Accounting Standards ASC 815 Overview

ASC 815 (Derivatives and Hedging) establishes accounting and reporting standards for derivative instruments and hedging activities. All derivatives must be recognized on the balance sheet at fair value, with changes in fair value generally recognized in earnings unless specific hedge accounting criteria are met.

Definition and Key Concepts

Derivative Definition

Under ASC 815, a derivative has these characteristics:

Characteristic	Description
Underlying	Value changes based on reference rate, price, index
Notional amount	Specified quantity (units, shares, dollars)
No initial net investment	Or smaller than for similar instruments
Net settlement	Can be settled net in cash or equivalent

Derivative Classification

Category	Balance Sheet	Earnings Impact
Trading	Fair value, current asset/liability	Changes in earnings
Hedging (fair value)	Fair value	Offset hedged item
Hedging (cash flow)	Fair value	Through OCI to earnings
Hedging (net investment)	Fair value	Through CTA

Hedge Types

Hedge Type	Purpose	Example
Fair value hedge	Offset exposure to changes in FV	Fixed-rate debt hedged with IRS
Cash flow hedge	Offset exposure to variable cash flows	Forecasted purchase hedged with forward
Net investment hedge	Offset FX exposure in foreign sub	Forward contract on subsidiary currency

How It Works in Practice

Fair Value Measurement

All derivatives at fair value:

Level	Input Type	Example
Level 1	Quoted prices, active markets	Exchange-traded options
Level 2	Observable inputs	Interest rate swaps (curve-based)
Level 3	Unobservable inputs	Complex structured products

Fair value hierarchy considerations:

Factor	Impact on Level
Market liquidity	Higher liquidity → Level 1/2
Model complexity	More complex → Level 3
Input observability	Less observable → Level 3
Credit adjustment	CVA/DVA may push to Level 3

Hedge Accounting Requirements

Documentation requirements (at inception):

Requirement	Description
Hedging relationship	Identify hedged item and hedging instrument
Risk being hedged	Specify the risk (interest rate, FX, commodity)
Effectiveness method	How effectiveness will be assessed
Hedge objective	Risk management objective and strategy
Excluded components	Time value, forward points, etc.

Effectiveness assessment:

Method	Description	Application
Dollar-offset	Compare changes in FV	Fair value hedges
Regression	Statistical relationship	Complex hedges
Critical terms match	Terms substantially identical	Simplified approach
Shortcut method	Perfect offset assumed	IRS hedging fixed debt

Journal Entries

Fair value hedge (simplified):

Account	Debit	Credit
Derivative asset	$100,000
Hedged item (debt adjustment)		$100,000
Hedged item (debt adjustment)	$95,000
Derivative asset		$95,000
P&L (ineffectiveness)	$5,000

Cash flow hedge (simplified):

Account	Debit	Credit
Derivative asset	$100,000
OCI		$100,000
OCI (reclassification)	$100,000
Revenue/Expense		$100,000

Worked Example

Interest Rate Swap Hedge Accounting

Scenario: Company issues $50M fixed-rate debt at 5.00% for 5 years and enters into pay-fixed, receive-floating swap to convert to floating rate.

Hedge documentation:

Element	Description
Hedged item	$50M fixed-rate debt, 5.00%, 5-year
Hedging instrument	$50M pay-fixed 5.00%, receive SOFR IRS
Risk hedged	Changes in fair value due to interest rates
Effectiveness method	Shortcut method (terms match)
Hedge designation	Fair value hedge

Initial recognition:

Date	Event	Journal Entry
Jan 1, 2025	Issue debt	Dr. Cash $50M, Cr. Debt $50M
Jan 1, 2025	Enter swap	No entry (fair value = 0)

Subsequent measurement (rates decline):

Date	Swap FV	Debt FV Change
Mar 31, 2025	($1,200,000)	$1,200,000
Jun 30, 2025	($800,000)	$800,000

Q1 journal entries:

Account	Debit	Credit
Loss on derivative	$1,200,000
Derivative liability		$1,200,000
Debt (FV adjustment)	$1,200,000
Gain on hedged item		$1,200,000

Net P&L impact: $0 (fully offset under shortcut method)

Balance sheet presentation:

Line Item	Amount
Debt (carrying value)	$51,200,000
Derivative liability	($1,200,000)
Net debt exposure	$50,000,000

Cash Flow Hedge Example

Scenario: Company forecasts purchasing EUR 10M of inventory in 6 months and enters forward to hedge FX risk.

