Ira Kawaller explains why the most common effectiveness test is statistically incorrect.
he authorities at the Financial Accounting Standards Board have not been eager to lay down specific guidance for assessing hedge effectiveness—a critical prerequisite for special hedge accounting treatment. In most cases, they want to leave it up to the people performing and auditing the test to determine what makes sense for them. As a result, there will likely be a variety of approaches that will be used, and auditors will have to evaluate each new method on a case-by-case basis. And that raises cause for concern. The basic idea behind the standard is that gains or losses in derivatives should offset changes in fair values or cash flows. The problem, however, comes when it’s time to assess whether a particular hedge is effective. Although it’s never explicitly stated in the documentation, there’s a widespread assumption that a hedge should pass if it can satisfy an “80/125 test.” According to this criterion, the measure of the results of the derivative relative to the gain or loss on the hedged item ideally should be 1 to 1, but a range from 0.80 to 1.25 is acceptable. While that standard may seem to be reasonably generous, it tends to break down quite easily; as a result, even well performing hedges can quickly fall out of hedge effectiveness and thus be denied hedge accounting. Let’s take, for example, a situation where the value a $1 million item changes by $5 dollars, but the value of the offsetting hedge changes by $10. The price changes are negligible, but the dollar-offset ratio—five divided by ten—falls well beyond the 80–125 band. Denial of hedge accounting in the current period makes little difference, in that the price effects are negligible, but suppose we get kicked out of hedge accounting and next period a significant price change occurs. Then we’re in trouble. There is a way out of this conundrum. If you fall out of the 80–125...