Most financial disasters follow a period of misreporting, concealment or false accounting. A common source of treasury disasters has been speculative losses on derivatives, together with their misreporting. As a result, all of us now have to report our derivatives more often and in more detail than ever before.
WHAT IS A DERIVATIVE?
A financial derivative is a liability or an asset whose value is derived from a market price or rate.
WHAT ARE DERIVATIVES FOR?
For a non-financial corporate, the primary use of derivatives is to hedge existing exposures to market prices. The derivative effectively insures us against adverse changes in the market price. When the market price goes against us, the value of the hedging derivative moves in our favour, reducing or eliminating the total change in our net hedged position.
For example, let’s say we’re due to receive and convert foreign currency at a future date. If the foreign currency exchange rate were to weaken, we would suffer a loss on the exchange rate. We can insure ourselves against any unwelcome changes in exchange rates by entering into a forward FX contract. The table below illustrates an adverse change in the FX rate, and hedging of 100% of the FX receivable value.
| Domestic currency value | |
| FX receivable value | Falls |
| Forward contract value | Improves |
| Net hedged value achieved | Unchanged |
The value of our net hedged receipt has been protected by the hedge.
WHY THE ACCOUNTING RULES?
The reasons for the modern accounting rules are very important:
- Some naughty people are tempted to use company money and derivatives for speculation when they shouldn’t.
- Their speculations often result in losses.
- It’s attractive for people to under-report their speculative losses.
- If that were allowed by accounting rules, they’d be further tempted to carry on speculating, in the hope of recouping the losses before being found out.
Excessive speculation of this kind wipes out companies. Modern accounting rules are designed to ensure that any speculative losses are recognised and reported promptly. This helps to discourage and detect unauthorised or unwise speculations.
HOW THE RULES ACHIEVE THEIR PURPOSE
The accounting rules require:
- Recording of all derivatives at their fair value, and their periodic remeasurement to fair value.
- Identifying the purpose of the derivative, and proving the purpose and effectiveness of any hedging.
- The immediate reporting of non-hedging gains or losses in the profit and loss account.
This means that reporting any speculative losses cannot be deferred. The default accounting treatment is ‘non-hedge’, which includes speculation. If we can’t positively prove we have an effective hedge, we have to account for it as a non-hedge. Indeed, if we fail the very strict ‘hedge effectiveness’ tests, we must always account under the non-hedge rules, regardless of our purpose or motivation.
LET'S LOOK AT AN EXAMPLE
CHALLENGING QUESTION
A derivative can be used for speculative or hedging purposes. Accounting standards require alternative accounting treatments depending on the purpose for which the derivative is being used.
Explain the accounting treatment required for:
a) A non-hedge derivative.
b) A derivative used in a cash-flow hedge.
WINNING ANSWER
| Step | (a) Non-hedge derivative | (b) Derivative in a cash-flow hedge |
| 1 | Record initially at fair value. | |
| 2 | Charge any transaction costs to profit and loss. | |
| 3 | Remeasure to fair value at each period end. | |
| 4 | Take gains or losses directly to profit or loss. | Take gains or losses to reserves ('park in equity'). Report them in other comprehensive income. |
| 5 | Not applicable. | Release ('recycle') cumulative gains or losses to profit or loss in the same period(s) as the hedged cash flows affect profit or loss. |
GET IT RIGHT EVERY TIME
The detail of our Winning Answer is easy to remember if you note:
The simple time order of the steps.
Initial recording at fair value, and periodic remeasurement to fair value (ie. steps 1-3) apply equally to all derivatives.
The accounting treatment only diverges in steps 4 and 5.
____________________
Author: Doug Williamson
Source: The Treasurer magazine
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