This section focuses on properly structuring a compliance unit. It details the duties
of senior management, describes how to align compliance with business lines, and
describes a range of compliance activities. The section ends with a review of common
compliance errors.
14 Nisan 2011 Perşembe
10 Nisan 2011 Pazar
Defining compliance risk
Compliance risk can be defined as ‘the risk to earnings or capital from violations, or
nonconformance with laws, rules, regulations, prescribed practices, or ethical standards’
(OCC Comptroller’s Handbook, 1997). Compliance programs typically originate
to satisfy external laws and regulations. As programs become more developed, they
start to include monitoring of adherence to internal guidelines and management
directives. One stumbling block is that compliance risk is often not subject to
sufficient scrutiny. Instead, ‘compliance risk is often overlooked as it blends into
operational risk and transaction processing.’1
Focusing exclusively on satisfying external compliance is a necessary but perhaps
not a sufficient standard. The derivatives markets continue to outpace the regulators
and oversight often lags behind the creation of new products and markets. The ‘crazy
quilt’ structure of derivatives’ regulations tends to compound these compliance
risks since oversight gaps occur. Given the overlapping and sometime conflicting
framework of oversight, this can be a real challenge. (See the Appendix for an outline
of US and UK regulatory schemes.) Compliance controls remain a front-line defense
and the proper goals should be to help insure against large losses as well as prevent
regulatory violations.
The typical reaction to compliance standards is that one needs only to maintain
minimal standards. Cooperation from the business staff is often limited. Compliance
is not a particularly popular topic among traders and salespeople since they focus
on business targets leading directly to higher compensation. Only grudgingly will
employees focus on this type of risk and often, the focus is on the negative duties of
compliance. The reality is that compliance can ‘empower people’. These controls
enable people to accomplish goals and ensure closure. ‘It is only when procedures
are neglected or abused that they become an impediment.’2
The other extreme may occur where compliance controls represent a virtual
straitjacket. In some organizations, compliance standards to satisfy regulatory
requirements are set so high that they become obstacles to daily business. Typically
this occurs when a company has suffered a major loss and attempts to ‘overcompensate’
for past errors.3 A companion danger is when internal controls are so rigid, an
exception must be made for normal, large-sized transactions. The automatic granting
of exceptions can easily undermine controls or foster an attitude that all standards
can be negotiated.
The dramatic growth and widespread usage of derivative instruments as well as
the diversity of market participants have provided fertile ground for disputes. Given
the large sums of money involved and the relatively small amount of initial cash
outlays (i.e. leverage), compliance failures have been costly. This has been a major
risk in the derivatives world since the Hammersmith and Fulham case in the 1980s,
through the Procter & Gamble fiasco of 1994–5, to today where companies in Asia
are attempting to renege on losing derivatives contracts.
Hammersmith and Fulham was a municipal UK entity that engaged in swap
transactions. The English courts determined that the transactions were outside the
scope of the municipality’s charter (i.e. ultra vires) and the municipality was not
required to pay accumulated losses of several hundred million pounds. A more
thorough legal review of the counterparty’s ‘capacity to contract’ would likely have
limited the losses suffered by the counterparty banks.
Procter & Gamble was able to avoiding paying much of its swap losses due to the
failure of the counterparty bank to provide accurate valuations and full disclosure
as to transaction risks. A stricter control oversight of client communications and of
periodic valuations sent to the client would likely have limited these losses by the
counterparty bank. The current litigation involving Asian companies centers again
around similar issues of disclosure and fiduciary duties, if any, that exist between
the swap counterparties. In today’s litigious environment, compliance errors often
have expensive consequences. 493
nonconformance with laws, rules, regulations, prescribed practices, or ethical standards’
(OCC Comptroller’s Handbook, 1997). Compliance programs typically originate
to satisfy external laws and regulations. As programs become more developed, they
start to include monitoring of adherence to internal guidelines and management
directives. One stumbling block is that compliance risk is often not subject to
sufficient scrutiny. Instead, ‘compliance risk is often overlooked as it blends into
operational risk and transaction processing.’1
Focusing exclusively on satisfying external compliance is a necessary but perhaps
not a sufficient standard. The derivatives markets continue to outpace the regulators
and oversight often lags behind the creation of new products and markets. The ‘crazy
quilt’ structure of derivatives’ regulations tends to compound these compliance
risks since oversight gaps occur. Given the overlapping and sometime conflicting
framework of oversight, this can be a real challenge. (See the Appendix for an outline
of US and UK regulatory schemes.) Compliance controls remain a front-line defense
and the proper goals should be to help insure against large losses as well as prevent
regulatory violations.
