Alternative Approaches to Testing Hedge Effectiveness under SFAS No. 133

INTRODUCTION Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities--An Amendment of FASH Statement No. 133, prescribes comprehensive new rules for accounting for derivative instruments (FASB 1998,2000). SFAS No. 133 (para. 3) standardizes the accounting treatment for derivative instruments by requiring all entities to report their derivatives as assets and liabilities on the balance sheet and to measure them at fair value. Reporting changes in the fair value of a derivative in earnings each quarter could create a matching problem. If the derivative is being used as an economic hedge, changes in the value of the derivative might increase (or decrease) reported earnings one period while the opposite change in the value of the hedged item affects earnings in a later period. To avoid distorting earnings, SFAS No. 133 (paras. 3, 20, and 28) permits firms to match the timing of the gains and losses of hedged items and their hedging derivatives, provided the derivative qualifies as a "highly effective" hedge. For a fair-value hedge, SFAS No. 133 (para. 22) permits the hedger to record the change in the fair value of the hedged item concurrently with the gain or loss on the hedging derivative. In the case of a cash-flow hedge, the effective portion of any changes in the hedging derivative's fair value is recorded in other comprehensive income until the change in the value of the hedged item is recognized in earnings (SFAS No. 133, para . 30). (1) In principle, a hedge is highly effective if the changes in fair value or cash flow of the hedged item and the hedging derivative offset each other to a significant extent. Hedged item refers to an asset or a liability or a prospective cash inflow or outflow. Derivative refers to any derivative or combination of derivatives used to hedge changes in fair value or cash flow. Hedged position refers to the combined hedged item and derivative. The hedged item can be a designated portion of an asset or liability or a designated expected future cash flow that is attributable to a particular risk (SFAS No. 133, paras. 21 and 28, and Derivatives Implementation Group [DIG] Issue E10 [FASB 2000]). To qualify a derivative position for hedge accounting, the hedging entity must specify the hedged item, identify the hedging strategy and the derivative, and document by statistical or other means the basis for expecting the hedge to be "highly effective" in offsetting the designated risk exposure. The documentation step is c alled prospective testing, and it must be done before entering into the hedge and on an ongoing basis to justify continuing hedge accounting. The hedger must also regularly perform retrospective testing to determine how effective the hedging relationship has been in actually achieving offsetting fair values or cash flows. This article examines the test choices that firms must make. Section 2 of Appendix A of SFAS No. 133 requires the use of statistical or other numerical tests for hedge effectiveness, unless a specific exception applies, but SFAS No. 133 does not endorse any specific testing methodology. The hedger must select the methodology, such as regression analysis, choose the measurement period, and specify an appropriate test statistic like adjusted [R.sup.2] along with the critical value to distinguish a "highly effective" hedge from one that is not, for example, an adjusted [R.sup.2] above 0.8. The article describes four existing methods of testing hedge effectiveness: (1) the Dollar-Offset Method, (2) the Relative-Difference Method, (3) the Variability-Reduction Method, and (4) the Regression Method. We refine the Variability-Reduction Method and the Regression Method to correct their potential to accept poorly performing hedges. …