Ask the Auditor: Cross Country Observations on Hedge Accounting
A Note on Hedge Accounting
Hedge accounting standards under US GAAP fall under the Financial Accounting Standards Board - ASC Topic 815 and with the detailed standards can be found at https://asc.fasb.org/815/tableOfContent
Outside the United States, different accounting standards apply. Generally, these standards reference International Financial Reporting Standards (IFRS), with the reporting on derivatives falling within IFRS 9.
There are distinct differences in how the two accounting boards view hedge accounting standards. Additionally, accounting standards vary between countries as well as for the business size and the type of elections that can be made at that level (example, ASPE in Canada.)
The information contained here is for reference only. Consult your auditors to determine how this might relate to your business.
Over the course of my career, I have worked with businesses in four different countries on two separate continents, operating under a multitude of different accounting standards. Over time, I have noticed one recurring theme: the propensity of US firms to use hedge accounting in contrast to their counterparts in Canada.
Hedge accounting
Hedge accounting adds an administrative burdens and requires an audit. It’s also completely optional, so why would a business take that on?
The reality is accounting for financial derivatives is complex, and many organizations run into the challenge of aligning the economic intent of why they hedge with their financial reporting objectives. The reality is sometimes those objectives are at odds with each other.
Crucially, with financial derivatives there are differences in measurement and recognition of the changes in the value of the hedge contract and the risk it is meant to hedge.
What this means is that, on occasion, hedging an economic risk in a business can complicate financial reporting.
Nonetheless the financial reporting focus of US firms helps explain this inclination toward hedge accounting when compared to Canadian companies.
Measurement, Recognition, timing & mismatches
Under fair value reporting, changes in the value of hedge contracts need to be recorded as gains or losses on the income statement.
This introduces a complication when hedging future cash flows that are not yet recognized on financial statements. Essentially, the changes in value of a financial derivative used to hedge economic risk are going to be reporting on the income statement of a business even when the risk being hedged has not yet been recognized/recorded.
‘American Exceptionalism’
In my experience the driver is generally the difference in the size and scale of businesses that hedge FX in Canada versus the United States.
In Canada, it is not uncommon for a business with less than US $10M in revenue to use derivatives to hedge FX risk. The Canadian economy is much smaller, and thus more exposed to foreign trade as a percentage of GDP, than the US economy. It also doesn’t have the benefit of having the world’s global trade and reserve currency.
In the United States, businesses generally do not have material exposure to FX risk until they are much larger. With added scale often comes added expectations around the importance of financial reporting. This emphasis, in my opinion, makes hedge accounting more appealing to US based businesses. It’s also easier for a larger business to access the specialized knowledge and resources required to apply hedge accounting—and the audits necessary as a part of this practice.
That said, in practice there are important considerations to take into account when assessing whether hedge accounting makes sense for your business. In the next few pieces, I will offer an overview of these considerations from the point of view of a FX & Treasury sales executive.
Read the previous article in the series: Building up from the Balance Sheet
Read the next article in the series: Hedge Accounting Effectiveness- practical considerations
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