ACCOUNTING

The Accounting Standards Board (ASB) is due to release an exposure draft (ED) on disclosure of derivatives and other financial instruments in either April or May. Conceivably there could be a standard in place by the end of the year. But even if that happens the ASB will have barely started to untie this most Gordian of knots.

The disclosure is the easy bit, the real fun starts as we all know with trying to sort out the measurement. Not only is this an immensely tricky issue in its own right – where every solution has a knock on effect throughout the financial statements, but the ASB also has to try and take note of the continuing developments on the international scene at the same time.

For instance, just before the ED hits the streets, an International Accounting Standards Committee (IASC) steering committee is due to publish a discussion paper on measurement.

What that paper finally comes up with on the controversial aspects of accounting for derivatives such as marking to market and hedge accounting will either put wind in the ASB’s sail or punch a hole in their hopes.

To add to the brew of complexity and international developments you can also add the pleadings of special interest groups. Now normally you could argue special pleadings could be ignored as amounting to nothing more than self-interest. But in the case of derivatives this isn’t entirely fair. If a standard on measurement is pushed through without careful consideration of how it will affect particular groups and industries then the accounting standard could affect the way that certain commercial transactions are performed. And as we are constantly being told: accounting standards should reflect commercial reality not change or dictate it.

One of the groups which has been in face-to-face discussion with the ASB and which has made sure its views on the paper have been thoroughly understood is the banks, led in part by the London Investment Banking Association (LIBA). LIBA believes that marking to market is not appropriate for all financial instruments and it is also stressing that management intention needs to be recognised. Now both of those positions would rather put a fly in the ASB’s ointment. But at the moment ASB is making soothing, reconciliatory noises stressing that it wants to work with the banks and not against them. In particular it admits banks have a particularly singular set of circumstances.

However, the banking business is separate and administered separately.

When any loan is made to a customer which carries a market risk in addition to credit risk – such as lending at a fixed rate of interest or denominated in a foreign currency – then that market risk is off-loaded internally from the banking arm to the trading arm by means of a swap.

Question: in that case is the bank marking to market? Answer: yes, according to the banks. Answer if you are the ASB? Don’t know, or to put it politely, we have an open mind.

Not that the ASB has an open mind to the basics. It and its counterparts across the globe have all convinced themselves their fundamental argument is right. The standard setters maintain that the traditional problem with derivatives is that they were not measured at all, they were off-balance sheet, and readers of the accounts did not know what was happening, despite the fact that they could have such a big impact. The answer according to the standard setters is to mark those derivatives to market. But once you have done that you are faced with the possibility that the derivative was being used to hedge some underlying instrument. That underlying instrument needs to be recognised by marking to market as well to make sure that all gains and losses are fully recognised and offset against each other.

That blanket solution also stops opportunities for cherry picking by recognising some transactions and ignoring others in a bid to smooth profits.

Provided you are not entirely devoted to pure historical cost accounting that reasoning – however it is applied in practice with industries such as banking – is hard to argue against.

What commentators do appear to be baulking at is the ASB’s attitude to hedging. The ASB says that under hedge accounting even realised gains and losses are not recognised in the period as they occur, but are deferred until the period in which the hedged transaction is recognised. This is justified on the grounds that there is no loss but merely an increase in the cost of the hedged item. The ASB also dislikes the way that hedge accounting relies on management intent. The ASB says: “A ‘hedge’ exists only in the mind of management and does not reflect any external linkage.

Inter alia this has the effect that identical instruments may be accounted for differently depending on management’s intention in respect of them.”

Not an idea that the ASB is keen on despite the stance of people such as LIBA. The ASB demonstrates the need to sort out hedging by quoting what it calls the German machine example. Order a machine for #25,000 from Germany and take out a forward contract to cover that cost. The deutschmark weakens and instead of costing you #25,000 the machine costs #12,500 instead.

Good news, the machine is cheaper: bad news you’ve made a loss by taking a punt on the currency. The two transactions are inextricably linked, but the ASB argues under those circumstances the company can at that moment conveniently decouple the events.

Some critics believe the ASB is fixated by the problem of hedging and has allowed it to drive its whole approach to derivatives. They further argue that the ASB is having difficulties both conceptually and practically making the issue fit with their definitions of assets and liabilities and it has been unable to know where to draw the line when it comes to hedges future transactions. Their answer to the German machine question is to claim the currency movement has caused merely an opportunity loss and question whether that should be recognised immediately through the profit and loss account.

This is one where accounting theory clashes rather messily with economic theory. How to clear up the mess is far from uncertain. The ASB is keen to spread the message that its approach, as always, is evolutionary not revolutionary. For that you could read that the ASB will fight to get some basic rules in place but allowing for industry exceptions and special cases, such as the banks. Over time you could then expect to see the number of exceptions shrinking. It will be a slow, painful and mind-boggling progress.

Peter Williams is a freelance journalist.