Introduction to Hedge Effectiveness
To qualify for hedge accounting, a hedging instrument must be expected and demonstrated to be highly effective in offsetting changes in either the fair value or the cash flows of the hedged item related to the hedged risk during the designated hedge period. If either the expectation or the demonstration of effectiveness is not met, hedge accounting will be disallowed and the changes in the hedge’s fair value will need to flow through the income statement.
Both businesses and financial institutions must assess the effectiveness of hedge relationships both at hedge inception and periodically afterward. This assessment is required whenever financial statements or earnings are reported and at least every three months. The assessment includes both prospective and retrospective evaluation of the hedge effectiveness.
While hedging relationships do not need to be perfectly effective, the degree of effectiveness in achieving risk management objectives must be evaluated at inception and in subsequent periods. If the initial assessment demonstrates expected high effectiveness and other hedge accounting criteria are met, hedge accounting can be applied.
In certain specific cases defined by ASC 815, some hedging relationships may be considered perfectly effective, eliminating the need for quantitative effectiveness assessment even at hedge inception. Criteria are provided to determine when a derivative qualifies as a perfect hedge.
Definition of Highly Effective:
The expectation for a highly effective hedging relationship is that it achieves offsetting changes in fair value or cash flows related to the hedged risk during the designated hedge period. The greater alignment between the terms of the hedged item and the hedging instrument, the higher the likelihood of high effectiveness.
When a quantitative assessment is required, "highly effective" is typically interpreted as the change in the fair value of the hedging instrument falling within 80% to 125% of the change in the fair value of the hedged item attributable to the hedged risk. Note, that US GAAP and international accounting standards diverge somewhat on this assessment - whereas US GAAP specifies the 80% - 125% standard IFRS 9 allows more flexibility so that a hedge close to that standard can still be considered highly effective (for example, if the hedge effectiveness was 79%).
Fair Value Hedges: In a highly effective fair value hedge, any difference between the change in the value of the derivative and the hedged item directly affects earnings. The gains and losses on the derivative and the hedged item may not perfectly offset each other, leading to potential earnings volatility.
Cash Flow Hedges: For a highly effective cash flow hedge, differences between the derivative's fair value change and the hedged cash flows' fair value change are not recognized in current earnings. Instead, the entire change in fair value of the derivative is deferred in Other Comprehensive Income (OCI) and released to earnings when the hedged item impacts earnings.
Timing and Frequency of Assessments
Initial prospective effectiveness assessments can be qualitative for certain hedging relationships. If not, a quantitative assessment is required at the earliest of specific trigger events. Ongoing effectiveness assessments are required for public entities and financial institutions at least every three months, although more frequent assessments can be chosen.
Consequences of Failing Effectiveness Assessment
If a hedging relationship fails an effectiveness assessment, it can result in volatility to reported earnings. In a fair value hedge, the change in the fair value of the derivative is recognized in earnings if the relationship fails either the prospective or retrospective assessment. In cash flow or net investment hedges, failure leads to immediate recognition of the derivative's fair value change in earnings.