As financial institutions increasingly incorporate derivatives into their balance sheet management strategies, they must navigate the complex accounting and valuation standards governing the financial reporting implications of using these types of instruments. Derivative use (particularly for interest rate risk management) requires adherence to accounting frameworks such as ASC 815 Derivatives and Hedging), ASC 820 Fair Value Measurement), and/or their international standard equivalents IFRS 9 (Financial Instruments) and IFRS 13 (Fair Value Measurement).
In order to meet those requirements, a detailed approach to hedge documentation, effectiveness testing, and valuation modeling is required. Irregularities or errors in any of these areas can result in earnings volatility, regulatory issues, and/or audit deficiencies.
Hedge Accounting Under ASC 815 and IFRS 9
Applying hedge accounting enables institutions one of the most optimal avenues toward aligning financial reporting results with economic hedging objectives. That said, applying and sustaining a hedge accounting designation includes a series of ongoing tasks, including:
- Formal Documentation
Institutions must establish formal hedge documentation at the inception of the hedge relationship. This includes defining the hedging instrument, the hedged item, the risk being hedged, the method of assessing hedge effectiveness, and the initial assessment thereof.
- Effectiveness Assessment and Monitoring
Regular assessment of hedge effectiveness is required to demonstrate that the hedge relationship is expected to be, and has been, highly effective. This includes both an initial assessment in its formal documentation (as stated above), as well as assessments to be performed over the life of the hedge relationship. Institutions may employ qualitative methods and/or quantitative methods such as regression analysis, the dollar-offset method, or other statistically appropriate techniques to meet this requirement.
- Accounting Entries and Recognition
Accurate journal entries accurately must reflect changes in fair value, realized gains or losses (net derivative settlements), and appropriately timed earnings recognition of those realized gains and losses. Misapplication of these entries can affect income volatility and perception of the hedging program.
- Disclosure Requirements
Financial statements must include quantitative and qualitative disclosures related to hedging activities. These include the fair value hierarchy classification, the nature of the hedging relationships, the notional amounts outstanding, and the impact on earnings and other comprehensive income (OCI).
Financial Instrument Valuation Support
Independent valuation of financial instruments is a critical component of both internal risk management and external financial reporting. This includes:
- Derivative Instruments
Institutions often use swaps, caps, floors, futures, and other derivative products to manage interest rate risk. These must be valued using market-based inputs and accepted pricing models that comply with the fair value hierarchy definitions outlined in ASC 820.
- Fixed-Income Securities and Structured Products
Institutions holding investment portfolios may also require fair value measurements of securities, including level 2 or level 3 instruments where market inputs are not directly quoted and/or observable.
- Model Validation and Calibration
For institutions using internal valuation models, it is important to validate those models periodically and benchmark against observable market data and/or independent models in preparation for audits or regulatory exams.
Hedge Accounting and Financial Valuation in Practice
- Cash Flow Hedges of Floating-Rate Debt
Financial institutions often hedge variable-rate funding sources, such as short-term borrowings or other market-sensitive funding sources, using interest rate swaps to synthetically fix a portion of funding costs. Proper designation and documentation are essential to ensure that unrealized gains and losses (due to changes in market value of the swaps) are recorded in other comprehensive income, rather than immediately recognized in earnings.
- Fair Value Hedges of Fixed-Rate Loans or Securities
When managing duration risk on fixed-rate instruments, institutions may designate fair value hedges that synthetically convert fixed-rate instruments to floating-rate, providing price and NEV protection as markets change in the future. These types of hedges require precise definition and valuation of both the hedging instrument and the hedged item.
- Third-Party Valuation for Audit and Regulatory Compliance
Independent valuations can serve as a key internal control to validate internal pricing models and to support the amounts recorded in financial statements and the disclosures required during audits or regulatory examinations.
Next Steps in Your Hedge Accounting and Financial Valuation Journey
Institutions seeking to improve the accuracy, consistency, and defensibility of their hedge accounting and valuation processes can benefit from engaging a specialized partner. HedgeStar supports credit unions and banks with technical hedge accounting services, independent derivative valuations, and regulatory-ready reporting solutions that align with industry standards and examiner expectations.
For more information or to schedule a consultation, contact us today!
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About HedgeStar – Hedging Made Simple
Founded in 2004, HedgeStar is a leading independent provider of outsourced valuation and independent hedge accounting services for financial instruments including interest rate, currency, and commodity derivatives. HedgeStar provides derivative fair value calculations, cash flow hedge accounting, fair value hedge accounting, net investment hedge accounting, and risk management services. The HedgeStar team is comprised of valuation experts, Certified Public Accountants (CPAs), and hedging program professionals. We deliver our services with a personal touch. We understand our clients and their portfolios and are an extension of their risk, finance and accounting departments. We strive to live by our core values every day.