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9.12 Qualitative assessments of effectiveness
Publication date: 31 Jul 2022
us Derivatives & hedging guide
If (1) a reporting entity performs an initial quantitative effectiveness assessment that demonstrates that the hedging relationship is highly effective and (2) can reasonably support at hedge inception an expectation of high effectiveness on a qualitative basis in subsequent periods, it may choose to perform its subsequent hedge effectiveness assessments qualitatively.
The election to perform subsequent assessments of effectiveness qualitatively may be made on a hedge-by-hedge basis, per ASC 815-20-35-2B. However, the initial quantitative method needs to be the same as the quantitative method that a reporting entity will document and use should it not be able to support an expectation of high effectiveness on a qualitative basis during the term of the hedge. See DH 9.12.3.
9.12.1 Qualitatively supporting high effectiveness in subsequent periods
To determine whether the reporting entity can reasonably support performing assessments of effectiveness after hedge inception on a qualitative basis, ASC 815-20-55-79G through ASC 815-20-55-79N states that the entity should consider the following:
- The results of the quantitative assessment of effectiveness performed at inception of the hedging relationship
Generally, the closer the initial quantitative assessment is to achieving perfect offset, the more support there is for using a qualitative assessment subsequently. When a hedge is close to failing the effectiveness test, it is less likely that a reporting entity will be able to support performing its subsequent effectiveness assessments qualitatively. - Alignment of the critical terms of the hedging instrument and the hedged item
If the terms are not aligned, a reporting entity should consider:- Which market conditions may cause the changes in fair values or cash flows attributable to the hedged risk to diverge as a result of the misalignment
- The extent and consistency of the correlation between the hedged item and hedging instrument
For example, if the only critical term that does not match is the underlying and past observations of changes in the underlyings of the hedged item and hedging instrument consistently exhibited high correlation, then performing subsequent assessments qualitatively is more likely to be supportable than if changes have not been consistently highly correlated. - Whether changes in market conditions could cause a divergence and whether there is a reasonable expectation that the hedging relationship is expected to remain stable or whether that divergence is expected to continue or recur
The implementation guidance in ASC 815-20-55-79N makes it clear that a reporting entity should consider the interaction of these factors in determining whether it can reasonably support performing subsequent assessments of effectiveness qualitatively. For example, if a hedging relationship was not close to failing the quantitative assessment of effectiveness nor was it close to being perfectly effective, a lack of consistent high correlation exhibited over time between the past changes in the underlyings of the hedged item and the hedging instrument would prevent the entity from reasonably supporting the subsequent use of qualitative assessments. However, if the example were changed such that the past changes had been highly correlated, then the entity might conclude it could reasonably support performing subsequent assessments of effectiveness on a qualitative basis.
9.12.2 Ongoing qualitative assessments
Reporting entities are required to perform an assessment at least quarterly. Using a qualitative assessment does not impact the required frequency.
When an entity performs qualitative assessments of hedge effectiveness, it shall verify and document whenever financial statements or earnings are reported and at least every three months that the facts and circumstances related to the hedging relationship have not changed such that it can assert qualitatively that the hedging relationship was and continues to be highly effective. While not all-inclusive, the following is a list of indicators that may, individually or in the aggregate, allow an entity to continue to assert qualitatively that the hedging relationship is highly effective:
- An assessment of the factors that enabled the entity to reasonably support an expectation of high effectiveness on a qualitative basis has not changed such that the entity can continue to assert qualitatively that the hedging relationship was and continues to be highly effective. This shall include an assessment of the guidance in paragraph 815-20-25-100 when applicable.
- There have been no adverse developments regarding the risk of counterparty default.
In the ongoing qualitative assessment, reporting entities should consider all sources of ineffectiveness, both in terms of probability and magnitude. The factors to consider may vary depending on the type of hedging relationship, but the analysis should consider all reasonably possible scenarios and should not be limited only to likely or expected ones, as specified in ASC 815-20-25-79(a). Reporting entities should also consider the existence of caps and floors that limit exposure in the hedged item when the hedging instrument does not have an offsetting cap or floor.
A reporting entity should implement a process to monitor whether facts and circumstances in the factors considered at hedge inception have changed during the period and since inception (both periodic and cumulative) that would cause it to no longer be able to use a qualitative assessment of hedge effectiveness.
