How the Fair Value Option Will Simplify Accounting for Some Hedging Transactions

By Arlette C. Wilson and Beverly Marshall

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Criteria for Hedge Accounting

The concept of hedging is for the losses (gains) on the hedged item to be offset by gains (losses) on the hedging instrument. The objective of hedge accounting is for these offsetting gains and losses to be reported in current earnings in the same accounting period.

In order to qualify for hedge accounting, the designated hedging instrument and hedged item must meet certain criteria, including the following:

• Formal documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge.
• An expectation, both at inception and on an ongoing basis, that the hedge relationship will be highly effective in achieving offsetting fair values or cash flows attributable to the risk being hedged.

At the time it designates a hedging relationship, an entity must define what method it will use to assess the hedge’s effectiveness in achieving the offsetting changes. Two acceptable methods are regression analysis and the dollar-offset method. The method chosen must be used consistently throughout the hedge period.

At least quarterly, the hedging entity must determine whether the hedging relationship has been highly effective in offsetting changes in fair value or cash flows through the date of the periodic assessment. If the hedge fails the effectiveness test at any time, the hedge ceases to qualify for hedge accounting.

FASB intended the term “highly effective” to have essentially the same meaning as “high correlation” as used in SFAS 80. Therefore, highly effective can be assumed to describe a fair value hedging relationship where the change in the fair value of the derivative hedging instrument is within 80% to 125% of the opposite change in fair value of the hedged item attributable to the hedged risk. Alternatively, one can assume an R-squared of 0.80 or higher is required when using a regression analysis technique. That is, if the hedged item is regressed with the hedging instrument, the coefficient of determination will be at least 0.80.

Assessing hedge effectiveness and measuring the ineffective part of the hedge can be quite complex, especially if regression or another statistical analysis approach is used. Those methodologies require appropriate understanding of the statistical inferences.

Fair Value Option Simplifies Certain Hedge Accounting

All derivatives must be marked to fair value, with the unrealized gain or loss included in current earnings. Special accounting is allowed if a derivative qualifies and is designated as one of the following:

• Fair value hedge,
• Cash flow hedge, or
• Hedge of a net investment in a foreign operation

The fair value option affects only fair value hedges of financial instruments. Special hedge accounting rules are still required to address the following:

• Fair value hedges of nonfinancial instruments (e.g., commodities),
• Cash flow hedges, or
• Hedge of a net investment in a foreign operation.

The general accounting for a fair value hedge is that both the change in fair value of the derivative and the change in fair value of the hedged item attributable to the risk being hedged are included in earnings.

The fair value option will allow companies to measure eligible financial instruments at fair value with realized and unrealized gains and losses recognized in the period in which they occur. Because all fair value changes in derivatives not designated for hedge accounting are included in current earnings, the reporting of fair value changes in financial instruments will automatically reflect this fair value hedge accounting and avoid the related burden of designating hedging relationships and tracking and analyzing hedge effectiveness.

Example

On January 1, 2008, Company X chooses to hedge its fixed-rate callable debt with a fixed-rate receive, variable-rate pay, interest-rate swap. First, the company must provide documentation supporting why and how it expects changes in the fair value of the swap to offset changes in the fair value of the fixed-rate callable debt. The company should document the historical relationship between changes in the swap and the callable debt over the most recent period that is not less than the expected term of the hedge. The method used for assessing this relationship should be chosen at inception of the hedge and formally documented. Two common techniques are the dollar-offset method and regression analysis. Company X provided the following documentation supporting its expectation of hedge effectiveness using the dollar-offset method for the four quarters prior to this hedge:

Next, the assessment and measurement of the hedging relationship must occur whenever the company’s earnings are reported, and at least every three months. The assessment of this hedge’s effectiveness may be difficult, because the debt has a callable feature but the swap does not. Assume the assessment
of hedge effectiveness resulted in the following:

Because the change ratio was less than 80% for the quarter ended September 30, 2008, Company X’s swap would cease to qualify for hedge accounting. The derivative would still be marked to fair value with the unrealized gain or loss reported in current earnings, but the changes in fair value of the debt would no longer be recognized.

A Step Toward Simplification

The fair value option will simplify accounting for this kind of hedging relationship. There will be no necessary documentation supporting the hedging relationship and the company’s risk management objective and strategy. There will be no assessing of hedge effectiveness, both prospectively and retrospectively. There will be no possibility of failing the hedge effectiveness test and not reporting the offsetting accounting. The fair value option will mark the callable debt to fair value at each reporting date, and the unrealized gain or loss will be included in current earnings. The swap’s change in fair value is also reported in current earnings, resulting in the offset being reported without the hassle required by special hedge accounting.

SFAS 159 will permit companies a one-time election to report certain financial instruments at fair value with the changes in fair value included in earnings. This will enable companies to achieve offset accounting for derivatives-hedging financial instruments without having to apply the more complex hedge accounting provisions—in particular, the assessment of hedge effectiveness. Although the complex accounting rules would continue for all qualified hedges other than the fair value hedge of financial instruments, this is a minor step toward simplifying the accounting for derivatives.

Arlette C. Wilson, PhD, CPA, CMA, CIA, is the Charles M. Taylor Professor of Accounting, and Beverly Marshall, PhD, CPA, is an associate professor of finance, both at Auburn University, Auburn, Ala.

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