures or repairs and maintenance, on the other side of the balance sheet, they would not allow a provision | contingent liability to be recognized simply because of management intent. An additional discussion of this issue is provided on this page.

Note: in addition to cash, cash equivalents or other financial instruments may also be restricted.

The accounting for cash is even simpler to summarize.

Cash is the balancing entry for a variety of transactions or events.

Cash is easy to recognize and easier to measure so IFRS | US GAAP only deal with the other side.

While the term cash is obvious, both IFRS and US GAAP define it stating (respectively):

Cash comprises cash on hand and demand deposits.
Consistent with common usage, cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. All charges and credits to those accounts are cash receipts or payments to both the entity owning the account and the bank holding it. For example, a bank's granting of a loan by crediting the proceeds to a customer's demand deposit account is a cash payment by the bank and a cash receipt of the customer when the entry is made.

That cash is measured at nominal value is so obvious, neither IFRS nor US GAAP go to the trouble of stating the obvious.

If an entity receives cash as a pre-payment for a future service, it applies IFRS 15 | ASC 606 to the credit side.

If an entity receives cash because it collects on a receivable, it also applies IFRS 15 | ASC 606 to the credit side.

Because it had applied IFRS 15 | ASC 606 when it recognized that receivable in the first place.

Note: IFRS 15.108 | ASC 606-10-45-4 states "...An entity shall account for a receivable in accordance with IFRS 9 | ASC 310 and ASC 326-20..." so IFRS 9 | ASC 310 and ASC 326-20 is, technically, the guidance applicable to the receivable, but mentioning this would only be picking nits.

If an entity receives cash because it borrows it, it applies IFRS 9 | ASC 405, 470, 480, 835, etc. to the credit side.

If an entity restricts cash to cover a potential legal judgment, it applies IAS 37 | ASC 450 to the debit side.

Technically, as they both are cash, the guidance applies to both sides, but more to the debit side.

If an entity expends cash to acquire raw material, a machine, a patent, it applies, well, you get the picture.

Cash

As noted above, the accounting for cash is simple. But, for the sake of completeness, a few examples:

Cash sale

1/1/X1, XYZ sold goods for 1,000 in cash.

XYZ uses a periodic inventory method so does not recognize cost of sales at the time of the sale.

More on this issue on this page.

1/1/X1 \| 1.1.X1
Cash on hand		1,000
	Revenue		1,000

Collection on a receivable

On 1/31/X1, XYZ collected 1,000 on an invoice issued a month earlier.

1/31/X1 \| 31.1.X1
Cash in bank		1,000
	Accounts receivable		1,000

Payment on a payable

On 1/31/X1, XYZ paid 1,000 to settle an invoice it received a month earlier.

31/1/X1 \| 31.1.X1
Accounts payable		1,000
	Cash in bank		1,000

A loan taken out

1/1/X1, XYZ took out a loan of 1,000,000.

1/1/X1 \| 1.1.X1
Cash in bank		1,000,000
	Loan		1,000,000

Capital investment

1/1/X1, XYZ's owners contributed capital of 1,000,000.

1/1/X1 \| 1.1.X1
Cash in bank		1,000,000
	Paid-in Capital		1,000,000

Stock sale

1/1/X1, XYZ sold shares with a 1,000 par value for 1,000,000.

1/1/X1 \| 1.1.X1
Cash in bank		1,000,000
	Paid-in Capital		1,000
	Additional paid-in Capital		999,000

Cash in transit is a bit more involved, but not much.

Cash in transit (float)

In some jurisdictions, cash in transit is not an issue.

12/31/X1, XYZ withdrew 500 to replenish petty cash, paid 250,000 rent, 850,000 wages, and collected 25,000 and 75,000 from two customers. It's operations were in a jurisdiction where real-time banking was the norm.

For example, SEPA (Single Euro Payment Area) payments usually clear the same day while Instant Credit Transfers (SCT Inst) clear in seconds.

12/31/X1 \| 31.12.X1
Petty cash		500
	Cash in bank		500
Pre-paid rent		250,000
	Cash in bank		250,000
Wages payable		850,000
	Cash in bank		850,00000
Cash in bank		25,000
	Accounts receivable: ABC		25,000
Cash in bank		75,000
	Accounts receivable: DEF		75,000

In other jurisdictions, the bank balance and balance sheet balance need to be reconciled.

12/31/X1, XYZ paid 250,000 rent, 850,000 wages, and collected 25,000 and 75,000 from two customers. It's operations were in a jurisdiction where bank transfers clear in 48 hours.

While SEPA (Single Euro Payment Area) payments usually clear the same day, depending on the time submitted, they can clear the next business day. (Non-SEPA) IBAN payments generally clear withing 24 to 48 hours, though they may take longer in some situations. In jurisdiction not part of IBAN, SWIFT (BIC) payments may take a week or more to clear.

While not specifically targeted at cash, the guidance for trade date versus settlement date should applied by analogy to cash receipts/payments. The timing of receipt/payment recognition may also be influenced by national legislation.

IFRS 9.B3.1.3 (edited) states: A regular way purchase or sale of financial assets is recognised using either trade date accounting or settlement date accounting as described in paragraphs B3.1.5 and B3.1.6...

The trade date is the date that an entity commits itself to purchase or sell an asset...
The settlement date is the date that an asset is delivered to or by an entity...

ASC 965-320-25-1 states: The accrual basis of accounting requires that purchases of securities be recorded on a trade-date basis. However, if the settlement date is later than the financial statement date, accounting on a settlement-date basis for such purchases is acceptable if both of the following conditions exist:

The fair value less costs to sell, if significant, of the securities purchased just before the financial statement date does not change significantly from the trade date to the financial statement date.
The purchases do not significantly affect the composition of the plan's assets available for benefits.

For example, one EU member state's legal requirements are: The moment of accounting recognition is the day of payment or currency acceptance, day of purchase or sale of currencies, foreign exchange, or of securities, date of payment, or direct debit from the client's account, the day of the order to the correspondent to make the payment, the settlement day of the bank's orders with the national bank clearing center, the day of crediting (currency) of the funds according to the report received from the bank's correspondent (message means a message in the SWIFT system, a bank notice, adopted medium, account statement, or other documents), negotiation date and settlement date spot trades (the accounting unit chooses whether to use accounting by day for spot trades trade or settlement day and consistently follows the chosen method within each group), date of negotiation and settlement of derivative transactions, date of issuance or acceptance of guarantee, or of the loan promise, the day the values are taken into custody, the day in accordance with paragraph 2.3.

XYZ Inc. Bank reconciliation schedule 12/31/X1 \| 31.12.X1
Cash on statement		2,000,000
-	Unrealized bank transfer (rent)	(250,000)
-	Unrealized bank transfer (payroll)	(850,000)
+	Unrealized bank transfers (accounts receivable: ABC, DEF)	100,000
Cash in bank		1,000,000

Assuming XYZ's bank sends preadvice notices of an incoming payments. Otherwise:

XYZ Inc. Bank reconciliation schedule 12/31/X1 \| 31.12.X1
Cash on statement		2,000,000
-	Unrealized bank transfer (rent)	(250,000)
-	Unrealized bank transfer (payroll)	(850,000)
Cash in bank		900,000

Same facts except, XYZ's jurisdiction was vieux jeu.

While most of the world has shifted to electronic cash transfers, some jurisdictions cling to physical bills of exchange (link). For example, in the United States, paper checks are still used for around 20% of all payments (link).

XYZ Inc. Bank reconciliation table 12/31/X1 \| 31.12.X1
Cash on statement		2,000,000
-	Check number 2510549	(250,000)
-	Checks number 2510550 to 2510933	(850,000)
+	Checks number 5441058 (ABC) and 287710 (DEF)	100,000
Cash in bank		1,000,000

Same facts except XYZ elected to journalize.

In some jurisdictions, particularly with legalistic national GAAPs that prescribe accounting procedures, accountants think they must journalize everything. As neither IFRS nor US GAAP dwell on accounting formalities, a reconciliation is sufficient. Nevertheless, journalizing is not disallowed and can be done.

12/31/X1 \| 31.12.X1
Rent		250,000
Wages & salaries		850,000
Cash: Cash in transit (clearing account)		100,000
	Cash: Cash in transit (clearing account)		250,000
	Cash: Cash in transit (clearing account)		850,000
	Receivables		100,000

1/2/X2 \| 2.1.X2
Cash: Cash in transit (clearing account)		250,000
Cash: Cash in transit (clearing account)		850,000
Cash: Cash in bank		100,000
	Cash: Cash in bank		250,000
	Cash: Cash in bank		850,000
	Cash: Cash in transit (clearing account)		100,000

Cash equivalents

Certificate of deposit

1/1/X1, XYZ acquired a three-month CD for 100,000. 3/31/X1, it received 100,864.

Implying an annual interest rate (in Excel syntax) of: 3.5%=((1+RATE(1,-100864,100000,0))^4)-1.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Certificate of deposit		100,000
	Cash		100,000

3/31/X1 \| 31.3.X1
Cash		100,864
	Cash equivalents: Certificate of deposit		100,000
	Interest revenue		864

Same facts except XYZ acquired a revolving, three-month CD it intended to hold for six months.

Dr / Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Certificate of deposit		100,000
	Cash		100,000

3/31/X1 \| 31.3.X1
Cash equivalents: Certificate of deposit		864
	Interest revenue		864

The interest was credited to the CD.

Its balance on 3/31/X1 (100,864) implied an annual interest rate (in Excel syntax) of:
3.5%=((1+RATE(1,-100864,100000,0))^4)-1 for Q1.

6/30/X1 \| 30.6.X1
Cash		101,612
	Cash equivalents: Certificate of deposit		100,864
	Interest revenue		748

The CD's balance on 6/30/X1 was 101,612 implying an annual interest rate (in Excel syntax) of:
3.0%=((1+RATE(1,-101612,100864,0))^4)-1 for Q2.

Same facts except XYZ expected interest rates to decline so it acquired a six-month CD. 6/30/X1, it received 101,735.

Implying an annual interest rate (in Excel syntax) of: 3.5%=((1+RATE(1,-101735,100000,0))^2)-1.

Dr / Cr

1/1/X1 \| 1.1.X1
Investments: Certificate of deposit		100,000
	Cash		100,000

ASC 230 defines cash equivalents as highly liquid investments readily convertible to known amounts of cash with a maturity of three months or less. While the IAS 7 definition does not discuss maturity, the three months or less criterion is specified by IAS 7.7. As the CD was for 6 months, XYZ classified it as a short term investment.

Note: if an order of liquidity balance sheet is prepared for IFRS purposes, this item would be reported in other financial assets (OtherFinancialAssets) not cash and cash equivalents (CashAndCashEquivalents).

3/31/X1 \| 31.3.X1
Cash		101,735
	Investments: Certificate of deposit		100,000
	Interest revenue		1,735

Financial instrument

1/1/X1, XYZ bought a three-month, zero coupon, 100,000 face value, investment grade promissory note for 98,906.

Implying an annual interest rate (in Excel syntax) of: 4.5% = ((1+(1+(RATE(1,-100000,98906,0)))^(1)-1)^4) - 1.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Commercial paper		98,906
	Cash		98,906

In the United States, commercial paper refers to high quality financial instruments with an original maturity of no more than 270 days. Internationally, the term may be used more loosely. However, any company that mischaracterizes commercial paper in a SEC filing may become the target of a disciplinary action.

