Not really – if a “perfect test” is
one that allows companies to get hedge accounting more
of the time. “People want the holy grail,” Mr. May of
Andersen says. “That is, something that will always make
them look effective. That is simply not out
there.”
In reality, there’s a choice of
methodologies and they span the gamut – all of them work
well in particular situations. The rules require a
reasonable method. “Whatever you choose,” says Mr. May,
“there has to be enough specific knowledge of the
specific application so that the methodology is
mathematically valid with regard to the hedges being
tested. Consultants and audit firms would love to have a
single solution,” he says; however, right now, “each
situation requires an individual solutions.” Simplicity,
which the market desires, is not attainable. (Indeed, it
has been an elusive concept since FAS 133’s
introduction.)
Perhaps the “perfect” test is one that
reflects both accounting and risk management
requirements. But while the accounting rule allows
hedgers to unwind positions when hedges fail, the impact
on income may be less tolerable. It’s therefore,
critical that companies employ a test methodology that
goes beyond the accounting to truly assess the chances
of a hedge remaining effective over its life. “You have
to start by trying to be consistent with risk management
and finance body of knowledge that can be applied,” says
Andrew Kalotay, president of Andrew Kalotay Associates,
a debt management advisory firm.
“The key is to find a methodology that
satisfies FASB’s requirements, but (also) promotes risk
management goals,” Dr. Kalotay says. “While it’s
perfectly acceptable to expect effectiveness and fail,
from an accounting perspective, it may not be from a
corporate disclosure or income volatility perspective.”
In other words, hedgers should really know at the
hedge’s inception whether they are likely to remain
effective, (as opposed to an assumption of knowledge for
accounting purposes).
Ideally, companies would choose a
test that would allow them to meet both accounting and
risk management goals. In the least, they need to
recognize that if their accounting-oriented test is
liberal they must have another performance measure to
get closer to their true performance.
Advice on this varies. Dr. Kalotay says
that the only valid test is one that accomplishes both
missions. His methodology, the “Volatility Reduction
Measure” (see below) is an approach that while not yet
adopted by the broad market appears to be gaining some
approval, and tacit approval from at least some
auditors.
This same theoretical approach (i.e.,
examining the volatility of the hedge item with and
without the hedge) is also described in an article Ira
Kawaller, of Kawaller & Co. in a recent article (see
http://www.kawaller.com/).
Mr. Kawaller, a DIG member, outlines several approaches
to measuring effectiveness as well as some of the
hurdles to effective testing (e.g., should you test for
the change in fair value or the actual level of fair
value, for example?)
Other experts note that it may be
dangerous to use a single effective measure that is
borderline liberal to satisfy accounting, once you’ve
already made the economic decision to enter that hedge.
Such an approach assumes that the actual decision to
enter the hedge went through some other, more
conservative testing, meaning that two separate tests
may be more appropriate.
Mr. May of Andersen notes that in
his work with clients, he makes sure that the first
decision is the risk-reduction decision. The next is the
search for the right effectiveness test to satisfy FAS
133. “There are situations where there is a good
economic reason to enter a hedge for risk reduction
purposes, but the hedge won’t meet the criteria of FAS
133 effectiveness,” he says. Companies will have to
decide whether the economics or the accounting matter
more. “At the end of the day, you will have to take
ineffectiveness into P&L,” says Mr. May. That
volatility may or may not meet the company’s overall
risk appetite.
