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9.3 Methods of assessing effectiveness
Publication date: 31 Jul 2022
us Derivatives & hedging guide
ASC 815-20-25 does not prescribe a specific method for assessing hedge effectiveness, but instead requires that a reasonable method based on the risk management objective and the nature of the hedging relationship be applied consistently to all similar hedges. Management should evaluate the manner in which it intends to assess hedge effectiveness because it could impact whether the hedging relationship is considered highly effective at inception and on an ongoing basis.
ASC 815-20-25-80 and ASC 815-20-25-81 require that assessments of effectiveness be reasonable and consistent with the originally documented risk management strategy. Management should also ensure that the method selected is adequately described in its hedge documentation. Failure to do so could result in the loss of hedge accounting from inception. The same effectiveness method documented at hedge inception should be used in subsequent periods, except as described in DH 9.3.5.
There may be advantages and disadvantages to different methods. Certain, more complex effectiveness methodologies may allow a hedging relationship to remain highly effective during the term of the hedge even when there are isolated periods of aberrant behavior in the underlying. As further discussed in section DH 9.11.4.1, one of the inherent disadvantages of the dollar-offset effectiveness method is that these isolated periods could result in the hedging relationship not being considered to be highly effective under this relatively straightforward approach. A more complex regression analysis, however, may not result in a similar outcome of losing hedge accounting. For example, the fact that there are multiple periods or data points included in a regression analysis would result in less weight being applied to any one particular data point, which may include the isolated period of aberrant behavior. That is, an isolated period may not have as significant an impact when it is only one of multiple data points used in a regression analysis.
To reduce the documentation burden of performing a quantitative assessment of effectiveness, ASC 815-20-25-3(b)(2)(iv)(01) permits a reporting entity to significantly reduce or eliminate its quantitative effectiveness assessments both at inception and on an ongoing basis when the hedging instrument and the hedged item are perfectly aligned as it relates to the hedged risk. In these cases, reporting entities are permitted to assume that the hedging relationship is perfectly effective.
If none of the methods in ASC 815-20-25-3(b)(2)(iv)(01) are applicable, then a quantitative method (also referred to as a “long-haul” method) must be used to assess hedge effectiveness at inception of the hedging relationship and at least quarterly.
If a reporting entity performs an initial quantitative assessment, the subsequent prospective and retrospective assessments of effectiveness may be performed qualitatively if certain conditions are met. See DH 9.12.
Figure DH 9-1 summarizes the methods of assessing effectiveness both at inception and on an ongoing basis.
Figure DH 9-1
Methods of assessing effectiveness – at inception and ongoing
Methods of assessing effectiveness – at inception and ongoing
View image
1Assuming other qualifying criteria are met
2If there is an adverse change in the risk of default, consider the need to dedesignate the hedging relationship. Certain other changes in the critical terms may require dedesignation.
3A reporting entity may choose to perform a quantitative assessment at any time. It may then revert to a qualitative assessment subsequently if it can reasonably support an expectation of high effectiveness on a qualitative basis for subsequent periods.
9.3.1 Assessing effectiveness with no initial quantitative assessment
When the critical terms of the hedging instrument and the hedged item are exactly the same as it relates to the hedged risk, ASC 815-20-25-3(b)(2)(iv)(01) provides a list of circumstances in which a reporting entity can avoid performing an initial quantitative assessment of effectiveness. In other words, the reporting entity may qualitatively assume the hedge is perfectly effective. Figure DH 9-2 describes the key information on each of these circumstances and where it is discussed in this chapter.
