We continue our series dealing with aggressive accounting moves, which although they may not be illegal, may very well be dangerous. Therefore, shareholders need to be aware of these dangers, while directors need to have a sharp eye in order to protect the shareholders. Our final article looks at derivatives - an instrument that is difficult to control if we lack the basic understanding of it.
Derivatives can be very useful instruments in the management of financial risk but their use needs extremely careful and constant scrutiny. Some situations in which the use of derivatives is needed include:
- when companies strike deals much in advance of the actual delivery of their product,
- or they may need foreign currency to pay a supplier when the supplies arrive,
- or they may enter into a loan agreement with a variable interest rate, etc.
Companies are therefore locked into the transaction without knowing what the actual inflow or outflow relating to the item in question is going to be. This is where derivatives can be used to control the transaction costs.
How do derivatives work?
As a simple example, consider an importer in the EU that has contracted to take delivery of goods in three months from a foreign country, and the price of these goods is agreed upfront in USD. When the time comes to pay, the company will have to sell Euro and buy US Dollars in order to pay the agreed amount. A financial manager will want to secure the interests of the firm by entering into an agreement whereby the company contracts upfront to buy Dollars against Euro in three months but at an exchange rate agreed upfront. In other words, the financial manager has fixed the exchange rate for the company and hence has removed the risk of the Dollar appreciating or the Euro falling in value against the Dollar. Such transactions that hedge the companies from risk are welcome and indeed they are necessary.
What we described above is in effect a derivative instrument! And we have used it as a hedging instrument! We note that the contract to purchase Dollars against Euro in three months’ time at today’s rate of 1.2 Dollars is a separate and distinct contract with our bank, and our supplier will probably not even know about it.
Figure 1 This is a derivative instrument, as explained in the example
Of course it ‘relates’ to the agreement we have with our supplier, but only in the sense that everything in the agreement with the bank ‘derives’ from the agreement we made with our supplier. We are able to agree with the bank to sell to us Dollars at a fixed rate because somewhere in the market the exact opposite need exists and someone needs to buy Euro and sell Dollars! This is where intermediaries like banks become useful (if they play their role properly) and help various parties hedge their transactions.
The risks associated with derivatives
However, hedging techniques can be complex and the derivatives used to hedge a transaction (or a group of transactions) are often not easy to understand or even to notice that they exist at all! Many times, a hedging agreement is a simple piece of paper that may not catch the attention of a controller. This gives rise to two types of risk that we will focus on here: firstly, the unauthorised use of derivatives, and secondly, the wrong use of derivatives.
So to put some numbers into the above example, if the agreed price was USD 100,000 and we wanted to fix the rate at today’s ruling exchange rate of 1 EUR = 1.2 USD we would agree to sell EUR 83,333 and buy Dollars in three months’ time at a rate of 1.2 USD, but this rate is agreed today. In three months’ time we would give away the Euro and receive 100,000 Dollars so that we can pay the supplier.
But if instead we made a mistake and instead of selling Euro we bought Euro at this rate and if the rate in three months was 1.1 Dollars, what would the result look like? In three months time we would have to
- buy the 100,000 Euro at 1.2 Dollars (as there is a contract that we have to observe)
- to do this we need to find 120,000 Dollars, so we sell 109,090 Euro at 1.1 to obtain the 120,000 Dollars and the exchange contract is settled
- we need to sell 90,909 Euro (the rate in three months is 1.1) to buy the 100,000 Dollars we need to pay the supplier.
- Originally the rate was 1.2 and if we had fixed the rate at 1.2 the supplies would have cost us 83,333 Euro. Instead it cost us 109,090 Euro to pay for our mistake plus 90,909 Euro to buy the Dollars we need to pay the supplier (the rate moved against us from 1.2 to 1.1). Total cost being199,999 Euro and not 83,333. Quite a difference!
This is not just theory - it happens in real life! An example where the risk formula went down the wrong way was a German energy conglomerate that contracted to sell petroleum at prices fixed in 1992 for a maximum of ten years. The company decided to hedge its risk of rising oil prices by using derivatives, only that the hedging was by mistake done in the reverse direction. When oil prices started falling losses started accumulating fast, costing the company USD 1.5 billion.
A very well known example of unauthorised use of derivatives in international banking is Nick Leeson in Barings Bank and another is Jerome Kerviel in Societe General. Both situations resulted from a clear lack of supervisory controls.
Financial Instruments and Accounting Standards
At present there are three accounting standards due to the complex issues involved. The main objective is that readers of the financial statements should be aware of the risks that an enterprise is facing. One constant theme is that financial instruments are not just used by financial institutions.
All derivatives are required to be recorded at fair value (briefly, this means at a value that the market would offer), with changes in fair value directly impacting on the results/profits. The first problem is to ensure that all derivatives are identified, and secondly to calculate the fair value, which may involve financial modelling such as for options. Sometimes it is just a question of getting information from the company’s bank such as for forward contracts. Also, there is a significant amount of additional information required to be included in the financial statements about a company’s exposure to risk and hedging policy. This information is in addition to what is included in the income statement and balance sheet i.e. in addition to the figures.
Finally, other complications exist when hedging is used. There are special hedge accounting rules, which may be availed of to lessen the impact of changes in fair value on the company’s results.
A company may enter into contracts of a speculative nature, which may be deemed for accounting purposes to include derivatives, known as embedded derivatives. An example is a contract in foreign currency, which is not the currency of either party e.g. a Polish company purchasing from an Italian company in US dollars. There is an additional exposure to foreign exchange risk and this must be separately accounted for as a derivative.
It can already be seen that this is a complex issue and companies need to identify derivatives and the extent that they are exposed to changes in their value impacting on their results, and ask themselves, is there a valid business reason for entering into such transactions?
Derivatives will remain in wide use by many companies, and for very good reasons. But companies will have to monitor their use to ensure that their risks are managed responsibly, to see if losses should be shown, and very importantly to ensure that any risks and the accounting treatments are disclosed with sufficient clarity so that shareholders can understand their potential impact on the earnings.
To start the process, the following questions must be taken into account:
- What hedging policies and programmes are in place?
- Are derivatives being used?
- Do controls exist to protect against the abuse of derivative transactions?
- What is the worst-case scenario of using derivatives?
- Is the accounting treatment as per generally accepted accounting practices, for example IFRS?
These are some questions that can begin to expose the level of risk accompanying certain transactions. Similarly to our previous articles - where we discussed how shareholders can identify "aggressive reporting", how the matching concept under IFRS can help in understanding the estimated cost of corresponding revenue, and how the balance sheet and asset valuation work - basic knowledge of IFRS can help a prudent shareholder judge whether the level of risk a company is willing to take on a transaction does not pose a threat to earnings.
This brings us to the end of our IFRS for Shareholders series, but watch this space for more IFRS commentary from us. Consider following GnosisLearning for more top quality articles, on Linkedin, Twitter or Facebook. And please get in touch with us at ClientService@GnosisLearning.com to let us know what other articles you would like to see from us!