Top Ten Reasons To Hate Derivatives Accounting

(this is an edited version of a piece that I recently published)

1) They impose stringent new investments in staff and systems and a significantly large extra work burden

2) They can cause artificial income statement volatility

3) They can cause artificial balance sheet (equity) volatility

4) They can lead to the dismissal of high-quality, value-adding employees

5) They can entrap companies into simple, potentially economically inferior, plain-vanilla hedges

6) They can discourage companies from entering into sophisticated, potentially economically superior, exotic hedges

7) They can annihilate hedges that had been delivering sensational economic results

8) They can lead to destabilizing earnings restatements

9) They expose companies to new truly ridiculous risks that did not exist before and that have nothing to do with how the entity makes a living

10) No one seems to know how they really work

This list clearly conveys a central message concerning derivatives accounting standards: they are an entirely counterproductive exercise because they do not necessarily do any good while creating lots of trouble. It is doubtful at best that FAS133-IAS39 enhance corporate risk management practices and disclosure and transparency are certainly not enhanced at all. The many negative consequences of the standards definitely outweigh any possible positive.

Should companies stop using derivatives in light of such hostile accounting? Not really. Corporates must forget about accounting effects and focus on economic effects. FAS133-IAS39 offer bad news all around and there really is no scaping some type of malaise so you might as well hedge in the best economically possible way, take the earnings volatility, and clearly explain to outside parties the artificial character of any derivatives-induced suprises. Treasurers and CFOs should choose to be free to enter into hedges that make the most economic sense and have the bravery to face any accounting nastiness with their boots on.

Manchester United-Dependent Earnings

(this is a reproduction of a piece that I recently published)

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.

Reluctantly Greek

(this is a reproduction of a piece that I published last month)

By forcing non-financial companies to record the mark-to-market of their derivatives positions in the balance sheet and, possibly, the income statement, the new derivatives accounting rules (the infamous FAS133 and IAS39) transform corporate treasurers into traders. Like a magic wand, the new standards suddenly expose treasurers to wild-swinging fluctuations in derivatives values, a worry that was previously the exclusive preserve of trading professionals who, after all, have always been paid based on those mark-to-market variations.

Without a doubt, FAS133 and IAS39 have dramatically altered hedging decisions inside corporate fortresses, and made life much harder for treasurers. Some of the well-known possible negative effects of the new standards are enhanced artificial income statement volatility, heavy workload, extra investments in systems, and large and disturbing earnings restatements due to implementation technicalities. Such are the unpleasanties forced upon companies by regulators. Most of the attention and analysis of the new rules have focused on those aspects (predictably so, as earnings volatility and restatements tend to hit the headlines).

A point that has been less covered is the fact that, by treating treasurers as if they were derivatives traders, accounting authorities now force the former to be exposed to those devious things prone to inflict cold sweats at night to every option trader in the world: the famous “greeks”, the parameters that in exquisite detail describe and enumerate the various mark-to-market risks faced by anybody that holds an option position. Delta, for example, tells us by how much the market value of the option would change following a small change in the underlying asset (foreign exchange, interest rates, commodity). Gamma, in turn, measures by how much delta itself would change after a small move in the underlying. Vega deals with the risk of changing volatility. Theta describes the option value´s sensitivity to the passage of time (unlike the case of fine wine, as time passes by an option is, generally, assumed to lose value). As the greeks are the tools conventionally used to measure options mark-to-market changes, FAS133 and IAS39 make them, for the first time, essentially relevant for corporates. Movements in gamma or vega can now have important balance sheet and earnings ramifications for companies whose executives (let alone shareholders) had never before heard of such terms.

It seems highly unfair to expose treasurers to new risks that have nothing to do with how their companies make a living and that did not priorly exist (such as volatility or the passage of time), and to make them monitor these risk parameters on a continuous basis like their stress-eating counterparts on the trading floor. The new accounting rules make very relevant what is in fact very irrelevant.

Let´s analyze some of the weird (and disturbing) effects that the greeks can inflict on corporates’ reported results. Take theta for instance. For a regular (“plain vanilla”) option, theta is always negative. That is, as time passes by the option´s value diminishes. In trading jargon, this is known as “time decay” and explains why options are said to be “wasting assets”. Time is beloved by option holders because it gives more chances for market movements, and this magnifies the opportunities for the option to expire in-the-money and deliver a payoff. Now imagine the press release of an options-using corporate that has suffered an earnings setback due to mark-to-market deterioration of its derivatives portfolio simply because, well, time went on: “Q2 was slower than expected because earnings suffered due to the fact that time passed by. If time had not passed by, we would have been fine. It´s not our fault that time passes by!”.

Things are even worse in the case of some exotic options, such as knock-out options, where the contract gets cancelled if the underlying asset reaches a certain pre-set level. These options can show flip-flopping greeks, that switch from negative to positive or vice versa (vanilla greeks, in contrast, never change sign). Theta can suddenly go from the usual negative to positive (the passage of time becomes valuable). Vega similarly flip-flops, in this case from the usual positive to negative (market fluctuation becomes undesirable). Thus, the following awe-striking corporate statement could take place: “Q1 results were helped by increased volatility; Q2 results were hurt by increased volatility” or “Increased volatility helped us before it harmed us”.

Forget the fact that investors and shareholders don´t really understand why volatility (never mind time) should matter when it comes to the bottom line of a non-financial company. With flip-flopping greeks, they can´t even understand whether the company is long volatility or short. Or long time or short time. Can you picture outsiders scratching their heads wondering whether the company benefits or not from the ticking of the clock? Surreal? You bet.