Financial Assets Text

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Cash and cash equivalents

Cash

Transactions

As a rule, the accounting for cash is obvious and does not need illustrating.

Nevertheless, for the sake of completeness, some journal entries are shown here.

Capital invetment

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

12/31/X1 \| 31.12.X1
Retained earnings		10,000
	Cash		10,000

Note, quarterly interest

1/1/X1 \| 1.1.X1
Cash		1,000,000
	Note		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.
Interest		18,750
	Cash		18,750

12/31/X5 \| 31.12.X5
Note		1,018,750
	Cash		1,018,750

Loan, quarterly repayment

1/1/X1 \| 1.1.X1
Cash		1,000,000
	Loan		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.
Interest		18,245
Loan		41,881
	Cash		60,126

While the accounting for goods and service sales is more complex, the cash side is usually straightforward.

The accounting for the sale and production of goods and services is covered in in detail here:

This page only provides a brief summary.

1/1/X1 \| 1.1.X1
Merchandise		10,000
	Accounts payable		10,000

1/2/X1 \| 2.1.X1
Cash on hand		100
	Revenue (merchandise)		100

The perpetual method is illustrated on the Inventory and cost of sales page.

1/2/X1 \| 2.1.X1
Cash in bank		200
	Revenue (merchandise)		200

1/2/X1 \| 2.1.X1
Cash in bank: Merchant account		294
Charge card processing expense		6
	Revenue (merchandise)		300

For some reason, the accounting for credit card fees led to an active discussion.

Even though the amounts involved are on the edge of materiality and the accounting treatment seems obvious, this discussion (link: proformative.com) went on for several years.

Note: it is not clear which EITF Zach was referring to as EITF 99-19 deals with net revenue in an agent/principal context, while EITF 92-5 and EITF 93-1 discuss deferred origination costs (not that it makes much difference as they have all been superseded by the ASC anyway).

Why? when it seems clear a fee charged to a merchant is for a service (payment processing), so should be treated as any other fee for any other service (expensed as incurred).

Perhaps it is because ASC 310-20-25-17 (edited, emphasis added) states: Credit card origination costs [the expense] shall be netted against the related credit card fee [the revenue], if any...

While this guidance applies to cardholders, not merchants, if applied by analogy to merchants, it would justify netting. Nevertheless, as the discussion suggests, netting is not common practice and justifying it by analogy would be a stretch.

Note: since we are on the topic, IFRS does not provide similar, explicit guidance for cardholders and some experts suggest this lack of guidance could lead to some differences (link / local link).

Also note: those that find this issue interesting could also read this paper (link / local link) where the TRG members discus the interaction between ASC 310 and ASC 606 when it comes to credit card fees.

1/2/X1 \| 2.1.X1
Cash at payment processor		67.38
Payment processing expense		2.52
	Revenue (merchandise)		69.90

Instead of going to the trouble of accepting payments directly, many online resellers, like this web site, prefer to use payment processors such as Stripe or PayPal. Other than requiring an additional account, the accounting procedure is comparable.

28/2/X1 \| 2.28.X1
Cash in bank		6,738
	Cash at payment processor		6,738

Products:

1/1/X1 \| 1.1.X1
Raw material		10,000
	Accounts payable: ABC company - Invoice # 123456		10,000

1/2/X1 \| 2.1.X1
Work in process		100
	Raw material		100
Work in process		300
	Wages payable		300

1/3/X1 \| 3.1.X1
Finished goods		700
	Work in process		700

The accounting for fixed and variable indirect costs is illustrated on the Inventory and cost of sales page.

1/4/X1 \| 4.1.X1
Accounts receivable: DEF company - Invoice # 23456		1,400
	Revenue		1,400
Cost of goods sold		700
	Finished goods		700

2/1/X1 \| 1.2.X1
Accounts payable: ABC company - Invoice # 123456		10,000
	Cash		10,000
Wages payable		30,000
	Cash		30,000

2/5/X1 \| 5.2.X1
Cash		1,400
	Accounts receivable: DEF company - Invoice # 23456		1,400

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.

Neither IFRS nor US GAAP define restricted cash but, in addition to sinking funds, 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...

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."

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.

While many of the below are considerably more common, ASC 210-10-45-4.a specifically focuses on "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," which is why this page illustrates a sinking fund first.

Pensions
Security deposits
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.

As a rule, bond buyers prefer a lump-sum principal repayment at the end of a bond's term. However, as the default risk associated with term bonds is greater than serial bonds, only the most highly rated public and private entities are generally able to issue 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 option may be to, in effect, convert the term bond into a serial bond using sinking fund. With a sinking fund, the bond issuer makes periodic payments to a trustee in that the trustee retires the debt. Assuming the trustee also guarantees retirement, the effect is the same as insurance as it, in effect substituting trustee's credit standing for the issuer's.

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.

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.

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

Cash in transit

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

Both US GAAP and IFRS define cash equivalents as short-term, highly liquid investments readily convertible to known amounts of cash with a maturity of three months or less. Interestingly, while the three months or less criteria is present in both IFRS and US GAAP, IAS 7 includes it in the guidance, while ASC 230 the glossary (not that it makes any difference).

Somewhat more importantly, ASC 230 (edited) states: "Generally, only investments with original maturities of three months or less qualify..." while 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..." This guidance is generally understood to mean a security may have a maturity of at most 92 days under US GAAP while, under IFRS, it could have a maturity of say 90 days plus, say, 3 or 4 additional days but no more than, say, a week.

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

Commercial paper (security)

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 many 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 on top) 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 food vouchers with a nominal value of 60,000. It paid 60,300 including a 0.5% processing fee. 1/31/X1, it included transferred vouchers with a nominal value of 20,000 to its employees as part of their January compensation.

In some jurisdictions, employee benefits such as meal allowances receive favorable tax treatment but only if provided as vouchers, pre-paid debit cards or a similar way.

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 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. However, companies may hold other, cash like-items such as postage and revenue stamps (above), or meal vouchers and other types or pre-paid benefits.

While vouchers can be used to pay for goods or services as if they were cash, the scope of goods and services may be limited by legislation. Similarly, once acquired, these vouchers may or may not be readily converted back into cash. Consequently, judgment should be used in classifying them as either cash equivalents or pre-paid expenses.

Note: as the amounts involved are generally insignificant, this issue is rarely given, outside of academic circles, any 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

Financial assets other than cash

Overall

Comming soon

Investments

Amortized cost (present value)

Debt instrument: explicit interest

1/1/X1, XYZ purchased a non-negotiable, one-year, 500,000 nominal value note paying a fixed, semi-annual coupon of 19,615 from ABC, an unrelated party, for 500,000.

Implying an annual interest rate of 7.99%.

Determined using Excel's =RATE function adjusted for semi-annual periodicity:
7.99% = ((1+RATE(1,19615,-500000,500000,0,1))^2) - 1

Dr/Cr

1/1/X1 \| 1.1.X1
Note		500,000
	Cash in bank		500,000

3/31/X1, 6/30/X1, 9/30/X1, 12/31/X1 \| 31.3.X1, 30.6.X1, 30.9.X1, 31.12.X1
Accrued interest		9,808
	Interest income		9,808

7/1/X1 \| 1.7.X1
Cash in bank		19,615
	Accrued interest		19,615

1/1/X1 \| 1.1.X2
Cash in bank		519,615
	Note		500,000
	Accrued interest		19,615

Debt instrument: implicit rate

1/1/X1, XYZ purchased a non-negotiable, one-year, 500,000 nominal value, zero coupon note for from ABC, an unrelated party, 462,963. The note was redeemed 12/31/X1. XYZ elected to use amortized cost accounting for the interim periods.

Determined using Excel's =RATE function: 7.99%=RATE(1,0,-462963,500000,0,1).

Dr/Cr

1/1/X1 \| 1.1.X1
Note		462,963
	Cash in bank		462,963

3/31/X1 \| 31.3.X1
Discount		8,994
	Interest income		8,994

P	Net note	Interest rate	Interest
A	B = B_(B+1) + D	C = (1+8%)^(1/4) - 1	D= B * C
1	462,963	1.94%	8,994
2	471,957	1.94%	9,168
3	481,125	1.94%	9,347
4	490,472	1.94%	9,528
	500,000		37,037

12/31/X1 \| 31.12.X1
Cash in bank		500,000
	Note		500,000
Discount		9,528
	Interest income		9,528

Alternatively

1/1/X1, XYZ purchased a non-negotiable, one-year, 500,000 nominal value, zero coupon note from ABC, an unrelated party, for 462,963. The note was redeemed 12/31/X1. XYZ elected to not apply the effective interest method for interim reporting purposes.

Implying an annual interest rate of 7.99%.

Determined using Excel's =RATE function: 7.99%=RATE(1,0,-462963,500000,0,1).

Dr/Cr

1/1/X1 \| 1.1.X1
Note		462,963
	Cash in bank		462,963

3/31/X1, 6/30/X1 and 9/30/X 31.3.X1, 30.6.X1 a 30.9.X1
Note		9,259
	Interest income		9,259

12/31/X1 \| 31.12.X1
Cash in bank		500,000
	Interest income		9,259
	Note		490,741

Same facts except XYZ elected to use a discount account.

1/1/X1 1.1.X1
Note		500,000
	Discount		37,037
	Cash in bank		462,963

3/31/X1, 6/30/X1 and 9/30/X 31.3.X1, 30.6.X1 a 30.9.X1
		9,348
	Interest income		9,348

12/31/X1 \| 31.12.X1
Discount		9,348
	Interest income		9,348
Cash in bank		500,000
	Note		500,000

Debt instrument: imputed rate

Imputed rate

Equity instrument: not remeasured

Equity instrument

Mark-to-market (fair value)

Debt instrument: fixed rate

1/1/X1, XYZ bought 500, 5-year, negotiable non-market traded, 1,000 nominal value notes with a fixed, semi-annual coupon of 29.56 each (14,782 in total). The coupon was paid each 7/15 and 1/15 to the holder of record each 6/15 and 12/15. XYZ paid 921.30 for each note (460,650 in total). The benchmark rate (i.e. AA corporate) on 1/1/X1 was 2%, implying a premium of 6% (comparable to the premium on similar notes). On 3/31/X1 and 6/30/X1, the benchmark rate was 2.1% and 2.2% respectively. XYZ sold the notes for 917.65 each (458,824 in total) on 7/31/X1.

Dr/Cr

1/1/X1 \| 1.1.X1
Notes		460,650
	Cash in bank		460,650

3/31/X1 \| 31.3.X1
Investment loss		1,862
	Notes		1,862
Accrued interest		7,391
	Interest income		7,391

(1,862) = 458,788 - 460,650

P	Expected cash flow	Market interest rate on 3/31/X1	Present value
A	B	C = (1 + 8.1%)^(1/2) - 1	D = B / (1 + C)^A
1	14,782	3.97%	14,217
2	14,782	3.97%	13,674
-	-	-	-
9	14,782	3.97%	10,412
10	514,782	3.97%	348,734
			458,788

6/30/X1 \| 30.6.X1
Notes		1,731
	Investment gain		1,731
Accrued interest		7,391
	Interest income		7,391

1,731 = 460,519 - 458,788

P	Expected cash flow	Market interest rate on 6/30/X1	Present value
A	B	C = (1 + 8.2%)^(1/2) - 1	D = B / (1 + C)^A
1	14,782	4.02%	14,211
2	14,782	4.02%	13,662
-	-	-	-
8	14,782	4.02%	10,785
9	514,782	4.02%	361,078
			460,519

7/15/X1 \| 15.7.X1
Cash in bank		14,782
	Accrued interest		14,782

7/31/X1 \| 31.7.X1
Cash		458,824
Investment loss		1,695
	Notes		460,519

Debt instrument: interim remeasurement

1/1/X1, XYZ bought 500, 5-year, market-traded 1,000 nominal value notes with a semi-annual coupon of 29.56 (14,782 total) for 921.30 each (460,650 total). The coupon was paid each 7/15 and 1/15 to the holder of record each 6/15 and 12/15. XYZ intended to sell the notes within one year and sold them 7/31/X1 for 917.65 (458,824 total). 3/31/X1 and 6/30/X1, the notes traded for 917.57 and 921.04 each.

Nominal rate 6.000203% = ((1+RATE(10,14782.51,-500000,500000,0,1))^2)-1

Implicit rate 7.999650% = ((1+RATE(10,14782.51,-460,650,500000,0,1))^2)-1

Dr/Cr

1/1/X1 \| 1.1.X1
Notes		460,650
	Cash in bank		460,650

3/31/X1 \| 31.3.X1
Investment loss		1,866
	Notes		1,866
Accrued interest		7,391
	Interest income		7,391

6/30/X1 \| 30.6.X1
Notes		1,735
	Investment gain		1,735
Accrued interest		7,391
	Interest income		7,391

7/15/X1 \| 15.7.X1
Cash in bank		14,782
	Accrued interest		14,782

7/31/X1 \| 31.7.X1
Cash in bank		458,824
Investment loss		1,695
	Notes		460,519

Debt instrument: variable rate

1/1/X1, XYZ bought 5 year notes with a total nominal value of and a variable, semi-annual coupon of benchmark rate + 7% for 500,000. The coupon was paid in arrears each 7/15 and 1/15 to the holder of record each 6/15 and 12/15. The benchmark rates on 1/1/X1, 3/31/X1, 6/30/X1, 9/30/X1 and 12/31/X1 were 1.00%, 1.20%, 1.18%, 1.21% and 1.15%. XYZ sold the notes on 12/31/X1 for 500,000.

Dr/Cr

1/1/X1 \| 1.1.X1
Notes		500,000
	Cash in bank		500,000

3/31/X1 \| 31.3.X1
Accrued interest		10,048
	Interest income: Notes		10,048

10,048 = 20,096 ÷ 2
20,096 = 500,000 x ((1 + 8.2%)^1/2 - 1)

6/30/X1 \| 30.6.X1
Accrued interest		10,000
	Interest income: Notes		10,000

10,000 = 20,048 - 10,048
20,048 = 500,000 x ((1 + 8.18%)^1/2 - 1)

7/15/X1 \| 15.7.X1
Cash in bank		20,048
	Accrued interest		20,048

12/31/X1 \| 31.12.X1
Cash in bank		500,000
	Notes		500,000
Accrued interest		9,916
	Interest income: Notes		9,916

Equity instrument

1/1/X1, XYZ acquired 10,000 ABC shares for 100 per share. 3/31/X1, the shares were trading at 102. 6/30/X1, the shares were trading at 101.5. 9/15/X1, XYZ sold the shares for 102.5.