Element	Description
Hedged item	Forecasted EUR 10M purchase
Hedging instrument	Forward to buy EUR 10M at 1.10
Risk hedged	Variability in USD cash flows
Effectiveness method	Critical terms match
Hedge designation	Cash flow hedge

Forward value changes:

Date	Forward FV	OCI Entry
Mar 31	$150,000	$150,000 credit
Jun 30	$200,000	$50,000 credit

At purchase (EUR strengthened):

Account	Debit	Credit
Inventory	$11,000,000
Cash		$11,000,000
OCI	$200,000
Inventory		$200,000

Net inventory cost: $10,800,000 (effective rate: 1.08)

Risks, Limitations, and Tradeoffs

Hedge Accounting Risks

Risk	Description	Consequence
De-designation	Hedge no longer qualifies	Earnings volatility
Ineffectiveness	Imperfect offset	P&L impact
Documentation failure	Incomplete at inception	Cannot apply hedge accounting
Forecasted transaction	Does not occur	OCI reclassified to earnings

Common Pitfalls

Pitfall	Description	Prevention
Late documentation	Hedge docs after trade	Concurrent documentation
Terms mismatch	Hedge and item don't match	Careful structuring
Over-hedging	Notional exceeds exposure	Match to forecasted amount
Probability assessment	Forecasted transaction uncertain	Document probability
Shortcut method abuse	Apply when terms don't match	Verify all criteria

Disclosure Requirements

Disclosure	Content
Objectives	Risk management strategy
Instruments	Types of derivatives used
Fair value	Carrying amounts by type
Gains/losses	By hedge type and ineffective portion
Credit risk	Maximum exposure, collateral
Concentrations	Significant counterparties

Recent Standards Updates

ASU 2017-12 Improvements

Change	Impact
Effectiveness threshold	Eliminated 80-125% requirement
Excluded components	Can recognize in OCI
Partial-term hedges	Allowed for fair value hedges
Last-of-layer method	Prepayable instruments

ASU 2020-04 Reference Rate Reform

Provision	Description
Contract modifications	Relief from derecognition
Hedge accounting	Expedients for IBOR transition
Held-to-maturity	No tainting from modifications

Checklist and Next Steps

Hedge documentation checklist:

Identify hedged item precisely
Identify hedging instrument
Specify risk being hedged
Document effectiveness method
State risk management objective
Address excluded components
Complete at or before designation

Ongoing monitoring checklist:

Assess effectiveness each period
Calculate and record ineffectiveness
Verify hedge still qualifies
Update forecasted transaction probability
Document any de-designations
Prepare required disclosures

Financial statement checklist:

Classify derivatives correctly
Measure at fair value
Record hedge adjustments
Track OCI for cash flow hedges
Disclose per ASC 815 requirements
Reconcile to risk management reports

Internal control checklist:

Related articles:

For model controls, see Model Governance and Controls Requirements
For operational risk, see Operational Risk in High-Volume Options Trading

Accounting Standards ASC 815 Overview

Accounting Standards ASC 815 Overview

Definition and Key Concepts

Derivative Definition

Derivative Classification

Hedge Types

How It Works in Practice

Fair Value Measurement

Hedge Accounting Requirements

Journal Entries

Worked Example

Interest Rate Swap Hedge Accounting

Cash Flow Hedge Example

Risks, Limitations, and Tradeoffs

Hedge Accounting Risks

Common Pitfalls

Disclosure Requirements

Recent Standards Updates

ASU 2017-12 Improvements

ASU 2020-04 Reference Rate Reform

Checklist and Next Steps

Related Articles

Training Programs for Derivative Users

Third-Party Vendor Management

Swap Execution Facilities and Designated Contract Markets