Think Your Hedges Are 100% Effective? Think Again.
Are you confident that your hedges are 100% effective?
Unfortunately, if it feels too easy, it probably hasn’t been done right or at all.
Even the most well-constructed hedges may contain some hedge ineffectiveness. Hedge accounting ineffectiveness can stem from numerous sources, including a lack of proper testing.
From our experience, most companies aren’t able to perform the proper hedge accounting testing. This leads to falsely assuming hedges are 100% and doing nothing, creating a ticking time bomb.
In this article, we’ll cover the importance of hedge accounting effectiveness testing and strategies you can use to test your hedges properly.
The Importance of Hedge Accounting Effectiveness Testing
Hedge accounting effectiveness testing is an important component of running your hedging program. It’s one of the eight pillars of the HEDGEHOG Method. Here are a few more reasons why hedge effectiveness is important:
Compliance and clean audit opinions - With the right hedge accounting testing controls, you can solidify a clean audit opinion, reducing the risk of a misstatement. Strong effectiveness testing also maximises compliance with IFRS and other regulatory agencies.
Accurate financials - Hedge accounting effectiveness testing is crucial to generating accurate financial statements. Misstatements in hedge accounting can lead to lost stakeholder trust and the program's discontinuance.
How to Properly Test Your Hedges
Implementing the proper hedge effectiveness testing can help position your business for success. Here are strategies your business can use to test your hedges properly.
Understand hedge effectiveness testing methods - Most businesses lack the internal know-how to perform the proper hedge accounting tests. There are two main groups of tests that should be completed: qualitative and quantitative. Qualitative tests confirm the economic relationship exists, while quantitative tests use regression and ratio analysis to confirm the numbers.
Measure hedge ineffectiveness - Proper testing of a hedge accounting program relies on measuring fair value changes in both the hedged item and the hedging instrument. Using the ‘lower of’ test is generally recommended to accomplish this for cash flow hedges. This test calculates the dollar amount allowed to be held within the Cash Flow Hedge Reserve in equity. Any portion posted to the income statement is deemed ineffective.
Quantify the ineffectiveness of mismatched receipts/payments - Sometimes, the timing mismatch between the settlement date of the hedged item and hedging instrument can lead to hedge ineffectiveness. To test the actual effectiveness, hypothetical forwards can be used to clone the date of expected receipts, with the difference in fair values at the reporting date being measured.
The Bottom Line
Hedge effectiveness can be impacted by a variety of factors, including the mismatched timing of cash flows, credit risk, off-market swaps, foreign currency basis spread, forward points in a FX forward contract, the time value of options, and interest rate floors.
To explore any of these items in more detail and the potential impact on your business, contact one of our team members today. We can help you pinpoint inefficiencies in your hedge effectiveness testing and suggest viable strategies to rework your testing procedures to maximize compliance, accuracy, and effectiveness.