Dr/Cr

1/1/X1 / 1.1.X1
Shares (ABC)		1,000,000
	Cash		1,000,000

3/31/X1 / 31.3.X1
Shares (ABC)		20,000
	Investment gain		20,000

6/30/X1 / 30.6.X1
Investment loss		5,000
	Shares (ABC)		5,000

9/15/X1 / 15.9.X1
Shares (ABC)		10,000
	Investment gain		10,000
Cash		1,025,000
	Shares (ABC)		1,025,000

ABC declared a dividend of 0.60 per share on 3/31/X1 and paid it out on 6/30/X1.

3/31/X1 \| 31.3.R1
Accrued revenue: dividends		6,000
Shares (ABC)		20,000
	Investment income: dividends		6,000
	Investment gain		20,000

6/30/X1 \| 30.6.R1
Cash		6,000
	Accrued revenue: dividends		6,000

Other comprehensive income

1/1/X1, XYZ purchased 100 equity instruments for 10 each, classifying them as available-for-sale. The instruments traded for 12 on 12/31/X1 and 15 on 12/31/X2. XYZ sold them for 16 on 6/30/X2 (deferred tax is not presented).

Dr/Cr

1/1/X1 \| 1.1.X1
Investment		10,000
	Cash in bank		10,000

12/31/X1 \| 31.12.X1
Investment		2,000
	Gain in OCI		2,000
Gain in OCI		2,000
	Accumulated OCI (US GAAP) \| Reserves (IFRS)		2,000

12/31/X2 \| 31.12.X2
Investment		3,000
	Gain in OCI		3,000
Gain in OCI		3,000
	Accumulated OCI \| Reserves		3,000

6/30/X2 \| 30.6.X2
Investment			1,000
		Gain in OCI		1,000
Gain in OCI			1,000
		Accumulated OCI \| Reserves		1,000
Cash in bank			16,000
Reclassification adjustment to OCI (US GAAP)			6,000
	Investment			16,000
	Gain to NI (not IFRS)			6,000
Accumulated OCI			6,000
		Reclassification adjustment to OCI		6,000

When an equity instrument is classified as available-for-sale per US GAAP, gains or losses are recognized in other comprehensive income until the security is sold, when they are recognized in net income (profit or loss).

ASC 320-10-35-1.b Investments in debt securities that are classified as available for sale shall be measured subsequently at fair value in the statement of financial position. Unrealized holding gains and losses for available-for-sale securities (including those classified as current assets) shall be excluded from earnings and reported in other comprehensive income until realized ...

To avoid double counting, a reclassification adjustment is made.

When an equity instrument is classified as available-for-sale per IFRS, gains or losses are recognized in other comprehensive income and never recognised in profit or loss (net income).

IFRS 9.4.1.4 ... an entity may make an irrevocable election at initial recognition for particular investments in equity instruments that would otherwise be measured at fair value through profit or loss to present subsequent changes in fair value in other comprehensive income (see paragraphs 5.7.5–5.7.6).

IFRS 9.5.7.5 At initial recognition, an entity may make an irrevocable election to present in other comprehensive income subsequent changes in the fair value of an investment in an equity instrument within the scope of this Standard that is neither held for trading nor contingent consideration recognised by an acquirer in a business combination to which IFRS 3 applies. (See paragraph B5.7.3 for guidance on foreign exchange gains or losses.)

IFRS 9.5.7.6 If an entity makes the election in paragraph 5.7.5, it shall recognise in profit or loss dividends from that investment in accordance with paragraph 5.7.1A.

XYZ Inc. Statement of changes in financial position and comprehensive income
For the year ended:	12/31/X3	12/31/X2	12/31/X1
Revenue	140,000	120,000	100,000
Expenses	(80,000)	(70,000)	(60,000)
Gain on sale of AFS Investment (US GAAP only)	6,000	-	-
Net income	66,000	50,000	40,000
Unrealized Gain on Investment	1,000	3,000	2,000
Reclassification adjustment (US GAAP only)	(6,000)	-	-
Comprehensive income	61,000	53,000	42,000

XYZ would have also included the sale in its second quarter interim report.

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:
1. To deliver cash or another financial instrument to a second entity
2. To exchange other financial instruments on potentially unfavorable terms with the second entity.
Conveys to that second entity a contractual right either:
1. To receive cash or another financial instrument from the first entity
2. 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:

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.

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:
1. One or more underlyings
2. 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:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. 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:
1. One or more underlyings
2. 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:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. 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.

Options

Options: trading

12/1/X1, XYZ bought a 60 day, 100 strike, at the money call option contract on ABC stock for 4.448. 12/31/X1, ABC stock closed at 110. 31/1/X2, it closed at 120 and XYZ exercised the option.

As most non-financial companies have no need to hold stock in other companies, when they do acquire stock options, the most common purpose, as in this illustration, is speculation. In contrast, other types of options, i.e. those related to commodities, are usually acquired for hedging as illustrated below.

There is, however, no rule that requires purchased stock options to be accounted as speculative and vice versa.

However, as a general rule, written options, unless part of a collar, are designated as speculative.

As stated in IFRS 9.B6.2.4: a written option does not qualify as a hedging instrument unless it is designated as an offset to a purchased option, including one that is embedded in another financial instrument (for example, a written call option used to hedge a callable liability). IFRS 9.B6.5.31 provides additional guidance on this issue.

While not identical nor as categorical, the guidance in ASC 815-20-25-94 to 97 and ASC 815-20-55-45 leads to generally comparable results.

For illustration purposes, ABC stock's price was exactly 100, interest rates 5%, dividend yield 0, implied volatility 25% and the option traded at exactly determined value. In the real world, strike and exercise prices are practically never equal and options do not trade at their determined values.

For options, the most common model is Black–Scholes (a.k.a. Black–Scholes–Merton), which can be built in Excel with a few deceptively simple formulas. It is also incorporated into several web pages (i.e. link, link, link).

While building the model is not particularly difficult, getting it to yield an acceptable result requires an accurate estimate of (future) volatility. Not easy. Thus, to avoid implying that calculating the value of options is simple or straightforward, our site does not include it in its downloadable Excel file.

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

Because this model relies on an estimate of volatility, and the market's consensus differs from that or any particular participant's, the market price and determined value never exactly equal.

Options generally expire on Friday regardless of date. This example assumes 12/31/X1 was a Friday simply for readability purposes.

Dr/Cr

12/1/X1 \| 1.12.X1
Financial assets: Call options: ABC 01/31/20X2 100 C Options trade in round lots so 100 x 4.448 = 445 (rounded).		445
	Cash		445
12/31/X1 \| 31.12.X1
Financial assets: Call options: ABC 01/31/20X2 100 C		625
	Gain		625

While the underlying economics can be complex, the accounting for derivatives is straightforward. As specified in ASC 815-10-35-1, derivatives are simply remeasured to fair value (at each balance sheet date).

Instead of providing similar, stand-alone guidance for (non-embedded) derivatives, IFRS 9 incorporates them into its guidance for financial assets (IFRS 9.4.1.1 to 4.1.5) and liabilities (IFRS 9.4.2.1 and 4.2.2). The result, however, is comparable.

Note: like US GAAP, IFRS provides separate, stand-alone guidance for derivatives used in hedging operations.

1/31/X2 \| 31.1.X2
Financial assets: Call options: ABC 01/31/20X2 100 C		931
	Gain		931
Investments: ABC stock		12,000
	Cash		10,000
	Financial assets: Call options: ABC 01/31/20X2 100 C		2,000

Same facts except ABC stock closed at 95 on 12/31/X1 and 90 on 1/31/X2.

Dr/Cr

12/1/X1 \| 1.12.X1
Financial assets: Call options: ABC 01/31/20X2 100 C		445
	Cash		445
12/31/X1 \| 31.12.X1
Loss		420
	Financial assets: Call options: ABC 01/31/20X2 100 C		420

Note: like US GAAP, IFRS provides separate, stand-alone guidance for derivatives used in hedging operations.

1/31/X2 \| 31.1.X2
Loss		24
	Financial assets: Call options: ABC 01/31/20X2 100 C		24

12/1/X1, XYZ sold a 60 day, 100 strike, at the money put option contract on ABC stock for 3.629. 12/31/X1, ABC stock closed at 110. 31/1/X2, it closed at 120.

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

Because this model relies on an estimate of volatility, and the market's consensus differs from that or any particular participant's, the market price and determined value never exactly equal.

Dr/Cr

12/1/X1 \| 1.12.X1
Cash Options trade in round lots so 100 x 3.629 = 363 (rounded).		363
	Financial Labilities: Put options: ABC 01/31/20X2 100 P		363
12/31/X1 \| 31.12.X1
Financial Labilities: Put options: ABC 01/31/20X2 100 P		335
	Gain		335

Note: like US GAAP, IFRS provides separate, stand-alone guidance for derivatives used in hedging operations.

1/31/X2 \| 31.1.X2
Financial Labilities: Put options: ABC 01/31/20X2 100 P		28
	Gain		28

Same facts except ABC stock closed at 95 on 12/31/X1 and 90 on 1/31/X2.

Dr/Cr

12/1/X1 \| 1.12.X1
Cash		363
	Financial Labilities: Put options: ABC 01/31/20X2 100 P		363
12/31/X1 \| 31.12.X1
Loss		203
	Financial Labilities: Put options: ABC 01/31/20X2 100 P		203

Note: like US GAAP, IFRS provides separate, stand-alone guidance for derivatives used in hedging operations.

1/31/X2 \| 31.1.X2
Loss		434
	Financial Labilities: Put options: ABC 01/31/20X2 100 P		434
Financial Assets: ABC stock		9,000
Financial Labilities: Put options: ABC 01/31/20X2 100 P		1,000
	Cash		10,000

Options: Compensation

12/31/X1, XYZ granted an employee an option to buy 1,000 of its shares at 125 per share in two years. The market price of the shares was 100 and comparable options traded for 9.286. The option vested immediately. 12/31/X3, the employee exercised the option.

As outlined in IFRS 2.11 | ASC 718-10-30-6, the expense associated with stock based compensation is measured at the grant date.

In this illustration, the option did not have any special features, so was comparable to other market traded options.

As this example illustrates a hypostatical transaction, this "market price" was calculated using the Black-Scholes option pricing model (link), a 5% interest rate and 25% implied volatility.

In the real world, options practically never trade at their determined value.

As outlined in IFRS 2.16 and ASC 718-10-30-2, stock based compensation, including options, is measured at fair value while IFRS 2.16 specifies this value should reflect market price (if available). Although ASC 718-10-30-2 does not specifically mention market price, as market price is a level one input, its guidance is comparable.

Note: options granted to employees often include features which makes their market price impossible to determine. In this situation, a valuation technique is used. Both IFRS 2.B1 to B38 and ASC 718-10-55-13 to 58 provide additional guidance on valuation techniques.

A discussion of fair value is available on this page.

Dr/Cr

12/31/X1 \| 31.12.X1
Expense: SBC		9,286
	APIC: SBC		9,286

As outlined in IFRS 2.14, if the grant vests immediately, the expense is recognized on the grant date.

In contrast, ASC 718-10-35-2, only addresses awards that vest over time (presumably because grant date vesting is uncommon in the US). However, in the absence of a vesting period, the expense would likewise be recognized at the grant date.

As outlined in ASC 718-10-35-2, the corresponding credit is made to equity (generally, paid-in capital). While IFRS 2.15 also outlines an increase in equity, it does not specify where in equity the increase should be recognized (presumably because it is obvious).

In this illustration, as XYZ's shares had a par value, so XYZ recognized the option in additional paid in capital.

12/31/X4 \| 31.12.X4
Cash		125,000
APIC: SBC		9,286
	Paid in capital		1,000
	APIC		133,286

Assuming each share had a par value of 1.

Same facts except the options vested at the end of each quarter.

Dr/Cr

12/31/X1 \| 31.12.X1
N/A		9,286
	N/A		9,286

While they go about it differently, IFRS and US GAAP require the award to be measured at the grant date.

IFRS 2 defines measurement date (emphasis added): the date at which the fair value of the equity instruments granted is measured for the purposes of this IFRS. For transactions with employees and others providing similar services, the measurement date is the grant date. For transactions with parties other than employees (and those providing similar services), the measurement date is the date the entity obtains the goods or the counterparty renders service.

In contrast, the ASC defines measurement date: the date at which the equity share price and other pertinent factors, such as expected volatility, that enter into measurement of the total recognized amount of compensation cost for an award of share-based payment are fixed.

ASC 718-10-30-6 then goes on to state (emphasis added): the measurement objective for equity instruments awarded to grantees is to estimate the fair value at the grant date of the equity instruments that the entity is obligated to issue when grantees have delivered the good or rendered the service and satisfied any other conditions necessary to earn the right to benefit from the instruments (for example, to exercise share options). That estimate is based on the share price and other pertinent factors, such as expected volatility, at the grant date.

However, as the award did not vest immediately, there was nothing to recognize.

3/31/X2 \| 31.3.X2
Expense: SBC		1,161
	APIC: SBC		1,161
Etc.

As outlined in IFRS 2.15 | ASC 718-10-35-2, the expense associated with stock based compensation is recognized over the vesting period.

Same facts, except the option vested each year over 10 years but only if the company hit its sales and probability targets, its average annual share price was above a specified amount and closed above a second specified amount, and (obviously) the employee remained with the company. The portion of the grant that did not vest in any particular year expired.

Dr/Cr

12/31/X1 \| 31.12.X1
N/A		GLWT
	N/A		GLWT

Good luck with that.

Seriously.

Seriously, good luck with that.

As stated in 718-10-55-11, if observable market prices of identical or similar equity or liability instruments of the entity are not available, the fair value of equity and liability instruments awarded to grantees shall be estimated by using a valuation technique that meets all of the following criteria:

It is applied in a manner consistent with the fair value measurement objective and the other requirements of this Topic.
It is based on established principles of financial economic theory and generally applied in that field (see paragraph 718-10-55-16). Established principles of financial economic theory represent fundamental propositions that form the basis of modern corporate finance (for example, the time value of money and risk-neutral valuation).

ASC 718-10-55-16 (emphasis added): A lattice model (for example, a binomial model) and a closed-form model (for example, the Black-Scholes-Merton formula) are among the valuation techniques that meet the criteria required by this Topic for estimating the fair values of share options and similar instruments granted in share-based payment transactions. A Monte Carlo simulation technique is another type of valuation technique that satisfies the requirements in paragraph 718-10-55-11 [¯\_(ツ)_/¯]. Other valuation techniques not mentioned in this Topic also may satisfy the requirements in that paragraph. Those valuation techniques or models, sometimes referred to as option-pricing models, are based on established principles of financial economic theory. Those techniques are used by valuation professionals, dealers of derivative instruments, and others to estimate the fair values of options and similar instruments related to equity securities, currencies, interest rates, and commodities. Those techniques are used to establish trade prices for derivative instruments and to establish values in adjudications. As discussed in paragraphs 718-10-55-21 through 55-50, both lattice models and closed-form models can be adjusted to account for the substantive characteristics of share options and similar instruments granted in share-based payment transactions.