The typical reaction to compliance standards is that one needs only to maintain
minimal standards. Cooperation from the business staff is often limited. Compliance
is not a particularly popular topic among traders and salespeople since they focus
on business targets leading directly to higher compensation. Only grudgingly will
employees focus on this type of risk and often, the focus is on the negative duties of
compliance. The reality is that compliance can ‘empower people’. These controls
enable people to accomplish goals and ensure closure. ‘It is only when procedures
are neglected or abused that they become an impediment.’2
The other extreme may occur where compliance controls represent a virtual
straitjacket. In some organizations, compliance standards to satisfy regulatory
requirements are set so high that they become obstacles to daily business. Typically
this occurs when a company has suffered a major loss and attempts to ‘overcompensate’
for past errors.3 A companion danger is when internal controls are so rigid, an
exception must be made for normal, large-sized transactions. The automatic granting
of exceptions can easily undermine controls or foster an attitude that all standards
can be negotiated.
The dramatic growth and widespread usage of derivative instruments as well as
the diversity of market participants have provided fertile ground for disputes. Given
the large sums of money involved and the relatively small amount of initial cash
outlays (i.e. leverage), compliance failures have been costly. This has been a major
risk in the derivatives world since the Hammersmith and Fulham case in the 1980s,
through the Procter & Gamble fiasco of 1994–5, to today where companies in Asia
are attempting to renege on losing derivatives contracts.
Hammersmith and Fulham was a municipal UK entity that engaged in swap
transactions. The English courts determined that the transactions were outside the
scope of the municipality’s charter (i.e. ultra vires) and the municipality was not
required to pay accumulated losses of several hundred million pounds. A more
thorough legal review of the counterparty’s ‘capacity to contract’ would likely have
limited the losses suffered by the counterparty banks.
Procter & Gamble was able to avoiding paying much of its swap losses due to the
failure of the counterparty bank to provide accurate valuations and full disclosure
as to transaction risks. A stricter control oversight of client communications and of
periodic valuations sent to the client would likely have limited these losses by the
counterparty bank. The current litigation involving Asian companies centers again
around similar issues of disclosure and fiduciary duties, if any, that exist between
the swap counterparties. In today’s litigious environment, compliance errors often
have expensive consequences. 493
External reporting: compliance and documentation risk
Billions of dollars have been lost in the financial services industry due to compliance
violations and documentation errors. The misuse or misapplication of derivative
instruments has been a major factor in many of these losses. The actual violations
have ranged from inadequate disclosure to clients, unlicensed sales personnel,
improper corporate governance, ultra vires transactions, and inadequate or errorprone
documentation. The root causes have been primarily insufficient or outdated
controls or failure to enforce controls. The media focus on these major losses due to
lax internal controls or violations of external regulatory requirements has become a
permanent blotch on the reputation of the industry.
While Value-at-Risk and stress scenarios can help optimize the use of risk capital
and improve returns, large equity losses are often the result not of market risk but
rather of compliance failures. Often it is a trusted or highly regarded employee (often
long standing) who causes the damage. Typically, the loss is not triggered by a single
event but occurs over time. A recent example occurred in Chicago in late 1998, where
a futures brokerage was being sold. Just prior to the scheduled closing, the CFO of
Griffin Trading Co. revealed that he had lost millions by trading stock options with
the firm’s money. The unauthorized trading went undetected for more than a year
and the company became another compliance casualty (see Ewing and Bailey, 1999).
