All derivatives within the scope of FAS133 must be recorded at fair value as an asset or liability. Hedge accounting may be applied if there is hedge documentation and gains and losses in the value of the derivative with gains and losses in the value of the underlying transaction.
To be designated and qualify for FAS 133 hedge accounting, a commodity (hedged item) and its hedging instrument must have a correlation ratio between 80% and 125%, and the reporting enterprise must have hedge documentation in place at the inception of the hedge. If these criteria are not met, hedge accounting cannot be applied. The non-applicability of hedge accounting can lead to significant volatility in corporate earnings. Now, the financial community has had enough experience with FAS 133 that companies and constituents better understand this process and are less critical of the volatile impact on earnings.
Creating forward commodity values to determine correlation, required by FAS 133, is not perfect due to the nature of different OTC derivative commodities and the fact that they are not quoted in exchanges like NYMEX and ICE. Many companies outsource this data collection to insure that industry methods and standards are achieved. As important as FASB 133 is in risk management and hedging, this reporting system has limited some creative hedges solely based on the potential negative impact on the companies’ earnings.