Derivatives as such
The very attribute of a derivative is that it has no value of its own. Yet, this instrument is expected to bring considerable volatility to an entity’s financial statements – specifically the balance sheet. The question arises as to what causes a derivative to create such an impact. Well, the point is that while a derivative does not have a value of its own, it derives its value from something else (underlying) – hence the name derivative. And, when that something else changes in its value, the value of derivative can be considerably higher or lower at different times.
Assume this, Co X identifies a share with a market value of $100. Co X has a reason to believe that the price of the share may decline in near future, and certainly not go above its current market price. It enters a promise to sell the share to another entity – Co Y for $105 say after 3 months, with a clause (option) to Co Y that if the share price is less than $105, Co Y does not need to buy the share.
Since Co X is taking a risk by allowing Co Y to buy the share at $105 only when the price will be more than $105 (option is with Co Y), the value of the agreement (option to sell) can be considerably high (assume that the price reaches to $140 – meaning thereby that Co X would be required to sell the share at $105 instead of the market price of $140), resulting into a liability for Co X. For Co Y, the value of the agreement will be positive, thereby resulting into the contract as an asset.
What we intend to bring on the table is the point that a derivative can be an asset or a liability, depending upon the value of the underlying, that is not controlled by either of the parties to the contract. And, this is likely to bring a huge volatility (upward and downward movements) to the balance sheet of the entity and income statement.
Hedge accounting is expected to manage the volatility at the incomes statement level, even though the balance sheet would remain unaffected – of course the counter value of the item that is hedged can match the balance sheet as well – however, the derivative shall be always separately recognized. This certainly results into a grossed-up balance sheet for a business as such.