Commercial paper is not defined by US GAAP but the Securities Act of 1933 (link) Sec 3.3 (edited): Any note, draft, bill of exchange, or banker’s acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months...

For example, while the IASB staff assumes "commercial paper is a short-term debt instrument that is sold publicly and held widely, and which matures in 90 or 180 days" (link / local link), EFRAG discusses "commercial paper/certificates of deposits with a maturity up to 12 months" (link / local link).

For example, Portugal Telecom was fined $1,250,000 (link) for mischaracterizing a note as commercial paper.

Proper accounting recognizes the face value of financial instrument separately from the associated discount (premium):

1/1/X1 \| 1.1.X1
Cash equivalents: Note		100,000
	Cash equivalents: Note / Discount		1,094
	Cash		98,906

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash equivalents: Note		100,000
Cash equivalents: Note / Discount		1,094
	Interest revenue		1,094

Nevertheless, with instruments classified as commercial paper (and short-term investments in general), the simplified approach illustrated here could be used. See the liabilities page for additional illustrations of discounts / premiums.

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash equivalents: Commercial paper		98,906
	Interest revenue		1,094

Same facts except the note was originally issued on 31.3.X0 with a one year term.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Note		98,906
	Cash		98,906

Commercial paper is generally understood to mean a financial instrument with an original maturity 270 days or less.

While this criterion comes from US law, it is recognized throughout the investing and regulatory communities.

The Securities Act of 1933 (link) Sec 3.3 (edited) as: Any note, draft, bill of exchange, or banker's acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months...

While we could not find an example of an ESMA enforcement action aimed at this issue, this regulator also interprets "commercial paper" the same way (link / local link). This implies, if a company misrepresents an unqualifying financial instrument as commercial paper, it may be subject to regulatory enforcement even if it is outside the authority of the US SEC.

In 2016, the SEC fined Portugal Telecom (link) $1,250,000 for mischaracterizing an unqualified note as commercial paper.

As the note's maturity on the date of issue was one year, XYZ did not recognize it as commercial paper. However, as its remaining maturity on the day of acquisition was three months, XYZ did recognize it as a cash equivalent.

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash equivalents: Note		98,906
	Interest revenue		1,094

Same facts except the note was originally issued on 8/1/X0, matured on 4/30/X1 and XYZ paid 98,543.

Technically, the note had an original maturity of 273 day not the 270 days discussed above. However, for simplicity, accountants use 270 as shorthand, so every month has 30 days and a year 360 ¯\_(ツ)_/¯

Implying an annual interest rate (in Excel syntax) of: 4.5% = ((1+RATE(1,-100000,98543,0))^(12/4))-1.

Dr / Cr

1/1/X1 \| 1.1.X1
Short-term investments: Commercial paper		98,543
	Cash		98,543

As outlined in the IAS 7.7 | ASC 230 definition, an investment must have an original maturity (maturity on the date of acquisition) of three months or less. As the note had four months to maturity, XYZ recognized or reported it as an investment instead.

3/31/X1 \| 31.3.X1
N/A

As outlined in the ASC 230 definition, an investment with an original maturity exceeding three months does not become a cash equivalent when its remaining maturity is three months. While not as explicit, IAS 7.7 does state (edited, emphasis added): "an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition." Different words, same result.

4/30/X1 \| 30.4.X1
Cash		100,000
	Short-term investments: Commercial paper		98,543
	Interest revenue		1,457

Negative rates

nnnnnnnnnnnnn not displayed nnnnnnnnnnnnn

1/1/X1 XYZ acquired a 90 day, 100,000 note for 100,125 and held it to maturity.

Implying an annual interest rate of -0.4984%.

Determined using Excel's =RATE function adjusted for quarterly periodicity: -0.4984% = ((1+RATE(1,-100000,100125,0,0,10%))^4) - 1

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Very short-term security		100,000
Cash equivalents: Deferred interest		125
	Cash		100,125

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash equivalents: Very short-term security		100,000
Interest expense		125
	Cash equivalents: Deferred interest		125

Same facts except XYZ transferred the funds to a zero-interest account.

1/1/X1 \| 1.1.X1
Cash: Account 123		100,000
	Cash: Account 321		100,000

3/31/X1 \| 31.3.X1
Cash: Account 321		100,000
	Cash: Account 123		100,000

Same facts except XYZ decided withdraw currency (ignoring bank charges).

1/1/X1 \| 1.1.X1
Cash: Currency		100,000
	Cash		100,000

3/31/X1 \| 31.3.X1
Cash		100,000
	Cash: Currency		100,000

Liquid valuable

1/1/X1, XYZ purchased postage and revenue stamps with nominal values of 1,000 and 2,000 respectively. In January, it mailed letters at a cost of 100 and paid 200 in administrative fees.

While most have moved on, some jurisdictions cling to traditional adhesive labels attached to physical documents to designate the payment taxes or administrative fees (never forgetting the all-important rubber stamp) the same way they prefer physical, paper, certified letters over, for example, DocuSign.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Postage stamps		1,000
	Cash		1,000
Cash equivalents: Revenue stamps		2,000
	Cash		2,000

While the guidance in IAS 7 and ASC 230 suggests that cash equivalents may only comprise investments such as treasury bills, commercial paper, money market funds, etc., companies may hold other, cash like-items such as postage and revenue stamps. As these "liquid valuables" can both be used to pay for goods or services and be readily converted back into cash, they should be recognized as cash equivalents on judgment alone.

In January
Postage		100
	Cash equivalents: Postage stamps		100
Taxes and fees		200
	Cash equivalents: Revenue stamps		200

Same fact except it purchased credit for a postage machine.

1/1/X1 \| 1.1.X1
Pre-paid postage		1,000
	Cash		1,000

In contrast to stamps, pre-paid postage cannot be readily converted back into cash. Consequently, it should be considered an accrual (pre-paid expense) not a cash equivalent.

In January
Postage		100
	Pre-paid postage		100

1/1/X1, XYZ purchased employee meal vouchers with a nominal value of 60,000. It paid 60,300 including a 0.5% processing fee. 1/31/X1, it included vouchers with a nominal value of 20,000 in January employee compensation.

In XYZ's jurisdiction, employee benefits such as meal allowances receive favorable tax treatment but only if provided in the form of vouchers or pre-paid debit cards.

In XYZ's jurisdiction, employees are compensated on a monthly basis. In some jurisdiction a different periodicity, for example weekly or bi-weekly, is used.

Dr/Cr

1/1/X1 \| 1.1.X1
Cash equivalents: Vouchers or Pre-paid employee benefits: Vouchers		60,000
Pre-paid employee benefits: Voucher fee		300
	Cash in bank		60,300

The definition of cash equivalents (IAS 7.7 | ASC 230) suggests they may only comprise financial instruments such as treasury bills, commercial paper or money market funds. However, in some jurisdictions companies hold other cash like instruments such postage stamps, revenue stamps, meal vouchers, etc. Occasionally questions as to their proper classification arise. As a general rule, if they can be readily converted back into cash, they would be cash equivalents otherwise they would be pre-paid expense.

Note: as the amounts involved are usually insignificant, this issue is rarely given, outside of academic circles, much thought, so practice varies.

1/31/X / 31.1.X1
Payroll: Fringe benefits: Food and beverage		20,100
	Cash equivalents: Vouchers or Pre-paid employee benefits: Vouchers		20,000
	Pre-paid employee benefits: Voucher fee		100

Restricted cash

1/1/X1, XYZ sold 1000, 10 year, 4.5% bonds with a sinking fund. XYZ paid both the coupon and 21,036 fund contribution each quarter. The fund's custodian guaranteed repayment.

As a rule, bond buyers prefer lump-sum principal repayments at the end of the bond term. However, as the default risk is higher than if principal is repaid periodically, only the most highly rated public and private entities are able to issue such term bonds.

One way less credit worthy organizations can do so is to insure them. However, the cost of insurance can be prohibitive.

Depending on the circumstances, a more cost effective alternative could be to, in effect, turn the term bond into a serial bond with a sinking fund. In this scenario, the debtor makes periodic payments to a trustee who retires the bond. This in effect substituting trustee's credit standing for the debtor’s allowing even less credit worth debtors to access the segment of the market that deals in term bonds.

In this illustration, the trustee's rating was AA while XYZ's only B. If XYZ had placed the bonds itself (assuming it could have), it would have had to offer a coupon in line with its credit standing. Assuming a AA rate of 4.5% and 3% spread, it would have had to offer a 7.5% coupon.

Thus, while the trustee did lock XYZ into a sub-market return, it was offset by the lower coupon.

A contribution of 21,036 implies a 3.5% annual return. At the time of the issue, the yield on AAA rated corporate debt implied an annual market rate of 4.2%. The difference compensated the trustee for the guarantee.

To determine the contribution, the trustee made this calculation:
21,036 = 1,000,000 ÷ (((1 + (1 + 3.5%)^1÷4 - 1)^10x4 - 1) ÷ ( (1 + 3.5%)^1÷4 - 1))

In excel syntax (rounded): 21036=1000000/(((1+(1+3.5%)^(1/4)-1)^(10*4)-1)/((1+3.5%)^(1/4)-1))
or simplified 21036=1000000/(((1+(1+3.5%)^(1/4)-1)^40-1)/((1+3.5%)^(1/4)-1)).

Note: the calculation may also be made: 20988=1000000/(((1+3.5%/4)^(10*4)-1)/(3.5%/4)). However, as this fails to scale the annual rate to an interim rate accurately, it should only be used by those, like the authors of this page (link), afraid of good math.

In excel syntax (rounded): 3.5%=((1+RATE(40,-21036,0,1000000,0))^4)-1.

As the sinking fund allowed XYZ to, in effect, substitute the trustee's credit standing for its own, it was able to offer a 4.5% coupon instead of (at minimum) 7.5%. The difference between the total cash outlay associated with the bond plus sinking fund (1,291,449) and a 7.5% loan (1,417,590) was significant.

In Excel syntax (rounded): 1291449=(40*21036)+10*1000000*4.5%.

In Excel (rounded): 1417590=40*1000000/((1-(1/(1+((1+7.5%)^(1/4)-1))^(10*4)))/((1+7.5%)^(1/4)-1)).

Note: the trustee had the option of buying the bonds on the open market, in effect, retiring them earlier. However, it was obligated to hold any such bonds until maturity as XYZ's creditor.

Also note: for simplicity, the illustration assumes the bonds were placed at face value. See the liabilities page for illustrations of bond discounts / premiums.

Dr / Cr

1/1/X1 \| 1.1.X1
Cash		1,000,000
	Bond		1,000,000

3/31/X1 \| 31.3.X1 So accruing entries need not be illustrated, the payment was made and recognized the last day of the quarter.
Bond sinking fund (restricted cash)		21,036
	Cash		21,036
Interest expense		11,250
	Cash		11,250

While both address the issue, IFRS and US GAAP only provide cursory guidance. This is unfortunate because the lack of specificity leads to differences of opinion as to what qualifies as "restricted cash."

For example, neither explicitly define "restricted cash."

This does not, however, mean they fail to address it at all.

For example, the IFRS definition of current assets (sub-paragraph d) suggests that a restriction turns cash, normally current, into a non-current asset. This in turn implies restricted cash must be evaluated as a separate, stand-alone accounting item regardless of whether it is specifically defined as such.

Similarly, IAS 7.7 specifies that for an investment to be reported as a cash equivalent, it must have a maturity of three months or less. As the economic substance of a restriction is comparable to a maturity, if applied to cash by analogy, this guidance suggests that any cash subject to a restriction exceeding three months cannot be classified as regular cash.

