To qualify for hedge accounting, a cash flow or fair value hedging relationship must be highly effective both (1) at the inception of the hedging relationship and (2) on an ongoing basis throughout the life of the hedge. ASC 815-20-25-79 clarifies that effectiveness must be considered in two specific ways: (1) prospectively and (2) retrospectively.

The prospective assessment is forward-looking and should consider the reporting entity’s expectation of whether the relationship will be highly effective over future periods in achieving offsetting changes in fair value or cash flows attributable to the hedged risk.

The retrospective assessment should consider whether the hedge was highly effective for the period ended.

Reporting entities may select a different method for performing the prospective and retrospective effectiveness assessments, as described in ASC 815-20-55-68. However, this flexibility is not often utilized in practice due to the unusual outcomes that can occur. For example, it is possible for the method used for the prospective assessment to indicate that the hedge is expected to be highly effective for future periods while the method used for the retrospective assessment demonstrates that the hedge has not been highly effective. In such a case, hedge accounting would not be allowed for the current period but could be applied in future periods. The reverse scenario is also possible. In that case, hedge accounting would be allowed for the current period, but could not be applied in future periods. To avoid such disparate results and to reduce the administrative burden of preparing two analyses, many reporting entities use the same method for both assessments.

Certain hedging relationships qualify for an assumption of perfect effectiveness under ASC 815-20-25-3(b)(2)(iv)(01). Under that guidance, a reporting entity’s requirement to assess effectiveness at inception of the hedging relationship may be performed qualitatively; no initial quantitative assessment is required.

If the hedging relationship cannot be assumed to be perfectly effective, a reporting entity will need to perform an initial prospective effectiveness assessment quantitatively. ASC 815-20-25-3(b)(2)(iv)(02) indicates that the quantitative assessment needs to be performed by the earliest of the following:

Private companies that are not financial institutions have more time to complete the initial quantitative assessment. See DH 11.3.

For public business entities and financial institutions, ongoing assessments of effectiveness are required whenever financial statements or earnings are reported, and at least as frequently as every three months. Requirements for private companies that are not financial institutions are addressed in DH 11.3.

Although an assessment of effectiveness is required at least every three months, a reporting entity may wish to, and in some cases is required to, perform this assessment more frequently (e.g., when using a dynamic hedging strategy). The designated hedge period should coincide with the rebalancing of the hedge. That requirement may be achieved through the performance of daily effectiveness assessments but, at a minimum, must support the daily or weekly frequency of rebalancing the portfolio. When initially designated, a reporting entity may not document a hedge period of monthly or quarterly if the hedge is being rebalanced on a daily or weekly basis.

Failing a prospective or retrospective assessment could result in unanticipated volatility to reported earnings. If a fair value hedging relationship fails to qualify for hedge accounting in a certain assessment period because it fails the retrospective assessment, the overall change in fair value of the derivative for that period is recognized in earnings with no offset in the form of a basis adjustment to the hedged item. The same is true for the next period if the fair value hedging relationship fails the prospective assessment.

If a cash flow/net investment hedging relationship fails to qualify for hedge accounting in a certain assessment period, the change in fair value of the derivative would not be deferred through OCI/CTA for that period; instead, it would be recognized through current earnings. The same is true for the next period if the cash flow/net investment hedging relationship fails the prospective assessment.