Accounting for corporate finance: hedging: hedge effectiveness
This guidance applies to companies which apply IAS 39 or FRS 26.
Assessing hedge effectiveness
IAS 39/FRS 26 require that a hedge must be assessed as ‘highly effective’ in order to qualify for hedge accounting. A hedge is regarded as highly effective if the following two criteria are met:
- At the inception of the hedge and in subsequent periods, the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated; and
- The actual results of the hedge are within a range of 80% - 125%.
In order to meet the first criteria, a company must perform a prospective hedge effectiveness assessment, which demonstrates the expectation that the hedge will be highly effective in achieving offset in the future. This can take a number of forms, such as a comparison of the critical terms of the hedging instrument with the hedged item; comparison of past changes in the fair values or cash flows of the hedged item and hedging instrument in respect of the hedged risk; or by demonstrating a high statistical correlation between the fair values and cashflows of the hedged items and those of the hedging instrument.
In order to meet the second criteria, the entity needs to perform a retrospective hedge effectiveness assessment. The test looks backwards to demonstrate whether or not the hedge relationship has been highly effective - i.e. whether the actual results are in a range of 80% - 125%.
For example, if the loss on the hedging instrument is 120 and the gain on the cash instrument being hedged is 100, offset can be measured by 120/100, which is 120%, or by 100/120 which is 83%. In each case, the company will conclude that the hedge is highly effective.
An entity is required to perform the prospective test at the inception of the hedge and at the beginning of each assessment period (as a minimum, this will be at the time annual or interim financial reports are prepared). If at any point during the hedging relationship the prospective test is not met, hedge accounting must be discontinued from that point.
If at the end of the period the retrospective test is not met, hedge accounting must be discontinued from the point at which the hedge relationship was no longer highly effective.
Both tests must be met for a period of a hedge relationship for hedge accounting to be available.
IAS 39/FRS 26 do not prescribe a single method for assessing hedge effectiveness, if only because this will be dependent upon an entity’s own risk management strategy and the nature of the risk being hedged. In addition, an entity can assess hedge effectiveness on either a period-by-period or cumulative basis. However, whatever method is used to test hedge effectiveness, a quantitative retrospective test must be performed to determine the amount of the ineffectiveness.
IAS 39/FRS 26 require documentation to be prepared at the inception of the hedge which details how effectiveness is to be assessed. The method should be reasonable and applied consistently, both in comparison to other similar hedges, and on a period-by-period basis.
Note that under IFRS 9 or FRS 102 (where Sections 11/12 are applied for financial instruments) the requirements relating to hedge effectiveness testing are less onerous.