Financial assets

Cash and cash equivalents

Cash is simple to summarize:

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

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

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

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

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

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

To maximize returns, companies typically invest excess cash. When cash is expected to be needed soon, firms allocate it to highly liquid, short-term investments. If these have a maturity of three months or less, they are classified as cash equivalents. Otherwise, they are classified as investments, either short or long-term investments depending their maturity and/or management intent.

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

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

IFRS does not specify how to interpret "say."

In practice, it is commonly interpreted as two to three business days, but never exceeding five.

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

Interestingly, ASC refers to 'original maturity' without defining it, an apparent role reversal compared to IFRS which does not use the term but rather states "from the date of acquisition," which is the definition of original maturity.

Note: many investments that qualify as cash equivalents pay interest. However, their three-months-or-less term invariably makes any potential difference between their present and future values so insignificant that it is not given accounting recognition making amortized cost accounting generally unnecessary.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

However, a careful read of the paragraph reveals that it actually states (emphasis added) "Examples include cash and cash equivalent balances held by a subsidiary that operates in a country where exchange controls or other legal restrictions... This implies restrictions beyond legal may also require disclosure.

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

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

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

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

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

Restricted cash is usually associated with:

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

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

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

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

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

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

Since this distinction is important for financial statement users, material restrictions of a discretionary nature should be reported separately in a way that clearly reflects their nature.

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

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

The accounting for cash is even simpler to summarize.

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

Cash is easy to recognize and even easier to measure, so IFRS | US GAAP focus on the other side of the transaction.

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

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

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

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

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

This is because IFRS 15 | ASC 606 had already been applied when the receivable was initially recognized.

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

If an entity receives cash as a result of borrowing, it applies IFRS 9 | ASC 405, 470, 480, 835, etc. to the credit side.

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

Technically, since both are cash, the guidance applies to both sides, though more so to the debit side.

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

Illustrative examples

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Financial assets other than cash

Investments

Overall

Investments come in two basic forms:

Investments are either debt or equity. There is no middle ground. True, some instruments, such as bonds convertible into shares, may seem like a blend, but a convertible bond is just a plain vanilla bond with a derivative (the conversion option) stuck on.

Like a butterfly, it starts off as debt then, if the conditions are right, it metamorphoses into equity, takes wing and flies into blue and sunny skies.

Or at least that is the way it could be described if one were trying to be poetical.

Stripped of such flourishes, these types of investments are generally labeled hybrid.

Then, if one keeps adding features, they cross into the realm of exotic (below).

Debt

On initial examination, it may seem counterintuitive to call debt an investment. Debts are usually liabilities, not assets.

Nevertheless, a "debt investment" represents a creditor's claim to specified economic resources, most often cash, of a debtor. Thus, from the perspective of the creditor, a.k.a. debt investor, it is an asset even though, from the perspective of the debtor, it is a liability.

Debt investments may take various forms. The most common are financial instruments, e.g. bonds or promissory notes, and loan agreements.

Regardless of form, the salient characteristic of debt investments is that debt investors have priority over equity investors (below) in the event of bankruptcy.

Note: while loans have the same general economic characteristics as debt securities, notes and bonds, the accounting treatment differs sufficiently enough to warrant a separate sub-section.

Equity

Like debt investments (above), equity investments represent a claim to economic resources. Unlike debt investments, this claim is not to specified, pre-defined resources, but rather the resources that remain after the claims of creditors have been settled.

Equity investments most often take the form of shares of stock. However, they may also be a stake in limited liability company or share in a partnership.

Regardless of form, the salient characteristics of equity investments is their holders lack a claim to specific economic resources, and their claims are fulfilled only after debt investors have been satisfied.

While various classes of shares can exist, few have a palpable effect on the investor's accounting. One (minor) exception: puttable preferred (priority) shares. While the effect is not nearly as dramatic as on the issuer, which has to report them as liabilities, investors holding puttable preferred shares may need to bifurcate the investment, stripping out the put option and accounting for it as an embedded derivative (below).

ASC 480-10-25-4 states: A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity.

While not as succinct, IAS 32.16–20 (including recently added 16A–F) provide comparable guidance.

