External reporting

The external reporting of the effect of financial instruments by end-users is the area
which attracts most of the commentary in the press on accounting for derivatives,
but as discussed in the previous section, neat answers will never be obtainable while
historical cost accounting is standard for these entities. The impossibility of coming
up with a neat answer is probably the explanation for the great amount of discussion,
although considerable effort has gone into trying to define tightly the scope of hedge
accounting. As discussed above, that is almost by definition a very subjective area.
Given that the primary financial statements (balance sheet and profit and loss
account) cannot currently be changed from historical cost, the various accounting
standards promulgated by various standard-setters concentrate on requiring extra
disclosures in the annual accounts. The usefulness of these is debatable, and as
accounts are hardly ever published until at least 60 days after the end of the year,

when positions can be changed with a five-minute phone call they cannot be any
more than an indication to investors of possible questions for management.
The most obvious sticking point is any fixed rate debt used for funding the
company. Unless this is revalued using the market yield curve, does it really make
sense to revalue the interest rate swap that converts some floating rate debt to fixed?
If the company is considered a poor credit risk and so its debt is trading at a
significant discount, should the accounts value it at the amount that it would
actually cost to buy it back? It seems intuitively wrong to record a gain just because
the company is considered more likely to go bankrupt! There are no easy answers to
such questions, and so the risk of accounting treatments leading to inappropriate
decisions is higher when dealing with investment decisions based on published
accounts than with management accounts.
As the published accounts may not reflect the full economic mark to market
position, there may be situations where management has to choose between hedging
the economic position and hedging the published numbers. Such a conflict of
objectives can be reduced by providing extra information in the accounts, and
educating the analysts who use it.

Conclusion
While the accounting function may seem simple until accountants start talking, we
have shown in this chapter some examples of how a clear and coherent policy is
essential to avoid the various traps which can cause accounting data to encourage
suboptimal decisions. It is important that policy on all such issues is clearly set out
at a senior and knowledgeable level on such matters as profit remittance which has
implications for both FX and interest allocation. Such policy needs to be implemented
in the systems and procedures throughout the organization, and monitored by
Control departments or Internal Audit. Inaccuracies are less likely to arise if senior
management does not fret at some ‘noise’ in the reported profits.