Hedge Accounting Effectiveness: The practical considerations
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 of 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 on how this might relate to your business.
Hedge accounting is its own animal, and requires specialized knowledge and support from external auditors to execute and apply it correctly. For finance teams considering engaging their external auditors on this topic, there are a few important considerations.
Why hedge accounting? – Transactional & documentation considerations
Quite simply, the intention behind hedge accounting is to align the economic intent of hedging with how financial reporting is carried out. In the absence of hedge accounting, unrealized gains or losses from derivatives will appear on the income statement as non-operating income, and thus impact earnings.
Hedge accounting takes these items off the income statement and places them into other comprehensive income (OCI), until the FX gain or loss is realized and applied directly to the line item that is being hedged, similar to the way accounts receivable or payable are reported. This offers a clearer picture of actual changes in OCI.
An important consideration, though, is the auditing function required to effectively manage hedge accounting. At the portfolio level, hedge accounting is allowed only under a limited set of circumstances. Sometimes auditors will ask for specific, individual, transactions that a hedge might be applied to. At times, I have seen CFOs at large multinationals digging up long-closed invoices to which a forward contract applied.
Ahead of using hedge accounting, then, finance teams need to decide prospectively which items and which risks are going to be hedged. This process needs to be documented, and how this is documented should be discussed with external auditors and agreed ahead of time.
Broader Contours – The centrality of hedge effectiveness
Backing away from the finicky details that can give some CFOs (and myself) migraines, there are broader points that should be considered when reviewing hedge accounting.
First and foremost, there needs to be an economic relationship between the item being hedged and the actual derivative executed. This is evaluated using a ‘hedge effectiveness test.’ Under different reporting standards, the way this test is conducted can vary. In general, though, there should be a close relationship in changes in the value of the underlying risk being hedged, and changes in the value of the derivative used to hedge that risk.
This test eliminates from consideration a lot of derivatives employed by businesses to manage FX, because those derivatives do not have a close linear price relationship to the underlying exposure being hedged.
This is another point to ask your auditor about. Not all brokers can give you an indication of what hedge effectiveness under these standards may look like for specific derivatives.
Ultimately, though, it is the auditors who will run the hedge effectiveness test.
Hedge Accounting Models
Now that we have covered the why, as well as the documentational and effectiveness considerations, it is important to outline the hedge accounting models that can be employed. There are only three:
Fair Value Hedge -The risk being hedged in a fair value hedge is a change in the fair value of an asset or a liability. This is often the model employed by balance sheet hedgers to align their hedge activities with their financial reporting objectives.
Cash Flow Hedges - The risk being hedged in a cash flow hedge is the exposure to variability in cash flows that is attributable to a particular risk and could affect the income statement. These are prospective cash flows, not yet recorded on financial statements. This is the type of hedge accounting model I most often see both Canadian and US businesses employ.
Net Investment Hedges – Often used by a parent to cover net investment in foreign operations via overseas subsidiaries, associates, joint ventures, or branches. This generally focuses on translational FX risk that is shown in the Cumulative Translation Adjustment section of the balance sheet. Hedge accounting at this level can be very tricky, requiring close alignment between financial reporting, treasury, and external auditors. This method is more often employed by larger companies US$2B+ in revenue), who tend to have these risks, and have the resources to apply hedge accounting in these scenarios.
In conclusion, some audit and financial reporting professionals spend their entire careers specializing in the finer details of hedge accounting. It is a complex arena. Nevertheless, it is important even for dilettantes considering hedging for the first time, as well as seasoned veterans, to have a broader understanding of why businesses opt to employ hedge accounting, and what it means for them in terms of how they execute and document their FX hedging programs.
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