Also, in its Tentative Agenda Decision on Demand Deposits with Restrictions on Use arising from a Contract with a Third Party, the IFRIC addressed this issue. In the fact pattern described, the entity "holds a demand deposit whose terms and conditions do not prevent the entity from accessing the amounts held..." Based on this fact pattern, the IFRIC concluded "the entity presents the demand deposit as cash and cash equivalents." Thus, by implication, if entity held a demand deposit whose terms and conditions did prevent it from accessing the amounts held, it would not classify it as cash or cash equivalents. While, obviously, the Tentative Agenda Decision does not specify what it would be classified as, restricted cash seems the logical choice.

US GAAP also avoids explicitly defining restricted cash. However, ASC 210-10-45-4.a does require non-current restricted cash to be reported separately. While the guidance does not explicitly state it must be classified as "restricted cash," doing so makes sense.

Specifically, ASC 210-10-45-4.a requires restricted cash to be segregated from regular cash if the restriction is for over a year.

While the guidance also suggests restricted cash need not be segregated at the bank account level, this is common (and good) practice.

In ASU 2016-18.BC9 (edited) the EITF also states: ... The Task Force considered defining restricted cash; however, it ultimately decided that the issue resulting in diversity in practice is the presentation of changes in restricted cash on the statement of cash flows. The Task Force's intent is not to change practice for what an entity reports as restricted cash or restricted cash equivalents...

What this (somewhat cryptic) explanation seems to be suggesting: restricted cash is too broad to define but, to paraphrase Supreme Court Justice Potter Stewart, "You know it when you see it."

More importantly, at least for entities registered with it, the US SEC sees it this way (edited, emphasis added):

Separate disclosure shall be made of the cash and cash items which are restricted as to withdrawal or usage. The provisions of any restrictions shall be described in a note to the financial statements. Restrictions may include legally restricted deposits held as compensating balances against short-term borrowing arrangements, contracts entered into with others, or company statements of intention with regard to particular deposits; however, time deposits and short-term certificates of deposit are not generally included in legally restricted deposits... (CFR § 210.5-02: link).

Nevertheless, this lack of specificity does not mean restricted cash can be ignored. Instead, it needs to be reported separately, especially if the restriction exceeds one year.

IAS 1.66.d specifies that if cash or a cash equivalent is "restricted from being exchanged or used to settle a liability for at least twelve months," it cannot be classified as current. Similarly, in IASB XBRL, RestrictedCashAndCashEquivalents is a separate item with reference is IAS 1.55 (rather than 1.66.d). This reference implies that material (link) restricted cash needs to be recognized and reported separately from unrestricted cash even in an order of liquidity balance sheet.

In US GAAP, ASC 210-10-45-4.a specifies that restricted cash is to be segregated from regular cash if the restriction is for over a year.

Note: while the paragraph also suggests restricted cash need not be segregated at the bank account level, keeping this cash in separate bank, or similar, accounts is good practice.

Similarly, ASC 230-10-50-8 suggests restricted cash and cash equivalents need to be disaggregated on the statement of financial position if material.

Note: if various reasons for restrictions exist, restricted cash would be further disaggregated by type.

To emphasize the point, in FASB XBRL, RestrictedCash and RestrictedCashEquivalents have the same prominence as Cash and CashEquivalentsAtCarryingValue.

In addition to the balance sheet, additional footnote disclosure is also required. Specifically, ASC 230-10-50-7 (edited) states: An entity shall disclose information about the nature of restrictions on its cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents...

While IFRS does not define restricted assets, the Glossary does define current assets (edited, emphasis added): ...(d) the asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.

Similarly, as outlined in 210-10-45-4.a, noncurrent restricted cash and claims cannot be included in current assets. To reinforce this guidance, the FASB XBRL includes RestrictedCashCurrent and RestrictedCashEquivalentsCurrent, and RestrictedCashNoncurrent and RestrictedCashEquivalentsNoncurrent tags. The items also point to ASC 230-10-50-8, suggesting each is to be presented as separate balance sheet line item if material.

For example, the authors of some web pages do not draw a distinguish between cash restricted due to legal or contractual constraints and simple management intent (link, link, link) classifying, for example, cash reserved for capex as restricted. Fortunately, the authors other pages (link, link, link) are more enlightened.

As far as ifrs-gaap.com is concerned; to be reported on the balance sheet as restricted, the cash must be restricted due to a legal or contractual obligation. Any cash "restricted" simply on the basis of management intent (i.e. cash held for expected future major repairs, capex, M&A, etc.) may be (if at all) disclosed in the footnotes only.

In CFR § 210.5-02 (link) the SEC specifies (emphasis added): Separate disclosure shall be made of the cash and cash items which are restricted as to withdrawal or usage. The provisions of any restrictions shall be described in a note to the financial statements. Restrictions may include legally restricted deposits held as compensating balances against short-term borrowing arrangements, contracts entered into with others, or company statements of intention with regard to particular deposits; however, time deposits and short-term certificates of deposit are not generally included in legally restricted deposits. In cases where compensating balance arrangements exist but are not agreements which legally restrict the use of cash amounts shown on the balance sheet, describe in the notes to the financial statements these arrangements and the amount involved, if determinable, for the most recent audited balance sheet required and for any subsequent unaudited balance sheet required in the notes to the financial statements. Compensating balances that are maintained under an agreement to assure future credit availability shall be disclosed in the notes to the financial statements along with the amount and terms of such agreement.

As the SEC makes fairly clear, legal or contractual restrictions should be presented on the balance sheet while restrictions based solely on company intent should only be discussed in the footnotes.

If good enough for the SEC, good enough for us.

This also applies to cash equivalents and securities.

Since the restriction exceeded one year, XYZ reported the sinking fund (restricted cash) in non-current assets.

Note: if an order of liquidity balance sheet is prepared for IFRS purposes, the sinking fund would be reported in other financial assets (OtherFinancialAssets) not cash and cash equivalents (CashAndCashEquivalents).

In excel syntax (rounded): 21036 = 1000000/(((1+(1+3.5%)^(1/4) - 1)^40-1)/((1+3.5%)^(1/4) - 1)).

In excel syntax: 11250 = 1000000 * 4.5% / 4

6/30/X1 \| 30.6.X1
Bond sinking fund		21,218
	Cash		21,036
	Interest income		182
Interest expense		11,250
	Cash		11,250

P	Fund contribution	Accumulated contribution	Interest rate	Interest income	Interest payment
A	B	C=B+C_(C+1)+E	D=(1+3.5%)^1÷4-1	E=CxD	F
1	21,036	21,036	0.86%	0	11,250
2	21,036	42,254	0.86%	182	11,250
3	21,036	63,655	0.86%	365	11,250
-	-	-	-	-	-
39	21,036	970,580	0.86%	8,131	11,250
40	21,036	1,000,000	0.86%	8,383	11,250
	841,449				450,000

1,291,449 = 841,449 + 450,000

1/1/X1, XYZ leased office space for an indefinite term and collected a 100,000 security deposit. It kept the funds in separate account. 12/31/X10, the lessee vacated the premises and XYZ returned the deposit.

Although ASC 210-10-45-4.a suggests restricted cash need not be segregated at the bank account level, doing so is good practice. IFRS does not specifically discuss this issue.

Neither IFRS nor US GAAP define restricted cash but, in addition to security deposits, it may be associated with:

As discussed in ASU 2016-18, the EITF considered but rejected defining restricted cash.

Specifically, in BC8 (edited) it states: The Task Force considered, but rejected, classifying changes in restricted cash or restricted cash equivalents that result from transfers between cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents on the basis of either the nature of the restriction (that is, investing activities) or the purpose for the restriction. The Task Force believes that internal transfers between cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents do not represent a cash inflow or outflow of the entity because there is no cash receipt or cash payment with a source outside of the entity that affects the sum of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents...

Reading between the lines, what the EITF seems to be saying is: we would rather not define restricted cash because, to paraphrase Supreme Court Justice Potter Stewart, "You know it when you see it."

IFRS also eschews defining restricted cash, but fails to discuss its reasons.

Note: in addition to cash, cash equivalents or other securities may also be restricted.

Unlike a sinking fund (previous example), a security deposit is recognized point of time. Also unlike a sinking fund, it is not discounted.

Specifically, ASC 835-30-15-3.c exempts "amounts intended to provide security for one party to an agreement (for example, security deposits, retainages on contracts)" from ASC 835-30-55-2 to 55-3 (which prescribe the interest method) so the restricted cash associated with these items is recognized at nominal value.

While IFRS does not provide similar, blanket guidance on interest imputation, IFRS 15.62.c does specify that deposits whose purpose is to provide protection to a service provider, in this case a lessor, need not be discounted.

Note: as ASC 606 and IFRS 15 are converged standards, the same result would be achieved by applying ASC 606-10-32-17.c instead of ASC 835-30-15-3.c.

Pensions
Sinking funds
Customer pre-payments
Compensating balances
Mandatory deposits at central banks
Letters of credit or standby LOCs
Collateral
Escrow
Etc.

The only restriction specifically discussed in IFRS is (IAS 7.48 to 52): "cash equivalent balances held by a subsidiary that operates in a country where exchange controls or other legal restrictions apply when the balances are not available for general use by the parent or other subsidiaries." This issue is not addressed by US GAAP nor, as it is even less common than sinking funds, illustrated here.

Foreign exchange restrictions, controls, or other governmentally imposed uncertainties are addressed by ASC 810-10-15-10.a.1.iii, but this guidance applies to foreign subsidies, not just cash balances.

Dr / Cr

1/1/X1 \| 1.1.X1
Cash (restricted)		100,000
	Returnable security deposit		100,000

12/31/X10 \| 31.12.X10
Returnable security deposit		100,000
	Cash (restricted)		100,000

Same facts except XYZ kept the funds in a 3.5% CD account.

1/1/X1 \| 1.1.X1
Cash: CD (restricted)		100,000
	Returnable security deposit		100,000

3/31/X1 \| 31.3.X1
Cash: CD (restricted)		864
	Returnable security deposit		864

P	Opening	Interest rate	Interest	Closing
A	B=E_(E+1)	C=(1+3.5%)^(1/4)-1	D=B*C	E=B+D
1	100,000	0.86%	864	100,864
2	100,864	0.86%	871	101,735
-	-	-	-	-
39	138,654	0.86%	1,198	139,852
40	139,852	0.86%	1,208	141,060

For the sake of simplicity, this example assumes the interest rate did not change throughout the lease term.

12/31/X10 \| 31.12.X10
Returnable security deposit		141,060
	Cash: CD (restricted)		141,060

Financial assets other than cash

Derivatives

Overall

Derivatives are not difficult to summarize:

Derivatives are financial instruments based on (derived from) something else
Derivatives come as either options or forwards

Most derivatives trade on exchanges and so resemble securities.

Derivatives are not, by definition, securities. However, as most trade on exchanges, they have all the salient characteristics of securities. The main difference, unlike stocks or bonds, derivatives are primarily a tool for speculation or hedging, not investment.

The ASC master glossary defines security (emphasis added): a share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer that has all of the following characteristics:

It is either represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer.
It is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment.
It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations.

A derivative is not a share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer but rather a financial instrument derived from a share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer. As such, it does not meet the definition of security.

Note: IFRS does not define the term security.

Some derivatives, such as stock options, can also be used as a form of currency, especially options used to compensate employees.