While compliance and documentation risks can never be eliminated, they can be
contained. This chapter is intended as a broad overview of compliance risk and
highlights the major issues confronting manager of derivatives sales staffs. It focuses
on practical methods to ensure compliance that will survive the continuing consolidation
of financial service companies and changes in regulatory oversight. This chapter
is divided into four main parts:
Ω Structuring a compliance unit
Ω Creating enforceable policies
Ω Implementing compliance policies
Ω Reporting and documentation controls.
There will be reference throughout the chapter to actual losses that have occurred
to emphasize the critical importance of appropriate controls. The goal is not to detect
actual problems. Rather it is to discover ineffective, omitted, or outdated controls
that could lead to actual losses. The reader should have an overview of why compliance
controls are critical and how they can be used to limit business risk.
A compliance unit should play an active role in a firm’s business strategy. It
enables business lines to optimize revenues by limiting non-market risks such as
credit, operations, and reputational risk. In many firms, however, compliance is
viewed as an add-on expense and an impediment to performance. It is perceived to
drain valuable resources and time and to serve as an adversary to achieving business
goals. This chapter reflects the view that compliance is necessary and beneficial.
Complying with external regulations and internal policies will insure greater consistency
of performance and will in the long run, reduce capital needed to fund incidences
of operational failure and fraud.
violations and documentation errors. The misuse or misapplication of derivative
instruments has been a major factor in many of these losses. The actual violations
have ranged from inadequate disclosure to clients, unlicensed sales personnel,
improper corporate governance, ultra vires transactions, and inadequate or errorprone
documentation. The root causes have been primarily insufficient or outdated
controls or failure to enforce controls. The media focus on these major losses due to
lax internal controls or violations of external regulatory requirements has become a
permanent blotch on the reputation of the industry.
While Value-at-Risk and stress scenarios can help optimize the use of risk capital
and improve returns, large equity losses are often the result not of market risk but
rather of compliance failures. Often it is a trusted or highly regarded employee (often
long standing) who causes the damage. Typically, the loss is not triggered by a single
event but occurs over time. A recent example occurred in Chicago in late 1998, where
a futures brokerage was being sold. Just prior to the scheduled closing, the CFO of
Griffin Trading Co. revealed that he had lost millions by trading stock options with
the firm’s money. The unauthorized trading went undetected for more than a year
and the company became another compliance casualty (see Ewing and Bailey, 1999).
While compliance and documentation risks can never be eliminated, they can be
contained. This chapter is intended as a broad overview of compliance risk and
highlights the major issues confronting manager of derivatives sales staffs. It focuses
on practical methods to ensure compliance that will survive the continuing consolidation
of financial service companies and changes in regulatory oversight. This chapter
is divided into four main parts:
Ω Structuring a compliance unit
Ω Creating enforceable policies
Ω Implementing compliance policies
Ω Reporting and documentation controls.
There will be reference throughout the chapter to actual losses that have occurred
to emphasize the critical importance of appropriate controls. The goal is not to detect
actual problems. Rather it is to discover ineffective, omitted, or outdated controls
that could lead to actual losses. The reader should have an overview of why compliance
controls are critical and how they can be used to limit business risk.
A compliance unit should play an active role in a firm’s business strategy. It
enables business lines to optimize revenues by limiting non-market risks such as
credit, operations, and reputational risk. In many firms, however, compliance is
viewed as an add-on expense and an impediment to performance. It is perceived to
drain valuable resources and time and to serve as an adversary to achieving business
goals. This chapter reflects the view that compliance is necessary and beneficial.
Complying with external regulations and internal policies will insure greater consistency
of performance and will in the long run, reduce capital needed to fund incidences
of operational failure and fraud.
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.
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.
