top of page

The Basics of ASC 815: An Explanation of Scope and Core Components

Minneapolis, MN | January 2, 2025 | By: John Trefethen, Director and Co-Founder


Global with currency icons. Text that says, "5 Best Practices to Avoid Errors in Foreign Currency Transactions"

Hedging activities and derivative instruments are core pillars of many risk management strategies. For accounting and treasury teams using hedging and derivatives, a solid understanding of Accounting Standards Codification Topic 815, Derivatives and Hedging (“ASC 815”) is critical.


ASC 815 impacts financial reporting and introduces complex requirements that organizations must navigate effectively. It is critical for corporate accountants and treasury teams to understand how ASC 815 affects their operations to ensure compliance and transparent financial reporting.

 

This article provides an overview of the hedge accounting guidance under ASC 815 so you can walk away with a basic understanding of the standard, including:

 

·      What is ASC 815?

·      The Core Components of ASC 815

·      Challenges in Applying ASC 815

·      The Benefits of Compliance


What is ASC 815?


ASC 815, issued by the Financial Accounting Standards Board (FASB), addresses the accounting standards for Derivatives and Hedging. It outlines the criteria for what meets the definition of a derivative instrument, hedge accounting treatment and provides guidance on recognizing, measuring, and disclosing derivatives and hedging activities in financial statements.

 

The primary objective of ASC 815 is to ensure that organizations properly account for these complex financial instruments, promoting transparency and consistency. By doing so, it helps stakeholders make better-informed decisions based on reliable and transparent financial information.


The Core Components of ASC 815


Three core components form the foundation of ASC 815, guiding how organizations should account for hedging and risk management activities in their financial statements. Let’s explore each of them in more detail.


Component 1: Derivative Instruments

 

Derivative instruments are financial contracts whose value is derived from one or more underlying assets, indices, currencies, or interest rates.  Because derivatives can subject entities to financial gains or losses, it is critical that companies have a process of identifying, communicating, and disclosing derivative activities in their financial statements.  Further, changes in the market value of derivatives are required to be recorded in earnings, which can distort the financial performance of the company’s operations.

 

Common examples of derivatives used for hedging include:

 

  • Forward contracts: Over-the-counter (OTC) agreements between a hedging company and a counterparty to exchange two currencies on a specified future date.

  • Futures contracts: Similar to forward contracts but traded on exchanges in standardized terms rather than negotiated directly with the counterparty.

  • Swaps: Contracts that enable two parties to exchange cash flows or obligations in one currency for those in another currency.

  • Options: Contracts that grant the buyer the right—but not the obligation—to exchange an asset at a specified rate on a specified date or within a specified timeframe.


Component 2: Hedging Relationships

 

Hedging relationships refer to the connection between a “hedged item” and a “hedging instrument” used to mitigate fluctuations in the price of the hedged item. Under ASC 815, there are three primary types of hedging relationships that qualify for hedge accounting treatment: fair value, cash flow, and net investment.

 

  • Fair Value Hedges: Hedges the risk of changes in the fair value of an asset, liability, or firm commitment by offsetting potential hedged item losses with gains from the hedge.

  • Cash Flow Hedges: Hedges the variability in future cash flows by securing the value of a future cash flow at a predetermined amount.

  • Net Investment Hedges: Hedges an organization’s net investment in a foreign operation against currency translation risk.


Component 3: Accounting Treatment

 

ASC 815 outlines how derivatives and hedging activities impact financial reporting and specifies the journal entries process for highly effective hedges and for derivatives not designated as hedges. In general, the process includes the following steps:

 

  • Measurement: Derivatives are recorded on the balance sheet at their fair value.

  • Recognition: Absent hedge accounting application, changes in fair value of the derivative are recognized in the income statement.

  • Hedge Accounting: If the derivative is designated as part of a hedging relationship, those changes in fair value may be offset by changes in fair value of the hedged item or may be deferred through other comprehensive income.  Recognition of the realized gains or losses from hedging instruments are also matched with the timing of the hedged item.

 

To qualify for hedge accounting, companies must meet two important criteria:

 

  1. Formal Documentation: The hedging relationship, risk management objective, and method of assessing effectiveness (how the relationship is proven to be highly effective) must be formally documented.

  2. Effectiveness Assessment: Within the documentation, the hedge must be demonstrated to be highly effective in offsetting the hedged risk.  Effectiveness assessments are re-performed at least quarterly in most cases.


The Challenges of Applying ASC 815 & Hedge Accounting

 

For companies that engage in hedging activities and aim to adopt hedge accounting, the application of ASC 815 can be complex. Common challenges include identifying eligible hedged items, fulfilling the formal documentation and effectiveness requirement, and accurately measuring the fair value of the hedging instrument(s).

 

Overcoming these hurdles requires meticulous review, specialized expertise, and close collaboration across teams. Without the necessary knowledge and collaboration, organizations risk non-compliance, financial misstatements, and/or potential reputational damage. To mitigate these risks, many organizations look to outside firms specializing in hedge accounting to ensure compliance with ASC 815.

 

Conclusion: ASC 815 Compliance Leads to Significant Benefits

 

ASC 815 provides a comprehensive framework for accounting for derivatives and hedging activities. While its complexities may be challenging, compliance delivers significant benefits, including:


  • Improved Transparency: Accurate representation of derivatives and hedging activities in financial reporting builds trust with stakeholders.

  • Enhanced Risk Management: Aligning financial reporting with risk mitigation strategies helps organizations navigate market volatility and stabilize earnings.

  • Reduced Financial Volatility: Effective hedge accounting increases stakeholder confidence and strengthens financial stability.

 

Together, these benefits strengthen an organization’s credibility, operational efficiency, and overall financial health. By understanding the principles of ASC 815 and leveraging the expertise of qualified professionals, organizations can turn hedge accounting into a strategic advantage.


Have more questions about ASC 815 or need expert assistance with hedge accounting? Talk to an expert at HedgeStar today!


 

 

Author: John Trefethen, Director and Co-Founder


Mobile: 612-868-6013

Office: 952-746-6040


HedgeStar Media Contact:

Megan Milewsky, Marketing Manager

Office: 952-746-6056

Join our mailing list for HedgeTalk!

Never miss an update

Categories

bottom of page