Once acquired, investment are:

Remeasured

These investments are initially measured at historical cost.

If an investment is acquired in a market transaction, common practice is to simply record the amount paid, its "historical cost," and move on. This practice generally yeilds an acceptable result.

Historically, the initial cost of assets, including investments, has been determined on the basis of arm's-length transactions. Over time, the guidance has evolved. Currently, the reference point is the orderly transaction between market participants discussed in IFRS 13 | ASC 820.

While the primary guidance for value is IFRS 13 | ASC 820, arm's-length transactions have not ceased to exist. For example, IAS 36 continues to mention market transactions, arm's-length transactions and orderly transactions. In the ASC, ASC 835-30-05-2 mentions both business transactions and bargained transactions entered into at arm's length. ASC 350-30-25-4 also mentions bargained exchange transactions that are conducted at arm's length, which provide reliable evidence about the existence and fair value of [in this case intangible] assets.

ASC 820-10-35-2A summarizes the key considerations for establishing fair value:

The asset or liability
The transaction
Market participants
The price
Application to nonfinancial assets
Application to liabilities and instruments classified in a reporting entity's shareholders' equity
Application to financial assets, financial liabilities, and nonfinancial items accounted for as derivatives under

While IFRS 9 fails to provide a similar summary, IFRS 9.15 to 56 do provide comparable guidance.

Generally, but not always. For example, IFRS 9.5.1.1 specifies that a financial asset or financial liability is initially measured at fair value plus or minus transaction costs unless that asset is carried at FVTPL in which case they would be expensed.

Unlike IFRS 9, US GAAP does not contain explicit guidance comparable to paragraph 5.1.1 regarding the treatment of transaction costs but relies on general accounting principles and practices to arrive at the same conclusion.

Nevertheless, the point is, when a financial instrument is acquired in an arm's-length transaction, its value is typically equal to the amount paid and would be recorded without adjustment. If it the instrument pays interest, the implied interest rate would be considered reasonable. However, if the instrument were not acquired in an arm's-length transaction, both its value and the any interest rate would need to be confirmed and, if they differed from fair value, adjusted.

If it was not acquired in such a transaction, its fair value is determined and it is initially measured at fair value.

Subsequently, they are remeasured to fair value at each balance sheet date.

Fair value is discussed in more detail on this page. However, the optimal way to determine fair value is on an active market.

IFRS | US GAAP defines active market: a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis (a list of active markets is included in the first equity illustration below).

If an active market does not exist, accountants face more challenges. These are discussed throughout the page as they relate to particular issues.

The changes in fair value are recognized and reported as gains or losses.

Depending on whether the investment is debt or equity and on whether IFRS or US GAAP is being applied, these gains and losses are reported in either profit and loss (IFRS) or net income (US GAAP), or other comprehensive income (common to both).

The former are accumulated in retained earnings, the latter in a separate subsection of equity (the exact classification depends on whether IFRS or US GAAP disclosure guidance is being applied).

Note: under IFRS, the gains and losses that pass through OCI may or may not be recycled to P&L, depending on the nature of the underlying item.

IFRS versus US GAAP.

While similar, IFRS and US GAAP are not identical. Some differences are minor others major.

For example, while IFRS classifies financial assets as fair value through profit and loss (FVTPL), fair value through other comprehensive income (FVOCI) and amortized cost (AC). US GAAP classifies financial assets as trading, available-for-sale (AFS) and held-to-maturity (HTM). However, as investments classified as trading are remeasured to fair value and reported in net income, AFS at fair value through other comprehensive income and HTM at amortized cost, this difference is mostly semantic.

Previously to IFRS 9, IAS 38 used classification very similar to current ASC 320-10-25-1 namely (IAS 39(2008).45 edited):

financial assets at fair value through profit or loss
held-to-maturity investments
loans and receivables
available-for-sale financial assets

IFRS 9, however, eliminated the held-to-maturity / loans and receivables categories replacing them with amortized cost and the available-for-sale classification replacing it with fair value through other comprehensive income.

While it retained the old approach for debt instruments (FVOCI gains and losses are recycled to P&L like they were when they were AFS), it eliminated recycling for equity investments, though it did retain the (irrevocable) option to classify these investments as FVOCI.