Figure DH 9-2
Instances when no initial quantitative effectiveness assessment is required if the critical terms of the hedging instrument and the hedged item are exactly the same
Instances when no initial quantitative effectiveness assessment is required if the critical terms of the hedging instrument and the hedged item are exactly the same
Brief description |
Hedged risk |
Derivative type |
Hedge type |
ASC references |
DH guide reference |
||
Shortcut method |
Interest rate risk in recognized financial assets or liabilities |
Interest rate swap |
Fair value or cash flow |
815-20-25-102 through ASC 815-20-25-117D 815-20-55-71 through ASC 815-20-55-79 815-20-55-199 through ASC 815-20-55-203 |
|||
Critical terms match method for forwards |
Risks other than interest rate risk |
Forward |
Cash flow or fair value |
815-20-25-84 through ASC 815-20-25-85 815-20-55-80A 815-20-35-9 through ASC 815-20-35-12 815-30-55-20 through ASC 815-30-55-23 |
|||
Terminal value method for options |
Variability beyond or within a specified level(s) |
Purchased option, net purchased option, or zero cost collar |
Cash flow |
||||
Change in variable cash flows method |
Interest rate risk |
Interest rate swap |
Cash flow |
||||
Hypothetical derivative method |
All eligible risks |
Any eligible type |
Cash flow |
||||
Net investment hedge spot method |
Foreign currency |
Forwards, options, cross currency swaps Foreign denominated nonderivatives |
Net investment |
815-35-35-5 through ASC 815-35-35-11 815-20-25-67 through ASC 815-20-25-71 815-35-35-12 through ASC 815-35-35-14 815-20-25-66 |
|||
Net investment hedge forward method |
Foreign currency |
Forwards, options, cross-currency swaps |
Net investment |
||||
Simplified hedge accounting approach (only for private companies that are not financial institutions) |
Interest rate risk |
Receive-variable, pay-fixed interest rate swap (including a forward-starting swap) |
Cash flow |
||||
In all cases in Figure DH 9-2, including the shortcut method, a reporting entity must assess the possibility of default by the reporting entity itself and the counterparty to the hedging instrument both at inception and on an ongoing basis, in accordance with ASC 815-20-35-10 and ASC 815-20-35-14 through ASC 815-20-35-18.
In addition, a reporting entity should perform an ongoing effectiveness assessment on at least a quarterly basis by verifying whether the critical terms of the hedging instrument or hedged item (including forecasted transactions) have changed in subsequent periods, as required by ASC 815-20-35-9 through ASC 815-20-35-13. With regard to monitoring the critical terms, a change in the counterparty in a derivative hedging instrument would not, in and of itself, be considered a change in a term that would require a dedesignation, as described in ASC 815-20-55-56A. See DH 10.2.2.2.
The reporting entity should document its assessment of the critical terms and credit risk as part of its ongoing documentation of effectiveness whenever financial statements or earnings are reported, and at least as frequently as every three months, as discussed in ASC 815-20-25-85 and ASC 815-20-35-9.
In addition, for a cash flow hedge of a forecasted transaction, the reporting entity should monitor whether the hedged cash flows remain probable of occurring and whether the timing of those expected cash flows varies from the original expected date(s).
9.3.2 Initial quantitative assessment of effectiveness
If none of the methods of assuming perfect effectiveness in Figure DH 9-2 are applicable, a long-haul quantitative method must be used to assess hedge effectiveness of the hedging relationship at inception. However, even if an initial quantitative assessment is performed, the subsequent prospective and retrospective assessments of effectiveness may be performed qualitatively when certain conditions are met, as discussed in DH 9.12.
At inception of the hedging relationship, ASC 815-20-25-3(b)(2)(iv)(03) requires a reporting entity to document whether it elects to perform subsequent retrospective and prospective hedge effectiveness assessments on a qualitative basis and, if so, how it intends to carry out that qualitative assessment. That guidance also requires that the reporting entity document which quantitative method it will use if (1) facts and circumstances of the hedging relationship change and it must quantitatively assess hedge effectiveness, or (2) the entity elects to perform a quantitative assessment. The prospective quantitative method used at inception must be consistent with the prospective quantitative method used in ongoing assessments.
