Critical Terms and the Short-Cut Method for Hedge Accounting: Will your auditors be happy?

This guest post is written by Gurpreet Banwait, the director of Insight Solutions Product Management at FINCAD.

For companies concerned with income statement volatility, complying with hedge accounting standards is a no-brainer.

If you are using a hedging strategy to minimize your risks, but not utilizing hedge accounting, then changes in the fair value of your derivatives will flow through to your income statement creating unnecessary volatility that can negatively impact your organization’s financials.  It’s understandable that organizations don’t want to add complexity to their daily routine, but they need to test for hedge effectiveness in a manner that will keep their auditors happy.  Critical Terms and the Short Cut Method have emerged as ways to comply with hedge accounting without performing some of the more complex testing.  However, there are still challenges associated with their implementation that companies need to be aware of.

1. FASB
   1. Companies need to provide an appropriate level of documentation outlining why they expect no ineffectiveness to arise from the hedging relationship. The risk here is that if this assumption of no ineffectiveness is proven to be incorrect, companies must de-designate, which will have an impact on financial statements. This risk can be quite high in certain cases and therefore providing this proof becomes very important. In fact, the necessary steps taken to provide this proof can lead many organizations to choose to comply with the long haul method as this method provides the required information. In fact, many companies will state they are using the critical terms approach, but confirm its application by using a test that is usually saved for the long haul method. However, this still saves the company time generating the necessary accounting entries if it can prove 100% effectiveness.

    

2. IFRS
   1. Retrospective testing needs to be conducted. This means that companies must put in place the proper processes to generate and analyze test results. This defeats some of the purpose of complying with a critical terms method. One of the main reasons why the critical terms method is not used under IFRS is due to the requirement to explicitly consider counterparty credit risk in the valuation of the derivative hedging instrument. One would not be able to conclude that the relationship is perfectly effective even if the critical terms matched, as the change in the fair value of the derivative hedging instrument can never be expected to perfectly offset the change in the fair value of the hedged item (the fair value of the former is impacted by the changes in credit risk of the two counterparties, while the fair value of the latter is not, and is only based on changes in fair value due to the hedged risk).

    

3. Future Changes
   1. Although future changes to hedge accounting standards are still being worked on and have yet to be approved, it appears that these simplified approaches will no longer be available. This is leading many companies to review their current process in preparation for these changes. For organizations that are considering complying with hedge accounting standards, it may make sense to look at more robust approaches now rather than making changes in the future.

    

Ultimately, whatever hedge accounting method you choose, you need to make sure that it fits your organization needs’ AND satisfies your auditors. The future is changing and companies need to be prepared to better handle the standards.

Note: Organizations should consult the appropriate financial accounting standards prior to applying hedge accounting or accounting for derivative financial instruments, including valuation. These currently include International Accounting Standard 39 – Financial Instruments: Recognition and Measurement, and in the U.S., Accounting Standards Codification 815 – Derivatives and Hedging. This article is for information purposes only and is not intended to prescribe in detail how to meet the requirements for hedge accounting or subsequently measure the value of financial instruments under International or U.S. accounting principles. In addition, an entity’s accountants should be involved in any assessment regarding the application of hedge accounting and/or the subsequent accounting and valuation for financial instruments including derivatives.