While there is often no other option, I (who am I link) am not a fan of valuation techniques described as "faking it a billion times until the reality emerges" so my site does not cover it.

However, those interested can start on this page (link), which provides a decent summary.

It is worth noting how careful the FASB was in its wording stating "those techniques are used by valuation professionals" without going so far as stating an entity should rely on such professionals.

This is especially important when US GAAP is applied at an international subsidiary of a multinational company. As accountants in many jurisdiction rely on external valuation professionals to support accounting measurements they may misinterpret this guidance to suggest that the opinion of such an expert is, in and of itself, an acceptable valuation technique.

The point is, regardless who makes the estimate, the entity's management is still ultimately responsible for its accuracy.

Hiding behind an expert options is not an option US GAAP offers, nor will it be a defense the SEC, if it goes that far, will accept.

If you have gotten this far, please continue at asc.fasb.org/1943274/2147480397/718-10-55-21

It reflects all substantive characteristics of the instrument (except for those explicitly excluded by this Topic, such as vesting conditions and reload features)...

While they do not mention Monte Carlo simulation techniques, IFRS 2.B1 to B41 provide comparably useful instructions.

3/31/X2 \| 31.3.X2
Expense: SBC		GLWT
	APIC: SBC		GLWT
Etc.

Forwards (futures)

12/15/X1, XYZ and ABC entered into a 30 day forward contract to buy/sell 10,000 units of item X at 50 per unit. Item X's unit fair value was 50.00 on 12/15/X1, 51.10 on 12/31/X1 and 47.40 on 1/14/X2. The contract allowed net settlement, but XYZ took delivery.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month.

This example assumes a one month duration and expiration half way through the month.

While unrealistic, it hopefully makes this and the following the illustrations easier to follow.

Item X was not a commodity, so did not have a level 1 fair value. It did, however, have a level 2b fair value.

Please go to this page for a discussion of fair value, valuation models and the levels of inputs for the valuation models.

As outlined in ASC 815-10-15-83, to be recognized as a derivative, a contract must require or permit net settlement. In contrast, IFRS is not as strict.

ASC 815-10-15-83.c specifies that a contract allows net settlement if:

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.

Items 1 and 2 are self-explanatory. Item 3 applies to situations where, for example, one party must pay a contract penalty if they renege (i.e. the buyer refuses to buy if market price falls below contract price) and that penalty is sufficient to compensate the other party for its loss.

Note: as US GAAP takes net settlement seriously, ASC 815-10-15-99 to 139 discuss it in some detail.

In the IFRS 9 definition, a contract may be considered a derivative even if it does not allow net settlement.

XYZ: Dr/Cr

12/15/X1 \| 1.15.X1: XYZ and ABC
Forward contract #123		N/A

As the two parties trusted one another, no cash changed hands, the forward had no value and no accounting recognition was necessary. Nevertheless, XYZ opened an account, so it could recognize the expected, future changes in fair value.

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1
Derivative financial assets: Forward contract #123		11,000
	Gain		11,000

1/14/X2 \| 14.1.X2
Loss		37,000
	Derivative financial liabilities: Forward contract #123		37,000
Inventory		474,000
Derivative financial liabilities: Forward contract #123		26,000
	Cash		500,000
Or simply

1/14/X2 \| 14.1.X2
Loss		37,000
	Derivative financial liabilities: Forward contract #123		11,000
Inventory		474,000
	Cash		500,000

Same facts except the companies settled net.

1/14/X2 \| 14.1.X2
Loss		37,000
	Derivative financial liabilities: Forward contract #123		11,000
	Cash		26,000

ABC: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract #123		N/A

As the two parties trusted one another, no cash changed hands, the forward had no value and no accounting recognition was necessary. Nevertheless, ABC opened an account, so it could recognize the expected, future changes in fair value.

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1
Loss		11,000
	Derivative financial liabilities: Forward contract #123		11,000

1/14/X2 \| 14.1.X2: ABC
Derivative financial assets: Forward contract #123		37,000
	Gain		37,000
Cash		500,000
	Revenue		474,000
	Derivative financial assets: Forward contract #123		26,000
Cost of sales		250,000
	Inventory		250,000

ABC had produced item X at a cost of 25 per unit.

Same facts except the companies settled net.

1/14/X2 \| 14.1.X2
Derivative financial assets: Forward contract #123		11,000
Cash		26,000
	Gain		37,000

Same facts except XYZ reneged.

If XYZ paid a contract penalty, ABC would use the net settlement procedure illustrated above. If not, ABC would record:

1/15/X2 \| 15.1.X2: ABC
Loss		11,000
	Derivative financial assets: Forward contract #123		11,000

As legitimate companies rarely renege on their agreements, the accounting for XYZ is not illustrated.

12/15/X1, XYZ entered into a 30 day futures contract to buy 10,000 units of commodity X at 50 when its market price was 50. The exchange required an initial margin deposit of 6%. Maintenance margin was 4%. Mark to market gains/losses were debited/credited to the margin account. XYZ settled margin calls by the end of the day.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month.

This example assumes a one month duration and expiration half way through the month.

While unrealistic, it should make the illustration below easier to follow.

Futures are generally marked to market each day.

For example (link):"Corn futures trade on CME Globex beginning the previous evening and officially settle for the day at 13:15 Central Time (CT). CME Group staff determine the daily settlement price of corn based on trading activity in the last minute of trading between 13:14:00 and 13:15:00.

"E-mini S&P 500 futures trading on CME Globex begin trade the previous evening (CT) at 5:00 p.m. The final daily settlement price is determined by a volume-weighted average price (VWAP) of all trades executed in the full-sized, floor-traded (the Big) futures contract and the E-mini futures contract for the designated lead month contract between 15:14:30 and 15:15:00 CT. The combined VWAP for the designated lead month is then rounded to the nearest 0.10 index point. This contract then remains closed for fifteen minutes between 15:15:00 and 15:30:00 and then resumes trading until 16:00:00 (4:00 p.m. CT) when CME Globex shuts down for one hour..."

The settlement price of commodity X, the fair value of the future (CX) and daily gain/loss

Date	Per unit	Total	CX	(Gain)/Loss
The future (CX) can be either an asset or (liability) balance. As losses are debited and gains (credited), the schedule presents them: (Gain) / Loss.
	A = Mkt	B = A x 10,000	C = B - 500,000	D = C_(C-1) - C
12/15/X1	50.0	500,000	0	0
12/16/X1	51.5	515,000	15,000	(15,000)
12/17/X1	52.5	525,000	25,000	(10,000)
12/18/X1	51.2	512,000	12,000	13,000
12/19/X1	49.7	497,000	(3,000)	15,000
12/20/X1	49.2	492,000	(8,000)	5,000
12/23/X1	48.2	482,000	(18,000)	10,000
12/24/X1	47.5	475,000	(25,000)	7,000
12/25/X1	43.7	437,000	(63,000)	38,000
12/26/X1	45.4	454,000	(46,000)	(17,000)
12/27/X1	47.7	477,000	(23,000)	(23,000)
12/30/X1	50.6	506,000	6,000	(29,000)
12/31/X1	51.1	511,000	11,000	(5,000)
01/01/X2	48.0	480,000	(20,000)	31,000
01/02/X2	44.6	446,000	(54,000)	34,000
01/03/X2	42.8	428,000	(72,000)	18,000
01/06/X2	41.9	419,000	(81,000)	9,000
01/07/X2	44.8	448,000	(52,000)	(29,000)
01/08/X2	47.5	475,000	(25,000)	(27,000)
01/09/X2	49.4	494,000	(6,000)	(19,000)
01/10/X2	49.9	499,000	(1,000)	(5,000)
01/13/X2	48.9	489,000	(11,000)	10,000
01/14/X2	47.4	474,000	(26,000)	15,000
				26,000

Dr/Cr

12/15/X1 \| 15.12.X1
Derivatives: Futures: CXF02		N/A
Due to its short duration, XYZ measured the derivative at intrinsic value which was zero. Although there was no asset or liability to recognize, XYZ opened an account so it could keep track of the derivative as its value changed. Note: As the derivative had no initial value, a balancing entry was not required.
Margin account		30,000
	Cash		30,000

XYZ recognized the change in fair value at the end of the reporting period: Dr/Cr

12/23/X1 \| 23.12.X1
Margin account		18,000
	Cash		18,000

12/23/X1, commodity X's market price (above) was 48.2.

This brought the derivative's value to (18,000) and the margin account to 12,000 = 30,000 + (18,000) triggering a margin call. XYZ deposited an additional 18,000 to bring the account's balance back up to 30,000 and keep the position open.

The following trading day, commodity X's market price settled at 47.5 which brought CX's value to (25,000) and the margin account's value to 23,000 = 48,000 + (25,000). As XYZ had deposited a total of 48,000, it did not receive a margin call.

Etc.

12/25/X1 | 25.12.X1

For illustration purposes, this example ignores holidays. While unrealistic, it hopefully makes it easier to follow.

Margin account

45,000

Cash

45,000

12/25/X1, commodity X's market price (above) was 47.5 which brought CX's value to (63,000) and the account's value to (5,000) = 48,000 + (63,000). To keep the position open, XYZ deposited another 45,000.

Note: for illustration purposes, this example ignores holidays. While unrealistic, it hopefully makes it easier to follow.

12/31/X1 \| 31.12.X1
Financial assets: Derivatives: Futures: CXF02		11,000
	Gain		11,000

By 12/31/X1, the market (above) moved back in XYZ's favor, so the derivative had a net asset value.

Note: XYZ's policy was to not withdraw increases to the margin account until the derivative's expiration.

1/6/X2 \| 6.1.X2
Margin account		18,000
	Cash		18,000

1/14/X2 \| 14.1.X2
Loss		37,000
	Financial liabilities: Derivatives: Futures: CXF02		37,000
Commodity X		474,000
Financial liabilities: Derivatives: Futures: CXF02		26,000
	Margin account		111,000
	Cash		389,000
Or simply

1/14/X2 \| 14.1.X2
Loss		37,000
Commodity X		474,000
	Financial liabilities: Derivatives: Futures: CXF02		11,000
	Margin account		111,000
	Cash		389,000

XYZ adjusted the derivative to fair value daily: Dr/Cr

12/16/X1 \| 16.12.X1
Financial assets: Derivatives: Futures: CXF02		15,000
	Gain		15,000

The initial change in market price (above) indicated a net gain, so XYZ recognized the derivative as an asset.

12/17/X1 \| 17.12.X1
Financial assets: Derivatives: Futures: CXF02		10,000
	Gain		10,000

12/18/X1 \| 18.12.X1
Loss		13,000
	Financial assets: Derivatives: Futures: CXF02		13,000

12/19/X1 \| 19.12.X1
Loss		15,000
	Financial liabilities: Derivatives: Futures: CXF02		15,000
The change in market price (above) indicated a net loss, so XYZ reclassified the derivative as a liability. Etc.

12/23/X1 \| 23.12.X1
Loss		10,000
	Financial liabilities: Derivatives: Futures: CXF02		10,000
Margin account		18,000
	Cash		18,000
12/23/X1, commodity X's market price (above) was 48.2. This brought the derivative's value to (18,000) and the margin account to 12,000 = 30,000 + (18,000). This triggered a margin call and XYZ had to deposit an additional 18,000 to bring the account back up to 30,000. Etc. The following trading day, commodity X's market price settled at 47.5 which brought CX's value to (25,000) and the margin account's value to 23,000 = 48,000 + (25,000). As XYZ had deposited a total of 48,000, it did not receive a margin call. The day after that, commodity X's market price settled at 47.5 which brought CX's value to (63,000) and the account's value to (5,000) = 48,000 + (63,000). To bring the account back up to 30,000, XYZ deposited 45,000. Etc. Etc.

1/14/X2 \| 14.1.X2
Loss		15,000
	Financial liabilities: Derivatives: Futures: CXF02		15,000
Commodity X		474,000
Financial liabilities: Derivatives: Futures: CXF02		26,000
	Margin account		111,000
	Cash		389,000
Or simply

1/14/X2 \| 14.1.X2
Loss		15,000
Commodity X		474,000
Financial liabilities: Derivatives: Futures: CXF02		11,000
	Margin account		111,000
	Cash		389,000

XYZ settled with the exchange daily: Dr/Cr

12/15/X1 \| 15.12.X1
Margin account		30,000
	Cash		30,000

12/16/X1 \| 16.12.X1
Financial assets: Derivatives: Futures: CXF02		15,000
Cash		15,000
	Gain		15,000
	Margin account		15,000

12/17/X1 \| 17.12.X1
Financial assets: Derivatives: Futures: CXF02		10,000
Cash		10,000
	Gain		10,000
	Margin account		10,000

12/18/X1 \| 18.12.X1
Loss		13,000
Margin account		13,000
	Financial assets: Derivatives: Futures: CXF02		13,000
	Cash		13,000
Etc.

XYZ settled net: Dr/Cr

Rather than take delivery, XYZ liquidated the position. The exchange returned the balance on the margin account.

1/14/X2 \| 14.1.X2
Loss		37,000
Cash		85,000
	Financial assets: Derivatives: Futures: CXF02		11,000
	Margin account		111,000

XYZ paid a premium (the derivative had an initial value): Dr/Cr

When XYZ entered into the contract, commodity X's market price was 49.90.

12/15/X1 \| 15.12.X1
Deferred expense		1,000
Margin account		30,000
	Financial assets: Derivatives: Futures: CXF02		1,000
	Cash		30,000

12/31/X1 \| 31.12.X1
Financial assets: Derivatives: Futures: CXF02		11,000
	Gain		11,000

1/14/X2 \| 14.1.X2
Loss		37,000
	Financial liabilities: Derivatives: Futures: CXF02		37,000
Commodity X		475,000
Financial liabilities: Derivatives: Futures: CXF02		26,000
	Margin account		111,000
	Cash		389,000
	Deferred expense		1,000
Or simply

1/14/X2 \| 14.1.X2
Loss		37,000
Commodity X		475,000
	Financial liabilities: Derivatives: Futures: CXF02		11,000
	Margin account		111,000
	Cash		389,000
	Deferred expense		1,000

Hedging

Forward (cash flow hedge)

As above, 12/15/X1, XYZ and ABC entered into a 30 day forward contract to buy/sell 10,000 units of item X at 50 per unit. Item X's unit fair value was 50.00 on 12/15/X1, 51.10 on 12/31/X1 and 47.40 on 1/14/X2. The contract allowed net settlement. Both designated the forward as a cash flow hedge. They did so because they expected to re-sell / sell item X in one month's time item and wanted to lock in its current market price.

