“Dollar offset method”
The dollar offset method is one of the accounting procedures recognised by the international accounting standards to determine the effectiveness of a hedge relationship.
Companies using derivative financial instruments to hedge their exposure to a market risk arising from underlying assets or liabilities might want to use hedge accounting to minimise income statement volatility. Such volatility is often caused by variations in the fair value or cash flows of both the [hedging instrument] and the [hedged item].
The US and international accounting standards, however, establish certain requirements to apply hedge accounting. One of these is to demonstrate that the hedging relationship is highly effective during its whole lifespan; that is, to show that the changes in the fair value or cash flows of the hedged item and hedging instrument offset each other.
In regard to the nature of the relationship, the company will be compelled to test its effectiveness using qualitative or quantitative methods. The dollar offset method is one of the most common examples in the latter group.
The dollar offset method involves comparing the variation in the fair value, present value or cash flow expectations of the hedged item with the variation in the fair value, present value or cash flow expectations of the hedging instrument. This process can be done either on a cumulative basis from the day of the designation or on a periodic basis.
Highly effective hedging relationships are those with offset ratios ranging from a minimum of 80% to a maximum of 125%, and the effectiveness test may be performed both prospectively and retrospectively.
Prospective hedge effectiveness tests are carried out by running simulations that analyse the dollar offset ratio under different likely risk scenarios. If the offset ratio in all those scenarios remains between 80% and 125%, the hedging relationship will be considered highly effective.