Meeting the “Highly Effective Expectation” Criterion for Hedge Accounting

Abstract

The continual attempts of FASB to revise and regularize the accounting treatment of derivatives positions in a firm's accounting statements has led to the recent Financial Accounting Standard No. 133. The use of hedge accounting procedures, which is generally highly desired by firms engaged in hedging with derivatives, may now require that the hedge be “highly effective.” the meaning of this term, however, is not fully specified. And, given both the versatility of derivatives and the “noise” (or “basis risk”) that can affect the relationship between the market for a derivative instrument and its underlying, it is not surprising that difficult cases can be found. Kawaller describes the “highly effective” criterion of the new rule and considers how it should best be applied.