Hedge accounting

For management decision-making all relevant instruments should be marked to
market. For the financial instruments this is conceptually straightforward, although
all but the largest end-users lack the critical mass of banks in terms of modelling
expertise and market price knowledge so for OTC instruments may rely on the
provider of the instrument. OTC instruments also suffer from a lack of liquidity, but
per se this should not affect their value, since most end-users intend to hold their
instrument until maturity.
The more difficult aspect can be in identifying the movements in value of the assets
or liabilities against which the financial transactions were entered into as hedges. If
an interest-rate swap is entered into as a hedge to fix the rate of a floating rate
debenture then it is easy to value the debenture using a market yield curve and show
how effective the hedge is. Such matching is similarly easy if a specific oil cargo in
transit is sold forward, or put options representing the same volume of oil as in the
cargo are purchased, since the physical commodity can be separately identified and
valued at the spot price.
Things become less clear-cut when considering the situation faced by an oil refinery
which has sold a three-month crack spread future. The volume sold may be chosen to
approximate the physical capacity of the refinery for the third month, but operational
realities may result in a slightly different actual throughput. The mix of refined
products that will be produced is not known exactly in advance, and hopefully will
depend on which provide the greatest profit at the time of sale. Should all the firm
purchases and sales for the third month, for the next three months, or for all time,
also be marked to market?
One way to make the decisions easier as to what to include in the mark-to-market
model is to transact trades in the underlying commodities between the operational
department and the treasury department. With this approach the operational department
treats treasury like any other customer, and mark-to-market accounting is
restricted to the treasury department. This certainly places a clear understandable
boundary around market operations. It has the disadvantage that the same position
may be valued differently in two departments within the one entity, but such a
mismatch has to happen somewhere in an entity using two methods of accounting.
In the case of a flexible refinery there is also the mismatch between the product mix
sold to treasury and that produced in fact.
Treating treasury as an external customer has implications for culture, and
possible choice of personnel, which need to be addressed. There is a danger that
operational department will feel exposed to treasury, and therefore recruit what is
effectively a subsidiary treasury function themselves, thus duplicating effort and
increasing costs unnecessarily. To prevent this it is necessary to have an overall firm
culture (with matching appraisal and bonus policies) which stresses cooperation.
We can also consider the case of the ice-cream manufacturer which has sold
heating degree days in a weather swap on the basis that the hotter the weather, the
more ice cream it will sell and thus the higher will be the gross margin. The swap
could be valued based only on actuals with historic averages for the future, or
including latest forecast. Which is considered most appropriate would depend on
whether the manufacturer sold direct to the public, in which case sales would only
be recognized on the day of consumption, or to wholesalers who might buy greater
quantities as soon as they saw more warm weather coming.

The fact that the profit or loss on the derivative transaction can be accurately and
precisely defined, while the hopefully opposite result which it is hedging is often
more difficult to measure, may result in treasury being unfairly criticized for losses
on hedges. One would expect hedges to lose money half the time – the benefit is that
the volatility of overall earnings should be lower and the risk of bankruptcy lower.
A particular situation which occurs frequently is FX transactions entered into to
hedge the results of the operations of foreign-currency subsidiaries. For end-users
the average-rate translation of profits is standard, and management may well have
entered into the hedge with the first priority being to protect the operating profits
line appearing in the published accounts rather than net assets. This is a clear case
of an inappropriate policy, in this case an accounting standard, leading to suboptimal
economic decisions. In such a situation it makes sense for management reports to
show the hedge marked to market, together with the effect of rate movements on the
projected profit of the foreign subsidiary.
It is clear that this is a field where there are few definitive answers, and judgement
is required by management to define what they want to gain from the information
they receive. Unless there is a move to full current cost accounting, any mark
to market information in an end-user environment will only ever be indicative
information. 489