9.3.3 Excluded components
A reporting entity may elect to exclude certain components of the change in value of the derivative from the assessment of effectiveness. This election may impact (1) the ability of a hedging relationship to qualify for an assumption of perfect effectiveness both at inception and on an ongoing basis and (2) whether a hedge will be considered highly effective.
ASC 815-20-25-82 provides guidance as to what may be excluded in a fair value or cash flow hedge.
- For forwards and futures contracts (and swaps) when the spot method is used:
- The change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price (the “forward points”)
Only the entire difference between the change in the total fair value of the derivative and the change in fair value due to changes in the spot rate may be excluded from the assessment of effectiveness.
- The change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price (the “forward points”)
- For currency swaps:
- The portion of the change in fair value of a currency swap attributable to a cross-currency basis spread
- For options (including eligible collars):
- Time value (the difference between the change in fair value and the change in undiscounted intrinsic value)
- Volatility value (the difference between the change in fair value and the change in discounted intrinsic or minimum value)
- Components of time value:
- Passage of time (theta)
- Volatility (vega)
- Interest rates (rho)
ASC 815-20-25-83 prohibits the exclusion of any other components. For example, a reporting entity is not permitted to exclude only part of the spot-forward difference when using the spot method.
Whether a component of the gain or loss on a derivative is excluded and the mechanics of isolating the change in time value of an option when assessing effectiveness should be applied consistently for similar hedges. See DH 9.3.4.
If a reporting entity elects to exclude the spot-forward difference in a net investment hedge with a derivative as the hedging instrument in accordance with ASC 815-35-35-4, it must do so for all net investment hedges with a derivative as the hedging instrument.
Recognition of excluded components is discussed in DH 6.3.1.2 for hedges of financial instruments, DH 7.2.1.3 for hedges of nonfinancial items, and DH 8.3.1.1 for foreign currency hedges. Presentation and disclosure of excluded components is addressed in FSP 19.4.
9.3.4 Consistent use of a method of assessing effectiveness
ASC 815-20-25-80 and ASC 815-20-25-81 require that the method(s) used to assess hedge effectiveness (including whether a component of the gain or loss on a derivative is excluded and the mechanics of isolating the change in time value of an option) be defined and documented at inception of the hedging relationship and that the method(s) be used consistently throughout the life of the hedge. The guidance also requires that a reporting entity assess hedge effectiveness for all similar hedges in a similar manner, unless a different method can be justified. If an entity chooses to record the change in excluded components currently in earnings for a fair value of cash flow hedge in accordance with ASC 815-20-25-83B, this election must be applied consistently to similar hedges.
9.3.5 Change in a method of assessing effectiveness
A reporting entity may change the method of assessing effectiveness, but (1) it must be an improved method, and (2) it must change the method for all similar hedges.
Should a reporting entity identify and wish to apply an improved method for assessing hedge effectiveness, ASC 815-20-35-19 states that it must dedesignate the existing hedging relationship and prospectively redesignate a new hedging relationship. However, as discussed in ASC 815-20-35-20 and ASC 815-20-55-55 through ASC 815-20-55-56, such a change is not considered a change in accounting principle and the wording “improved method” was not meant to imply that a change to a new method must be considered “preferable” under ASC 250-10-45-2.
The new method of assessing hedge effectiveness should be applied prospectively, and the same method should be applied to all similar hedges. A change in whether a component is excluded or the mechanics of isolating the change in time value of an option in assessing effectiveness each constitute a change in method, as indicated in ASC 815-20-25-81. Consequently, ASC 815-35-35-4 indicates that a change from the spot method to the forward method for a net investment hedge or vice versa (i.e., whether the spot-forward difference is excluded from the assessment of effectiveness) must follow the same guidance as any other change in method.
If a reporting entity chooses to change whether to exclude components from the assessment of effectiveness (e.g., changing from the spot method to the forward method), the new method must be an improved method.
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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