For example, significant weather events could have an impact on certain agricultural commodities such that two indices that were highly correlated previously would diverge (see ASC 815-20-55-79R). Alternatively, a significant increase in the credit risk of the counterparty to the hedging instrument in a fair value hedge of interest rate risk in a financial instrument may indicate that the hedging relationship will no longer be highly effective at achieving offsetting changes in fair value.
The results of the reporting entity’s qualitative assessment should be documented. The extent of the documentation may vary, but generally we expect more robust documentation as the need for judgment increases.
9.12.3 Impact of changes in facts and circumstances
When there has been a change in facts and circumstances such that the entity can no longer assert qualitatively that the hedging relationship was and continues to be highly effective, a quantitative test will need to be performed for that hedging relationship, and potentially, other similar hedging relationships.
If an entity elects to assess hedge effectiveness on a qualitative basis and then facts and circumstances change such that the entity no longer can assert qualitatively that the hedging relationship was and continues to be highly effective in achieving offsetting changes in fair values or cash flows, the entity shall assess effectiveness of that hedging relationship on a quantitative basis in subsequent periods. In addition, an entity may perform a quantitative assessment of hedge effectiveness in any reporting period to validate whether qualitative assessments of hedge effectiveness remain appropriate. In both cases, the entity shall apply the quantitative method that it identified in its initial hedge documentation in accordance with paragraph 815-20-25-3(b)(2)(iv)(03).
Often, the change in facts and circumstances will affect other similar hedges. However, there may be instances when a change only affects particular hedging relationships, for example, an adverse change in counterparty credit risk would only affect hedges with that counterparty.
It may be prudent to perform a quantitative test if there has been a change in facts and circumstances that could cause a decrease in effectiveness, even if the magnitude of the change does not appear to be significant. In other words, reporting entities should consider performing a quantitative test even when they still suspect there is some “headroom” in the effectiveness ratio.
While not necessary in all cases, some reporting entities may choose to periodically perform a quantitative assessment, rather than only performing the test qualitatively, as a control to monitor the continued ability to use the qualitative assessment.
A reporting entity is required to perform a quantitative assessment in a subsequent period if it no longer meets the requirement to use the qualitative assessment (e.g., due to changes in facts and circumstances). The quantitative method applied in that case must be consistent with (1) the method used for the initial prospective quantitative assessment and (2) the method documented at hedge inception. See DH 9.3.2 and DH 9.3.4.
When an entity determines that facts and circumstances have changed and it no longer can assert qualitatively that the hedging relationship was and continues to be highly effective, the entity shall begin performing subsequent quantitative assessments of hedge effectiveness as of the period that the facts and circumstances changed. If there is no identifiable event that led to the change in the facts and circumstances of the hedging relationship, the entity may begin performing quantitative assessments of effectiveness in the current period.
The FASB observes in paragraph BC213 of the Basis for Conclusions to ASU 2017-12 that it did not intend for reporting entities to override judgments and conclusions made in prior periods when applying the qualitative method in those prior periods was deemed appropriate. We believe this concept applies as long as the qualitative assessment process in those prior periods was valid. In other words, we do not believe the Board’s observation in the Basis for Conclusions can be used to grandfather a nonexistent or invalid qualitative process that did not previously detect an effectiveness issue due to a flaw in design or execution.
9.12.4 Reverting to qualitative after a quantitative assessment
After performing a quantitative assessment of hedge effectiveness for one or more periods, a reporting entity may revert to qualitative assessments of hedge effectiveness if it can reasonably support an expectation of high effectiveness on a qualitative basis for subsequent periods.
A specific event or circumstance may cause a temporary disruption to the market that results in an entity concluding that the facts and circumstances of the hedging relationship have changed such that it no longer can assert qualitatively that the hedging relationship was and continues to be highly effective. In those instances, if the results of the quantitative assessment of effectiveness do not significantly diverge from the results of the initial assessment of effectiveness, that market disruption should not prevent the entity from returning to qualitative testing in subsequent periods. If the results of the quantitative assessment of effectiveness do significantly diverge from the results of the initial assessment of effectiveness, the entity should continually monitor whether the temporary market disruption has been resolved when determining whether to return to qualitative testing in subsequent periods.
The event or circumstance that prevented use of a qualitative assessment might be temporary or isolated and its effects may have passed such that the hedged item and hedging instrument now behave more consistently relative to one another as they had at the time of the initial effectiveness assessment.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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