The FASB Staff posted the agenda items for the Derivatives Implementation Group’s (DIG) final meeting of the year (see, http://www.fasb.org/derivatives/activities.shtml). The agenda for the December 16 meeting includes some critical issues for MNC treasuries, as well as hopes of resolution of long-running debates on how to account for embedded derivatives. In particular, the Staff has prepared responses on the critical question of identifying the characteristics of a debt host.

Effectiveness testing
Perhaps most notable is the return of items 6-3 and 6-11. Both items date back to the DIG’s June meeting (related Executive Brief) and refer to effectiveness testing on a cumulative vs. period-by-period basis. The two were initially part of a "troika" of effectiveness issues. One of those issues (in addition to several net investment items) had reappeared on the DIG’s agenda for its October meeting (see, prior Executive Brief).

Item 6-8 (see, June 24-25 DIG meeting agenda) became DIG Issue E-7 (see http://www.fasb.org/derivatives/issuee7.shtml).

At the June meeting, it appeared that the DIG had reached a pretty clear tentative conclusion. Yet when the FASB Staff posted its official write-up, 6-3 and 6-11 were not posted (prior Current Position). Basically, the Staff concluded that (1) they were unresolved or (2) that there are related issues that prevent the DIG’s conclusion from being presented on the web site for comment. In such cases, the Staff rewrites and brings back the conclusion for further DIG deliberation.

The two effectiveness items are critical to the mechanics of effectiveness testing. They ask whether in assessing effectiveness on a retrospective (or ongoing) basis, should companies compare fair value changes on a period to period basis, or else on cumulative basis since inception. The latter approach would "smooth" out any period-specific market volatility and spikes in ineffectiveness, and since prospective assessment is based on expectation of effectiveness overtime, so should the actual assessment.

Initially, it seemed that 6-3 and 6-11 were straightforwardly resolved:

• For cash flow hedges, the regression analysis that "re-asserts" the hedge relationship should be cumulative, and rerun whenever there’s ineffectiveness identified by the dollar-offset method. On a period-by-period basis, the dollar-offset measure applies.
• With fair value hedges, the prospective effectiveness measures will be defined at designation and could be based on a period shorter than the life of the hedge. When a new hedge is put in place, of course, new "cumulative" expectations must be asserted.

However as the two possible views outlined by the FASB staff illustrate, the end conclusion may not be this simple. Basically, View A agrees that a cumulative measure makes sense, but View B says that such an approach may hide period-to-period ineffectiveness, hence must be disqualified.

View A says: "In periodically assessing retrospectively the effectiveness of a fair value or cash flow hedge in having achieved offsetting changes in fair values or cash flows under a dollar-offset approach, the entity is required to compare the cumulative changes in the hedging instrument’s fair values or cash flows to the cumulative changes in the hedged transaction’s fair values or cash flows attributable to the risk hedged. Assessing effectiveness retrospectively on a cumulative basis is consistent with the requirement in paragraph 30(b) to base the calculation of the effective portion of a cash flow hedge on cumulative gain or loss on the derivative from inception of the hedge."

View B says: "In periodically assessing retrospectively the effectiveness of a fair value or cash flow hedge in having achieved offsetting changes in fair values or cash flows under a dollar-offset approach, the entity is required to base its comparison of changes in fair values or cash flows on a period-by-period approach, which period cannot exceed three months. Fair value or cash flow patterns of the hedging instrument or the hedged transaction in periods prior to the period being assessed are not relevant. Assessing hedge effectiveness cumulatively does not require an entity to promptly de-designate a hedge when the hedging relationship becomes no longer effective because of the occurrence of certain events."

"Paragraph 26 makes it clear that the periodic assessment of the effectiveness of a fair value hedge focuses on changes in fair value occurring after the last date on which compliance with the effectiveness criterion was established. The cumulative approach was rejected because that approach may mask or hide a hedging relationship’s failure to meet the effectiveness criterion for a few discrete periods simply because the cumulative effectiveness ratio had been high in prior periods."

If View B prevails, it may threaten much of the DIG’s good work in creating a simpler, more practical way to assess hedge effectiveness.

Other agenda items

Definition of a Derivative

Hedging–General

Foreign Currency Hedges

Transition Provisions

Issues Resolved by the FASB Staff

Embedded Derivatives

Hedging–General

Fair Value Hedges