For its part, US GAAP took a somewhat more drastic approach by eliminating the AFS option for equity investments altogether.

So, FVOCI and AFS can still be considered synonyms, but only in the context of debt investments.

For example, IFRS requires all equity investments to be remeasured to fair value and offers the (irrevocable) option to classify then as FVOCI. US GAAP no longer offers an AFS option for equity investments but does allow them to be carried at cost less impairment (except by investment companies).

More broadly, IFRS tends to emphasize the economics of transactions, whereas ASC focuses more on explicit contractual terms.

This difference is subtle but pervasive. For example, comparing the IFRS | US GAAP definition of an effective interest rate one notices that the latter starts with the contractual interest rate while the former with estimated future cash payments or receipts. Digging deeper, one also notices that the former even finds contractual terms somewhat distasteful by specifying that contractual cash flows can be used but only in those rare cases when it is not possible to reliably estimate the cash flows or the expected life.

Emphasis added: The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability. When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate (see paragraphs B5.4.1–B5.4.3), transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).

Emphasis added: The rate of return implicit in the financial asset, that is, the contractual interest rate adjusted for any net deferred fees or costs, premium, or discount existing at the origination or acquisition of the financial asset. For purchased financial assets with credit deterioration, however, to decouple interest income from credit loss recognition, the premium or discount at acquisition excludes the discount embedded in the purchase price that is attributable to the acquirer's assessment of credit losses at the date of acquisition.

To some extent, US GAAP's preference for contractual terms is anderstandable given the SEC's predilection for legal form, a common characteristic of most governmental agencies, and its close working relationship with the FASB.

Evidenced by, for example, the FASB's decision to include the SEC's guidance in the ASC, which some go as far as calling kowtowing.

Another difference often mentioned as major is IFRS 9.4.2A (particularly the business model test in subparagraph a) versus ASC 320-10-25-1 (particularly subparagraphs a and b), which some interpret to mean US GAAP allows entities to use AFS (above) willy nilly.

ASC 320-10-25-1 (edited, emphasis added) states: At acquisition, an entity shall classify debt securities into one of the following three categories:

Trading securities. If a security is acquired with the intent of selling it within hours or days, the security shall be classified as trading. However, at acquisition an entity is not precluded from classifying as trading a security it plans to hold for a longer period. Classification of a security as trading shall not be precluded simply because the entity does not intend to sell it in the near term.
Available-for-sale securities. Investments in debt securities not classified as trading securities or as held-to-maturity securities shall be classified as available-for-sale securities.

Some interpret this wording to suggest that unless the company is a day trader, it can classify all its investments as AFS.

And, in the past, before AFS was restricted to just debt securities, this may have been true. However, given that current US GAAP does not allow equity investments to be classified as AFS, its guidance is objectively stricter than IFRS, at least as far as equity investments go.

Further details and additional differences are explored throughout this section.

Not remeasured

As above, these investments are initially measured at historical cost.

If an investment is acquired in a market transaction, common practice is to simply record the amount paid, its "historical cost," and move on. This practice generally yeilds an acceptable result.

ASC 820-10-35-2A summarizes the key considerations for establishing fair value:

The asset or liability
The transaction
Market participants
The price
Application to nonfinancial assets
Application to liabilities and instruments classified in a reporting entity's shareholders' equity
Application to financial assets, financial liabilities, and nonfinancial items accounted for as derivatives under

While IFRS 9 fails to provide a similar summary, IFRS 9.15 to 56 do provide comparable guidance.

Nevertheless, the point is, if for example debt instrument is acquired in an arm's-length transaction its value would typically equal the transaction price and would be recorded without adjustment. Similarly, the implied interest rate would be a priori reasonable. However, if it were not acquired in an arm's-length transaction both its value and the interest rate would need to be confirmed and, if they differed from fair value, adjusted.

A similar approach applies to evaluating equity investments, though in this case, interest rate considerations are not relevant.

If it was not acquired in such a transaction, its fair value is determined and it is initially measured at fair value.

Unlike above, these investments are not subsequently remeasured, but accounted for at amortized cost.

