In order to qualify for special fair value hedge accounting, the derivative and the hedged item must satisfy a following number of criteria.
1. At inception of the hedge, there must be formal documentation of the hedging relationship and the entity’s risk-management objective and strategy. Documentation should also identify the hedging instrument, the hedged transaction, the nature of the risk being hedged, and a plan for assessing the effectiveness of the hedge.
1. At inception of the hedge, there must be formal documentation of the hedging relationship and the entity’s risk-management objective and strategy. Documentation should also identify the hedging instrument, the hedged transaction, the nature of the risk being hedged, and a plan for assessing the effectiveness of the hedge.
2. Both at inception and on an ongoing basis, the hedging relationship must be assessed to determine if it is highly effective in offsetting the risk exposure associated with changes in the hedged item’s fair value. The effectiveness of the hedging instrument must be assessed whenever financial statements or earnings are reported and at least every three months.
3. The hedged item is specifically identified as part or all of a recognized asset, recognized liability, or unrecognized firm commitment. The hedged item may be a single asset or liability or a portfolio of similar assets or liabilities.
4. The hedged item has exposure to changes in fair value, due to the hedged risk, that could affect earnings. For example, decreasing prices could affect an existing inventory of materials and result in lower gross profits.
5. The hedged item is not an asset or liability that is being measured at fair value, with changes in fair value, both positive and negative, being currently recognized in earnings. For example, an investment in securities, classified as a trading portfolio, would not qualify for special hedge accounting. The unrealized gains and losses on the portfolio would already be recognized in earnings, and changes in the value of a designated derivative would also be recognized currently in earnings. Therefore, special hedge accounting would only be allowed if generally accepted accounting principles (GAAP) do not already require the hedged item to be measured at fair value.
6. For nonfinancial assets (such as inventory) or liabilities, the risk being hedged against is the change in value of the entire item at its actual location rather than a change in value due to a different location or a component part. Therefore, you could not hedge an inventory of butter by designating price changes of milk as the risk being hedged.
7. Financial assets or liabilities and nonfinancial commitments with a financial component can be designated as hedged items if certain types of risks, such as those related to benchmark interest rate risk, foreign currency exchange rates, and creditworthiness are being hedged. Two or more of the above risks may be hedged simultaneously. Prepayment risk may not be designated as the risk being hedged.