#### Reconciling the Cost Approach and the Fair Value Approach

FAS 133 declared that all foreign exchange transactions (derivatives), including those that are embedded in host contracts, are assets or liabilities and should be recorded as such at their fair value on the balance sheet. The embedded derivatives must be bifurcated from the host contract and then fair valued as if they were standalone derivatives.

All hedges must be documented and proven to be a highly effective hedge of the hedged position. If not, then any changes in the fair value are to be recorded in current earnings. If the hedge is fully effective but the amount differs from the underlying exposure, that difference – hedge ineffectiveness – must be fully reported in current earnings. The type of hedge accounting varies with the nature of the risk being hedged. For the first time, US GAAP is requiring hedging performance, rather than hedging intent, as the criterion for determining whether to apply deferral accounting for the derivative gain or loss.

#### Fair Value, Cash Flow and Investment Hedges

FAS 133 differentiates three hedge types: fair value hedge, cash-flow hedge, and net investment hedge. A fair value hedge is a derivative that hedges the value of the asset, liability, or firm commitment. Cash-flow hedges are derivatives which hedge the variability of anticipated future cash flows, whether from a forecasted transaction or variable rate commitment. A net investment hedge tries to minimize the foreign exchange effect on foreign investment. Changes in fair value of a fair value hedge and its underlying value are recorded in earnings. If hedge accounting treatment cannot be used, then changes in the derivative’s value will flow through earnings.

Changes in fair value, cash flow and investment hedges are recognized as balance sheet items – other comprehensive income (OCI) for cash-flow hedges and cumulative translation adjustment (CTA) for net investment hedges. The cash flow hedges are recorded on the after-tax basis in Accumulated Other Comprehensive Income (AOCI), a retained earnings account in accordance with FAS 130. The AOCI is reclassed into earnings when underlying hedged item impacts earnings and not for example when thr hedge is terminated. They are released to earnings as the underlying exposure is realized. If the hedge is a net investment hedge, the effective portion is recorded as well in AOCI but is released into earnings only when subsidiary is subsequently sold or liquidated.

Thinking in balance sheet terms, we can easily differentiate between fair value hedges and cash flow hedges. The position of fair value hedges appears in the balance sheet where the hedge can be booked directly into balance sheet to offset the hedged position. The cash flow hedges do not have at first any position in the balance sheet or the position does not generate any balance sheet risk, for example variable rate loan or investment. However, the variability in cash flows can arise from these items.

#### FAS 133 Hedge Types

Illustration 1 shows different hedge types. The foreign currency hedges can be cash flow hedges, fair value hedges or net investment hedges. In illustration 1 we see examples for these hedge types. Using these examples we can easily differentiate between the various hedge types.

Source: Derivative Accounting & Hedging Under FAS 133, Greenwich Treasury Advisors

#### Fair Value

The biggest cause for confusion in FAS 133 is its use of the term “fair value”. It is always used in the sense for valuing a derivative on the balance sheet. However, how this value will be derived has to be defined in the actual hedge documentation and there are theoretically 64 possible calculations for estimating the change in fair value of the hedged item and the change in fair value of the hedge instrument. In order to qualify for hedge accounting the company has to develop and document its approach to risk management. It has to determine its intent of using derivatives in its risk management policies.

For example, a company which imports parts from Germany and Japan may have the policy to hedge 100 per cent of its purchases in Japan but only 50 per cent of its purchases in Germany. The hedging policy is a dynamic document that can be changed or modified at any time, but everything has to be documented. All derivatives held have to be identified, including embedded and compound derivatives. The appropriate valuation method for all derivatives has to be defined as well. These methods can vary, for example interest swaps can be valued according to the written information from the bank, options can be valued according to the well accepted valuation model, forward contracts can be valued using market spot or forward rates. The hedges have to be designated and effective. If the derivative is not designated as effective as a hedge, the change in its fair value is then included in earnings.

To qualify for hedge accounting, a hedging relationship is required to comply with an entity’s established policy for what constitutes high effectiveness in achieving offsetting changes in fair value, but that does not eliminate the possibility of some ineffectiveness. Measurement of hedge ineffectiveness for a particular hedging relationship should be consistent with the entity’s risk management strategy and its documented method of assessing hedge effectiveness for the particular hedging relationship. Hedge ineffectiveness affects earnings because there is no offsetting adjustment of the hedged item’s carrying amount.

All or only a proportion of a derivative may be designated as the hedging instrument. If only a proportion is used, it should be expressed as a percentage of the entire derivative. Two or more derivatives or portions of derivatives may be jointly designated as a hedging instrument. At least quarterly, the hedging entity must determine whether the hedging relationship has been highly effective in having achieved offsetting changes in fair value or cash flows through the date of the periodic assessment.

We can differentiate three methods to determine the hedge effectiveness: dollar-offset method, regression and value at risk calculation or other statistical analysis. There is a big risk that hedge effectiveness test will fail when applying dollar offset method. The dollar-offset method is simply a ratio of the change in the fair value of the hedge instrument as specified in the documentation by the change in the fair value of the hedged item’s hedged risk, again as specified in the documentation. This ratio, typically calculated as a percentage, should be within a range of 80-125 per cent. If we apply a regression analysis, market practice agrees that the R2 must be 80 per cent or better to pass the test. Table 1 shows that when using the dollar offset method and the value of hedged item changes to 150 and the value of the hedge instrument changes to 195 the hedge is not more effective. However if we apply simple regression method, the R2 is still over 99 per cent and the hedge effectiveness is passed.

