Jaimini Bhagwati: How to reform hedge accounting

Unless regulators change standards, companies will continue to use complex structures to hide risk

A repeat feature of the recent wrong-doing in JP Morgan and futures brokerages Peregrine Finance Group and MF Global is that those responsible for protecting the interests of shareholders and maintaining market probity were bystanders at best. As regulators come under fire again, it is striking that there is little scrutiny of causality stemming from shortcomings in accounting. This article argues that flawed or fudged accounting practices and particularly hedge accounting are at the heart of blunders or worse, with profoundly serious financial and economic consequences.

A hedging transaction reduces the market or credit risk of an asset or liability. For example, if a stock is bought a perfect, no-residual-risk hedge would be to simultaneously sell the same stock at the same price. In practice, firms which intend to reduce risk superimpose hedging transactions on asset or liability portfolios. Even in good-faith hedging cases, the mapping between underlying securities and hedge transactions is deliberately inexact to leave some upside potential with an acceptable amount of residual risk. However, at times firms try to confuse regulators by using complex transactions to take open-ended, profit-motivated risk and falsely claim that the intention was to hedge an underlying portfolio. How do we know what was the intention, particularly when auditors are occasionally complicit with errant firms?

History is replete with evidence of firms consciously putting out misleading information about the extent of risk exposure on their books. For example, in 1993 the German conglomerate Metallgesellschaft’s (MG) Refining and Trading arm established large hedging positions in energy derivatives (details are available in “MG’s Hedging Debacle” by Anand Shetty and John Manley, Iona College at: userwww.sfcu.edu/~ibec/papers/39.pdf). These hedging transactions were ostensibly to reduce MG’s exposure to deliver oil products at fixed prices in the future. MG’s total losses as it closed out its derivatives positions amounted to $1.3 billion, and its share price fell by 50 per cent from November 1993 to February 1994. In 2001 when Enron went bankrupt it became evident that its auditor Arthur Andersen had colluded with Enron to obfuscate the latter’s energy derivatives exposure numbers.

The hedge accounting norms of the Financial Accounting Standards Board (FASB) of the US and the International Accounting Standards Board (IASB) headquartered in the UK, whose rules are used in the European Union, Canada, Brazil, South Korea and other countries, have been incrementally improved. However, the mischief continues and on 13 July 2012, JP Morgan announced that to-date it has lost $5.8 billion on credit derivatives positions taken by its London-based Chief Investment Office (CIO) traders. It is possible that the CIO’s purported hedging transactions would have been detected as naked risk positions earlier if these credit derivatives had been marked to market on a daily basis.

How is hedge accounting different from regular accounting? Under regular accounting, assets or liabilities are marked-to-market individually. In the case of hedging transactions, hedge accounting norms allow the gains or losses on underlying assets/liabilities and hedging instruments to be clubbed together. This is because marking just the underlying portfolios to market without taking the hedging instruments into account would provide incorrect estimates of the value of the hedged assets and liabilities. This accounting forbearance has been misused by those taking open-ended risk to not mark securities to market. Often the misleading logic is that the complex transactions used for hedging are not liquid and hence the underlying instruments and associated derivatives should be treated as held-to-maturity securities. The antidote to such chicanery is for hedge accounting norms to require the marking to market of the entire balance sheet, including all hedge transactions or held-to-maturity portfolios on a daily basis. If market valuations are not available for involved assets because the instruments are not liquid enough or not readily replicated the value assigned should be zero, to make it difficult to retain such assets.

On 19 June 2012, the Financial Stability Board (FSB) secretariat issued a status report on the “Progress in implementing G20 Recommendations on Financial Regulatory Reform” (financialstabilityboard.org/publications/r_120619b.pdf). This report was timed to coincide with the G20 Summit in Mexico and includes a table which lists timelines and institutions responsible for implementation of the proposed reforms. Serial number 20 in the table states that by mid-2013 the accounting standard setters, namely IASB and FASB, are to “achieve a single set of high-quality, global accounting standards, and complete their convergence project”. Earlier, IASB had proposed improvements to hedge accounting and, after receiving comments, new hedge accounting requirements were to be concluded by mid-2011. It is a year since that target date; but, while some improvements have been made in disclosure of off-balance sheet exposures, work remains to be done in the classification of financial instruments, impairment and issues related to hedge accounting. As recently as 15 July 2012, Michel Prada, the IASB chairman, expressed his frustration at the US Securities and Exchange Commission (SEC) stalling the harmonisation of the Generally Accepted Accounting Principles (GAAP) of the US with IASB’s International Financial Reporting Standards (IFRS).

In India, to begin with, penalties for regular accounting offences need to be raised. For example, in February 2012 it was reported that the accounting regulator, the Institute of Chartered Accountants of India (ICAI), had imposed a paltry fine of Rs 5 lakh on Pricewaterhouse (PW) India. This Indian affiliate of PricewaterhouseCoopers (PwC) was guilty of committing a series of excessively obvious mistakes which resulted in the Rs 14,000-crore fraud at Satyam. In sharp contrast, in April 2011, the SEC and the Public Company Accounting Oversight Board had fined PW India $7.5 million.

Concurrently, our wider concern has to be that the details which surround hedge accounting will overwhelm G20 efforts. Further, IASB and FASB are not likely to achieve international consensus when confronted with strongly held parochial views or vested interests within national jurisdictions. Consequently, ICAI has not only to keep a close watch on developments at the G20 level on improvements in accounting but also act independently to improve our hedge accounting rules and compliance. For instance, we need a sub-group of experts under the ambit of India’s National Advisory Committee on Accounting Standards to review the extent to which India-based firms are complying with the best hedge accounting practices, and write up improved norms to plug loopholes. Thereafter, the updated guidelines need to be incorporated in the Companies (Accounting Standards) Rules under the Companies Act.

 

The writer is India’s High Commissioner to the UK. These views are personal.
j.bhagwati@gmail.com