However, derivatives may also be just contracts or even parts of contracts.

The ASC master glossary defines financial asset as (edited): cash, evidence of an ownership interest in an entity, or a contract that both:

Imposes on one entity a contractual obligation either:

To deliver cash or another financial instrument to a second entity
To exchange other financial instruments on potentially unfavorable terms with the second entity.

Conveys to that second entity a contractual right either:

To receive cash or another financial instrument from the first entity
To exchange other financial instruments on potentially favorable terms with the first entity.

The use of the term financial instrument in this definition is recursive (because the term financial instrument is included in it), though it is not circular. The definition requires a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument.

Contractual rights and contractual obligations encompass both those that are conditioned on the occurrence of a specified event and those that are not. All contractual rights (contractual obligations) that are financial instruments meet the definition of asset (liability) set forth in FASB Concepts Statement No. 6, Elements of Financial Statements, although some may not be recognized as assets (liabilities) in financial statements—that is, they may be off-balance-sheet—because they fail to meet some other criterion for recognition...

Note, the IFRS glossary provides a much simpler definition of financial instrument: any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Both IFRS and US GAAP define a contract broadly: an agreement between two or more parties that creates enforceable rights and obligations. However, if a contract meets the definition, it ceases being a simple agreement between two or more parties and becomes a derivative.

Interestingly, the IFRS definition is somewhat broader than its US GAAP counterpart so more instruments may qualify as derivatives under these standards.

IFRS master glossary (edited, emphasis added) states: a derivative is a financial instrument or other contract ... with all three of the following characteristics:

its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).
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.
it is settled at a future date.

ASC 815-10-15-83 (emphasis added) states: A derivative instrument is a financial instrument or other contract with all of the following characteristics:

Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:

While the basic IFRS definition does not specify that a notional amount must be stated, the expanded definition (IFRS 9.BA.1 to BA.5) does state that a derivative usually has a notional amount.

One or more underlyings
One or more notional amounts or payment provisions or both.

Initial net investment. The contract 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.
Net settlement. The contract can be settled net by any of the following means:

Its terms implicitly or explicitly require or permit net settlement.
It can readily be settled net by a means outside the contract.
It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

The most obvious difference, unlike ASC 815, IFRS 9 does not require net settlement.

IFRS 9 discusses its lack of this requirement in more detail in BA.2 which states (edited, emphasis added): the definition of a derivative in this Standard includes contracts that are settled gross by delivery of the Underlying item (eg a forward contract to purchase a fixed rate debt instrument). An entity may have a contract to buy or sell a non-financial item that can be settled net in cash or another financial instrument or by exchanging financial instruments (eg a contract to buy or sell a commodity at a fixed price at a future date). Such a contract is within the scope of this Standard unless it was entered into and continues to be held for the purpose of delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. However, this Standard applies to such contracts for an entity’s expected purchase, sale or usage requirements if the entity makes a designation in accordance with paragraph 2.5 (see paragraphs 2.4–2.7).

Note: if the contract "was entered into and continues to be held for the purpose of delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements," it would fulfill the definition of firm commitment "a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates." This implies that an entity could hedge one firm commitment with another firm commitment.

Nevertheless, as both IFRS 9 and ASC 815 do require a zero or small net investment, perhaps the most important distinguishing feature of a derivative, the impact of the other differences, while it cannot be ignored altogether, is, on actual day-to-day practice, marginal.

Most forwards (including swaps) and some options (i.e. embedded options) fall into this category.

Embedded derivatives only become an issue if they alter a simple contract in a way that makes it, or a portion, look like or, more importantly, behave like a derivative.

In other words, if a contract that would not normally need to be accounted for as a derivative (remeasured to fair value) includes a provision(s) making it resemble a derivative, it, or the offending portion, will need to be treated as if it were derivative (remeasured to fair value).

While not identical, the guidance on how to deal with embedded derivative(s) under IFRS and US GAAP is comparable.

IFRS 9.4.3.4 (emphasis added): If a hybrid contract contains a host that is not an asset within the scope of this Standard, an embedded derivative shall be separated from the host and accounted for as a derivative under this Standard if, and only if:

the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8);
a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (ie a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

ASC 815-15-25-1 (emphasis added): An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

Also worth noting, while embedded derivatives have legitimate uses, for example a conversion option attached to a bond, they can also be included in contracts to gratuitously obfuscate the actual market risks inherent in those contracts. In these situations, identifying and bifurcating embedded derivatives is one of the more changing tasks facing both accountants and auditors. However, once found and removed, the accounting is simple. The host contract is accounted for as a contract and the derivative as a derivative.

For this reason, there is no need for separate illustrations specifically aimed at embedded derivatives.

Note: while only US GAAP defines embedded derivatives, IFRS does a good job explaining them.

ASC 815.20 (edited) defines: [an] embedded derivative [comprises] implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument.

IFRS 9.4.3.1 explains: an embedded derivative is a component of a hybrid contract that also includes a non-derivative host—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument.

IFRS 9.4.3.1 makes this point clearly by stating (edited): An embedded derivative is a component of a hybrid contract that also includes a non-derivative host—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified ...

While somewhat less succinct, the guidance in 815-15-15-2 and 815-15-15-4 makes the same general point.

An additional discussion of how to identify a derivative, which would also be applicable in identifying an embedded derivative, is provided in the following sub-section.

IFRS and US GAAP thus refer to them generically as financial instrument.

The IFRS master glossary (edited, emphasis added) defines a derivative as: a financial instrument or other contract...with all three of the following characteristics...

ASC 815-10-15-83 (edited, emphasis added): a derivative instrument is a financial instrument or other contract with all of the following characteristics...

That something else is known as an underlying.

An underlying is usually a financial, industrial or agricultural commodity.

The salient issue is fungibility.

With financial commodities, it tends to be absolute. One share of XYZ stock is the same as any other (in the same class). One 100 EUR bank note is the same as any other 100 EUR bank note (even if the serial numbers are different). One percent point of interest is the same as any other percent point.

With industrial and agricultural commodities, the issue becomes somewhat more complicated.

While the underlying oil in all (US) oil futures is the same, the actual oil is not. For example, ASC 815-10-55-82 discusses various grades (light versus heavy, sweet versus sour) stored at various location (i.e. Cushing, Oklahoma). Similarly, while every pork belly future is the same, not every pork belly makes bacon with the same degree of deliciousness.

Fortunately, while it will make the hedge less than 100% effective, it will not preclude hedge accounting.

For example, the underlying for a call option on XYZ's stock is XYZ's stock. The underlying in an EUR/USD swap is the euro (for one party) and dollar (for the other). The underlying in a pork belly future is the pork belly (or, actually, a bunch of pork bellies). The underlying in an oil forward is, well, oil.

However, the underlying may also be an event or condition, for example average temperature or rainfall during a specified period, which is why both IFRS and US GAAP provide a definition.

As is its habit, US GAAP provides more thorough guidance.

ASC 815-10-15-88 states (edited): an underlying is a variable that ... usually is one or a combination of the following:

A security price or security price index
A commodity price or commodity price index
An interest rate or interest rate index
A credit rating or credit index
An exchange rate or exchange rate index
An insurance index or catastrophe loss index
A climatic or geological condition (such as temperature, earthquake severity, or rainfall), another physical variable, or a related index
The occurrence or nonoccurrence of a specified event (such as a scheduled payment under a contract).

Preferring the less wordy approach, IFRS discusses the underlying in its definition of a derivative (edited): ... [a derivative's] value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’)....

When the underlying is a security or commodity, the accounting is not particularly difficult.

Derivatives based on securities (stocks or bonds) or commodities (such as grain or oil) commonly trade on markets so act like securities. As such, these "plain vanilla" derivatives are easy to recognized and simple to measure. All one needs to do is find their symbol and record their closing price.

While commonly known as securities, derivatives do not meet the technical definition of securities.

This issue is discussed in more detail above.

Technically, only the fair value of market traded derivatives is obvious. If, for example, the fair value of an untraded employee stock option needs to be determined, some effort will be required. This issue is discussed in more detail below.

While common in the US or UK, not all markets use symbols.

For example, Börse Frankfurt (link) refers to its securities by name.

All derivatives are remeasured to fair value.

For this reason, US GAAP provides clear and concise guidance.

ASC 815-10-35-1 states: All derivative instruments shall be measured subsequently at fair value .

ASC 815-10-35-1A does include an exception (a.k.a. practical expedient) for receive-variable, pay-fixed interest rate swaps used for hedging, but only for non-public companies (in the scope of ASC 815-20-25-133 to 138).

To make certain the point gets across ASC 815-10-10-1.b states: Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments. Derivative instruments should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (that is, gains or losses) that are attributable to the risk being hedged and that arise while the hedge is in effect.

While IFRS eschews similarly clear statements, the result is comparable.

As outlined in IFRS 9.4.1.1, a financial asset is measured at amortised cost, fair value through other comprehensive income (FVtOCI) or fair value through profit or loss (FVtPL).

As outlined in IFRS 9.4.1.2, a financial asset is measured at amortised cost if it (a) "is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows and (b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding."

As outlined in IFRS 9.4.1.2A, a financial asset is measured at FVtOCI if it (a) "is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets and (b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding."

Since a derivative (that is an asset) does not qualify to be classified as outlined in either IFRS 9.4.1.2 or IFRS 9.4.1.2A, it is classified, by process of elimination, as FVtPL.

While seemingly obvious and perhaps redundant, if a financial asset is classified as FVtPL in accordance with the above guidance, IFRS 9.5.2.1.c specifies that it will subsequently be measured at FVtPL.

When it comes to liabilities, IFRS 9.4.2.1 states (edited, emphasis added): An entity shall classify all financial liabilities as subsequently measured at amortised cost, except for: (a) financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that are liabilities, shall be subsequently measured at fair value...

For traded derivatives, this is usually their market price.

For non-traded derivatives, and traded derivatives held for hedging, it is usually something other than market price.

A more detailed discussion is available below.

Even hybrid derivatives, such as condors and butterflies and iron condors and iron butterflies (the more colorful the name the better), as they are assembled out of plain vanilla derivatives, are not particularly changeling.

When the underlying is something more "exotic," such as a condition (i.e. temperature or rainfall) or event (i.e. earthquake, flood, payment or default), recognizing and measuring the derivative can be more challenging.

Exotic derivatives are usually "exotic" because they have a non-standard underlying.

While neither the best nor most reliable source for accounting and finance information (except for their chart of accounts page: link), Wikipedia does occasionally provide a useful list (link).

Derivatives with exotic underlyings often involve only two parties which can make them harder to identify than their "plain vanilla" cousins, especially if they are hiding inside a larger contract.

Market traded derivatives are obvious. Similarly, any derivative that involves a third party clearing agent, tends to be based on an agreement that clearly spells out the rights and obligations of the contracting parties, making it too simple to identify.

But, if based on a contract between only between two parties, where the only barrier to convoluted phraseology designed to befuddle, confuse and obfuscate is imaginativeness, putting a finger on the derivative can be challenging, although both IFRS and US GAAP do give it the old college try.

As defined in the master glossary, a derivative is a financial instrument or other contract within the scope of IFRS 9 (see paragraph 2.1 of IFRS 9) with all three of the following characteristics:

its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).
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.
it is settled at a future date.

Note: as this definition is somewhat broader than its US GAAP counterpart, more instruments qualify as derivatives under IFRS than US GAAP.