Discount rate
Non-banks need to consider the discount rate they use, but there is no simple
answer. Banks blithely reach for LIBOR in nearly any situation because that is the
rate at which they can lend and borrow in the market (unless they are beset by
rumours of impending bankruptcy). A non-bank may well face a rather higher rate
for loans, although it should be able to obtain a rate very similar to the banks for
deposits. Thus if an industrial organization is short of cash it might consider valuing
future predicted cashflow streams at its cost of borrowing.
Otherwise if LIBOR is used, a trader would appear to make profits on inception for
loans to counterparties at rates above LIBOR but below the organization’s cost of
borrowing, although this profit would leak away as the real cost of funding was
recognized over time. However, it does not seem sensible for such an organization
valuing options using the Black–Scholes model to use anything other than LIBOR as
the input parameter. This is an area where consensus has not yet been reached.
answer. Banks blithely reach for LIBOR in nearly any situation because that is the
rate at which they can lend and borrow in the market (unless they are beset by
rumours of impending bankruptcy). A non-bank may well face a rather higher rate
for loans, although it should be able to obtain a rate very similar to the banks for
deposits. Thus if an industrial organization is short of cash it might consider valuing
future predicted cashflow streams at its cost of borrowing.
Otherwise if LIBOR is used, a trader would appear to make profits on inception for
loans to counterparties at rates above LIBOR but below the organization’s cost of
borrowing, although this profit would leak away as the real cost of funding was
recognized over time. However, it does not seem sensible for such an organization
valuing options using the Black–Scholes model to use anything other than LIBOR as
the input parameter. This is an area where consensus has not yet been reached.
3 Nisan 2011 Pazar
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
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
Accounting for end-users
End-users are different because financial instruments are only part of the business.
While financial instruments can easily be marked to market since the assets are
fungible and there are more or less liquid two-way markets, this does not apply to
assets such as factories or work in progress. Thus such entities use historical cost
accounting as a default. However, they may use accrual accounting or mark to
market for their trading assets.
The pure historical cost method does not recognize the cost of borrowing in the
trading accounts because that is included with all the other borrowing costs for the
organization, and delays recognizing the profit until the sales invoice is due. The
accrual method includes all the costs, but at their final cash value, and spreads the
profit over the period of the deal. The mark to market method calculates the net
present value of all income and costs, but recognizes the gain immediately. As the
spot and forward prices of oil move over the following six months, the mark to market
method would recognize any net differences each day, but with such a cleanly hedged
position the effect would be unlikely to be much different from the smooth drip
shown which represents the interest on the net profit (592*6%/2ó18).
Profit is recognized earlier in the mark to market method. Losses are recognized at
the same time under all methods, since the historical cost and accrual methods are
not symmetrical, because they embrace the concept of prudency. Applying such lack
of uniformity requires more human judgement. This illustrates the higher risk
associated with longer-term trades, where the acceleration in the recognition of profit
is most marked.
While financial instruments can easily be marked to market since the assets are
fungible and there are more or less liquid two-way markets, this does not apply to
assets such as factories or work in progress. Thus such entities use historical cost
accounting as a default. However, they may use accrual accounting or mark to
market for their trading assets.
The pure historical cost method does not recognize the cost of borrowing in the
trading accounts because that is included with all the other borrowing costs for the
organization, and delays recognizing the profit until the sales invoice is due. The
accrual method includes all the costs, but at their final cash value, and spreads the
profit over the period of the deal. The mark to market method calculates the net
present value of all income and costs, but recognizes the gain immediately. As the
spot and forward prices of oil move over the following six months, the mark to market
method would recognize any net differences each day, but with such a cleanly hedged
position the effect would be unlikely to be much different from the smooth drip
shown which represents the interest on the net profit (592*6%/2ó18).
Profit is recognized earlier in the mark to market method. Losses are recognized at
the same time under all methods, since the historical cost and accrual methods are
not symmetrical, because they embrace the concept of prudency. Applying such lack
of uniformity requires more human judgement. This illustrates the higher risk
associated with longer-term trades, where the acceleration in the recognition of profit
is most marked.
Kaydol:
Kayıtlar (Atom)