Measuring Hedge Effectiveness for Fas 133 Compliance

inancial Accounting Standard (FAS) No. 133 requires that all derivatives be marked to market and that changes in their market value be recognized in earnings in the current period. Derivatives may qualify for special hedge accounting treatment, however, provided they are used to hedge specific risks and an effective hedging relationship can be documented. Companies that meet these requirements are permitted to recognize offsetting gains or losses on the hedged item in the same period as any loss or gain on the hedging instrument, potentially dampening the overall impact on earnings.1 For businesses that use derivatives for risk management, failure to qualify for hedge accounting can have considerable tax consequences. What’s more, the mismatch in the timing of income recognition may induce income volatility that does not accurately reflect underlying economic performance. This income volatility can have a substantial impact on other managerial decisions and contractual obligations faced by the company, which may influence the choice of hedging instrument or even whether to hedge at all.2 An assessment of hedge effectiveness is required by FAS 133 at least every three months and whenever financial statements or earnings are reported by the firm. However, the Financial Accounting Standards Board (FASB) leaves the