External reporting

The discussion above has shown that even with freedom to choose policies there are
plenty of ways in which reported accounting information can be misleading. For
external reporting there are the additional restrictions of legal regulations and
accounting standards, as well as the complications of separate legal entities. A given
trading desk frequently trades in several legal entities, the entity for each individual
trade being chosen based on where it is most tax-efficient.
While the paradigm of current-cost accounting for published accounts was investigated
in some detail during the inflation of the 1970s, it has sunk with very little
trace and virtually all published sets of accounts are prepared on a historic cost
basis. However, that would present a most misleading picture for most trading
houses. Treatments vary between countries, e.g. in the UK, banks therefore use the
‘true and fair’ override, in other words breaking the accounting rules laid down by
the law to use more appropriate methods. The particular, more appropriate, method
used is marking the trading assets and liabilities to market prices. In Switzerland
the individual entity statutory accounts are prepared on a historic cost basis and so
are of little use to understanding profitability, but group accounts are published
using International Accounting Standards which do permit marking to market.

This is not the place for a discussion of the meaning of published accounts, but if
one assumes that they are for the benefit of current and potential investors, who in
a commonsense way define profit as being the amount by which the net assets of the
group have grown, then all the earlier discussion about FX seems unnecessary here
since the net assets approach will give the answer that they seek. However, there is
one important difference which is that published consolidated profits of groups of
companies are generally performed based on the accounts of the individual entities
rather than looking at the whole list of assets and liabilities. Thus a profit made in
GBP in a Swiss subsidiary of an American bank may be converted first to CHF and
then to USD. This raises the likelihood that at least one of the conversions will be
done using the average rate method as discredited above. If so, then the reported
profit can depend on which entity a given transaction is booked in, which is not
sensible.

We see that the position correctly shows no profit if we view both sides in any one
currency, here USD are shown as well as GBP. However, if one had to produce a
profit number using just the Zurich reported loss of CHF200 and the Sydney reported
loss of AUD330 (both of which are correctly calculated) it is difficult to see how one
would ever come up with 0!
Management accounting is generally indifferent to whether an instrument is offbalance
sheet. The significance is higher concerning published accounts, and the
effect can be seen in the following example, which compares the effect of a futures
position with that of a ‘cash’ position in the underlying, and also of a marginned
‘cash’ position. As can be seen, the numbers appearing on the balance sheet are
much smaller for the off-balance-sheet futures position.

Readers of accounts have no way of knowing how many such instruments are held
from the balance sheets. The notes to the accounts give some information about
notional values, but often at a fairly aggregated level which is often difficult to
interpret.
Trading groups also have other assets, of which the most material is often property.
These are generally not marked to market. Integrated finance houses which have
significant income from say asset management or corporate finance activities will
generally report those activities using a historical cost method. The resultant mixing
of historical-cost and market values makes the published accounts very hard to
interpret. 486