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To apply hedge accounting, the hedging instrument needs to be expected to be and actually shown to be highly effective in offsetting changes in fair value or cash flows of the hedged item related to the hedged risk during the period that the hedge is designated. If either is not met, hedge accounting is not permitted.
For public business entities and financial institutions, effectiveness assessments are required at hedge inception and periodically thereafter, with an assessment required whenever financial statements or earnings are reported, and at least every three months. This periodic assessment needs to be performed on both a prospective basis (to reconfirm forward-looking expectations) and a retrospective basis (to determine whether the hedging relationship was highly effective).
Hedging relationships do not have to be perfectly effective to qualify for hedge accounting. However, the extent of effectiveness in achieving the risk management objectives documented at inception of the hedging relationship must be assessed, both at inception and in each subsequent period. If the initial assessment of effectiveness demonstrates that the hedge relationship is expected to be highly effective and the other requirements to apply hedge accounting are met, a reporting entity is eligible to apply hedge accounting at inception.
In certain limited circumstances specified in ASC 815, some hedging relationships may be considered perfectly effective, and thus, reporting entities may avoid the need to assess effectiveness quantitatively, even at hedge inception. In these cases, the guidance specifically identifies criteria that will allow the derivative to be considered a perfect hedge of the hedged risk, in which case, a quantitative analysis is not required. See DH 9.3.1.
If the hedging relationship does not qualify for an assumption of perfect effectiveness, the initial assessment of effectiveness is required to be quantitative. See DH 9.11. However, if certain criteria are met, subsequent effectiveness assessments may be performed on a qualitative basis. See DH 9.12 for discussion of (ongoing) qualitative assessments of effectiveness.

9.2.1 Definition of highly effective

ASC 815-20-25-75 requires an expectation that the relationship between a hedging instrument and the hedged item will be “highly effective” in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period that the hedge is designated.
The more closely the terms of the hedged item and hedging instrument align, the more likely the hedging relationship will be considered highly effective.
Although having an expectation that the hedging relationship will be highly effective is fundamental to qualifying for hedge accounting, the term is not explicitly defined. When a quantitative effectiveness assessment is required, the term highly effective has been interpreted in practice to mean that the change in fair value of the designated portion of the hedging instrument is within 80 to 125% of the change in the fair value of the designated portion of the hedged item attributable to the risk being hedged.
Even though qualifying hedging relationships might be highly effective, in many cases, the effectiveness will not be perfect (i.e., the gains and losses on the hedging instrument will not be perfectly offset by the losses and gains on the hedged item). High effectiveness does not guarantee that there will be no earnings volatility.
  • Fair value hedges

    For a highly effective fair value hedge, any difference between the change in value of the derivative and the hedged item directly affects earnings since both (1) the entire change in fair value of the derivative hedging instrument and (2) the change in the fair value of the hedged item (attributable to the hedged risk) are reflected in earnings for each reporting period, and the two changes may not perfectly offset each other. For example, in a fair value hedge, if the derivative’s fair value decreases by $100, but the hedged item’s fair value attributable to the hedged risk increases by $90, a net loss of $10 will result when gains and losses on both the derivative and the hedged item are recorded in the income statement.
  • Cash flow hedges

    For a highly effective cash flow hedge, any difference between (1) the change in fair value of the derivative and (2) the change in fair value of the hedged cash flows attributable to the risk being hedged will not be recognized in current earnings. The entire change in fair value of the derivative is deferred in OCI and will be released to earnings when the hedged item/transaction impacts earnings. This amount may not exactly offset the earnings impact of the hedged item/transaction.

9.2.2 Required effectiveness assessments

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.

9.2.3 Timing of initial prospective effectiveness assessment

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:
  • The first quarterly hedge effectiveness assessment date
  • The date that financial statements that include the hedged transaction are available to be issued
  • The date that the hedge no longer qualifies for hedge accounting
  • The date of expiration, sale, termination, or exercise of the hedging instrument
  • The date of dedesignation of the hedging relationship
  • For a cash flow hedge of a forecasted transaction, the date that the forecasted transaction occurs


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

9.2.4 Frequency of ongoing effectiveness assessments

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.

9.2.5 Consequence of not being highly effective in a given period

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.
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