Derivatives & Hedge Accounting

Derivative = all three

Underlying + notional · little or no initial investment · net settlement.

Measurement

Fair value on the balance sheet; changes to net income unless hedge accounting applies.

Hedge models

Type	Hedges	Derivative gain or loss
Fair value	Recognized items, firm commitments, fixed-rate items	Net income (with hedged item's change)
Cash flow	Forecasted transactions, variable-rate items	Other comprehensive income (OCI), then reclassified
Net investment	Foreign operation	OCI (translation adjustment)

Qualifying

• Documentation at inception; highly effective (≈ 80–125%); forecasted transactions probable.
• Ineffectiveness not separately measured; same income statement line as the hedged item.
• Forecasted transaction no longer probable → reclassify OCI to earnings now.

Other

Normal purchases and sales exception. Embedded derivatives: bifurcate if not clearly and closely related.

Exam traps

• Hedge accounting is optional and needs documentation at inception — it can't be applied retroactively.
• The notional amount isn't recorded; only the derivative's fair value is on the balance sheet.
• Cash flow hedge gains and losses leave OCI when the hedged item affects earnings — for example, when the hedged inventory purchase is sold.