A company enters into a derivatives contract to hedge its exposure to changes in the fair value of a recognized asset. The derivative is designated as a fair value hedge. During the period, the fair value of the derivative increased by $10,000, and the fair value of the hedged asset decreased by $9,000. What is the net effect of these fair value changes on the company's net income for the period?
- AIncrease of $19,000
- BNo effect on net income, as changes are recognized in OCI.
- CDecrease of $1,000
- DIncrease of $1,000
Show answer & explanationAnswer & explanation
Correct answer: D. Increase of $1,000
In a fair value hedge, both the gain or loss on the hedging derivative and the offsetting loss or gain on the hedged item (attributable to the hedged risk) are recognized in current earnings. This is done to show the effectiveness of the hedge in mitigating risk. Here, the derivative has a $10,000 gain, and the hedged asset has a $9,000 loss. Both are recognized in net income. The net effect on net income is a gain of $10,000 (derivative) - loss of $9,000 (hedged asset) = $1,000 increase in net income.
Why the other options are wrong
- A. This would be the sum of the absolute changes, not the net effect.
- B. This is characteristic of a cash flow hedge (effective portion), not a fair value hedge.
- C. This would be true if the derivative decreased and the asset increased by similar amounts, or if the derivative gain was smaller than the asset loss.
Fair Value Hedge
A type of hedge that aims to mitigate exposure to changes in the fair value of a recognized asset or liability, or an unrecognized firm commitment.
- Both the derivative and the hedged item are marked to market through earnings.
- Reduces income volatility by offsetting gains/losses in net income.
- Effectiveness is crucial; ineffectiveness is recognized in earnings.
Memory trick: Hedge's Purpose: Fair Value to Income, Cash Flow to OCI's Dome.