How are derivatives valued on the balance sheet? How is the adjustment to fair value recorded differently for a cash flow hedge versus a fair value hedge? That is, how does the fair value adjustment of each type of hedge affect current period net income and the accounting equation? What are the three criteria that must be met for a derivative to be classified as a hedge?   Once entities decide to buy or sell derivatives to hedge economic risks, they then need to decide whether they want to use hedge accounting; it is an election, not a requirement, even when the derivatives are for the economic purpose of hedging. This election is reminiscent of inventory accounting. Just like when a company selects an inventory method, a company is not required to select the accounting method (LIFO, FIFO, weighted average, specific unit) that most closely corresponds with the physical movement of inventory, although they are free to do so. If entities decide to elect hedge accounting, the following documentation criteria requirements must be met: 1) documentation at hedge inception designating the derivative as a hedge, 2) evidence of hedge effectiveness, that is, that the derivative is at least 90% correlated with the hedged risk, and 3) evidence that the hedged risk affects net income. Entities may decide not to use hedge accounting because they determine it is too complicated or expensive: they may not want to keep track of everything required or to maintain appropriate internal controls around the information. Whatever the reason, if they decide not to use hedge accounting, or if they are not eligible for hedge accounting treatment, the derivative is treated like any other financial instrument following the relevant guidance within US GAAP (ASC 815). This generally means that the derivative’s change in fair value each period runs through net income. The entity would use the narrative portions of their annual report to explain any financial statement volatility to their shareholders and describe the economic risks they are hedging. If the entity decides that it is going to both hedge its economic risk and use hedge accounting, then it needs to identify what kind of hedge it is: a fair value hedge, a cash flow hedge, or a hedge of a net investment in a foreign operation. In this case, we are focusing on the first two types: fair value and cash flow hedges. The hedge classification depends upon what kind of risk the entity is hedging. Are they hedging a firm commitment to buy or sell that's not yet recognized in the financial statements? If so, it is a fair value hedge. Are they hedging something that's a future planned transaction, but they haven't actually entered into any sort of firm commitment yet? In that case, it’s a cash flow hedge.[1] If it's a fair value hedge, the change in the fair value of the derivative goes to net income along with the change in fair value of the hedged item. Remember, the existence of the “hedged item,” like a firm commitment, is what makes the hedge a fair value hedge rather than a cash flow hedge. Thus, both the change in fair value of the derivative and of the hedged item go to net income even if the fair value change in the hedged item would not have previously been recognized in the financials.  If it's a cash flow hedge, some of the fair value change of the derivative can go through OCI instead of net income. The allocation between OCI and net income is driven by the “effectiveness” of the hedge. The notion of effectiveness recognizes that hedges are not perfectly correlated with the risk they are intended to hedge.  (If they were, then that hedge would be 100% effective.) Whatever amount of the fair value change in the cash flow hedge correlates with the fair value change of the hedged risk is considered to be the “effective” part of the hedge. This amount is booked to OCI instead of net income. The remainder of the fair value change in the derivative is deemed “ineffective” and is booked to net income. The change in derivative fair value associated with the effective portion is deferred in OCI until settlement when the entity realizes the final gain or loss; then everything gets re-routed through net income.