Amortized cost accounting begins by assuming that the historical cost of an investment equals the present value of cash flows associated with the investment.

If the interest rate implied by this present value is reasonable, the investment is recognized at its nominal value. Subsequently, any interest received is recorded as interest revenue without adjustment.

However, if the implicit rate is not reasonable, the investment is recognized at its present value determined using an imputed interest rate. The difference between this present value and the investment's nominal value (discount, premium or deferred interest) is then amortized using the effective interest method. This amortization adjusts the amount of interest revenue recognized.

In the ASC, the imputation of imputed interest is so important that it deserves its own sub-topic: ASC 835-30.

While it would have been nice if IFRS had followed suit, unfortunately, it does not discuss "imputation" or even address the issue in the core standard. So, instead of a nice, memorable term such as "imputed interest" to describe situations where an entity determines that the fair value at initial recognition differs from the transaction price (with reference to IFRS 9's B section). Fortunately, once there IFRS 9.B5.1.2A provides guidance that leads to the same result as ASC 835-30.

Determining and using an imputed rate not only fulfills the specific guidance outlined in ASC 835-30 | IFRS 9.B5.1.2A, but also the general fair value guidance discussed above.

IFRS versus US GAAP

While similar, IFRS and US GAAP are not identical. Some differences are major, others minor.

Perhaps the most obvious difference is how the two standards treat equity investments.

Under IFRS 9, all equity investments are remeasured to fair value, but may be reported either FVPL or FVOCI (although the FVOCI election is irrevocable).

Under ASC 321, equity investments are remeasured to fair value with no option to report remeasurement gains and losses in OCI. However entities may elect to measure equity investments without readily determinable fair values at cost less impairment. In addition, entities that do remeasure to fair value have the option (ASC 820-10-35-59) to apply a simplified net asset value per share approach, which IFRS does not offer.

Note: this difference mostly disappears at investment companies that apply ASC 946, because this topic requires fair value. However, the ASC 820-10-35-59 option is available to all entities.

More broadly, IFRS tends towards the economics of transactions, while the ASC prefers to focus on explicit contractual terms.

US GAAP's preference for contractual terms is further reinforced by the SEC's predilection for legal form, a common characteristic of most governmental agencies, and its close working relationship with the FASB.

Evidenced by, for example, the FASB's decision to include the SEC's guidance in the ASC, which some go as far as calling kowtowing.

Some may consider the IFRS versus US GAAP approach to impairment a major difference. Specifically, IFRS uses a so-called two bucket approach, while US GAAP prefers to dance with CECL.

Somewhat confusingly, the "two bucket" approach actually comprises three stages.

In the first bucket, stage one impairments on assets with normal credit risk (12-month expected credit losses) are recognized.

In the second bucket, stage two impairments (assets with significant credit risk increase, lifetime expected credit losses) and stage three impairments (credit-impaired assets—lifetime expected credit losses, along with interest income calculated on the net basis) are recognized.

The current expected credit loss model requires entities to estimate lifetime expected credit losses for most financial assets right from initial recognition, regardless of changes in credit risk

While some argue that US GAAP’s single-stage approach is more conservative, given its immediate recognition of lifetime expected credit losses, its overall impact compared to IFRS’s three-stage model is often marginal. Some argue that US GAAP’s single-stage approach is more conservative due to its immediate recognition of lifetime expected credit losses. However, its overall impact compared to IFRS’s three-stage model is often marginal.

Further details and additional differences are explored throughout this section.

Illustrative examples

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Derivatives

Overall

Derivatives are not difficult to summarize:

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

Most derivatives trade on exchanges and so resemble securities.

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

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

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

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

Note: IFRS does not define the term security.

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

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

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

Imposes on one entity a contractual obligation either:

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

Conveys to that second entity a contractual right either:

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

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

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

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

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

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

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

its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).
it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
it is settled at a future date.

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

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

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

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

Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
Net settlement. The contract can be settled net by any of the following means:

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

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

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

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

Nevertheless, since both IFRS 9 and ASC 815 require a zero or small net investment, arguably the most important distinguishing feature of a derivative, the impact of other differences, while not negligible, remains marginal in day-to-day practice.

