The Hindu Business Line : Accounting for hedging transactions

There is a huge difference between a simple forward exchange contract that is taken to shield against exchange rate movements and a complicated hedge transaction that looks at maximising profits. Hedging transactions are complicated, and accounting for them even more so

Dubious energy trades and corporate fiascos appear to enjoy a special relationship in the US. A few years back, Enron did everything that should not have been done with special purpose vehicles (SPVs) resulting in mammoth regulatory and governance lapses.

Recently, Amaranth Advisors LLC (AAL) went public that it had suffered a $6-billion loss in September inclusive of $560 million in one day in wrong-way bets on natural gas derivatives. Sixty-five per cent of the capital of the firm was wiped out, resulting in investors clamouring for their money and the firm wooing prospective buyers for a sell-off. The wrong-way trades have been traced to a broker who has been given the marching orders.

While this can be passed off as a one-off situation in the risky world of hedging, there could be something that prompts investors to smell such situations in advance.

Accounting has long advocated the concept of exception reporting, whereby anything above a certain benchmark normal is looked into in detail to confirm normality. Had an investor mapped the profits of AAL with those generated by other hedge funds, he could probably been happier off today. However, this episode is quite likely to bring us back to the topic of accounting standards and investor losses.

Hedging one's bets

Hedging transactions are complicated and accounting for them is even more so. However, if a firm follows International Financial Reporting Standard 7 (IFRS 7) — on financial instruments disclosures — the investor could get some idea of a firm's business profile and aid in taking a decision on his investment.

An entity must group its financial instruments into classes of similar instruments and when disclosures are required make them by class.

The two main categories of disclosures required by IFRS 7 are (i) information about the significance of financial instruments, and (ii) information about the nature and extent of risks arising from financial instruments.

The Indian situation

In India, as of now, we are content with AS-11 — accounting for foreign exchange transactions — which speaks of forward contracts. An exposure draft on an accounting standard on financial instruments was issued some time back and it appears that it is being fine-tuned before the standard is issued in 2007. There is a huge difference between a simple forward exchange contract that is taken to shield against exchange rate movements and a complicated hedge transaction that looks at maximising profits.

Till the disclosure norms are made mandatory through a standard, one would have to rely on the published net asset values read with the disclaimer — funds are subject to market risks and past performance is not a guarantee for future performance.

(The author is a Hyderabad-based chartered accountant.)

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