by Lisa Wallace
Accounting for derivatives is a complex task with volumes of guidance outlining a myriad of detailed rules and exceptions. However, if you can affirmatively answer the following three questions, you should feel comfortable that your financial statements are materially correct.
- Have all derivatives been identified?
- Are all derivatives recorded on the balance sheet at the appropriate fair market value?
- Have the appropriate amounts been stored in OCI?
Have all derivatives been identified?
Appropriate controls around trading, including segregation of duties related to confirmation and reconciliation, facilitate this process. Additionally, “derivatives” executed outside of treasury must be considered, namely features that might exist in purchasing or other contracts that meet the definition of a derivative. A process to identify such contracts must be in place and consistently followed.
Are all derivatives recorded at the appropriate fair market value?
Once all derivatives are identified they need to be recorded at fair market value based on the appropriate market inputs. Counterparties can be a source for inputs and comparisons, but not for valuations. Valuations should be calculated internally. When calculated by a third party the company should understand the inputs to the valuations. Credit is another consideration, including the company’s own credit as it impacts liabilities.
Have the appropriate amounts been stored in OCI?
Identifying amounts to be stored in OCI is really the heart of hedge accounting; without special hedge accounting all changes in derivative value would be recorded immediately in the income statement. All amounts deferred in OCI must be related to contracts that have met the documentation requirements, including effectiveness testing. Measurement of effectiveness, which directly impacts the OCI balance, has also become an area of increased focus from auditors. Finally, the probability that the underlying anticipated transactions will occur must be assessed and supported.