Unlike ASC 815, the IFRS 9 definition does not specify that a notional amount be stated or that the contract must allow net settlement. However as the key characteristic of a derivative, a zero or small net investment, is included in both definitions, applying the guidance in practice yields few palpable differences.

Note: unlike IFRS 9, ASC 815-10-15-13 also outlines 15 specific contracts beyond its scope, and then goes on to explain, in some detail, the criteria that must be met for each exception to be applied.

As stated in ASC 815-10-15-83: A derivative instrument is a financial instrument or other contract with all of the following characteristics:

Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:

One or more underlyings
One or more notional amounts or payment provisions or both.

Initial net investment. The contract 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.
Net settlement. The contract can be settled net by any of the following means:

Its terms implicitly or explicitly require or permit net settlement.
It can readily be settled net by a means outside the contract.
It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

While only US GAAP defines embedded derivatives, IFRS does a good job explaining them.

ASC 815.20 (edited) states: [an] embedded derivative [comprises] implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument.

IFRS 9.4.3.1 states: an embedded derivative is a component of a hybrid contract that also includes a non-derivative host—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument.

In general, embedded derivatives are only an issue if they alter a contract, which would not normally be accounted for as a derivative, in such a way that it, with their inclusion, begins to resemble a derivative.

While somewhat less succinct, the guidance in 815-15-15-2 and 815-15-15-4 makes the same general point.

Or, put differently, if a contract that would not normally need to be remeasured to fair value includes provisions that make fair value appropriate, that contract will either need to be accounted for as a derivative (remeasured to fair value) as a whole, or bifurcated with its derivative portion(s) accounts for as a derivative(s).

While not identical, the guidance on how to deal with embedded derivative(s) under IFRS and US GAAP is comparable.

the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8);
a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (ie a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

However, once found and removed, the accounting is simple. The host contract is accounted for as a contract and the derivative as a derivative. For this reason, there is no need for separate illustrations specifically aimed at embedded derivatives.

If the underlying is a market traded security or commodity, pricing a derivative is relatively straightforward. If the underlying is an index of market traded securities or commodities, since the constituents of the index are market traded, pricing the derivative is still relatively straightforward.

If, however, the index is based on, for example, property values, inflation, the weather, public/market/political mood (a.k.a. macro events), which need to be estimated and evaluated, getting a reliable result becomes more challenging.

Fortunately, in practice, identifying a derivative is not particularly difficult.

Any contract trying to be creative with its terms probably is, or at least contains, a derivative.

For example, a contract where XYZ agrees to deliver 100 units of item X with quality Y on 6/30/X1 and ABC agrees to pay 10,000 on 7/31/X1 is most certainly not a derivative.

On the other hand, a contract where XYZ agrees to pay and ABC 10,000 if it rains for more than 10 from days from 6/30/X1 to 7/31/X1 while ABC agrees to do the same if it does not, most certainly is.

As a rule of thumb, a derivative is a contract, or part of a contract, that includes the word "if", if this two letter word determines or alters the timing, and especially amount, of the cash that will eventually change hands.

The same applies if this if is buried deep in the bowels of a contract that tries, very very hard, to pretend no if is present.

While only US GAAP defines embedded derivatives, IFRS does a good job explaining them.

While somewhat less succinct, the guidance in 815-15-15-2 and 815-15-15-4 makes the same general point.

Or, put differently, if a contract that would not normally need to be remeasured to fair value includes provisions that make fair value appropriate, that contract will either need to be accounted for as a derivative as a whole, or bifurcated with its derivative portion(s) accounted for as a derivative(s): remeasured to fair value.

Derivatives are all about fair value.

For this reason, US GAAP provides clear and concise guidance.

ASC 815-10-35-1 states: All derivative instruments shall be measured subsequently at fair value.

While IFRS eschews similarly clear statements, the result is comparable.

As outlined in IFRS 9.4.1.1, a financial asset is measured at amortised cost, fair value through other comprehensive income (FVtOCI) or fair value through profit or loss (FVtPL).

Since a derivative (that is an asset) does not qualify to be classified as outlined in either IFRS 9.4.1.2 or IFRS 9.4.1.2A, it is classified, by process of elimination, as FVtPL.

Derivatives are not investments. They are tools for speculation or hedging.

Thus, while a case can be made for not remeasuring some investments to fair value, there is no valid reason for not doing so with derivatives.

Unfortunately, not that all managers see it this way. Instead, some would rather pretend derivatives, especially embedded derivatives, did not exist or, if they do, their value did not change.

This is also why the guidance, particularly US GAAP's guidance, is as involved and extensive (once requiring its own DIG: Derivatives Implementation Group) as it is: to shock and awe unruly managers, bludgeoning them into submission with its sheer bulk and complexity.

But enough hyperbole, the need for extensive guidance was famously demonstrated at Enron (link) and somewhat less famously at companies like GE (link).

Here, managers refused to acknowledge, until it was too late, the real value of contracts they signed and financial instruments they created. Worse, auditors not only went along, but some even helped. Why? Some say greed. Others claim the accounting guidance in force at the time was not up to the task.

Whatever the reason, most managers at most companies have since learned to live with guidance specifically designed to make gaming the system impossible, or at least very, very difficult. Unfortunately, some still balk at having to report the real value of derivatives by devising ever more complex and convoluted contractual terms whose only purpose is to obscure and obfuscated the existence of derivatives.

For this reason, at some companies, applying the guidance and auditing the results, especially the guidance on embedded derivatives, continues to be a game of Whac-A-Mole.

Unfortunately, even the best guidance cannot stop the game unless it is applied diligently. Fortunately, given its volume and complexity, a diligent accountant should always find the appropriate paragraph if he or she looks hard enough.

On the flip side, this volume and complexity also puts covering every detail is beyond the scope of this page. Also, as there are other sites that do a decent job, such as this 500 page roadmap (link) or 300 page guide (link, local link), it is unnecessary.

While not identical, the guidance on how to deal with embedded derivative(s) under IFRS and US GAAP is comparable.

the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8);
a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (ie a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

Or, to paraphrase Supreme Court Justice Potter Stewart, "You know it when you see it."

Overall, derivatives can be classified as either options or forwards.

An option conveys the right but not obligation to perform at a specified price and time.

That performance generally involves either the purchase or sale of the underlying, though it can involve an exchange of one underlying for another, or simply a payment.

Note: the time need not be fixed. For example, while European style options may only be exercised at expiration, American style options can be exercised at any time, provided they are in the money.

A forward conveys the right and obligation to perform at a specified price and time.

Forwards may be further subdivided into futures and swaps, but may also be more difficult to pin down .

Forwards only involve two parties, i.e. a buyer and seller.

Futures, in contrast, go through clearing agencies (a.k.a. clearing houses or exchanges) so they involve three parties: the buyer, the seller and the exchange. This both increases liquidity and eliminates counterparty risk.

As a rule, futures are also marked to market daily (the daily gain or loss is added or subtracted from the trader’s margin account). Thus, if the market goes against one of the two parties, the third (the clearing agent) issues a margin call or closes out the losing position, which eliminates the risk of non-performance. The exchange may also suspend trading if the price movement exceeds a set range.

Consequently, forwards are only used when the two parties trust one another enough to accept counterparty risk. As the parties to forwards generally comprise sophisticated organizations, the market for these derivatives has traditionally been unregulated.

However, in reaction to past problems, legislative changes (for example link, link) have sought to eliminate counterparty risk by making more contracts centrally cleared. While these derivatives still (technically) involve only two parties, they have standardized terms and initial margin requirements set by a clearing house, so are safer.

Note: in the US, clearing agencies are regulated at the national level by the SEC (link) or CFTC (link). In the EU (link / local link) they are regulated at the member state level. In other jurisdictions, i.e. Canada (link) they may be regulated at a sub-national level.

Unlike regular forwards, requiring the two parties to purchase / sell the underlying, swaps involve the exchange of cash flows pegged to an underlying, for example, interest or interest rates, foreign currencies or foreign currency exchange rates, inflation, etc. Like forwards, swaps are often acquired directly from a counterparty or OTC, so carry comparable counterparty risk unless centrally cleared (for example link).

The accounting for the same swap may also be different for each of the two counterparties.

For example, a fixed for variable interest rate swap would be accounted for as a fair value hedge by one party while the variable for fixed swap as a cash flow hedge by the counterparty.

For example, a credit default swap is not really a swap (obligating the two parties to exchange the underlying or associated cash flows). Instead, a CDS is more like an option, requiring the protection seller to pay the protection buyer if the reference entity defaults (or some other trigger event occurs).

Or, even more accurately, it is a form of insurance (one of the better summaries: link / local link). As a result, both IFRS and US GAAP devote attention to comparing derivatives and insurance to make sure each is recognized appropriately. While investing, a detailed discussion of this guidance is beyond the scope of this page.

Note: it has been argued that all options are, in fact, a form or insurance. This page does not share this opinion. The reason, insurance contracts are generally negotiated by two comparably informed and rational parties so faithfully reflect the cost of the risk being transferred. Options, on the other hand, trade on markets so often reflect the market's occasional bouts of, in the words of one central banker, irrational exuberance (or its antonym).

For this reason, this page recommends not using options, or any option like derivatives, for any purpose other than speculation, even though neither IFRS nor US GAAP preclude designating them as hedges.

That performance generally involves either the purchase or sale of the underlying, though it can involve an exchange of one underlying for another, or simply a payment.

Some derivatives may be either or.

For example ASC 815-20 defines a weather derivative as: a forward-based or option-based contract for which settlement is based on a climatic or geological variable. One example of such a variable is the occurrence or nonoccurrence of a specified amount of snow at a specified location within a specified period of time.

Note: while IFRS 9 mentions weather derivatives (IFRS 9.B2.1), it does not define them.

While complicated in detail, the accounting for derivatives is equally easy to summarize:

Derivatives may be recognized as assets, liabilities or expenses
Derivatives are initially measured at fair value or zero
Derivatives are subsequently remeasured to fair value
If used to mitigate risk, hedge accounting is applicable.

IFRS | US GAAP hedging guidance is extensive and complicated, and with good reason.

Like the force, derivatives can be used for good or evil.

In the right hands, they can eliminate risk and iron out volatility.

For example, if XYZ's management knows XYZ will need 20,000 million BTUs of gas next year, it can always wait until next year. But, what if a major gas producer invades a major gas distributor and the price of gas skyrockets?

To eliminate the risk, XYZ could buy the gas today. But, where would it keep it? And, how would it pay for it?

Or, XYZ could put down a small percentage and get a future instead. Sure the margin account will need to be maintained, but that is a small price for knowing, with 99.9999% certainly, that XYZ will get its 20,000 million BTUs at a price that is certain today.

Maintaining a margin account (as illustrated below) can be expensive. To avoid the cost, XYZ could get a forward instead. But, unless it is 99.9999% certain the counterparty will not renege in case of catastrophe or war (or simply because it wants to), the future is the safer option.

One can never eliminate the the possibility of a meteor, but the odds are pretty low.

In the wrong ones, they can manage earnings or even threaten the economy.

Everyone remembers Enron, the poster child for using under reported financial instruments to show profits right up to bankruptcy (link). Not that other, seemingly more respectable, companies have not stooped to managing earnings with derivatives, even if less famously (link).

For example, unlike XYZ (above) ABC has no need for gas but its management has been considering the rhetoric coming out of one, unnamed country and thinks the price of natural gas will go up.

To take the bet, all it needs is a bit of cash for a margin deposit on a future. If war breaks out, party time. If not, ABC's shareholders, and perhaps its creditors if things go badly enough, take the hit.

