Derivatives and Hedge Accounting Under US GAAP
By SimplyCPA · 11 October 2026
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- Definition: A derivative has an underlying and a notional amount, needs little or no initial net investment, and can be net settled.
- Measurement: Every derivative is recognised on the balance sheet at fair value.
- No hedge accounting: Fair value changes go straight to earnings.
- Fair value hedge: Changes in the derivative and in the hedged item (for the hedged risk) both go to earnings, so they offset. Cash flow hedge: The derivative's change goes to OCI and is reclassified to earnings when the hedged transaction affects earnings.
- Qualifying: Formal documentation at inception and a highly effective relationship are required; the hedge results are presented in the same income statement line as the hedged item.
What is a derivative?
Under ASC 815, a financial instrument or other contract is a derivative if it has all three characteristics:
- An underlying and a notional amount (or payment provision) — for example, an interest rate applied to $1 million, or a currency rate applied to €500,000.
- No or a small initial net investment compared with other contracts with similar responses to market changes.
- Net settlement — the contract can be settled net, through a market mechanism, or by delivering an asset readily convertible to cash.
Common examples: forwards, futures, swaps and options. Scope exceptions include "normal purchases and normal sales" contracts for physical delivery used in the ordinary course of business.
Basic measurement
All derivatives are recognised as assets or liabilities at fair value. Without hedge accounting, changes in fair value go to earnings every period — which creates volatility if the derivative was bought to offset a risk elsewhere. Hedge accounting fixes that mismatch.
The three hedge types
| Hedge | What's hedged | Derivative's fair value change goes to |
|---|---|---|
| Fair value hedge | Exposure to changes in the fair value of a recognised asset or liability, or a firm commitment (e.g. fixed-rate debt) | Earnings — and the hedged item is adjusted for the hedged risk through earnings, so the two offset |
| Cash flow hedge | Variability in cash flows of a forecasted transaction or a variable-rate asset or liability | OCI, then reclassified to earnings when the hedged transaction affects earnings |
| Net investment hedge | Foreign currency exposure of a net investment in a foreign operation | OCI (cumulative translation adjustment) |
Qualifying for hedge accounting
- Formal documentation at inception: the hedging relationship, the risk management objective, the hedging instrument, the hedged item, and how effectiveness will be assessed.
- Highly effective: the relationship must be expected to be highly effective in offsetting the hedged risk, assessed at inception and on an ongoing basis. Since ASU 2017-12, the whole change in the fair value of a highly effective cash flow hedge goes to OCI — "ineffectiveness" is no longer measured separately.
- Results are presented in the same income statement line as the hedged item's earnings effect.
Example: cash flow hedge of a forecasted purchase
On October 1, a US company expects to buy inventory for €1,000,000 in March and enters a forward contract to buy euros at $1.10. At December 31 the forward's fair value has risen to $30,000.
December 31: Dr Forward contract (asset) 30,000; Cr OCI 30,000.
In March, the forward settles and the inventory is purchased; the accumulated OCI stays in equity until the inventory is sold.
When the inventory is sold: the gain is reclassified from OCI to cost of goods sold, offsetting the higher euro cost.
Embedded derivatives
A derivative feature inside a host contract (for example, an equity-indexed return in a debt instrument) is separated and accounted for as a derivative only if: it isn't clearly and closely related to the host; the hybrid isn't already measured at fair value through earnings; and a separate instrument with the same terms would be a derivative.
Disclosure
Entities disclose the objectives and strategies for using derivatives, the volume of activity, fair values by instrument type, and the gains and losses by hedge type and income statement line.
Derivatives and hedging are tested mainly in the BAR Discipline, with basic recognition in FAR. See also FAR investments.