Hedge Effectiveness Testing as a Screening Mechanism for Hedge Accounting: Does It Work?. (January 2015)

• Record Type: Journal Article
• Authors: Frestad, Dennis; Beisland, Leif Atle
• Is Part Of: Journal of accounting, auditing & finance. Volume 30:Number 1(2015:Jan.)
• Page Start: 35
• Page End: 56
• Publication Date: 2015-01
• Subjects: screening mechanism -- cash flow hedging -- non-hedgeable risk -- hedgeable risk -- SFAS 133 -- IAS 39 -- fair-value accounting -- hedge accounting -- non-financial firms -- prospective hedge effectiveness; Accounting -- Periodicals; Auditing -- Periodicals; Finance -- Periodicals; 657
• DOI: 10.1177/0148558X14549457
• Languages: English
• ISSNs: 0148-558X

Abstract

Accounting for financial instruments has been subject to much controversy, particularly accounting practices related to derivatives held for hedging purposes. For cash flow hedges, poor matching may result when fair-value accounting is prescribed for the hedging instrument and historical cost is prescribed for the assets that generate the "highly probable forecast transaction" to be hedged. Fair-value accounting may therefore induce excess variations in earnings, which could make a firm appear to be more risky than it actually is. The alternative to fair-value accounting offered by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to firms with hedging programs, hedge accounting, is allowed only if the designated hedge passes a test for prospective hedge effectiveness. We develop a model for the prospective hedge effectiveness of cash flow hedges and find that the "highly effective" criterion of the FASB and IASB fails to recognize the scope of variation of the hedge effectiveness of pure hedges for different types of risk exposures. Prospective hedge effectiveness is not a reliable signal of a speculative component in a derivative portfolio and, consequently, the current "highly effective" screening mechanism cannot effectively separate pure hedges from derivative portfolios that are partly or fully influenced by speculation. We link these and other findings to the current efforts of the FASB and IASB to reform accounting for financial instruments.