Effectiveness is the key to hedge accounting

While FAS 133 has been around for over two years in near-final format (some of the DIG guidance on effectiveness dates back to 1999), there remains a fair amount of confusion in the market about FAS 133 effectiveness requirements and how companies must comply.

What FAS 133 requires, what available methodologies are out there, and how companies are choosing to apply the effectiveness criteria is of critical importance to FAS 133 adopters. Indeed, the effectiveness test is at the center of FAS 133. Why? Because effectiveness determines whether or not special (i.e., hedge) accounting will fulfill its promise of reducing income statement volatility.

A hedge that fails the effectiveness test must be marked to market. So if a company is keen on going through the operational costs and administrative hassles of adopting FAS 133, mainly for the purpose of being able to smooth out such price volatility, then failing the effectiveness test is clearly defeating the entire purpose.

Some hedges are exempt from this testing and measurement discipline. There’s a special class of interest rate swaps that qualify for what the FASB has called the “shortcut.” The shortcut allows companies to presume some plain vanilla swaps that are perfectly matched (i.e., in terms of duration, notional amount, etc.) are automatically effective. So, while elsewhere in FAS 133, hedgers must value the changes in the hedge and the underlying, and compare the two, with the shortcut hedgers need only value one side and assume the other leg of the transaction is a perfect offset. (Whether it truly is a perfect hedge from a risk management standpoint is another matter.)

Viewed within the narrow confines of FAS 133’s accounting rules, making sure hedges are effective is key to special accounting. Without it, there’s not much point in trying to comply with this complex standard. Viewed more broadly, meanwhile, making sure hedges are effective at reducing risk is key to treasury’s mandate.

Some of the critical questions facing treasurers, therefore, are as follows:

(1)    What exactly are FAS 133’s effectiveness requirements?

(2)    What are the allowed and available methodologies for testing effectiveness?

(3)    What are most people using?

(4)    What are software vendors offering as part of their risk management/analytical tool kits?

(5)    What will auditors approve?

(6)    Is there an “optimal” test (i.e., a test that more often than not qualify a hedge for special accounting)? Or, is there an optimal test for particular hedge strategies?

(7)    Is it better to have a liberal test or a more conservative one?

(8)    Is it possible to have a test that satisfies accounting rules and meets risk management goals at the same time?

FAS133.com spoke with various experts in the field, from auditors and consultants, to practitioners, quantitative analysts and software vendors to gather some intelligence on the emerging market practices. This two-part special report presents some of the results from this research.