Worse, what if, instead of a future, ABC's management convinced an unsuspecting counterparty to take the other side of a forward, perhaps by obfuscating the forward's existence by embedding it into a contract whose esoteric nomenclature was specifically designed to befuddle and confuse the uninitiated?

And what about that counterparty’s owners and credits, and their creditors, and their creditors...?

Sure, most of the time, nothing that dramatic happens. But, once in a while, organizations like LTCM or AIG remind everyone how explosive the mix of passion, ambition, greed, recklessness and excess trust can be.

Enron, the poster child for obfuscation, does not make this list because, created out of a merger between Houston Natural Gas and InterNorth, it was never trusted by anyone of consequence so never posed a systemic risk.

The regulator's job is to make sure managers stick to the right side of even though, all about chasing peace with little passion and not much ambition, doing so is about as much fun as driving the speed limit. The accounting guidance, and practitioners applying it, are there to make sure regulators get the information they need.

IFRS | US GAAP explicitly states it exists to serve investors and creditors (a.k.a capital providers).

This point is explicitly made in the conceptual framework.

CF 1.2 | CON 8.1.OB2 (emphasis added) states: The objective of general purpose financial reporting1 is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.

It is not aimed at regulators.

While implied by its stated aim (above), to make sure the point gets across, the conceptual framework also states:

CF 1.10 | CON 8.1.OB2 OB10: Other parties, such as regulators and members of the public other than investors, lenders, and other creditors, also may find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.

Nevertheless, unlike the everyday items every company reports (revenue, cost of sales, PP&E, debt, leasing, etc.), only some companies report derivatives. Given the danger the carless use of derivatives can pose, regulators pay extra special attention to that subset, not only to make sure they are following accounting guidance to the letter but, by implication, not doing anything silly.

So, while financial reports may not be primarily directed to this "other group", the nature and detail of the information they require make clear that standard setters (especially the FASB) were thinking about the needs of regulators when it comes to derivatives.

Note: in the past, it has been argued that management did not always misuse derivatives intentionally, but simply did not receive adequate information from accountants using inadequate guidance. Given that most managers are taught about derivatives in most MBA programs (and can design their own managerial accounting if they need more information), this argument has always seemed dubious, but could have been plausible. Not any longer. Given the nature and detail of the information required by today's IFRS, and especially US GAAP, no one can claim ignorance anymore.

And just the guidance itself has an ataractic effect. At over 300 pages printed out, ASC 815 is formidable. Its sheer volume and detail makes finding novel ways of avoiding it so difficult all but the most determined give up.

While not nearly as voluminous, the hedge accounting section in IFRS 9 is not easy, bedtime reading either.

Making the situation somewhat more complicated, companies may also elect to continue applying IAS 39 until the IASB finalizes its macro hedging project.

Also worth noting, while broadly similar, IFRS and US GAAP guidance is far from converged, making a dual filers job that much harder.

For example, just one illustration of how to assess hedge effectiveness is almost a page long.

ASC 815-25-55-1E This Example illustrates the guidance in Sections 815-20-25, 815-20-35, and 815-25-35 for how an entity may assess hedge effectiveness in a fair value hedge of natural gas inventory with futures contracts. Assume that the hedge satisfied all of the criteria for hedge accounting at inception.

ASC 815-25-55-2 Entity A has 20,000 million British thermal units of natural gas stored at its location in West Texas. To hedge the fair value exposure of the natural gas, Entity A sells the equivalent of 20,000 million British thermal units of natural gas futures contracts on a national mercantile exchange. The futures contracts prices are based on delivery of natural gas at the Henry Hub gas collection point in Louisiana.

ASC 815-25-55-3 The price of Entity A's natural gas inventory in West Texas and the price of the natural gas that is the underlying for the futures contracts it sold will differ as a result of regional factors (such as location, pipeline transmission costs, and supply and demand). Entity A therefore may not automatically assume that the hedge will be highly effective at achieving offsetting changes in fair value, and it cannot assess effectiveness by looking solely to the change in the price of natural gas delivered to the Henry Hub. The use of a hedging instrument with a different underlying basis than the item or transaction being hedged is generally referred to as a cross-hedge. The principles for cross-hedges illustrated in this Example also apply to hedges involving other risks. For example, the effectiveness of a hedge of interest rate risk in which one interest rate is used as a surrogate for another interest rate would be evaluated in the same way as the natural gas cross-hedge in this Example.

ASC 815-25-55-4 Both at inception of the hedge and on an ongoing basis, Entity A might assess the hedge's expected effectiveness on a quantitative basis based on the extent of correlation in recent years for periods similar to the spot prices term of the futures contracts between the spot prices of natural gas in West Texas and at the Henry Hub. If those prices have been and are expected to continue to be highly correlated, Entity A might reasonably expect the changes in the fair value of the futures contracts attributable to changes in the spot price of natural gas at the Henry Hub to be highly effective in offsetting the changes in the fair value of its natural gas inventory. In assessing effectiveness during the term of the hedge, Entity A must take into account actual changes in spot prices in West Texas and at the Henry Hub. The period of time over which correlation of prices should be assessed would be based on management's judgment in the particular circumstance.

ASC 815-25-55-5 Entity A may not assume that the change in the spot price of natural gas located at Henry Hub, Louisiana, is the same as the change in fair value of its West Texas inventory. The physical hedged item is natural gas in West Texas, not natural gas at the Henry Hub. In identifying the price risk that is being hedged, Entity A also may not assume that its natural gas in West Texas has a Louisiana natural gas component. Use of a price for natural gas located somewhere other than West Texas to assess the effectiveness of a fair value hedge of natural gas in West Texas would be inconsistent with this Subtopic and could result in an assumption that a hedge was highly effective when it was not. If the price of natural gas in West Texas is not readily available, Entity A might use a price for natural gas located elsewhere as a base for estimating the price of natural gas in West Texas. However, that base price must be adjusted to reflect the effects of factors, such as location, transmission costs, and supply and demand, that would cause the price of natural gas in West Texas to differ from the base price.

ASC 815-25-55-6 Consistent with Entity A's method of assessing whether the hedge is expected to be highly effective, the hedge would not be perfectly effective and there would be a net earnings effect to the extent that the actual change in the fair value of the futures contracts attributable to changes in the spot price of natural gas at the Henry Hub did not offset the actual change in the spot price of natural gas in West Texas per million British thermal units multiplied by 20,000.

ASC 815-25-55-7 That method excludes the change in the fair value of the futures contracts attributable to changes in the difference between the spot price and the forward price of natural gas at the Henry Hub in assessing effectiveness. The excluded amount would be recognized in earnings through an amortization approach in accordance with paragraph 815-20-25-83A or a mark-to-market approach in accordance with paragraph 815-20-25-83B and presented in the same income statement line item as the earnings effect of the hedged item in accordance with paragraph 815-20-45-1A.

Making that volume and detail approachable to a casual observer is a fool's errand.

Googling hedge accounting either leads to pages that simply reiterate the guidance omitting all detail (i.e. link, link) or ones, such as this 500 page roadmap (link) or 300 page guide (link, local link), that makes one think one may be better off simply reading the original.

Note: this page (link), while a bit short on references, provides a good, approachable comparison of US GAAP and IFRS, and is recommended.

Having said that, this site's aim is to make that volume and detail approachable to a casual observer (disclaimer).

This section glosses over many details so is not aimed at the practitioner who will be applying the guidance in the real world. Instead, it is aimed at the casual observer curious what the fuss is about or who would just like to join in the dinner conversation when it turns, as all dinner conversations inevitably do, to derivatives and hedging.

Options that start off as assets remain assets (same as options that start off as liabilities).

For example, if XYZ acquired a 90 day call option with an exercise price of 100 on a stock that was trading for 90, it would pay around 148 and recognize an asset. If it wrote a put option instead, it would receive around 1,047 and recognize a liability.

Note: while an option's fair value can decline to zero, it can never cross zero so an option will remain an asset (liability) until it expires (or is so close to expiration that it stops trading).

Forwards and futures, on the other hand, may change back and forth.

For example, a 200 forward call contract on a commodity trading for 210 would be an asset. If the commodity's price fell to 190, it would change from an asset into a liability. If the price again increased to 205, it would change back into an asset, and so on.

For example, if XYZ and ABC agreed to buy/sell (or settle net) 100 units a commodity at 10 per unit when its market price was 10 per unit, the forward would have zero value until the commodity's market price changed.

For example, if XYZ granted its employees options to acquire its shares, it would recognize a compensation expense equal to the fair value of those options.

Derivatives are all about fair value. Unlike other financial assets and liabilities, derivatives are mostly used for speculation or hedging, so no reason for not remeasuring them exists.

For example, one cornerstones for US GAAP's guidance on derivatives (ASC 815-10-10-1.b, edited) is: Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments...

While the IASB has never spelled out any "cornerstones," since IFRS requires all derivatives to be measured at fair value, presumably it shares the same opinion.

Remeasuring receivables makes little sense. No active market for them exists and, while they can be factored, most companies hold them until collection. The same applies to loans, notes or bonds a company holds solely to collect interest and principal. It makes even less sense to remeasure payables.

While a case can be made for remeasuring other financial liabilities, the fact a decrease in the debtor's credit standing would generate gains means such proposals have never gained any traction (outside academic circles).

Derivatives may also be used as a form of employee compensation and occasionally to buy goods or other services.

However, determining fair value in these transactions is just as important.

For this reason, IFRS 2 and ASC 718 require share-based payment transactions, including transactions involving stock options, to be measured at fair value. The only difference, unlike for option used for peculation or hedging, those given to employees as compensation for services to be rendered need not be remeasured to fair value each reporting date.

While on the topic, while similar, the guidance in IFRS 2 and ASC 718 is not identical.

Specifically, IFRS 2.10 requires equity-settled share-based payment transactions to be measured at the fair value of the goods and services received and then at the fair value of the equity instruments issued only if the fair value of the goods or services cannot be estimated reliably.

In contrast, ASC 718-10-30-2 specifies that “the cost of goods obtained or services received in exchange for awards of share-based compensation generally shall be measured based on the grant-date fair value of the equity instruments ...” It does not give the option of measuring the equity instruments by reference to the goods or services acquired.

However, as most services acquired in share based transactions come from employees (in which case IFRS 2.11 and 12 require the services to be measured at the fair value of the equity instruments), this difference has little impact in most situations.

As a result, US GAAP provides categorical guidance.

ASC 815-10-35-1 states: All derivative instruments shall be measured subsequently at fair value .

While IFRS eschews similarly clear statements, the result is comparable.

As outlined in IFRS 9.4.1.1, a financial asset is measured at amortised cost, fair value through other comprehensive income (FVtOCI) or fair value through profit or loss (FVtPL).

Since a derivative (that is an asset) does not qualify to be classified as outlined in either IFRS 9.4.1.2 or IFRS 9.4.1.2A, it is classified, by process of elimination, as FVtPL.

Unfortunately, not that all managers see it this way.

Instead, some would rather pretend derivatives, especially embedded derivatives, did not exist or, if they did, their value did not change.

But enough hyperbole, the need for extensive guidance was famously demonstrated at Enron (link) and somewhat less famously at companies like GE (link).

Whatever the reason, most managers at most companies have since learned to live with guidance specifically designed to make gaming the system impossible, or at least very, very hard. Unfortunately, some still balk at having to report the real value of derivatives by devising ever more complex and convoluted contractual terms whose only purpose is to obscure and obfuscated the existence of derivatives.

