Uses

The purpose of accounting is to be able to list the assets and liabilities of the
organization. This is the balance sheet. The increase in the net assets in a period
(plus any amounts paid out as dividends) is the amount by which wealth has
increased. This is the profit for the period. This simple paradigm should be constantly
remembered in the following discussion. Those concerned with setting accounting
standards for historical-cost accounting spend many hours defining what is an
asset or a liability, and how their values should be measured. For mark-to-market
accounting these definitions are much simpler:
Ω An asset is something that has value to the holder and its market value is the
amount of cash which a rational independent third party would pay now to
acquire it.
Ω A liability is an obligation to another party and its market value is the amount of
cash which a rational independent third party would accept now in exchange for
taking on the obligation.
Traders and management care about the reported profit figures because they
determine their bonuses. Most traders are not interested in the balance sheet, instead
preferring to judge their exposures from the ‘greeks’, the sensitivities. Regulators and
senior management are more likely to consider what information the balance sheet
can give regarding exposures, and about adherence to capital requirements. Balance
sheet information and profit numbers are used together to calculate returns on
capital. These numbers are often important to senior management in determining
where to shrink or expand business activities.
Regulatory capital requirements typically apply at the level of individual legal
entities, as well as of groups. Trading businesses frequently consist of many legal
entities and so it is important that the balance sheet can be accurately split by legal
entity. This may sound simple, but most decision-making systems and any daily
ledgers support only an individual business line. Combined with the fact that traders
care little for legal-entity split, it can be a major challenge to obtain and consolidate
this information on a timely basis.
On the other hand, some of the calculations of capital are often only implemented
in systems owned by the financial reporting department, which tend to be more
focused on the split between legal entities than on the split between business lines.

Thus while in many more advanced organizations there is a wish to charge the usage
of capital to the business lines which use it, the information required to do so may
not be available. As a result, such capital charges may be calculated on a somewhat
ad-hoc basis, leading to inaccuracies and disputes which distract staff time from
earning money for the business.
Any profit calculation that does not involve subtracting two balance sheets carries
an increased risk of being erroneous. Unfortunately it is all too common to find that
daily profits are reported based on spreadsheets which may not capture all the assets
and liabilities. When the financial reporting department attempts to add up the net
assets at the end of the month, there are numerous differences which nobody ever
has time to fully clear.
The solution to these problems is to prepare the daily profits from trading ledgers
which use the double-entry discipline, and have all information split by legal entity
and business line. If these trading ledgers feed the general ledger at the end of the
month then reconciliation issues become vastly more manageable. The importance
of keeping the ledgers split by transaction currency and of reconciling internal
positions on a daily basis is explained in the following subsections.
A separate risk is that trading lines attempt to ‘smooth’ their profit, since senior
management asks them awkward questions if profits go up and down. In some
cases swings are indeed due to inaccurate accounting, often because of inadequate
systems, and so an assumption may arise that all such swings are errors. In fact
many well-hedged positions will show volatility of earnings, and users of the accounting
reports should be educated not to panic at such moves.