The value-at-risk approach calculates the reduction in the volatility after the hedge compared to the volatility of the hedged item alone. If the reduction were greater than some agreed-upon parameter, say 80 per cent then the hedge relationship would pass this hedge effectiveness test.

Dollar offset values of the position | Dollar offset values of the hedge | Difference between 80 and 125% |
---|---|---|

100 | 85 | yes |

110 | 99 | yes |

115 | 115 | yes |

120 | 130 | yes |

150 | 195 | no (130%) |

R^{2} |
0.99330046 | yes |

We can further improve the outcome of the hedge effectiveness test if we aggregate the numbers for hedge documentation purposes. A company with export sales in euros to Italy, Germany, Spain, etc., should not have individual hedge documentations for export sales to each country but aggregate sales together. Another way to reduce forecast error risk is to lower the hedge ratio or to hedge in layers or tiers.

If a hedge relationship fails the retrospective hedge effectiveness test, then the hedge is terminated, and the deferred gain or loss on the derivative is recognized currently in earnings and then reported as a separate item in the footnotes in the annual report. For this reason, nearly all companies will only do hedge accounting if they are very certain that the hedge will indeed be highly effective.

Hedging can also be voluntarily terminated. The ability to voluntarily take hedges on and off at will without impacting prior deferral amounts means that all kinds of dynamic hedging strategies are implicitly allowed. However, since all prior deferred amounts remained deferred, FAS 133 prohibits companies from terminating their profitable hedges (i.e. cherry picking) so that selective hedge profits could be reported into current earnings. As mentioned already the hedge effectiveness test has to be repeated at least once per quarter. However it wouldn’t be FAS 133 if there weren’t some exceptions.

#### Exceptions for Applying the Hedge Effectiveness Test

There are three exceptions to the requirement for applying the hedge effectiveness test:

- When the critical terms of the hedge instrument and the hedged position are the same.
- The shortcut method for interest rate swaps.
- The hypothetical derivative method.

Any time the corporation has the possibility of applying for any of these exceptions it should try to do so. This will reduce workload.

FAS 133 requires that written options must be fully marked-to-market, with gains and losses recorded in earnings. A combination of option (e.g. participation option, range forward) assuming that it passes the effectiveness test and not a net premium is received, the written and purchased options have the same maturity, the amount of written option is not greater than the amount of the purchased option can qualify for hedge accounting. The bias against option hedging as per original version of FAS 133 is thereby eliminated. Also the bias against using the non-derivative instruments is partly removed. A non-derivative instrument denominated in a foreign currency may be designated as a hedge of the foreign currency exposure of an unrecognized firm commitment denominated in a foreign currency or a net investment in a foreign operation. Designation of a foreign-currency-denominated debt instrument as both the hedging instrument in a net investment hedge and the hedged item in a fair value hedge is allowed. However designation of debt instrument in the cash flow hedge, hedge of forecasted foreign currency transaction is not allowed. Also combination of debt instrument and derivative instrument will not receive the hedge accounting treatment, for example euro borrowing and euro-yen currency swap to hedge yen denominated receivables or net investment in Japan. The disallowance of using synthetic forward contracts for forecasted foreign currency transaction using debt instruments is currently not a meaningful disadvantage because forward contracts follow very closely interest differentials. However in case of capital restrictions this could become a real disadvantage.

There are also certain exceptions in what is considered to be a derivative. Excluded are certain insurance contracts, weather-related derivatives, derivative contracts of the company’s own stock, etc. As a result, the Financial Accounting Standards Board’s latest FAS 133 compendium, the “Green Book,” contains 800 pages.

FAS 133 requires that at the time a company designates a hedging relationship, it must document the method it will use to assess the hedge’s effectiveness in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged. The hedge documentation can be thought of as a mathematical algorithm for calculating numbers that are recorded in specific income statement, comprehensive income, and balance sheet accounts. The algorithm is to be so precise that anyone reading the documentation could apply it and arrive at the same numbers. However due to the complexity of FAS 133, the discretion about choosing the method to calculate the changes in the fair value and hedge effectiveness test the process can be influenced by the participants.

With FAS 133 now in place everybody who wants to obtain the hedge accounting treatment has to provide sufficient documentation. The appropriate documentation is the key. This in itself is not bad, because no company should execute any hedging activities without prior agreed hedging strategy and policy. However the excessive documentation will not improve hedging decisions. With all these requirements the financial manager is now not only investing time to find the best economic hedging solution but also to fulfill many accounting requirements.

Not all instruments can be used for all hedging purposes. Debt instruments can be used for net investment hedges and fair value hedges of foreign exchange exposure. Also combinations of debt instruments and derivative instruments are not allowed. Debt instruments cannot be used to create synthetic foreign exchange contracts to hedge forecasted exposure. There are also restrictions when using complex structures and special consideration must be taken into account, see above, when implementing options strategies. The FAS 133 bureaucratic approach to hedging has increased the compliance work considerably. Companies that apply only short term hedging or for relatively small amounts should consider to record all hedging activities directly into P&L without applying for hedge accounting.

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