Item X was not a commodity, so did not have a level 1 fair value. It did, however, have a level 2b fair value.

Please go to this page for a discussion of fair value, valuation models and the levels of inputs for the valuation models.

As outlined in ASC 815-10-15-83, to be recognized as a derivative, a contract must require or permit net settlement. In contrast, IFRS is not as strict.

ASC 815-10-15-83.c specifies that a contract allows net settlement if:

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.

Note: because US GAAP takes net settlement seriously, ASC 815-10-15-99 to 139 discuss it in some detail.

In the IFRS 9 definition, a contract may be considered a derivative merely because it is settled at a future date.

As this is a characteristic shared by practically every contract involving the purchase or sale of some item and to make sure the definition is interpreted correctly, IFRS 9.BA2 includes an expanded discussion of this issue: 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).

In a fair value hedge, the hedged item is an asset or liability making the accounting straight forward. In a cash flow hedge, the hedged item is not an asset or liability, which makes the accounting a two-step process.

It may also be a firm commitment which, once designated, becomes an asset or liability as its fair value changes.

The ASC 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 comparable, the IFRS 9 definition is more succinct: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Note: only firm commitments designated as hedged items receive accounting recognition. Undesignated firm commitments do not make it to the balance sheet.

In a fair value hedge, the change in fair value (gain/loss) associated with the hedging instrument (the derivative) and the gain/loss associated with the hedged item are both recognized in net income. However, since they are inversely correlated, they offset one another so the net gain/loss is zero (if the hedge is 100% effective).

Instead, the hedged item is an expected (forecasted) transaction. As a forecasted transaction is not recognized as an asset or liability, it cannot generate the gain/loss to offset the gain/loss on derivative.

The ASC 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.

While comparable, the IFRS 9 definition is more succinct: an uncommitted but anticipated future transaction.

In order to bypass net income, the gain/loss is first included in other comprehensive income (OCI) then accumulated in its own, stand-alone section of equity. The manner in which this accumulation is derecognized, then depends on if the entity is applying IFRS or US GAAP.

Overcomplicated? Perhaps. But, this was the only way the standard setters could think of to have their cake (recognize all gains and losses) and eat it too (avoid making net income more volatile as a result).

XYZ: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract #123		N/A

As XYZ and the counterparty trusted one another, no cash changed hands, the forward had no value and no accounting recognition was necessary. Nevertheless, XYZ opened an account, so it could recognize the expected, future changes in fair value.

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1: to remeasure the derivative to other comprehensive income
Derivative financial assets: Forward contract #123		11,000
	OCI: Gain (Forward contract #123)		11,000

Item X's unit market price was 50.00 on 12/15/X1 and 51.10 on 12/31/X1.

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

In a cash flow hedge, the gain/loss from the remeasurement of the derivative bypasses net income and is recognized in other comprehensive income (OCI) instead.

Technically, as outlined in IFRS 9.6.5.11.b (IAS 39.95.a) | ASC 815-30-35-3, if the relationship between the hedged item and hedging instrument is highly effective, the change in the fair value of the designated hedging instrument that is included in the assessment of hedge effectiveness is recognized in other comprehensive income.

In other words, the ineffective gain/loss is striped out and recognized in net income.

However, in this illustration, the hedge was fully effective, so the entire gain was recognized in OCI.

12/31/X1 \| 31.12.X1: to close the period
OCI: Gain (Forward contract #123)		11,000
	AOCI (Forward contract #123)		11,000

In a cash flow hedge, the gain/loss from the remeasurement of the derivative bypasses net income and is recognized in other comprehensive income (OCI). Similarly, the accumulation bypasses retained earnings and is recognized in accumulated other comprehensive income (AOCI).

While US GAAP (i.e ASC 815-10-25-3) consistently refers to this section of equity as accumulated other comprehensive income, IFRS somewhat confusingly, considers it a reserve. Thus, the cash flow hedge reserve (IFRS 9.6.9.7) would be presented on a (XBRL tagged) balance sheet in the Other Reserves (OtherReserves) section.

However, in the footnotes, the section is labeled Accumulated Other Comprehensive Income (AccumulatedOtherComprehensiveIncomeAbstract) section ¯\_(ツ)_/¯.

1/14/X2 \| 14.1.X2: to remeasure the derivative to OCI
OCI: Loss (Forward contract #123)		37,000
	Derivative financial liabilities: Forward contract #123		37,000
Item X's unit market price was 47.40 on 1/14/X2.
1/14/X2 \| 14.1.X2: to move the loss to accumulated OCI
AOCI (Forward contract #123)		37,000
	OCI: Loss (Forward contract #123)		37,000

1/14/X2 \| 14.1.X2
IFRS \| US GAAP

1/14/X2 | 14.1.X2: to acquire item X, settle the derivative and move (not reclassify) the AOCI to inventory

As stated in IFRS 9.6.5.11.d.i (edited, emphasis added): if a hedged forecast transaction subsequently results in the recognition of a non-financial asset [like inventory] or non-financial liability ... the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset [such as inventory] or the liability. This is not a reclassification adjustment (see IAS 1) and hence it does not affect other comprehensive income.

While similar, the guidance in IAS 39 for reclassification adjustments is subtlety different:

IAS 39.98 (edited): If a hedge of a forecast transaction subsequently results in the recognition of a non-financial asset or a non-financial liability ... then the entity shall adopt (a) or (b) below:

It reclassifies the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95 to profit or loss as a reclassification adjustment (see IAS 1 (revised 2007)) in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods that depreciation expense or cost of sales is recognised). However, if an entity expects that all or a portion of a loss recognised in other comprehensive income will not be recovered in one or more future periods, it shall reclassify from equity to profit or loss as a reclassification adjustment the amount that is not expected to be recovered.
It removes the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95, and includes them in the initial cost or other carrying amount of the asset or liability.

Inventory		474,000
Derivative financial liabilities: Forward contract #123		26,000
	Cash		500,000
Inventory		26,000
	AOCI (Forward contract #123)		26,000

XYZ re-sold item X on 1/31/X2.

To simplify the illustration, XYZ sold item X in a single sale.

1/31/X2 \| 31.1.X2
Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		500,000
	Inventory		500,000

1/14/X2 \| 14.1.X2: to acquire item X and settle the derivative
Inventory		474,000
Derivative financial liabilities: Forward contract #123		26,000
	Cash		500,000

XYZ re-sold item X on 1/31/X2.

To simplify the illustration, XYZ sold item X in a single sale.

1/31/X2 | 31.1.X2: to recognize the hedged transaction in earnings

ASC 815-30-35-39 states (emphasis added): If the hedged transaction results in the acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other comprehensive income that are included in the assessment of effectiveness shall be reclassified into earnings in the same period or periods during which the asset acquired or liability incurred affects earnings (such as in the periods that depreciation expense, interest expense, or cost of sales is recognized).

Applying this guidance, accumulated gains/losses will remain in AOCI until the forecast transaction occurs. In this illustration, this is when XYZ sold item X, not when it bought item X.

If item X had been a raw material, XYZ would have had to keep track of the accumulation as it moved through the manufacturing process and recognize it in income when the goods produced with item X were sold. Likewise, if item X had been a machine, it would have had to keep tack so it could have been added to the machine’s depreciation.

In some situations, keeping track can prove challenging.

For example, when this guidance was first introduced, one of our clients decided to cease hedging its purchases of polyisobutylene because it would have been too difficult to keep track of. Specifically it lacked the software to keep tract of each bulk polyisobutylene purchase as it made its way through the manufacturing process to eventually emerge as a piece of chewing gum.

Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		500,000
	Inventory		474,000
	AOCI (Forward contract #123)		26,000

ABC: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract #123		N/A

As ABC and the counterparty trusted one another, no cash changed hands, the forward had no value and no accounting recognition was necessary. Nevertheless, ABC opened an account, so it could recognize the expected, future changes in fair value.

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1: to remeasure the derivative to other comprehensive income
OCI: Loss (Forward contract #123)		11,000
	Derivative financial liability: Forward contract #123		11,000

Item X's unit market price was 50.00 on 12/15/X1 and 51.10 on 12/31/X1.

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

In a cash flow hedge, the gain/loss from the remeasurement of the derivative bypasses net income and is recognized in other comprehensive income (OCI) instead.

In other words, the ineffective gain/loss is striped out and recognized in net income.

However, in this illustration, the hedge was fully effective, so the entire gain was recognized.

12/31/X1 \| 31.12.X1: to close the period
AOCI (Forward contract #123)		11,000
	OCI: Loss (Forward contract #123)		11,000

While US GAAP (i.e ASC 815-10-25-3) consistently referes to this section of equity as accumulated other comprehensive income, IFRS somewhat confusingly, considers it a reserve. Thus, the cash flow hedge reserve (IFRS 9.6.9.7) would be presented on the balance sheet in the Other Reserves (OtherReserves) section.

However, in the footnotes, the section is labled Accumulated Other Comprehensive Income (AccumulatedOtherComprehensiveIncomeAbstract) section ¯\_(ツ)_/¯.

1/14/X2 \| 14.1.X2: to remeasure the derivative to OCI
Derivative financial assets: Forward contract #123		37,000
	OCI: Gain (Forward contract #123)		37,000
Item X's unit market price was 47.40 on 1/14/X2.
1/14/X2 \| 14.1.X2: to move the gain to accumulated OCI
OCI: Gain (Forward contract #123)		37,000
	AOCI (Forward contract #123)		37,000

To sell item X at its market price (47.40 per unit) on 1/14/X2.

1/14/X2 \| 14.1.X2
Accounts receivable		474,000
	Revenue		474,000

While the derivative was cash settled, ABC sold item X with customary, 30-day payment terms.

Cash		26,000
	Derivative financial assets: Forward contract #123		26,000
AOCI (Forward contract #123)		26,000
	Revenue		26,000
Or simply

1/14/X2 \| 14.1.X2
Accounts receivable		474,000
Cash		26,000
AOCI (Forward contract #123)		26,000
	Derivative financial assets: Forward contract #123		26,000
	Revenue		500,000

Forward (fair value hedge)

As above, 12/15/X1, XYZ and ABC entered into a 30 day forward contract to buy/sell 10,000 units of item X at 50 per unit. Item X's unit fair value was 50.00 on 12/15/X1, 51.10 on 12/31/X1 and 47.40 on 1/14/X2. The contract allowed net settlement. Both designated the forward as a hedge of fair value. XYZ did so because it was committed to sell item X to DEF for 600,000 on 1/15/X2. ABC did so because, it wanted to lock in the market price of its item X in stock.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month.

This example assumes a one month duration and expiration half way through the month.

While unrealistic, it hopefully makes this and the following the illustrations easier to follow.

Item X was not a commodity, so did not have a level 1 fair value. It did, however, have a level 2b fair value.

Please go to this page for a discussion of fair value, valuation models and the levels of inputs for the valuation models.

As outlined in ASC 815-10-15-83, to be recognized as a derivative, a contract must require or permit net settlement. In contrast, IFRS is not as strict.

ASC 815-10-15-83.c specifies that a contract allows net settlement if:

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.

Note: because US GAAP takes net settlement seriously, the ASC discusses it, in some detail, in ASC 815-10-15-99 to 139.

In the IFRS 9 definition, a contract may be considered a derivative merely because it is settled at a future date.

As outlined in IFRS 9.6.5.2.a | ASC 815-20-25-12.a, only a recognized asset, liability or unrecognized firm commitment may be designated as the hedged item in a fair value hedge.

The ASC 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 comparable, the IFRS 9 definition is more succinct: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Item X was a near commodity ABC had acquired previously.

As outlined in IFRS 9.6.5.2.a | ASC 815-20-25-12.a, any recognized asset, including inventory, may be designated as the hedged item in a fair value hedge. However, most manufacturers see little point in trying to hedge their finished goods. Even if they did, since it is not possible to use a future, finding a counterparty to a forward would be challenging.

Hedge accounting mitigates the earnings volatility undesignated derivatives (above) cause. Thus, if an entity does enter into a future or forward contract, designating it as a hedging item, if possible, yields benefits.

Note: the accounting for a fair value hedge of inventory is discussed in ASC 330-10-35-7A which (edited) states: If inventory has been the hedged item in a fair value hedge, the inventory's cost basis for purposes of subsequent measurement shall reflect the effect of the adjustments of its carrying amount made pursuant to [ASC] 815-25-35-1.b. ASC 815-25-35-1.b (edited) states: The gain or loss ... on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings... Example 7 (ASC 815-25-55-30 to 39) reinforces this guidance with an illustration.

Also note: while IAS 2 does not specifically discuss inventory hedging, IFRS 9.6.5.8.b (edited) does state "the hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item ... and be recognised in profit or loss." The result is thus comparable.

In contrast, producers of commodities or near commodities do. Commodities trade on active markets, so are simple to hedge. While near commodities are not as easy, their producers are usually sophisticated enough to perceive when current market prices are high enough to make locking them in worthwhile.

Physical commodities (metals, minerals, hydrocarbons, grains, meats, etc.) with "quoted prices ... in active markets for identical assets or liabilities..." have level 1 fair value.

As a general rule, whenever an asset has level 1 fair value, a future associated with that asset is also traded on an active market so as easy to acquire as opening a margin account.

Note: the advantage of futures is they are easy to acquire. The disadvantage of futures is that their underlying commodity is practically never identical to the item being hedged. As a result, hedging with futures (unless the underlying is a financial commodity such as a share, bond, foreign currency or interest rates), is practically never fully effective. In contrast, because they are negotiation by the two parties, perfectly effective forwards are not uncommon.

Some manufactured items, such as transistors or capacitors are, for all intents and purposes, commodities. Other items, such as memory chips, solenoids, electric motors or linear actuators, while not identical, are very, very similar. Nevertheless, these items do not trade on "active markets" so have level 2.b fair value: "quoted prices for identical or similar assets or liabilities in markets that are not active."

Thus, if an entity wishes to hedge such an item, it first needs to find a counterparty willing to take the other side of a forward contract, which is not always simple or easy.

Note: unlike futures which are rarely 100% effective, because they are negotiation by the two parties, the opposite is often true with forwards.