For this reason, at some companies, applying the guidance and auditing the results, especially the guidance on embedded derivatives, continues to be a game of Whac-A-Mole.

A derivative's fair value may be its market, intrinsic or calculated (determined) value.

While IFRS 9 | ASC 815 requires derivatives to be measured at / remeasured to fair value, it does not specify how fair value should be determined. Instead, this is addressed IFRS 13 | ASC 820 (see the fair value page).

To summarize, IFRS 13 | ASC 820 requires fair value to be determined on the basis market value if possible.

Thus, if a derivative is market traded, its fair value reflects its market price. If the derivative is not market traded but the underlying is, the derivative's fair value reflects its intrinsic value. If neither the derivative nor the underlying are market traded, the derivative's fair value must be determined.

After fair value has been determined, IFRS 9 (IAS 39) | ASC 815 take over and provides the remaining guidance.

To summarize, IFRS 9 | ASC 815 requires the changes in the derivative's fair value (gains/losses) to be:

recognized in net income (speculation),
offset with the gains/losses on the underlying (fair value hedge) or
recognized in comprehensive income (cash flow hedge).

Note: in some situations, the derivative’s fair value is broken down into its components (intrinsic value and time value). The gains/losses on each of part are then recognized separately. Occasionally, only the gains/losses on intrinsic value are recognized.

When both the derivative and its underlying is market traded, time value is calculated by subtracting intrinsic value from market value. When a derivative is not market traded but its underlying is, fair value is determined by adding time value (which needs to be calculated) to intrinsic value. When neither the derivative nor its underlying is traded on the market, the fair value of the derivative as a whole is determined first. This fair value may then be then allocated to the intrinsic and time value components.

As outlined in ASC 815-20-25-82, time value may be broken down further into θ (theta), ν (vega) ρ (rho) in that any of these components may be excluded from the assessment of a hedge's effectiveness.

As outlined in IFRS 9.6.5.15, an option’s time and intrinsic values may be accounted for separately, but IFRS 9 does not allow breaking time value down into its constituent parts.

Also note: IFRS 9 allows IAS 39, which is comparable overall but different in detail, to continue to be applied.

Market value should be obvious. It is the price at which the derivative is trading on the applicable market.

In general, futures and options are measured at market value.

Note: some derivatives only trade OTC where market prices may not be reliable or available. In this case, fair value needs to be determined. Some derivatives are also embedded in larger contracts. If comparable market traded derivatives cannot be found, their fair value must also be determined.

Also note: some derivatives trade on multiple markets. For this reason, IFRS 13.18 | ASC 820-10-35-6 specifies that market price should be the price on the principal market even if even the price on a different market is better.

Intrinsic value is somewhat less obvious than market price. It is the difference between the underlying's market price and the derivative's strike price (or zero).

While neither IFRS nor US GAAP provide a general definition of intrinsic value, both discuss it in the context of stock options.

IFRS 2 defined terms: The difference between the fair value of the shares to which the counterparty has the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price (if any) the counterparty is (or will be) required to pay for those shares. For example, a share option with an exercise price of CU15,4 on a share with a fair value of CU20, has an intrinsic value of CU5.

ASC master glossary: The amount by which the fair value of the underlying stock exceeds the exercise price of an option. For example, an option with an exercise price of $20 on a stock whose current market price is $25 has an intrinsic value of $5. (A nonvested share may be described as an option on that share with an exercise price of zero. Thus, the fair value of a share is the same as the intrinsic value of such an option on that share.)

For example, both a 90 call forward (or future) and 90 call option on a 100 stock would have an intrinsic value of 10.

However, a 100 call forward on a 90 stock would have an intrinsic value of (10), while the option's would be 0.

In general, forwards, exotics and non-traded derivatives, such as embedded options, are measured at intrinsic value.

Occasionally, most often with embedded options, fair value cannot be determined by reference to a market. In these situations, a valuation technique is used instead.

While it would be logical to refer to fair value calculated using such a technique as "calculated fair value," the ASC master glossary defines "calculated value: a measure of the value of a share option or similar instrument determined by substituting the historical volatility of an appropriate industry sector index for the expected volatility of a nonpublic entity's share price in an option-pricing model."

To avoid potential confusion, this page labels fair value calculated using a valuation technique determined fair value.

IFRS does not define "calculated value" so using this term in an IFRS context would be acceptable.

Regardless of terminology, the model generally used to value forwards and futures is straightforward.

S₀ = F₀ x (1 + R_f)^T

S₀ = Spot price, F₀ = Future (forward) price, R_f = Risk free rate for maturity T, T = Time.

While various models for options exist, Black–Scholes (a.k.a. Black–Scholes–Merton) is most common in practice.

Note: while this model can be built in Excel with a few deceptively simple formulas or found incorporated into several web pages (link, link, link) applying Black–Scholes in practice is less straightforward.

While building the model is not particularly challenging, getting it to yield an acceptable result is.

The reason, as programmers say, GIGO.

For the model to produce an accurate result, it has to be fed accurate data including volatility.

While calculating historical volatility is simple (i.e., in Excell format =STDEVP(A1:A12)*SQRT(12)), using historical volatility to estimate future value is absurd.

Instead, for the result to make any sense, expected future volatility needs to be used. And there is the rub. Estimating future volatility accurately is hard, and estimating it with 100% accuracy impossible.

So, to avoid implying that calculating the fair value of options is simple or straightforward, we do not include this model in our downloadable Excel file.

However, for those willing to take the chance, this site (link) provides easy to follow instructions.

While the model is deceptively simple, getting it to produce accurate results requires an accurate estimate of future volatility.

And this is hard even with plain vanilla options where some market data is available. When it comes to options with special features, such as those used to compensate employees, the difficult goes up.

For example, determining the fair value of an option award that vests over 10 years but only if the company achieves a specified profit target and its shares trade above a set amount in each of those ten years, and the employee remains with the company, can be a challenge, even for a PhD.

But, as they say, if it were easy, everybody'd be doing it.

Note: as Black–Scholes is only appropriate for market traded ("plain vanilla") options with no friction, ASC 718-10-55-16 discusses additional ways to value options with special features. These models can also be used to estimate the value of options on commodities where there may be considerable friction (storage costs, transportation fees, an underlying not identical to the hedged item, etc.).

Also note: to avoid having to deal with the issue of friction, this page assumes all our options are perfectly aligned (see IFRS 9 B6.5.32 and 33).

Myron Scholes and Fischer Black developed the original formula while Robert Merton improved it. For their contribution, Scholes and Merton received a Nobel prize in 1997 (Fischer Black unfortunately died in 1995).

Interestingly, both Scholes and Merton also served on the board of LTCM (Long-Term Capital Management) and helped John Meriwether develop the strategy that almost lead to the meltdown of the financial system in 1998 (the Federal Reserve stepped up for the rescue).

Is there a moral to this story? Hard to say, but perhaps that developing a mathematical model in an academic clean room is different from making it work in the not so spotless real world.

Or maybe that only really smart people get to make really big mistakes, since no one else is ever trusted enough by enough people to really F... things up.

If used for speculation, the list is be applied in order: 1. market value, 2. intrinsic value, 3. determined value.

If the derivative is traded on a market, its fair value equals its market price. Simple.

If the derivative is not traded on a market but the underlying is, its fair value equals its intrinsic value. Also simple.

Unless the derivative is an option with special features that need to be considered.

If neither the derivative nor the underlying is traded on a market, the accountant first takes a deep breath then, after the panic attack subsides, uses a valuation technique (as discussed in more detail on this page).

For hedging, it depends how hedge is designated, how its effectiveness measured, the exemption(s) applied, etc.

As the above sentence implies, the guidance on hedging with derivatives is not succinct, easy to read or simple to apply.

For example, in IFRS, just the guidance on hedge effectiveness comprises IFRS 9.6.4.1.c (and B6.4.4 to 11) or IAS 39.AG105 to AG113A (IFRS 9 allows entities to continue to apply IAS 39).

In US GAAP, it is even more voluminous (ASC 815-20-25-72 to 131).

Perusing the guidance, it almost seems like the standard setters went out of their way to make it as arcane as possible so as to dissuade all but the most determined.

Be that as it may, the basics are not that complicated and can be summarized in a few, relatively simple examples.

Disclaimer

Trying to learn how to apply all IFRS | US GAAP guidance on hedging by surfing the internet is like trying how to learn how to use a table saw by watching YouTube.

So, while the few rudimentary examples on this page illustrate how hedge accounting works in general, they are no substitute for a detailed study of the guidance preferably assisted by a qualified and experienced professional.

Derivatives may be used to create risk, a.k.a. trading or speculation.

Everyone know the adage: no risk, no reward.

Derivatives make creating risk easy.

For example, if XYZ's management believes the price of crude oil will rise, it could create risk by buying oil. If the risk pays off, the reward is the resulting gain. However, this risk would be difficult and expensive to create. Not only would XYZ need to find a seller and finance the purchase, it would also need to cover transportation and/or storage costs. And, as no one sells just a few barrels of oil, the initial outlay would be significant.

Or, XYZ could enter into a futures contract (link). Not only would finding a seller be easy (assuming it had an account with a broker or exchange), but a few futures contracts cost considerably less than a tanker full of oil. Also, as it would only need to come up with a margin deposit (around 10%, give or take), the initial outlay would be a fraction. And that's not all. If the risk pays off, the resulting gain is amplified by the margin, perhaps more than 10 fold.

Party time!

However, people sometimes forget the corollary: no risk, no punishment.

If, instead of going up, the price of oil falls, XYZ's punishment would be swift. It would receive a margin call. It would either have to top up its margin deposit, putting more money at risk, or the account would be closed, locking in the loss forever.

The safer way to create risk is with an option.

With an option, as the position’s value can never turn negative, there is no risk of a margin call (unless one borrowed to acquire the option).

However, as the cost of options is usually higher, the reward is lower but, punishment remains more or less the same (assuming one does not top up one's margin deposit).

Note: while buying (both call and put) options is, relatively speaking, safe, writing them, not so much. Puts are not that bad. All they may require is paying more than market. Calls are another story. If someone really wants to really ride the roller-coaster, writing naked calls is the ticket (assuming one has a level III brokerage account).

Actually, this metaphor does not do this particular risk justice.

A more apt comparison: playing Russian roulette with 3 full cylinders.

Derivatives may also be used to mitigate risk, a.k.a. hedging.

A classic, but nonetheless good, example is a baker and farmer.

The baker's risk is that a failed crop will drive up prices making its future grain cost more. The farmer's risk is that a bumper crop will drive down prices making its harvest worth less.

The baker can mitigate risk with a call future which puts a ceiling on the price it will need to pay. Obviously, if there is a bumper crop, the baker will pay more than market, but this risk is offset by the elimination of the price uncertainty.

While it could be argued that the risk has been eliminated, hedging is rarely 100% effective.

For example, a grain future is pegged to a generic grain delivered at a central location while the baker may need a specific variety delivered somewhere else.

Unlike futures, forward contracts are negotiated by the two parties, so these contracts are often 100% effective.

ASC 815-25-55-38 provides a brief illustration of this issue. However, even though it addresses nature gas, ASC 815-25-55-1 to 7 provides a more through discussion of the various factors that affect effectiveness.

Fortunately, neither IFRS nor US GAAP require a hedging relationship to be 100% effective to qualify for hedge accounting. Instead, the hedge only needs to be highly effective, which IAS 39.AG105.b defines as 80% to 125%.