Most forwards (including swaps) and some options (e.g. 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 clearly and 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 (e.g. 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, embedded derivatives certainly have legitimate applications, for example, a straightforward conversion option attached to a bond serves a clear purpose. However, their presence in contracts is often anything but straightforward. Rather than existing to facilitate transparency, they are frequently included as a tool to gratuitously obfuscate the actual economic reality, distorting the visibility of market risks in a way that is anything but accidental. This intentional complication not only makes it harder for financial statement users to assess a contract's true nature, but also turns the process of identifying and bifurcating them into a formidable challenge for accountants and auditors alike. These professionals must comb through layers of contractual language, dissect financial instruments, and apply complex accounting standards just to unveil what should have been apparent from the outset.

However, once identified, the accounting itself 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 locations (e.g. 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).

More succinctly, 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 as securities. As such, these "plain vanilla" derivatives are easy to recognize and simple to measure. All one needs to do is find their symbol and record the corresponding closing price.

Although commonly referred to 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 subsequently be measured at fair value.

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

To ensure 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 (FVOCI) 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 FVOCI 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, IFRS 9.5.2.1.c requires that, once classified as FVTPL under the above guidance, it be subsequently 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 challenging.

When the underlying is something more "exotic," such as a condition (e.g. temperature or rainfall) or event (e.g. 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 (aside from its 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 structured as a contract between only two parties, where the sole barrier to convoluted phraseology designed to befuddle, confuse, and obfuscate is sheer imaginativeness, deciphering the deliberate obscurantism can prove challenging, although both IFRS and US GAAP do give it the old college try.

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

its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).
it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
it is settled at a future date.

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

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

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

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

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

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

Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
Net settlement. The contract can be settled net by any of the following means:

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

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

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

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

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

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

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

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 (i.e. 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.)

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 challenging 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.

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 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.

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 (FVOCI) 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.

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.

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 obfuscate 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 end 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 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 can also be more difficult to pin down.

Forwards only involve two parties, e.g. 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, e.g. 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 interesting, 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 bipolar opposite).

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% certainty, 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 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 creditors, 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, having emerged from a merger between Houston Natural Gas and InterNorth, it was never trusted by anyone of consequence and thus 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 careless use of derivatives can pose, regulators pay extra special attention to that subset, not only to ensure compliance with accounting guidance but also to prevent managers from 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 rather lacked adequate information due to accountants working with insufficient guidance. Given that most managers are taught about derivatives in MBA programs, and can design their own managerial accounting if they need additional information, this argument has always seemed dubious, though perhaps plausible. Not anymore. Given the scope and detail of today's IFRS, and especially US GAAP, ignorance is no longer a valid excuse.

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 no easy, bedtime reading either.

Companies may also choose to continue applying IAS 39, an option that will remain until the IASB finalizes its macro hedging project.

Also worth noting, IFRS and US GAAP remain far from converged, making a dual filer’s job significantly 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 (e.g. 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 begin as assets remain assets (just as options that begin 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 of 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 options used for speculation 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 (FVOCI) 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 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 obfuscate 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 make covering every detail 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.

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 takes over, providing 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) and 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 15 on a share with a fair value of 20 has an intrinsic value of 5.

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 the most commonly used 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 (e.g., in Excel 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 difficult, 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 increases.

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, everyone would 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 led 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 the 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 overly 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 knows 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. Then, 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 acquireing (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 natural gas, ASC 815-25-55-1 to 7 provides a more thorough discussion of the various factors that affect effectiveness.

Fortunately, neither IFRS nor US GAAP requires 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 assesses 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 basic 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 experience, no one cares about net investment hedging.

The main reason I hear, consolidation forex differences end up OCI just like cash flow hedges. So, even though the hedge would slightly rearrange OCI, financial statement users would not 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 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. They are also often entered into without any premium being paid or received, so they 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 example 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 sense, hedging the cash that will need to be expended to acquire the raw material. The further into the 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 (e.g. link, link) or pages like this 500 page roadmap (link) or 300 page guide (link, local link), which make one think one is better off 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.

Illustrative examples

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