Accounting For Derivatives

The derivative gain or loss is reported in other comprehensive income or in current earnings, as necessary, to adjust the balance in other comprehensive income to an amount that equals the lesser of a) the cumulative gain or loss on the derivative or b) the cumulative change in expected future cash flows on the hedged transaction. The result is that the excess cumulative gain or loss on the derivative is considered ineffective and recognized in earnings. The accumulated gains and losses are recognized in earnings in the same period(s) as the hedged asset, liability, or forecasted transaction affects earnings.

An interest rate swap could be entered into to hedge the cash flow associated with a recognized asset. A company holding variable-rate investments would have varied cash inflows as the market rate changes. To hedge these future cash inflows, the company could enter into an interest rate swap to receive a fixed flow of income and pay a variable rate of interest that would effectively convert the variable-rate investments to fixed-rate investments. The future cash inflows related to these investments would then be constant, and the swap would result in an effective cash flow hedge.