Hedge Effectiveness Testing

Hedge Effectiveness Testing – To qualify for special hedge accounting, hedge effectiveness must be assesses prospectively (i.e., before the fact) and retrospectively (after the fact, but no less frequently than quarterly).  (815-20-25-79) The methods used to for these effectiveness assessments must be defined with the hedge documentation; and this method must be applied as prescribed. If the entity decides to improve upon this method, the original hedge must be de-designated and a new hedge relationship needs to be stipulated. If the same method is not applied to similar hedges, a justification for using differing methods is required. (815-20-25-81)

Entities may elect to exclude specific components of hedge results from the hedge effectiveness assessment. Allowable excluded items are (a) differences between spot and forward (or futures prices), if the derivative is or contains a forward or futures contract, or (b) the time value or the volatility value of options, if the derivative is or contains an option contract. (815-20-25-82)

As a rule, whenever the underlying exposure relates to a price, interest rate, or currency exchange rate that is not precisely identical to the underlying of the associated hedging derivative, some degree of hedge ineffectiveness must be expected.  On the other hand,, when entities are able to clearly identify and enter into a hypothetical derivative—i.e., a derivative that perfectly offsets the changes in fair values or cash flows of the designated hedged item—they can and should expect the hedge to perform perfectly, generating no earnings impacts attributable to hedge ineffectiveness.  (815-20-25-84)

The FASB has not sanctioned any particular methodology for assessing hedge effectiveness, and devising such tests is often non-trivial. Hedging entities are encouraged to discuss their intended approaches with their external auditors prior to initiating any hedging transactions.