XYZ: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract		N/A

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1: to remeasure the derivative and firm commitment so a financial report could be drafted
Derivative financial assets: Forward contract		11,000
	Gain		11,000
Loss		11,000
	Firm commitment		11,000

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

1/14/X2 \| 14.1.X2: to remeasure the derivative and firm commitment
Loss		37,000
	Derivative financial liabilities: Forward contract		37,000
Firm commitment		37,000
	Gain		37,000

1/14/X2 \| 14.1.X2: to acquire the inventory and settle the derivative
Inventory		474,000
Derivative financial liabilities: Forward contract		26,000
	Cash		500,000

1/15/X2 \| 15.1.X2: to re-sell the inventory and honor the firm commitment
Receivable: DEF		600,000
	Revenue		600,000
Cost of goods sold		500,000
	Inventory		474,000
	Firm commitment		26,000

ABC: Dr/Cr

12/15/X1 \| 1.15.X1
Forward contract		N/A

Note: as the account's value was zero, no balancing entry was made.

12/31/X1 \| 31.12.X1: to remeasure the derivative and inventory so a financial report could be drafted
Loss		11,000
	Derivative financial liabilities: Forward contract		11,000
Inventory		11,000
	Gain		11,000

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

1/14/X2 \| 14.1.X2: to remeasure the derivative and inventory
Derivative financial assets: Forward contract		37,000
	Gain		37,000
Loss		37,000
	Inventory		37,000

1/14/X2 \| 14.1.X2: to sell the inventory and settle the derivative
Cash		500,000
	Revenue		474,000
	Derivative financial assets: Forward contract		26,000
Cost of goods sold		374,000
	Inventory		374,000

ABC had acquired the inventory for 400,000. It carried it at cost until it was sold.

374,000 = 400,000 + 11,000 - 37,000.

Future (cash flow hedge)

As above 12/15/X1, XYZ entered into a 30 day futures contract to buy 10,000 units of commodity X at 50 when its market price was 50. The exchange required an initial margin deposit of 30,000. XYZ acquired the future because it expected to sell 10,000 units of item X in a month and so designated the future as a cash flow hedge. Commodity X's unit market price was 51.10 on 12/31/X1 and 47.40 on 1/14/X2. Item X's market price was 51.25 on 12/31/X1 and 47.15 on 1/14/X2. XYZ settled the future net.1/31/X2.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month.

This example assumes a one month duration and expiration half way through the month.

While unrealistic, it hopefully makes this and the following the illustrations easier to follow.

Both the accounting for a margin deposit and marking to market is illustrated above.

Item X was a specific grade of commodity X. While not identical, it was generally comparable.

It may also be a firm commitment which, once designated, becomes an asset or liability as its fair value changes.

The ASC 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 comparable, the IFRS 9 definition is more succinct: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Note: only firm commitments designated as hedged items receive accounting recognition. Undesignated firm commitments do not make it to the balance sheet.

While comparable, the IFRS 9 definition is more succinct: an uncommitted but anticipated future transaction.

Unlike commodity X, item X did not trade on market so did not have a level 1 fair value. It's fair value could, however, be determined using a level 2 input.

To simplify the illustration, XYZ sold commodity X in a single sale.

Dr/Cr

12/15/X1 \| 15.12.X1
Derivatives: Futures: CXF02		N/A
Due to its short duration, XYZ measured the derivative at intrinsic value which was zero. Although there was no asset or liability to recognize, XYZ opened an account so it could keep track of the derivative as its value changed. Note: As the derivative had no initial value, a balancing entry was not required.
Margin account		30,000
	Cash		30,000

12/23/X1 \| 23.12.X1
Margin account		18,000
	Cash		18,000

12/23/X1, commodity X's market price was 48.2.

The market price of commodity X, the fair value of the future (CX) and daily gain/loss

Date	Per unit	Total	CX	(Gain)/Loss
The future (CX) can be either an asset or (liability) balance. As losses are debited and gains (credited), the schedule presents them: (Gain) / Loss.
	A = Mkt	B = A x 10,000	C = B - 500,000	D = C_(C-1) - C
12/15/X1	50.0	500,000	0	0
12/16/X1	51.5	515,000	15,000	(15,000)
12/17/X1	52.5	525,000	25,000	(10,000)
12/18/X1	51.2	512,000	12,000	13,000
12/19/X1	49.7	497,000	(3,000)	15,000
12/20/X1	49.2	492,000	(8,000)	5,000
12/23/X1	48.2	482,000	(18,000)	10,000
12/24/X1	47.5	475,000	(25,000)	7,000
12/25/X1	43.7	437,000	(63,000)	38,000
12/26/X1	45.4	454,000	(46,000)	(17,000)
12/27/X1	47.7	477,000	(23,000)	(23,000)
12/30/X1	50.6	506,000	6,000	(29,000)
12/31/X1	51.1	511,000	11,000	(5,000)
01/01/X2	48.0	480,000	(20,000)	31,000
01/02/X2	44.6	446,000	(54,000)	34,000
01/03/X2	42.8	428,000	(72,000)	18,000
01/06/X2	41.9	419,000	(81,000)	9,000
01/07/X2	44.8	448,000	(52,000)	(29,000)
01/08/X2	47.5	475,000	(25,000)	(27,000)
01/09/X2	49.4	494,000	(6,000)	(19,000)
01/10/X2	49.9	499,000	(1,000)	(5,000)
01/13/X2	48.9	489,000	(11,000)	10,000
01/14/X2	47.4	474,000	(26,000)	15,000
				26,000

This brought the derivative's value to (18,000) and the margin account to 12,000 = 30,000 + (18,000).

This triggered a margin call and XYZ had to deposit an additional 18,000 to bring the account back up to 30,000.

Etc.

The day after that, commodity X's market price settled at 47.5 which brought CX's value to (63,000) and the account's value to (5,000) = 48,000 + (63,000). To bring the account back up to 30,000, XYZ deposited 45,000.

Etc.

Note: as illustrated in the futures example above, XYZ could have elected to recognize the changes in fair value each day. If it had, in addition to increases in the margin deposit, it would have recognized gains/losses on both the derivative and the forest transaction. However, daily recognition is unusual and not illustrated.

12/25/X1 | 25.12.X1

For illustration purposes, this example ignores holidays.

While unrealistic, it hopefully makes the example easier to follow.

Margin account

45,000

Cash

45,000

12/31/X1 \| 31.12.X1: to remeasure the derivative to OCI
Derivative financial assets: CXF02		11,000
	OCI: Gain (CXF02)		11,000

Commodity X's unit market price was 50.00 on 12/15/X1 and 51.10 (see above) on 12/31/X1.

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

Note: as illustrated in the futures example above, XYZ could have elected to recognize the changes in fair value each day. However, daily recognition is unusual, so a single, end-of-period adjustment was made instead.

In a cash flow hedge, the gain/loss from the remeasurement of the derivative bypasses net income and is recognized in comprehensive income (OCI).

In other words, the ineffective gain/loss is striped out and recognized in net income.

However, in this illustration, the hedge was fully effective, so the entire gain was recognized.

12/31/X1 \| 31.12.X1: to close the period
OCI: Gain (CXF02)		11,000
	AOCI (CXF02)		11,000

However, in the footnotes, the section is labled Accumulated Other Comprehensive Income (AccumulatedOtherComprehensiveIncomeAbstract) section ¯\_(ツ)_/¯.

1/6/X2 \| 6.1.X2
Margin account		18,000
	Cash		18,000

1/14/X2 \| 14.1.X2: to remeasure the derivative to OCI
OCI: Loss (CXF02)		37,000
	Derivative financial liabilities: CXF02		37,000
Item X's unit market price was 47.40 on 1/14/X2.
1/14/X2 \| 14.1.X2: to classify the loss in accumulated OCI
AOCI (CXF02)		37,000
	OCI: Loss (CXF02)		37,000

1/14/X2 \| 14.1.X2
IFRS \| US GAAP

1/14/X2 | 14.1.X2: to acquire item X, settle the derivative and move (not reclassify) the AOCI to inventory

As stated in IFRS 9.6.5.11.d.i (edited, emphasis added): if a hedged forecast transaction subsequently results in the recognition of a non-financial asset [like inventory] or non-financial liability ... the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset [like inventory] or the liability. This is not a reclassification adjustment (see IAS 1) and hence it does not affect other comprehensive income.

While similar, the guidance in IAS 39 for reclassification adjustments is subtlety different:

It reclassifies the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95 to profit or loss as a reclassification adjustment (see IAS 1 (revised 2007)) in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods that depreciation expense or cost of sales is recognised). However, if an entity expects that all or a portion of a loss recognised in other comprehensive income will not be recovered in one or more future periods, it shall reclassify from equity to profit or loss as a reclassification adjustment the amount that is not expected to be recovered.
It removes the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95, and includes them in the initial cost or other carrying amount of the asset or liability.

Inventory		474,000
Derivative financial liabilities: CXF02		26,000
	Cash		500,000
Inventory		26,000
	AOCI (CXF02)		26,000

1/31/X2 \| 31.1.X2
Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		500,000
	Inventory		500,000

1/14/X2 \| 14.1.X2: to acquire item X and settle the derivative
Inventory		474,000
Derivative financial liabilities: CXF02		26,000
	Cash		500,000

1/31/X2 | 31.1.X2: to recognize the hedged transaction in earnings

Applying this guidance, accumulated gains/losses will remain in AOCI until the forecast transaction occurs. In this illustration, this is when XYZ sold item X, not when it bought item X.

In some situations, keeping track can prove challenging.

Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		500,000
	Inventory		474,000
	AOCI (CXF02)		26,000

Same facts except the hedge was highly but not fully effective.

The future was for commodity X, a standard grade of X. XYZ actually expected to acquire was commodity Xa, a specific grade of X. As a result, the hedge was not 100% effective and XYZ actually paid 480,000 in total.

ASC 815-30-55-1A (Example 1) illustrates this issue in a stand-alone example. IFRS 9 does not provide a similar illustration, but Example 16 does illustrate combined commodity price risk and foreign currency risk hedge (cash flow hedge/cash flow hedge combination).

While forward contracts are between only two parties so can be customized to eliminate all ineffectiveness, future contracts are standardized and practically never fully effective.

Fortunately, neither IFRS nor US GAAP require the hedge to be fully effective to qualify for hedge accounting.

As stated in IFRS 9.6.4.1.c (edited): the hedging relationship [must meet] all of the following hedge effectiveness requirements:

there is an economic relationship between the hedged item and the hedging instrument ...
the effect of credit risk does not dominate the value changes that result from that economic relationship ... and
the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. However, that designation shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting...

The guidance continues in IFRS B6.4.4 to 11 (IAS 39.AG105 to AG113A), but a detailed discussion of this guidance is beyond the scope of this illustration.

As stated in 815-20-25-75 (edited): To qualify for hedge accounting, the hedging relationship, both at inception of the hedge and on an ongoing basis, shall be expected to be highly effective in achieving either of the following:

Offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated (if a fair value hedge)
Offsetting cash flows attributable to the hedged risk during the term of the hedge (if a cash flow hedge)...

The guidance continues up ASC 815-20-25-131, but a detailed discussion of this guidance is beyond the scope of this illustration.

IFRS | US GAAP

1/14/X2 | 14.1.X2: to acquire item X, settle the derivative and move the AOCI to inventory

As stated in IFRS 9.6.5.11.d.i (edited, emphasis added): if a hedged forecast transaction subsequently results in the recognition of a non-financial asset [like inventory] or non-financial liability ... the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset [like inventory] or the liability. This is not a reclassification adjustment (see IAS 1) and hence it does not affect other comprehensive income.

While similar, the guidance in IAS 39 for reclassification adjustments is subtlety different:

It reclassifies the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95 to profit or loss as a reclassification adjustment (see IAS 1 (revised 2007)) in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods that depreciation expense or cost of sales is recognised). However, if an entity expects that all or a portion of a loss recognised in other comprehensive income will not be recovered in one or more future periods, it shall reclassify from equity to profit or loss as a reclassification adjustment the amount that is not expected to be recovered.
It removes the associated gains and losses that were recognised in other comprehensive income in accordance with paragraph 95, and includes them in the initial cost or other carrying amount of the asset or liability.

Inventory		480,000
Derivative financial liabilities: CXF02		26,000
	Cash		506,000
Inventory		26,000
	AOCI (CXF02)		26,000

1/31/X2 \| 31.1.X2
Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		506,000
	Inventory		506,000

1/14/X2 \| 14.1.X2: to acquire item X and settle the derivative
Inventory		480,000
Derivative financial liabilities: CXF02		26,000
	Cash		506,000

1/31/X2 | 31.1.X2: to recognize the hedged transaction in earnings

Applying this guidance, accumulated gains/losses will remain in AOCI until the forecast transaction occurs. In this illustration, this is when XYZ sold item X, not when it bought item X.

In some situations, keeping track can prove challenging.

Accounts receivable		1,000,000
	Revenue		1,000,000
Cost of sales		506,000
	Inventory		480,000
	AOCI (CXF02)		26,000

Future (fair value hedge)

As above 12/15/X1, XYZ entered into a 30 day futures contract to buy 10,000 units of commodity X at 50 when its market price was 50. The exchange required an initial margin deposit of 30,000. XYZ acquired the future because it had committed to sell 10,000 units of item X to DEF for 60 per unit on 1/15/X1 and so designated the future as a fair value hedge of a firm commitment. Commodity X's market price was 51.10 on 12/31/X1 and 47.40 on 1/14/X2. Item X's market price was 51.25 on 12/31/X1 and 47.15 on 1/14/X2. XYZ settled the future net.

In practice, most futures contracts have a longer duration. They also generally expire on the third Friday of the month. This example assumes a one month duration and expiration half way through the month. While unrealistic, it makes the illustration easier to present.

Both the accounting for a margin deposit and marking to market is illustrated above.

As outlined in IFRS 9.6.5.2.a | ASC 815-20-25-12.a, only a recognized asset, liability or unrecognized firm commitment may be designated as the hedged item in a fair value hedge.

The ASC 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 comparable, the IFRS 9 definition is more succinct: a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Item X was a specific grade of commodity X. While not identical, it was generally comparable.

Unlike commodity X, item X did not trade on market so did not have a level 1 fair value. It's fair value could, however, be determined using a level 2 input.

Dr/Cr

12/15/X1 \| 15.12.X1
Derivatives: Futures: CXF02		N/A
Due to its short duration, XYZ measured the derivative at intrinsic value which was zero. Although there was no asset or liability to recognize, XYZ opened an account so it could keep track of the derivative as its value changed. Note: As the derivative had no initial value, a balancing entry was not required.
Margin account		30,000
	Cash		30,000

12/31/X1 \| 31.12.X1: to remeasure the derivative and firm commitment so a financial report could be drafted
Derivative financial assets: Forward contract		11,000
	Gain		11,000
Loss		12,500
	Firm commitment		12,500

As the duration was short, there was no material difference between the fair value of the contract and the spot element | price that needed to be considered (see IFRS 9.6.2.4.b | ASC 815-20-25-82.d).

