Understanding Hedge Effectiveness & Probability Assessments
There has been some confusion around the ASC 815 rules set regarding effectiveness assessments and probability assessments.
Both are required under the accounting guidance, but they evaluate the hedge relationship from two different perspectives. In this blog, we will cover the requirements for both assessments, discuss how to navigate a failure of either requirement and the effects on special hedge accounting results.
A cash flow hedge designation requires a probability assessment of an anticipated transaction. ASC 815-20-25-15 states that a forecasted transaction must be probable to receive special hedge accounting. It must be probable within the hedge period defined in inception documentation originally prepared to qualify for cash flow hedge accounting treatment. The guidance provides companies five criteria considered key to an evaluation of the probability of a forecasted transaction (ASC 815-20-55-24).
- The frequency of similar past transactions
- The financial and operational ability of the entity to carry out the transaction
- Substantial commitments of resources to a particular activity (for example, setting up sales and marketing operations to support anticipated sales in a new country/currency)
- The extent of loss or disruption of operations that could result if the transaction does not occur
- The likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (for example, what is the likelihood that an entity that intends to issue 10-year bonds could raise cash another way, like a common stock offering?)
The effectiveness assessment is a hurdle that evaluates whether the hedge and the hedged item offset one another in a highly effective way. The updated guidance allows this analysis to be performed qualitatively or quantitatively. Regression testing is a quantitative test used to prove that the change in the value of the hedge (derivative) is highly effective at offsetting the change in the value of the hedged item (forecasted transaction). If the regression results in an R2>.80 with a Slope between .8 and 1.25, then the hedge relationship is considered highly effective and hedge accounting is permitted. Qualitative assessments are documented assertions that the derivative’s terms are essentially the same as the hedged items.
Failing to Meet Requirements
The accounting treatment is different when either of these criteria fails in whole or in part.
Let’s look at the effectiveness test implications first. If an effectiveness test fails at the end of a period, then all of the hedge accounting applied since the prior effectiveness test is disallowed. This could be a quarter or a month, depending on the company’s testing frequency.
To be more precise, if there is a separate prospective and retrospective test, then each is handled independently. If the retrospective test fails, then hedge accounting is disallowed since the last successful test. If the prospective test passes, a company can continue to assert a highly effective relationship in the future. We usually see the same test for both the retrospective and prospective tests. So, under a failed regression test scenario, all future changes in derivative value would not qualify for hedge accounting together with any changes in value post the last successful test result. A good way to keep things straight is to consider the assessment test as a yes or no to hedge accounting. A pass means hedge accounting is permitted, and a fail means it is not.
Once hedge accounting is permitted via an effectiveness test proving the derivative is appropriate for the exposure, then the probability assessment takes place. Under the accounting rules, probability is segregated into three distinct categories: Probable, Possible and Remote.
Probable is typically a transaction that is 80% likely to occur within the hedge period. Possible would be transactions that might not meet the 80% likely threshhold, but are more than 20% likely to occur within the hedge period plus two months. Remote is a transaction that is less than 20% likely to occur within the hedge period, plus 2 months.
When a forecast is reduced, the accounting treatment on the associated derivative also changes. Any amounts associated with forecasts that are still probable to occur within the originally designated hedge period are treated normally under the cash flow hedge rules. If the transaction is still probable in the two months beyond the hedge period, but not in the hedge period itself, the hedge should be de-designated and re-designated. Amounts that are still “possible” to occur must be de-designated (hedge accounting stopped) with the associated amounts recorded in AOCI left until the hedged item occurs. There is no income impact to this treatment; however, all subsequent changes in the value of the hedge are recorded in foreign currency gain/loss similar to a balance sheet hedge. All amounts deemed “remote” will be canceled, which means any amounts previously recorded to AOCI must be flushed into income in the hedged line item (e.g. revenue, expense, etc.) and all future changes in value are recorded to foreign currency gain/loss in income.
To recap: the effectiveness test comes first and either permits or disqualifies the hedge relationship from cash flow hedge accounting treatment. After the test is passed, a probability test is performed to assess whether the hedged items are probable, possible or remote. Each of the amounts in these categories must be addressed for hedge accounting purposes.
Hedge accounting rules can be confusing, especially during times of market turmoil.
To keep things straight, an effectiveness test is used to assert that a hedge relationship is highly effective. The test must be passed to qualify for cash flow hedge accounting treatment. Once the test is passed, then a probability assessment of a forecasted transaction (e.g. anticipated sales or expenses) is undertaken. Under normal conditions, most hedged items will be probable to occur. But as forecasts are reduced, some of the hedged items may fall into a possible or remote category. The three categories follow different accounting treatments from continue hedge accounting, to de-designation or, in rare cases, to the cancellation of the hedge relationship altogether.
If your company, like many today, is experiencing a change in the forecast or a reduction in your hedged item, Hedge Trackers can help you assess the best course of action, hedge accounting treatment and how to protect against falling forecasts in the future. Please contact our team here.