96-J-14. Saito, Shizuki, "Mark-to-Market Accounting and Hedge Accounting: In Case of Derivative Instruments Hedging Cash Flow Exposures", May 1996.

This paper investigates the accounting for derivative instruments used for hedging. Defects of the mixed attribute model like an elective mark-to-market hedge accounting could be eliminated by marking all primary and derivative financial instruments to market through earnings. That would reasonably replace the special accounting (i.e., hedge accounting) applicable to hedges of market value exposures.

This mark-to-market accounting for all financial instruments, however, would not replace any special accounting applicable to hedges of cash flow exposures associated either with present monetary financial instruments or with forecasted future transactions. In the case of a floating rate debt instrument, for example, changing market rates result in a change in
the effective interest rate without a corresponding change in its fair value.

If a swap contract is used to change the cash flows on the debt instrument from a floating rate to a fixed rate, marking it to market with changes in value taken to earnings would then fail to reflect the earnings effect of the hedging transaction. But the transaction could also be designated as trading to be marked to market since the resulting position as a synthetic instrument with a fixed interest rate is exposed to market value risks.

The interest rate swap still hedges not only cash flow exposures but also market value exposures even if the floating rate instrument, whose variable cash flows are fixed by the swap contract, is financed by or invested in a fixed rate financial instrument. Market value gains recognized on the swap contract here offset market value losses recognized on the fixed rate instrument, and vice versa.

However, in the case of financial liabilities whose market value gains or losses are not recognized in earnings, the corresponding swap position should not be measured at market value either. Hedging cash flow exposures is the case where the hedged instrument is not held for trading and its return is not measured in terms of changing market values but of realized cash flows. This partly explains where hedge accounting is warranted.