As I analyzed in a prior post, the mark-to-market tyrany imposed by the new derivatives accounting rules expose companies reported results to things called “theta” and “gamma”. These are not the only ridiculous new risks that regulators create for treasurers. There is also, for instance, implied volatility which is a crucial component of the market value of an option. The varying levels of implied volatility (which are graphically depicted by the famous “volatility smile”) essentially depend on the opinions and gut feelings of traders. In effect, then, the new rules expose corporates earnings and debt-equity ratios to the most unseemly of contingencies: traders’ minds. Just like it is wrong to expose them to theta and the other “greeks”, it doesn´t seem fair to expose non-financial companies to the unpredictable figure of implied volatility. A corporate´s results should not be artificially influenced by decisions made in trading floors around the world by testorone-filled, bonus-hungry, and panic-prone dealers.
Incredibly, for those corporates that use options to hedge their underlying risks, earnings could swing simply because time went on. Or because traders enter into a panicky mood. Hard work, inventiveness, and diligence on the part of the company and its employees could be made to lose shine by FAS133 and IAS39 for the most idiotic and unrelated of reasons. The message from the accounting regulators is crystal clear: no matter how much you work, how creative you are, and how diligently you run the business, if you decide to use options to hedge your risks your reported earnings and debt-equity ratios will always be subject to bad news due to changes in (among other unseemly factors) theta and the volatility smile. Unless one decides to completely stop its usage of options, the reported results based on which the outside world judges the health of the company will be inextricably linked to time decay and implied volatility.
Why not Manchester United match results? Why not link the earnings and leverage ratio of any derivatives-employing company to the success of the red devils on the pitch? Perhaps reported income could be made to go up by 1% every time United obtains a victory? Down by 1% in case of a defeat? 2% if the rival is Arsenal? I mean, surely this can’t be more ridiculous than linking companies accounts to the ticking of the clock or the mood swings of traders around the world. If the earnings of a shoemaker can go down because we are all three months older or because the volatility smile is glowing, why can´t they be made to go down when Munited is going through a slump? Since we are already in the accounting twilight zone (courtesy of the accountants that devised FAS133 and IAS39), why stop at theta and the smile? In the search for factors that having absolutely no direct link to a corporate’s bottom line are nonethelss given the power to heavily influence such results, one could do worse than choosing football scores.
Of course, the mere fact that such an idea could be conceived points to the tremendous inappropriateness of the new accounting standards when it comes to non-financial companies that use derivatives for hedging purposes. A rule that exposes reported results to totally unrelated, alien, and uncontrollable variables is not a healthy rule. It is a completely botched exercise. An accounting weapon of mass destruction.
The new derivatives accounting standards have been deemed the most complicated for non-financial corporations ever to be introduced. As many treasurers, finance directors, CFOs, and even CEOs can surely attest such definition is more than appropriate. It is not only that the new standards blackmail companies into certain hedging strategies that may well be economically inferior. It is not only that the penalty for not yielding to those demands would be deeply undesirable income volatility. It is not just that the new rules are also extremely challenging from an implementation point of view and often provoke troubling earnings restatements. Or that they can require vast investments in worked hours and new systems. As we have analyzed here, they also unfairly create new risks that did not exist before and that have absolutely nothing to do with how a company makes a living, with some of them being truly ridiculously (and dangerously) unrelated.
In light of all this, it is tempting to argue that the new standards have to go. They are so deeply flawed that regulators should dump them entirely, the sooner the better. For all those disaffected executives tired of having their financial statements made dependent of factors as ridiculously unrelated as the performance of Manchester United would be, this doctrine is surely music to their ears.