US GAAP – Financial Instruments 

Hello, I’m Iain Alexander from KPMG’s US Accounting and Reporting Group in London.

One of the areas of frequent concern in US GAAP is the complexity around financial instruments, so this session is to highlight some of the issues around derivatives, hedging, and the classification of financial instruments. 

Derivatives, like foreign exchange contracts or interest rate contracts, have to follow strict accounting rules in US GAAP – they are recorded at fair value (which broadly speaking, is market price), with changes in that value being recognised in the profit and loss account, and an asset or liability recorded to reflect the other side of the entry.  This is a common concept with IFRS but may be very alien if you are starting with UK GAAP.

Identifying freestanding derivative instruments, ie separate contracts, ought to be straightforward; but derivatives can also be embedded in other things – sales contracts, loan agreements for example, and may be in early termination clauses in the latter – and these also may need to be accounted for separately,  in the same way as freestanding derivatives.  Again, this is a familiar concept under IFRS, but the detailed rules are different.
 
One common reason for companies to enter into a derivative at all, is to hedge an exposure, such as foreign exchange, market value or interest rate movements.  US GAAP, like IFRS, permits hedge accounting for fair value hedges, cash flow hedges and net investment hedges, and like IFRS, if the rules for applying hedge accounting are followed, that accounting allows volatility to be reduced.  However, ‘following the rules’ in this instance typically means ‘to the letter’; NOT to follow the rules even to some small degree is likely to mean that no hedge accounting is permitted.

As is so often the case, timely completion of relevant documentation is vital for hedge accounting, including quarterly reassessments of hedge effectiveness – note that the latter reassessment is NOT an automatic IFRS condition.
US GAAP also currently has some methods for short-cutting the assessment of hedge effectiveness, for interest rate contracts and foreign exchange contracts; both of these reduce the workload for preparers of financial statements, and the use of these methods requires very strict criteria to be followed.

Whether a financial instrument is debt or equity (or split between the two) under IFRS is not easy but is comparatively simple compared to the debt vs equity model under US GAAP. 

At a basic level, under US GAAP puttable common shares are treated as equity, though US GAAP also has the concept of temporary equity for shares that will be redeemed at the holder’s option.  And for preferred shares (preference shares as we more typically call them) as there is no equivalent to the IFRS rule that a contractual obligation gives rise to liability classification, preference shares without a specific redemption date would usually be treated as equity under US GAAP, not liabilities. 

Beyond that, debt with conversion features, contracts that are driven to some degree by the fair value of the issuer’s shares and similar instruments often require a multi-layer analysis of interlocking guidance.  This is very specialised knowledge, and requires care to carry out an analysis and to set up the financial reporting systems to cope.

As a consequence, many companies we have worked with do keep the complexity of their financial instruments to a minimum, to help manage the accounting complexities that would arise.

While these rules are of general relevance to all companies, we do see pre (and indeed post) IPO technology companies with preference shares and other capital instruments put in place to secure development funding that need to be analysed  carefully – particularly if the capital structure is being reviewed prior to IPO.