Note: IFRS 9 and ASC 815-20 eschew similar numeric quantification.

IFRS 9.6.4.1.c has moved to an effectiveness criterion that asses the economic relationship, effect of credit risk and hedge ratio. Nevertheless, entities may continue to apply IAS 39, so 80% to 125% is still commonly, though not universally, used in practice.

Entities that have transitioned to IFRS 9 apply the guidance outlined in IFRS 9.B6.4.4–B6.4.6 (economic relationship), IFRS 9.B6.4.7–B6.4.8 (effect of credit risk) and IFRS 9.B6.4.9–B6.4.11 (hedge ratio).

US GAAP has never provided similar bright line guidance. Instead, ASC 815-20-25-72 to 131 provide an extensive discussion of hedge effectiveness.

Nevertheless, 80% to 125% is commonly used as rule of thumb when making an initial assessment of whether a hedge will likely qualify before its effectiveness is examined more thoroughly.

Note: while ASC 815-20-25-102 to 104 outline a "shortcut method" under which an entity can assume 100% effectiveness for an interest rate swap provided specified conditions are met, this does not mean that the hedge will necessarily be 100% effective.

The farmer can mitigate risk by writing a call future. Obviously, the farmer's situation is more complex. If its crop fails, the farmer will still need to deliver the grain or (since a future is a derivative) settle net (pay the difference between the strike and market price). To eliminate all risk, the farmer will need a more sophisticated hedging strategy (or crop insurance).

Derivatives are always remeasured to fair value (above).

If held for speculation, this makes net income more volatile.

If held for hedging, it has the opposite effect.

Hedge accounting allows the remeasurement gains/losses to either bypass net income (cash flow hedge) or cancel each other out (fair value hedge).

IFRS and US GAAP outline three basic types of hedges:

IFRS 9 specifies the three types of hedges in IFRS 9.6.5.2.

It outlines the accounting for each in IFRS 9.6.5.8 to 6.5.10, IFRS 9.6.5.11 to 12, and IFRS 9.6.5.13 and 14.

ASC 815 both specifies the hedges and outlines the basic accounting in ASC 815-20-35-1.

The ASC then discusses the individual types in separate sub-topics: ASC 815-25, ASC 815-30 and ASC 815-35.

In addition to the three basics types, ASC 815 provides guidance for contracts in entity's own equity (ASC 815-40) and weather derivatives (ASC 815-45).

In contrast, IFRS 9 only mentions weather derivatives in passing (IFRS 9.B2.1) and does not specifically address "contracts in entity's own equity." In this Webinar (link, local link) the IASB did, however, discuss how its guidance applies to the classification of derivatives on own equity.

cash flow
fair value
net investment (not covered)

I realize I'm breaking the fourth wall but, in my (who am I link) experience, no one cares about net investment hedging.

The main reason I hear, consolidation forex differences end up OCI just like cash low hedges. So, even though the hedge would rearrange OCI a bit, financial statements users wouldn't notice or, if they did, care much.

Also, investments in subsidiaries tend to be long-term. To hedge them properly would require a constant stream of new hedges. Again, not worth the aggravation or expense. Sure, if a loan was used to set up a foreign operation, why not designate it as a hedging instrument. But who in their right mind would take out a loan, and pay interest, just to rearrange OCI a bit.

So, I decided why bother. Putting these pages together isn't easy so why waste time and effort on something no one cares about? However, this may just be my experience and I may have made a mistake. So, if net investment hedging is a burning a hole in your brain, please write. If I get enough requests, I'll add an example or two.

As the name implies, a cash flow hedge fixes the amount of an expected future receipt or disbursement of cash.

IFRS refers to this as a forecast transaction while in US GAAP the transaction is forecasted.

IFRS 9 defines forecast transaction: an uncommitted but anticipated future transaction.

The ASC glossary defines Forecasted Transaction: a transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices.

For example, before the end of a period, XYZ estimated it would probably need to buy goods, with a then market price of 20,000, in a future period at a future market price. To hedge that forecasted transaction, it entered into an at the money call forward. At the end of the period, the market price of the goods increased to 22,000, so XYZ recognized a gain of 2,000 on the forward. Since there was no offsetting loss, it recognized the gain in other comprehensive income and accumulated on the balance sheet in a separate section of equity dedicated to cash flow hedges. When it bought the goods, their market price was 24,000. However, as it had timed the forward correctly, the counterparty settled for 4,000, making XYZ's net outlay 20,000 (XYZ could have also exercised the forward, in which case it would have paid the counterparty 20,000 and the counterparty would have delivered the goods).

As outlined in IFRS 9.6.3.3 | ASC 815-20-25-15.b, to qualify for hedge accounting, a forecast transaction must to be highly probable | probable. As discussed in more detail on this page, highly probable | probable equates to a likelihood of 75% to 80% or higher.

In contrast to futures, forwards can be customized so the underlying can be anything, not just a commodity. The are also often entered into without any premium being paid or received, so are free.

However, as they are only between two parties, they do carry counterparty risk.

In contrast to fair value hedges (below), there is no offsetting gain or loss associated with a hedged item.

Note: if XYZ had, instead of merely forecasting it would need to buy the goods, entered into a firm commitment to buy the goods (with a third party), it could have designated that firm commitment as a hedged item and accounted for the forward as a fair value hedge.

In order for a financial instrument to be classified as a derivative according to ASC 815, it has to allow net settlement (either directly or through a market mechanism). While IFRS 9 does have the same strict requirement, since practically all derivatives are settled net anyway, it is a moot point.

Note: this example also assumes the counterparty did not renege on its obligation, which is always a risk associated with forwards though not futures.

Note: the amount accumulated in equity is, as illustrated below, treated differently under IFRS and US GAAP.

Like a cash flow hedge (above), a fair value hedge can fix the amount of an expected future receipt or disbursement. Unlike a cash flow hedge, it paired with an asset or liability so, instead of bypassing net income, the gain/loss on the derivative is offset against the loss/gain on the hedged item.

For example, if the derivative hedges a firm commitment involving a payment or disbursement, it is, in effect, hedging that cash flow. Same as if, for example, it is used to hedge a receivable or payable denominated in a foreign currency against foreign exchange risk.

However, IFRS 9.6.5.2.a does not preclude, and 815-20-25-12.e specifically allows, any asset or liability, including a non-financial asset or liability, being designated the hedged item. The derivative can thus hedge the fair value of any item, even one the entity does not intend to sell or settle (convert to cash).

In addition to recognized assets and liabilities, unrecognized firm commitments may also be designated as hedged items.

Before designation, such a firm commitment is unrecognized, so is neither an asset nor a liability. After designation, it is remeasured to fair value so becomes an asset or liability. As its fair value changes, it can also change from one to the other, back and forth.

For example, before the end of a period, XYZ agreed to buy a commodity, with a then market price of 20,000, in a future period at a future market price. To hedge that firm commitment, it entered into an at the money call future. At the end of the period, the market price of the commodity increased to 22,000, so XYZ recognized a gain of 2,000 on the forward and an offsetting loss of 2,000 on the firm commitment. When it bought the commodity, its market price was 24,000. However, as it had timed the future correctly, its broker settled for 4,000, making XYZ's net outlay 20,000 (XYZ could have also exercised the future, in which case it would have taken delivery and paid the 20,000 balance).

In addition to recognized assets and liabilities, IFRS 9.6.5.2.a | ASC 815-20-25-12.a allows unrecognized firm commitments to be designated as hedged items.

IFRS 9 defines a firm commitment: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

ASC 815 also defines firm commitment, but somewhat more thoroughly: an agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.

Unlike forwards, futures are easy to acquire. To get one, one does not need to find a counterparty willing to take the other side of the contract, but merely have an account with a broker or exchange.

However, also unlike forwards, where the counterparties are often willing to transact cost free, futures come at a premium. They also require a margin deposit, usually somewhere around 10% of the strike price.

For simplicity, this examples ignores both the transaction cost and deposit. Also for the sake of simplicity, it assumes the firm commitment was for a commodity identical to the future's underlying.

In order for a financial instrument to be classified as a derivative according to ASC 815, it has to allow net settlement (either directly or through a market mechanism). While IFRS 9 does have the same strict requirement, since futures are traded on a market the market itself facilitates net settlement.

Note: both IFRS 9 and ASC 815 discusses fair value hedges before cash flow hedges. However, as cash flow hedges are more popular, this site presents them first.

Besides foreign currencies and firm commitments, few companies have any use for fair value hedging.

While most EU / US based companies face little foreign exchange risk, companies in smaller jurisdictions can face enormous foreign exchange challenges, so commonly hedge their exposure. Fortunately, they mostly only hedge currency pairs, so the accounting, as illustrated on this page, is straightforward.

In contrast, large, multinational companies operating across multiple jurisdictions often use more sophisticated strategies to both manage and exploit forex risk. However, a discussion of these strategies, and the associated accounting, is beyond the scope of this web site.

When a company agrees to buy or sell at a fixed price well into the future, it exposes itself to considerable risk. As most companies try to avoid such risk, these agreements are relatively uncommon. Nevertheless, for the subset of companies that do make firm commitments, hedging the exposure is a very good idea.

ASC 815 defines firm commitment: An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.

While the IFRS 9 definition (A binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates) is not as comprehensive, it is comparable.

Note: if a company merely wants to hedge its exposure to market prices without making any commitments, it can always designate the derivative as a cash flow hedge so, in effect, have its cake and eat it too.

Why would, for example, a manufacturer or refrigerators hedge the fair value of the steel it has already bought and intends to use to make refrigerators? Similarly, it makes little sense to hedge the fair value of receivables or payables (unless they happen to be denominated in a foreign currency) or swap predictable fixed interest payments for unpredictable variable ones.

As a rule, commodities producers do a lot of fair value hedging. But, this exception proves the rule. Most companies are not commodities producers. It makes little sense for a manufacturer of products to hedge the fair value of raw material going into those products.

What does, on the other hand, make a lot of sense, hedging the cash that will be expended to acquire raw material it expects to need in the future. The further away that future, and the more volatile the price, the more sense it makes.

However, this would be a cash flow hedge, not a fair value hedge.

Fixed for variable swaps are accounted for as fair value hedges, while variable for fixed as cash flow hedges. Swapping fixed interest payments for variable ones thus only makes sense if the liability is remeasured to fair value. Since most liabilities at most companies are measured at amortized cost, this type of hedging is only common at providers of financial services and generally part of a sophisticated strategy, a discussion of which is beyond the scope of this web page.

Caveat

While hedge accounting basics are straightforward and can be illustrated with a few, simple examples (below), at over 300 pages, US GAAP's guidance on derivatives and hedging is neither succinct nor easy to digest.

While not as circumlocutory, IFRS's guidance is no easy, bedtime reading either.

Making matters somewhat more complicated, IFRS 9 does, however, allows entities to continue to apply the hedging guidance in IAS 39, at least for now.

Not that the internet is much help. Googling hedge accounting either brings up pages that simply reiterate the guidance omitting all detail (i.e. link, link) or pages like this 500 page roadmap (link) or 300 page guide (link, local link), which make one think one is better reading the original.

Not that surfing the internet looking instructions on how to account for derivatives is a good idea anyway. Like those trying to learn how to use a table saw by watching YouTube, most people will sooner or later realize hedge accounting is something best taught by qualified, and especially experienced, professionals. And hopefully, they will realize this while they still have a few fingers left.

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