As the hedge was not 100% effective, 1,500 = 12,500 - 11,000 was reported in net income.

1/14/X2 \| 14.1.X2: to remeasure the derivative and firm commitment
Loss		37,000
	Derivative financial liabilities: Forward contract		37,000
Firm commitment		41,000
	Gain		41,000

1/14/X2 \| 14.1.X2: to settle the derivative and acquire the inventory
Cash		4,000
Derivative financial liabilities: Forward contract		26,000
	Margin account		30,000
Inventory		471,500
	Cash		471,500

1/31/X2 \| 31.1.X2: to re-sell the inventory and honor the firm commitment
Receivable: DEF		600,000
	Revenue		600,000
Cost of goods sold		500,000
	Inventory		471,500
	Firm commitment		28,500

Variable for fixed swap (cash flow hedge)

1/1/X1, XYZ bought a five-year, 500,000 nominal value note paying a variable, semi-annual coupon of benchmark rate + 7%. The coupon was paid in arrears each 7/15 and 1/15 to the holder of record each 6/15 and 12/15. To hedge the cash flows associated with the note, XYZ entered into a five-year variable for fixed swap at 8% (for illustration purposes, the swap is settled on the interest payment date). The benchmark rates on 1/1/X1, 3/31/X1, 6/30/X1, 9/30/X1 and 12/31/X1 were 1.00%, 1.20%, 1.18%, 1.21% and 1.15%. XYZ did not sell the notes.

Dr/Cr

1/1/X1 \| 1.1.X1
Notes		500,000
	Cash in bank		500,000

3/31/X1 \| 31.3.X1
Comprehensive income: Loss: Hedged investment		3,897
	Interest rate swap		3,897
accumulated comprehensive income (reserve)		3,897
	Comprehensive income: Loss: Hedged investment		3,897
Accrued interest		10,048
	Net income: Interest income		10,048
Net income: Interest income (reclassification adjustment)		240
	accumulated comprehensive income		240

P	Nominal interest	Swapped interest	Difference	Variable interest rate	PV of difference
A	B=500,000 x ((1+8.00%)^1/2-1)	C=500,000 x ((1+8.20%)^1/2-1)	D = C - B	E = (1 + 8.24%)^1/2 - 1	F = D ÷ (1 + E)^A
1	20,096	19,615	(481)	4.02%	(462)
2	20,096	19,615	(481)	4.02%	(444)
-	-	-	-	-	-
9	20,096	19,615	(481)	4.02%	(337)
10	20,096	19,615	(481)	4.02%	(324)
					(3,897)

6/30/X1 \| 30.6.X1
Interest rate swap		680
	Comprehensive income: Gain: Hedged investment		680
Comprehensive income: Gain: Hedged investment		680
	accumulated comprehensive income (reserve)		680
Accrued interest		10,048
	Net income: Interest income (interest on notes)		10,048
Net income: Interest income (reclassification adjustment)		192
	accumulated comprehensive income		192

(680) = 3,217 - 3,897

P	Nominal interest	Swapped interest	Difference	Variable interest rate	PV of difference
A	B=500,000 x ((1+8.00%)^1/2-1)	C=500,000 x ((1+8.20%)^1/2-1)	D = C - B	E = (1 + 8.24%)^1/2 - 1	F = D ÷ (1 + E)^A
1	20,048	19,615	(433)	4.01%	(416)
2	20,048	19,615	(433)	4.01%	(400)
-	-	-	-	-	-
8	20,048	19,615	(433)	4.01%	(316)
9	20,048	19,615	(433)	4.01%	(304)
					(3,217)

7/15/X1 \| 15.7.X1
Cash in bank		20,096
	Accrued interest (receipt of interest)		20,096
Interest rate swap (settlement of swap)		433
	Cash in bank		433

Fixed for variable swap (fair value hedge)

1/1/X1, XYZ bought a five-year note with a nominal value of 500,000 and fixed, semi-annual coupon of 19,615.25 for 500,000. The coupon was paid each 7/15 and 1/15 to the holder of record each 6/15 and 12/15. To hedge the notes' fair value, XYZ acquired five-year fixed for variable swap at benchmark rate + 7% (for illustration purposes, the swap is settled on the interest payment date). 1/1/X1, 3/31/X1, 6/30/X1, 9/30/X1 and 12/31/X1 the benchmark rates were 1.00%, 1.20%, 1.18%, 1.21% and 1.15%. XYZ sold the notes for 497,571 on 12/31/X1.

Implicit rate 7.999899%=((1+RATE(10,19615,-500000,500000,0,1))^2) - 1

Dr/Cr

1/1/X1 \| 1.1.X1
Notes		500,000
	Cash in bank		500,000
Interest rate swap		0
	Cash in bank		0

3/31/X1 \| 31.3.X1
Loss: Hedged investment		3,897
	Notes		3,897
Interest rate swap		3,897
	Gain: Hedging instrument		3,897
Accrued interest		10,048
	Interest income: Notes		9,808
	Interest income: Interest rate swap		240

(3,897) = 496,103 - 500,000

P	Expected cash flow	Variable interest rate on 3/31/X1	Present value
A	B	C = (1 + 8.20%)^1/2 - 1	D = B ÷ (1 + C)^A
1	19,615	4.02%	18,857
2	19,615	4.02%	18,129
-	-	-	-
9	19,615	4.02%	13,759
10	519,615	4.02%	350,385
			496,103

P	Fixed interest	Variable interest	Difference	Variable rate	PV of difference
A	B	C = 500,000 x ((1+8.20%)^1/2-1)	D = C - B	E = (1 + 8.24%)^1/2 - 1	F = D ÷ (1 + E)^A
1	19,615	20,096	481	4.02%	462
2	19,615	20,096	481	4.02%	444
-	-	-	-	-	-
9	19,615	20,096	481	4.02%	337
10	19,615	20,096	481	4.02%	324
					3,897

6/30/X1 \| 30.6.X1
Notes		680
	Gain: Hedged investment		680
Loss: Hedging instrument		680
	Interest rate swap		680
Accrued interest		10,000
	Interest income: Notes		9,808
	Interest income: Interest rate swap		192

680 = 496,783 - 496,103

P	Expected cash flow	Variable interest rate on 6/30/X1	Present value
A	B	C = (1 + 8.18%)^1/2 - 1	D = B ÷ (1 + C)^A
1	19,615	4.01%	18,859
2	19,615	4.01%	18,132
-	-	-	-
8	19,615	4.01%	14,322
9	519,615	4.01%	364,771
			496,783

(680) = 3,217 - 3,897

P	Fixed interest	Variable interest	Difference	Variable rate	PV of difference
A	B	C=500,000 x ((1+8.18%)^1/2-1)	D = C - B	E = (1 + 8.24%)^1/2 - 1	F = D ÷ (1 + E)^A
1	19,615	20,048	433	4.01%	416
2	19,615	20,048	433	4.01%	400
-	-	-	-	-	-
8	19,615	20,048	433	4.01%	316
9	19,615	20,048	433	4.01%	304
					3,217

7/15/X1 \| 15.7.X1
Cash in bank (interest payment)		19,615
Cash in bank (swap settlement)		433
	Accrued interest		20,048

12/31/X1 \| 31.12.X1
Loss: Hedged investment		967
	Notes		967
Interest rate swap		967
	Gain: Hedging instrument		967
Accrued interest		9,916
	Interest income: Notes		9,808
	Interest income: Interest rate swap		108
Cash in bank		497,571
	Notes		497,571
Cash in bank		2,429
	Interest rate swap		2,429

1/15/X2 \| 15.1.X2
Cash in bank (interest payment)		19,615
Cash in bank (swap settlement)		361
	Accrued interest		19,976

Forex hedge

The accounting for a forex hedge is illustrated on this page.

Option

1/1/X1 XYZ forecast it would need to buy 2,000 units of a commodity on 12/31/X1. For some inexplicable reason, it decided to hedge the cash flow with an option and so paid a 24,472 premium to acquire an at the money call.

This illustration assumes the option was for the exact grade of commodity XYZ intended to acquire. It also assumes the option traded at exactly its determined value and there was no need to make any adjustments to reflect storage fees, transportation costs or other actual conditions. The option was also for a short enough period that the time value of money (IFRS 9.B6.5.4 | ASC 815-20-25-84, ASC 815-20-25-120 and 121) did not need to be considered.

As outlined in IFRS 9 B6.5.32 and 33, hedge accounting only applies to the "aligned time value" of options.

Aligned time value is the time value of an option where all critical terms (life, underlying, etc.) are fully aligned with hedged item. If the two are not fully aligned, the entity bases its accounting on a hypothetical option (IFRS 9.B6.5.5). It recognizes the differences between this hypothetical option and the actual option in net income.

While the ASC does not have an aligned time value concept, ASC 815-20-25-84 does provide guidance on evaluating the critical terms of the hedging instrument and of the hedged item. A hypothetical derivative method is mentioned in ASC 815-20-25-3.F and discussed in ASC 815-30-35-25 through 35-29. It also figures in the evaluation of the Shortcut Method (ASC 815-20-25-117D).

While unrealistic, these assumptions make the accounting simpler and illustration easier to present.

Unlike forwards and futures, options act like insurance. While this characteristic makes them ideal for speculation, it makes them poor and expensive tools for managing risk.

Like forwards and futures, options can be used to manage risk.

Unlike forwards and futures, they do not merely substitute one for another but, just like insurance, eliminate it.

Forwards and futures do not eliminate risk; they reorganize it.

In the classic baker/farmer example, the baker exchanges one risk (having to pay more if a failed crop drives up prices) for another (not being able to pay less if a bumper crop drives prices down).

This obviously makes sense if one risk (having to pay more than one has budgeted especially if what one has budgeted is all one has or can borrow) is worse than the other.

For the farmer, the situation is reversed.

This characteristic makes forwards and futures mutually beneficial and (practically) cost free.

Forwards, are between just two parties and so, for the most part, cost free.

Futures, as they involve at least one third party (the clearing agent), carry a cost (i.e. link). Nevertheless, relative to the notational amount, this cost is generally small.

Well, not just like.

While buying a put option on oil is comparable to insuring a ship full of oil (below), the probability the price of oil will sink is higher than a ship. Since no rational party takes on high probability risk without adequate compensation, relative to the notational amounts, options tend to be considerably more expensive. This cost is often further inflated by the asymmetry between buyers and sellers of options (below) that is less prevalent between buyers and sellers of insurance.

If an oil producer buys a put option on oil and the price of oil goes down. No worries, the risk has been eliminated.

Well, not really. The risk is still there. It has simply been assumed by the counterparty to the option.

So, unlike forwards and futures (above), options are not mutually beneficial. Since no rational party takes on risk without compensation, their cost is significant (below).

Since options are asymmetrical, they limit losses but offer (theoretically) unlimited gains.

Obviously, for a gain on a call option to be unlimited, the underlying's price would have to rise to infinity. This is not possible. Gains on put options are always limited because an underlying's value cannot fall below zero (unless the underlying is interest and central banks again decide to start charging savers a fee for saving).

For example, a 90 day at the money call on a stock trading at 100 would cost around 550. If the stock's price went up by 50%, that 550 would turn into a gain of 4,450. If the price went down, the loss would be at most 550.

The same cannot be said about forwards and futures. Since they are symmetrical, the potential loss can be as high as, or even higher than, the potential gain. For those old enough to remember, this was entertainingly fictionalized in the movie Trading Places.

Note: writing options is riskier, especially uncovered calls, which carry a risk comparable to futures.

Since options are one-sided, their reaction to the market is also one-sided.

While neither IFRS nor US GAAP preclude designating options as asymmetrical, loss-only hedges, they do not make the accounting easy or, in US GAAP's case, particularly appealing.

Similarly to IFRS.9.6.2.4.a, ASC 815-20-25-82 allows the time and intrinsic elements of options to be separated from one another.

Unlike IFRS 9, both of ASC 815's subsequent measurement options (ASC 815-20-25-82A and 82B) lead to an expense being recognized throughout the hedge term, even if the hedged transaction (as illustrated in Example 31, ASC 815-20-55-235 to 238) occurs several years later.

As stated in IFRS 9.6.5.15.b.i (edited): if the hedged item subsequently results in the recognition of a non-financial asset ... the entity shall remove the amount from the separate component of equity and include it directly in the initial cost or other carrying amount of the asset ...

As illustrated in the body of the example, this guidance means an expense is not recognized until the non-financial asset affects P&L (i.e. the inventory is sold).

This expense front loading more or less eliminates any benefit from excluding all or a part of the hedging instrument's time value, which makes options unattractive instruments for hedging unless their total fair value makes them effective, which does not happen very often.

As option's writer always charges a fee (demands a premium) for taking on the risk. Given that most option writers are more sophisticated than most options buyers, most option buyers end up overpaying.

Writing puts or covered calls is fairly common, even among amateur investors.

However, while all option traders share a gambler's mentality (if they did not, they would stick to AAA bonds or dividend paying blue-chips), buyers are generally more willing to try their luck than sellers, who, since their upside is limited, prefer to back up their trading with rigorous analysis and rarely open a position unless the market is, as one central banker once put it, irrationally exuberant.

In contrast, buyers of insurance not only tend to be comparably savvy to sellers of insurance but usually go out of their way to, coolly and rationally, negotiate mutually beneficial contracts that do not result in their overpaying.

This fact is not lost on the standard setters. For example, in ASC 815-20-55-235 to 237 the option buyer spends $9,250 to get $6,000 back in four years. Hardly a good investment. In the similarly realistic example presented on this page, the option buyer loses 59% of the 24,472 paid in just one year.

Note: occasionally, an option may also be embedded in larger contracts and may appear, at least on the surface, cost free. However, as no rational entity assumes risk without compensation, the cost of the option(s) is always buried somewhere, usually a purchase or sales price higher than it would have been. For this reason, embedded options, like all other derivatives, must be separated from the host contract and accounted for as derivatives (assuming the entire contract is not remeasured to fair value as discussed in IFRS 9.B4.3.1 | ASC 815-15-25-4).

Consequently, this site recommends against using options for hedging purposes.

However, as the guidance does not preclude using them this way, a few examples are, unfortunately, necessary.

While an option as whole may be designated as the hedge, this is not sufficiently common to warrant a separate illustration. Instead, options are generally separated into time value and intrinsic value in that each component is accounted for separately as outlined in IFRS 9.6.2.4.a | ASC 815-20-25-82.

