De-Mystifying Hedge Effectiveness Testing

The old adage, “if it’s too good to be true, it probably is,” sums up hedge effectiveness testing perfectly. If you think the process is easy and straightforward because your hedges are 100% effective, you need to look closer. 

The variables that test hedge effectiveness are constantly changing, meaning your testing processes should be undertaken regularly.  Undertaking the appropriate hedge effectiveness testing can help you position your business for success, making it important to understand the critical ways to test your hedge relationships at inception, and every reporting period at a minimum. .

Why is Hedge Effectiveness Testing Important?

Hedge effectiveness testing is a crucial component of meeting the criteria for obtaining hedge accounting treatment; however, stakeholders and managers do not understand this practice widely. Just recently, a prospective client reached out to us wondering why their auditor was saying their hedge was ineffective. After conducting some pro-bono analysis, we uncovered that the Day 1 fair value of the derivative, at the inception of the hedge was causing issues. 

When your hedge effectiveness testing lacks clarity from the beginning, you risk having continuous errors. Hedge effectiveness looks to minimise certain risks of hedging. Without the proper controls, your business has heightened risks of monetary losses over the life of the hedging instrument. 

How to review your Hedge Effectiveness Testing approach?

Review your hedge relationship documentation or hedge accounting policy and comfirm what type of testing should be done. For example, are you to use a hypothetical derivative approach and should this be by dollar offset method or regression? If this all feels too hard or simply is way over your head then ask a hedge accounting specialist for support. This is a very technical area and most finance professionals will not have this niche skill in the locker. 

What are the Risks of foregoing Hedge Effectiveness Testing?

Failure to conduct a thorough testing approach could result in your hedge accounting program getting pulled, creating immediate gains and losses on the income statement.

Furthermore, not fully understanding your hedge effectiveness testing process can lead to issues when your business has an audit. The auditor will test the effectiveness of your hedge to determine if you are following the accounting standards. If errors are uncovered, you may be disallowed from using hedge accounting. 

Do you feel confident in your approach and compliance with IFRS 9? If not, please reach out to one of our team members to schedule a consultation. 

One of the ways your business can reduce risk is to have the proper components working in your hedge effectiveness testing. Working with one of our team members can help you determine if there are any shortcomings in your hedge effectiveness testing. 

For more information on Hedge Accounting or advice on a specific hedge accounting challenge, contact our team.