Many of the changes included in the ED relate to effectiveness testing and measurement. Shortcut method (for interest rate swaps) and critical terms match method (for other risks/instruments) would be eliminated. However, the quantitative testing (i.e. regression, sensitivity testing) required by the “long haul” method is replaced in many cases by a qualitative approach. The hedger will only need to demonstrate that an economic relationship exists between the hedge and the hedged item.
With the quantitative testing requirement being virtually eliminated for many hedge relationships, the focus in the future will be on identifying and measuring the effective changes in the underlying hedged transaction. According to paragraphs 122-126 of the ED, the measurement of hedge ineffectiveness shall be based on a comparison of the change in fair value of the actual derivative designated as the hedging instrument and the present value of the cumulative change in expected future cash flows on the hedged transaction. The amount to be deferred in accumulated other comprehensive income will be the amount associated with the changes in fair value of the present valued hedged transactions’ cash flows. This is a fundamental change in the cash flow concept as under current guidance OCI reflects the portion of the derivative that is effective and under the proposed guidance OCI will reflect the entire change in value of the hedged item. This means any over or under performance of the hedge will be reflected in income, similar to fair value and net investment hedging. (Currently only over performance of a cash flow hedge is reflected in income.)
For entity’s including time value in the assessment and measure of effectiveness, the trick is going to be figuring out how to capture the expected date of the hedged transaction(s) to model a derivative that matches such expected date. For most cash flow hedging relationships, the designated forecasted transactions are related to a group of transactions within a specified period. In this case, entities will be allowed to model a derivative that would settle within a reasonable time period (generally one month) of the cash flows related to the hedged transactions. It also appears that companies should not assume the underlying’s maturity date equals the hedge maturity date.
As the focus shifts away from assessing effectiveness, and moves towards measuring actual ineffectiveness in a hedging relationship, entities are going to have to establish processes and procedures to support how they determine the expected date of the forecasted transaction in order to best reflect the appropriate amounts of hedge ineffectiveness in income.