Note: unlike IFRS 9, ASC 815-20-25-82 also allows time value to be broken down into its components θ (theta), ν (vega) ρ (rho). However, illustrations of all the permutations are beyond the scope of this page.

For illustration purposes, the commodity traded at exactly the call's strike price of 100 when XYZ opened the position.

The commodity’s market price and call option's fair value at the end of each month were:

Date	Per unit market price	Position intrinsic value	Per option fair value	Position fair value
An option's fair value comprises its intrinsic value and its time value. The ASC master glossary defines the time value of an option: the time value of an option is equal to the fair value of an option less its intrinsic value. Rearranging the equation, fair value equals time value plus intrinsic value. Interestingly, while IFRS 9.6.5.15 does discusses how to account for time value, IFRS does not specifically define the term. Not that it makes any difference, because the rest of the guidance makes it clear that time value plus intrinsic value equal fair value. While IFRS 9.6.5.15 \| ASC 815-20-25-82 allows only intrinsic value to be designated as a hedging instrument, time value must still be accounted for. This implies the option's fair value must be periodically updated. In this illustration, XYZ does so each month. Note: if an option trades on a market, fair value equals its market price. If an option does not trade on a market, its fair value needs to be determined (calculated). A discussion of this issue is provided in the introduction to this section.
	A	B = (A -100) x 2000, If > 0	C	D = 2,000 x C
1/1/X1	100	0	12.236	24,472
1/31/X1	104	8,000	14.237	28,474
2/29/X1	111	22,000	18.698	37,396
3/31/X1	104	8,000	12.924	25,848
4/30/X1	95	0	6.890	13,780
5/31/X1	90	0	4.054	8,108
6/30/X1	87	0	2.496	4,992
7/31/X1	92	0	3.543	7,086
8/31/X1	104	8,000	9.026	18,052
9/30/X1	108	16,000	10.996	21,992
10/31/X1	106	12,000	8.416	16,832
11/30/X1	107	14,000	8.025	16,050
12/31/X1	105	10,000	0.000

IFRS | US GAAP

XYZ recognized changes in fair value each month and published quarterly financial reports.

P	Fair value	Intrinsic value	Time value	∆ intrinsic value	∆ time value	Total gain (loss)
	A above	B above	C = A - B	D=B_(B+1)-B	E=C_(C+1)-C	F = D + E
0	24,472	0	24,472	0	0	0
1	28,474	8,000	20,474	8,000	(3,998)	4,002
2	37,396	22,000	15,396	14,000	(5,078)	8,922
3	25,848	8,000	17,848	(14,000)	2,452	(11,548)
4	13,780	0	13,780	(8,000)	(4,068)	(12,068)
5	8,108	0	8,108	0	(5,672)	(5,672)
6	4,992	0	4,992	0	(3,116)	(3,116)
7	7,086	0	7,086	0	2,094	2,094
8	18,052	8,000	10,052	8,000	2,966	10,966
9	21,992	16,000	5,992	8,000	(4,060)	3,940
10	16,832	12,000	4,832	(4,000)	(1,160)	(5,160)
11	16,050	14,000	2,050	2,000	(2,782)	(782)
12	10,000	10,000	0	(4,000)	(2,050)	(6,050)
				10,000	(24,472)	(14,472)

1.1.X1
Derivative		24,472
	Cash		24,472

31.1.X1: to remeasure the derivative to other comprehensive income
Derivative		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		3,998
	Derivative		3,998

As a general rule, when entities do use options as hedging instruments, they separate time and intrinsic values, and designate intrinsic values as the hedge.

The reason, an option's total fair value rarely changes in a way that makes the option as a whole a sufficiently effective hedging instrument. While not impossible, it is uncommon enough that it need not be illustrated.

As outlined in IFRS 9.6.5.15 (B6.5.29 to 33), when the intrinsic and time values of an option are separated and intrinsic value is designated as the hedge, the fair value of each of the components is accounted for separately.

This item represents the gain or loss from remeasuring the intrinsic value of the option.

This item represents the gain or loss from remeasuring the time value of the option.

28.2.X1
Derivative		14,000
	OCI (IV G/L)		14,000
OCI (TV G/L)		5,078
	Derivative		5,078

31.3.X1
OCI (IV G/L)		14,000
	Derivative		14,000
Derivative		2,452
	OCI (TV G/L)		2,452
To close the period and recognize the accumulated gain/loss
OCI (IV G/L)		8,000
	Accumulated OCI (IV reserve)		8,000
Accumulated OCI (TV reserve)		6,624
	OCI (TV G/L)		6,624
Etc.

For illustration purposes, XYZ recognized the remeasurement gains and losses on a monthly basis but reported them on a quarterly basis. Consequently, at the end of the quarter, it accumulated the net three-month gain or loss on the balance sheet in accumulated other comprehensive income (AccumulatedOtherComprehensiveIncome).

Note: the items comprising accumulated other comprehensive income are (with one exception) labeled "reserves".

IASB XBRL AccumulatedOtherComprehensiveIncome:

RevaluationSurplus
ReserveOfExchangeDifferencesOnTranslation
ReserveOfCashFlowHedges
ReserveOfGainsAndLossesOnHedgingInstrumentsThatHedgeInvestmentsInEquityInstruments
ReserveOfChangeInValueOfTimeValueOfOptions
ReserveOfChangeInValueOfForwardElementsOfForwardContracts
ReserveOfChangeInValueOfForeignCurrencyBasisSpreads
ReserveOfGainsAndLossesOnFinancialAssetsMeasuredAtFairValueThroughOtherComprehensiveIncome
ReserveOfInsuranceFinanceIncomeExpensesFromInsuranceContractsIssuedExcludedFromProfitOrLossThatWillBeReclassifiedToProfitOrLoss
ReserveOfInsuranceFinanceIncomeExpensesFromInsuranceContractsIssuedExcludedFromProfitOrLossThatWillNotBeReclassifiedToProfitOrLoss
ReserveOfFinanceIncomeExpensesFromReinsuranceContractsHeldExcludedFromProfitOrLoss
ReserveOfGainsAndLossesOnRemeasuringAvailableforsaleFinancialAssets
ReserveOfRemeasurementsOfDefinedBenefitPlans
AmountRecognisedInOtherComprehensiveIncomeAndAccumulatedInEquityRelatingToNoncurrentAssetsOrDisposalGroupsHeldForSale
ReserveOfGainsAndLossesFromInvestmentsInEquityInstruments
ReserveOfChangeInFairValueOfFinancialLiabilityAttributableToChangeInCreditRiskOfLiability

The gains/losses associated with the change in fair value of the intrinsic value are accumulated in equity and presented (IASB XBRL) as ReserveOfCashFlowHedges.

Specifically, the label documentation states: a component of equity representing the accumulated portion of gain (loss) on a hedging instrument that is determined to be an effective hedge for cash flow hedges. [Refer: Cash flow hedges [member]].

Note: this item would also be used if the option as a whole were designated as the hedging item. However, this would be unusual as, when entities do use options as hedging instruments, they generally separate time and intrinsic values, designating only intrinsic values as hedges.

The gains losses associated with the change in fair value of the time value are accumulated in equity and presented as (IASB XBRL) ReserveOfChangeInValueOfTimeValueOfOptions.

Specifically, the label documentation states: a component of equity representing the accumulated change in the value of the time value of options when separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the changes in the intrinsic value.

30.4.X1
OCI (IV G/L)		8,000
	Derivative		8,000
OCI (TV G/L)		4,068
	Derivative		4,068

31.5.X1
Derivative		0
	OCI (IV G/L)		0
OCI (TV G/L)		5,672
	Derivative		5,672

30.6.X1
Derivative		0
	OCI (IV G/L)		0
OCI (TV G/L)		3,116
	Derivative		3,116
Accumulated OCI (IV G/L)		8,000
	OCI (IV G/L)		8,000
Accumulated OCI (TV G/L)		10,404
	OCI (TV G/L)		10,404

31.7.X1
Derivative		0
	OCI (IV G/L)		0
Derivative		2,094
	OCI (TV G/L)		2,094

31.8.X1
Derivative		8,000
	OCI (IV G/L)		8,000
Derivative		2,966
	OCI (TV G/L)		2,966

30.9.X1
Derivative		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		4,060
	Derivative		4,060
OCI (IV G/L)		16,000
	Accumulated OCI (IV G/L)		16,000
OCI (TV G/L)		1,000
	Accumulated OCI (TV G/L)		1,000

31.10.X1
OCI (IV G/L)		4,000
	Derivative		4,000
OCI (TV G/L)		1,160
	Derivative		1,160

30.11.X1
Derivative		2,000
	OCI (IV G/L)		2,000
OCI (TV G/L)		2,782
	Derivative		2,782

31.12.X1
OCI (IV G/L)		4,000
	Derivative		4,000
OCI (TV G/L)		2,050
	Derivative		2,050
Accumulated OCI (IV G/L)		6,000
	OCI (IV G/L)		6,000
Accumulated OCI (TV G/L)		5,992
	OCI (TV G/L)		5,992

31.12.X1: to close the position and derecognized the accumulated reserves
Cash		10,000
	Derivative		10,000
Accumulated OCI (IV G/L)		10,000
	Inventory		10,000
Inventory		24,472
	Accumulated OCI (TV G/L)		24,472

Same facts except XYZ recognized the change in time value as an expense.

As outlined in IFRS 9.B6.5.29.b, if the hedge relates to a time period, the changes in time value are recognized as an expense. This unrealistic example shows this approach using the same facts as above.

IFRS 9.B6.5.29 outlines two approaches to time value.

The first (B6.5.29.a), applies if the option is hedging a transaction, while the second (B6.5.29.b) if it is hedging a time period.

As a rule, cash flow hedges hedge transactions, while fair value hedge time periods.

Note: unlike ASC 815-20-25-83A/83B, which offer a similar policy election, IFRS 9 does not allow the entity to make the choice. Instead, if the entity is hedging a transaction, B6.5.29.a is mandatory. If it is hedging a time period, B6.5.29.b is mandatory.

Important

This example is included for comparison purposes only. The following illustration is realistic.

1.1.X1
Derivative		24,472
	Cash		24,472

31.1.X1
Derivative		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		1,959
Expense		2,039
	Derivative		3,998

28.2.X1
Derivative		14,000
	OCI (IV G/L)		14,000
OCI (TV G/L)		3,039
Expense		2,039
	Derivative		5,078

31.3.X1
OCI (IV G/L)		14,000
	Derivative		14,000
Derivative		2,452
Expense		2,039
	OCI (TV G/L)		4,491
OCI (IV G/L)		8,000
	Accumulated OCI (IV G/L)		8,000
OCI (TV G/L)		506
	Accumulated OCI (TV G/L)		506
Etc.

30.4.X1
OCI (IV G/L)		8,000
	Derivative		8,000
OCI (TV G/L)		2,029
Expense		2,039
	Derivative		4,068

31.5.X1
Derivative		0
	OCI (IV G/L)		0
OCI (TV G/L)		3,633
Expense		2,039
	Derivative		5,672

30.6.X1
Derivative		0
	OCI (IV G/L)		0
OCI (TV G/L)		1,077
Expense		2,039
	Derivative		3,116
Accumulated OCI (IV G/L)		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		6,738
	Accumulated OCI (TV G/L)		6,738

31.7.X1
Derivative		0
	OCI (IV G/L)		0
Derivative		2,094
Expense		2,039
	OCI (TV G/L)		4,133

31.8.X1
Derivative		8,000
	OCI (IV G/L)		8,000
Derivative		2,966
Expense		2,039
	OCI (TV G/L)		5,005

30.9.X1
Derivative		8,000
	OCI (IV G/L)		8,000
OCI (TV G/L)		2,021
Expense		2,039
	Derivative		4,060
OCI (IV G/L)		16,000
	Accumulated OCI (IV G/L)		16,000
OCI (TV G/L)		7,118
	Accumulated OCI (TV G/L)		7,118

31.10.X1
OCI (IV G/L)		4,000
	Derivative		4,000
Expense		2,039
	OCI (TV G/L)		879
	Derivative		1,160

30.11.X1
Derivative		2,000
	OCI (IV G/L)		2,000
OCI (TV G/L)		743
Expense		2,039
	Derivative		2,782

31.12.X1
OCI (IV G/L)		4,000
	Derivative		4,000
OCI (TV G/L)		11
Expense		2,039
	Derivative		2,050
Accumulated OCI (IV G/L)		6,000
	OCI (IV G/L)		6,000
Accumulated OCI (TV G/L)		126
	OCI (TV G/L)		126

31.12.X1
Cash		10,000
	Derivative		10,000
Accumulated OCI (IV G/L)		10,000
	Inventory		10,000

More realistically ABC paid 14,850 for a put option to hedge a decline in the commodity's fair value.

Dr/Cr

Date	Per unit market price	Position intrinsic value	Per option fair value	Position fair value
An option's fair value comprises its intrinsic value and its time value. The ASC master glossary defines the time value of an option: the time value of an option is equal to the fair value of an option less its intrinsic value. Rearranging the equation, fair value equals time value plus intrinsic value. Interestingly, while IFRS 9.6.5.15 does discusses how to account for time value, IFRS does not specifically define the term. Not that it makes any difference, because the rest of the guidance makes it clear that time value plus intrinsic value equal fair value. While IFRS 9.6.5.15 \| ASC 815-20-25-82 allows only intrinsic value to be designated as a hedging instrument, time value must still be accounted for. This implies the option's fair value must be periodically updated. In this illustration, XYZ does so each month. Note: if an option trades on a market, fair value equals its market price. If an option does not trade on a market, its fair value needs to be determined (calculated). A discussion of this issue is provided in the introduction to this section. Also note: while IFRS and US GAAP both require time value to be separated and accounted for, their methodologies are significantly different as are the reported results.
	A	B = (A -100) x 2000, If > 0	C	D = 2,000 x C
1/1/X1	100	0	7.425	14,850
1/31/X1	104	0	5.817	11,634
2/29/X1	111	0	3.672	7,344
3/31/X1	104	10,000	5.293	10,586
4/30/X1	95	20,000	8.656	17,312
5/31/X1	90	26,000	11.218	22,436
6/30/X1	87	16,000	13.061	26,122
7/31/X1	92	0	9.509	19,018
8/31/X1	104	0	3.396	6,792
9/30/X1	108	00	1.771	3,542
10/31/X1	106	0	1.598	3,196
11/30/X1	107	0	0.615	1,230
12/31/X1	105	0	0.000

As they react differently to market forces, puts and calls do not trade at symmetrical prices.

As outlined in IFRS 9.6.3.7, an entity may designate an item in its entirety or a component of an item as the hedged item. In this illustration, ABC only designated the decline (not increase) in the commodity's fair value as the hedged item.

ABC recognized changes in fair value each month and published quarterly financial reports.

Period	Position fair value	Intrinsic value	Time value	∆ intrinsic value	∆ time value	Total gain (loss)
0	14,850	0	14,850	0	0	0
1	11,634	0	11,634	0	(3,216)	(3,216)
2	7,344	0	7,344	0	(4,290)	(4,290)
3	10,586	0	10,586	0	3,242	3,242
4	17,312	10,000	7,312	10,000	(3,274)	6,726
5	22,436	20,000	2,436	10,000	(4,876)	5,124
6	26,122	26,000	122	6,000	(2,314)	3,686
7	19,018	16,000	3,018	(10,000)	2,896	(7,104)
8	6,792	0	6,792	(16,000)	3,774	(12,226)
9	3,542	0	3,542	0	(3,250)	(3,250)
10	3,196	0	3,196	0	(346)	(346)
11	1,230	0	1,230	0	(1,966)	(1,966)
12	0	0	0	0	(1,230)	(1,230)
				0	(14,850)	(14,850)

1.1.X1
Derivative		14,850
	Cash		14,850

31.1.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
OCI (TV)		1,979
Expense		1,238
	Derivative		3,216

28.2.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
OCI (TV)		3,053
Expense		1,238
	Derivative		4,290

31.3.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
Derivative		3,242
Expense		1,238
	OCI (TV)		4,480
OCI (TV)		552
	Accumulated OCI (TV)		552
Etc.

30.4.X1
Derivative		10,000
	Gain		10,000
Loss		10,000
	Inventory		10,000
OCI (TV)		2,037
Expense		1,238
	Derivative		3,274

31.5.X1
Derivative		10,000
	Gain		10,000
Loss		10,000
	Inventory		10,000
OCI (TV)		3,639
Expense		1,238
	Derivative		4,876

30.6.X1
Derivative		6,000
	Gain		6,000
Loss		6,000
	Inventory		6,000
OCI (TV)		1,077
Expense		1,238
	Derivative		2,314
OCI (TV)		6,752
	Accumulated OCI (TV)		6,752

31.7.X1
Loss		10,000
	Derivative		10,000
Inventory		10,000
	Gain		10,000
Derivative		2,896
Expense		1,238
	OCI (TV)		4,134

31.8.X1
Loss		16,000
	Derivative		16,000
Inventory		16,000
	Gain		16,000
Derivative		3,774
Expense		1,238
	OCI (TV)		5,012

30.9.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
OCI (TV)		2,013
Expense		1,238
	Derivative		3,250
Accumulated OCI (TV)		7,133
	OCI (TV)		7,133

31.10.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
Expense		1,238
	OCI (TV)		892
	Derivative		346

30.11.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
OCI (TV)		729
Expense		1,238
	Derivative		1,966

31.12.X1
Derivative		0
	Gain		0
Loss		0
	Inventory		0
Expense		1,238
	OCI (TV)		8
	Derivative		1,230
Accumulated OCI (TV)		171
	OCI (TV)		171

Note: as the derivative had a zero balance, there was nothing to recognize.

Similarly, as the Accumulated OCI (TV) also had a zero balance, there was nothing to derecognize.

Same facts except the hedged item was a firm commitment in a fair value hedge.

1.1.X1
Derivative		24,472
	Cash		24,472

31.1.X1: to remeasure the derivative
Derivative		8,000
	Gain		8,000
Loss		8,000
	Firm commitment		8,000
OCI (TV G/L)		3,998
	Derivative		3,998

As outlined in IFRS 9.6.5.15, when the intrinsic and time values of an option are separated and intrinsic value is designated as the hedge, the fair value of each of these two components is accounted for separately (also see IFRS 9.B6.5.29 to 33).

While the gain / loss from the change in intrinsic value can be offset, the gain / loss from the change in time value continues to be recognized in other comprehensive income (OCI).

28.2.X1
Derivative		14,000
	Gain		14,000
Loss		14,000
	Firm commitment		14,000
OCI (TV G/L)		5,078
	Derivative		5,078

31.3.X1
Loss		14,000
	Derivative		14,000
Firm commitment		14,000
	Gain		14,000
Derivative		2,452
	OCI (TV G/L)		2,452
Etc.

31.12.X1: to close the position
Cash		10,000
	Derivative		10,000
Inventory		24,472
	Accumulated OCI (TV G/L)		24,472

XYZ recognized changes in fair value each month and published quarterly financial reports.

P	Fair value	Intrinsic value	Time value	∆ intrinsic value	∆ time value	Total gain (loss)
	A above	B above	C = A - B	D=B_(B+1)-B	E=C_(C+1)-C	F = D + E
0	24,472	0	24,472	0	0	0
1	28,474	8,000	20,474	8,000	(3,998)	4,002
2	37,396	22,000	15,396	14,000	(5,078)	8,922
3	25,848	8,000	17,848	(14,000)	2,452	(11,548)
4	13,780	0	13,780	(8,000)	(4,068)	(12,068)
5	8,108	0	8,108	0	(5,672)	(5,672)
6	4,992	0	4,992	0	(3,116)	(3,116)
7	7,086	0	7,086	0	2,094	2,094
8	18,052	8,000	10,052	8,000	2,966	10,966
9	21,992	16,000	5,992	8,000	(4,060)	3,940
10	16,832	12,000	4,832	(4,000)	(1,160)	(5,160)
11	16,050	14,000	2,050	2,000	(2,782)	(782)
12	10,000	10,000	0	(4,000)	(2,050)	(6,050)
				10,000	(24,472)	(14,472)

Note: this schedule is comparable the one presented in example 31.

ASC 815-20-55-235 to 237 (edited):

	12/31/X1	12/31/X2	12/31/X4	12/31/X4
Ending market price of commodity	77	76	74	81

Time value	7,500	5,500	3,000	-
Intrinsic value	2,000	1,000	-	6,000
Total (ending fair value of position)	9,500	6,500	3,000	6,000

Change in time value	(1,750)	(2,000)	(2,500)	(3,000)
Change in intrinsic value	2,000	(1,000)	(1,000)	6,000
Total gain (loss)	250	(3,000)	(3,500)	3,000

Dr/Cr

12/31/X0
Derivative		9,250
	Cash		9,250

12/31/X1
Derivative		250
	OCI		250
COGS		2,313
	OCI		2,313

12/31/X2
OCI		3,000
	Derivative		3,000
COGS		2,313
	OCI		2,313

12/31/X3
OCI		3,500
	Derivative		3,500
COGS		2,313
	OCI		2,313

12/31/X4
Derivative		3,000
	OCI		3,000
COGS		2,313
	OCI		2,313

7/1/X5
Cash		6,000
	Derivative		6,000
AOCI		6,000
	COGS		6,000

However, for the sake of readability, the periods are presented in rows, as in all our illustrations.

1/1/X1
Derivative		24,472
	Cash		24,472

1/31/X1: to remeasure the derivative to other comprehensive income
Derivative		4,002
	OCI		4,002
COGS		2,039
	OCI		2,039

Obviously, amortizing the derivative through COGS leads to a mismatch of revenue and expenses. To avoid this mismatch, the derivative could be amortized to inventory.

Unfortunately, ASC 815-20-25-83A explicitly states (and example 31 illustrates) "the initial value of the component excluded from the assessment of effectiveness shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument."

ASC 815-20-55-235 to 237 (edited):

	12/31/X1	12/31/X2	12/31/X4	12/31/X4
Ending market price of commodity	77	76	74	81

Time value	7,500	5,500	3,000	-
Intrinsic value	2,000	1,000	-	6,000
Total (ending fair value of option)	9,500	6,500	3,000	6,000

Change in time value	(1,750)	(2,000)	(2,500)	(3,000)
Change in intrinsic value	2,000	(1,000)	(1,000)	6,000
Total gain (loss)	250	(3,000)	(3,500)	3,000

12/31/X0
Derivative		9,250
	Cash		9,250

12/31/X1
Derivative		250
	OCI		250
COGS		2,313
	OCI		2,313

12/31/X2
OCI		3,000
	Derivative		3,000
COGS		2,313
	OCI		2,313

12/31/X3
OCI		3,500
	Derivative		3,500
COGS		2,313
	OCI		2,313

12/31/X4
Derivative		3,000
	OCI		3,000
COGS		2,313
	OCI		2,313

7/1/X5
Cash		6,000
	Derivative		6,000
AOCI		6,000
	COGS		6,000

This mismatch makes hedging with options an unattractive policy choice for most entities.

2,039 = 24,472 ÷ 12

2/28/X1
Derivative		8,922
	OCI		8,922
COGS		2,039
	OCI		2,039

3/31/X1: to close the period and recognize the accumulated gain/loss
OCI		11,548
	Derivative		11,548
COGS		2,039
	OCI		2,039
OCI		7,494
	AOCI		7,494
Etc.

4/30/X1
OCI		12,068
	Derivative		12,068
COGS		2,039
	OCI		2,039

5/31/X1
OCI		5,672
	Derivative		5,672
COGS		2,039
	OCI		2,039

6/30/X1
OCI		3,116
	Derivative		3,116
COGS		2,039
	OCI		2,039
AOCI		14,738
	OCI		14,738

7/31/X1
Derivative		2,094
	OCI		2,094
COGS		2,039
	OCI		2,039

8/31/X1
Derivative		10,966
	OCI		10,966
COGS		2,039
	OCI		2,039

9/30/X1
Derivative		3,940
	OCI		3,940
COGS		2,039
	OCI		2,039
OCI		23,118
	AOCI		23,118

10/31/X1
OCI		5,160
	Derivative		5,160
COGS		2,039
	OCI		2,039

11/30/X1
OCI		782
	Derivative		782
COGS		2,039
	OCI		2,039

12/31/X1
OCI		6,050
	Derivative		6,050
COGS		2,039
	OCI		2,039
AOCI		5,874
	OCI		5,874

12/31/X1: to close the position and derecognized the accumulated OCI
Cash		10,000
	Derivative		10,000
AOCI		10,000
	COGS		10,000

Same facts except XYZ recognized the gains/losses in earnings.

As a policy choice, XYZ opted to apply ASC 815-20-25-83B instead of ASC 815-20-25-83A:

1/1/X1
Derivative		24,472
	Cash		24,472

1/31/X1
Derivative		4,002
COGS		3,998
	OCI		8,000

While both ASC 815-20-25-83B and illustration showing how to apply ASC 815-20-25-83B (example 10) specify that the change in fair value of the excluded component is included in earnings, neither specify the exact expense item that should be recognized.

While example 10 (ASC 815-30-55-63 to 64) and example 31 (ASC 815-20-55-235 to 237) illustrate the two ways to account for options (ASC 815-20-25-83B and ASC 815-20-25-83A), example 10 does so on a per commodity item basis. Not only is this somewhat less realistic (options generally trade in round lots), it makes the two examples (marginally) harder to compare.

ASC 815-30-55-63 and 64 (edited):

	12/31/X1	12/31/X2	12/31/X4	12/31/X4
Ending market price of commodity	127.25	125.50	124.25	130.75

Time value	7.50	5.50	3.00	0.00
Intrinsic value	2.25	0.50	0.00	5.75
Total (ending fair value of option)	9.75	6.00	3.00	5.75

Change in time value	(1.75)	(2.00)	(2.50)	(3.00)
Change in intrinsic value	2.25	(1.75)	(0.50)	5.75
Total gain loss	0.50	(3.75)	(3.00)	2.75

12/31/X0
Derivative		9.25
	Cash		9.25

12/31/X1
Derivative		0.50
Earnings		1.75
	OCI		2.25

12/31/X2
OCI		1.75
Earnings		2.00
	Derivative		3.75

12/31/X3
OCI		0.50
Earnings		2.50
	Derivative		3.00

12/31/X4
Derivative		2.75
Earnings		3.00
	OCI		5.75

7/1/X5
Cash		5.75
	Derivative		5.75
AOCI		5.75
	Earnings		5.75

To rectify these shortcomings, example 10 (edited) is presented here with the same assumptions as example 31:

	12/31/X1	12/31/X2	12/31/X4	12/31/X4
Ending market price of commodity	77	76	74	81

Time value	7,500	5,500	3,000	-
Intrinsic value	2,000	1,000	-	6,000
Total (ending fair value of position)	9,500	6,500	3,000	6,000

Change in time value	(1,750)	(2,000)	(2,500)	(3,000)
Change in intrinsic value	2,000	(1,000)	(1,000)	6,000
Total gain (loss)	250	(3,000)	(3,500)	3,000

12/31/X0
Derivative		9,250
	Cash		9,250

12/31/X1
Derivative		250
Earnings		1,750
	OCI		2,000

12/31/X2
OCI		1,000
Earnings		2,000
	OCI		3,000

12/31/X3
OCI		1,000
Earnings		2,500
	OCI		3,500

12/31/X4
Derivative		3,000
Earnings		3,000
	OCI		6,000

7/1/X5
Cash		6,000
	Derivative		6,000
AOCI		6,000
	COGS		6,000

However, since the derivative is hedging an expected inventory acquisition, it would be logical to recognize it as cost of goods sold, similarly to how the expense is recognized example 31 (which illustrates how to apply ASC 815-20-25-83A).

2/28/X1
Derivative		8,922
COGS		5,078
	OCI		14,000

3/31/X1
OCI		14,000
	Derivative		11,548
	OCI		2,452
AOCI		6,624
	OCI		6,624
Etc.

Same facts except the hedged item was a firm commitment in a fair value hedge.

1/1/X1
Derivative		24,472
	Cash		24,472

1/31/X1
Derivative		4,002
	Gain		4,002
Loss		4,002
	Firm commitment		4,002
COGS		2,039
	Derivative		2,039

Obviously, amortizing the derivative through COGS leads to a mismatch of revenue and expenses. To avoid this mismatch, the derivative could be amortized to inventory.

Unfortunately, ASC 815-20-25-83A explicitly states "the initial value of the component excluded from the assessment of effectiveness shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument."

This mismatch makes hedging with options an unattractive policy choice for most entities.

2,039 = 24,472 ÷ 12

2/28/X1
Derivative		8,922
	Gain		8,922
Derivative		8,922
	Firm commitment		8,922
COGS		2,039
	Derivative		2,039

3/31/X1
Loss		11,548
	Derivative		11,548
Firm commitment		11,548
	Gain		11,548
COGS		2,039
	Derivative		2,039
Etc.

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