Derivative Losses, Corporate Treasuries, and Accounting for Derivatives

Recently a lot of corporate treasuries in India burned their fingers by investing in Derivatives. The cumulative losses estimated to be of the tune of 20 billion rupees. The losses were incurred mainly due to the complex FX and interest rate derivative deals bought by corporate treasuries. Now let us first understand in layman’s term what derivatives are and how one can use them. Derivatives, as the name suggests, derive their values from underlying instruments e.g. the value of a FX option depends on the exchange rate, volatility, interest rates etc. Derivatives were invented to hedge risk[s] i.e. they can also be thought as an insurance against an unfavorable future event. Due to business activities a corporation faces various financial risks, and by buying a derivative or getting into derivative contract she can hedge the risk[s]. But managing risk is not the only use of derivatives; one can also use derivatives for trading; where one can bet on his/her future market view (speculation). One important feature of derivatives is leverage, which means by investing a little amount one may be able to make a big gain or loss (if one is speculating only). Other interesting feature of derivatives is, until recently, they were off balance sheet items.

Corporations primarily use derivatives to hedge their risk, but as discussed earlier as derivatives are off balance sheet items; which has potential to lure some corporate treasurers to become speculators knowingly or unknowingly. This is what exactly happened in India where corporate treasurers bought complex exotic FX and Interest rate derivatives. No body cared as long as they were making money; but as their market turned otherway (dollar weakening against rupee), they incurred heavy losses. Three issues need attention here; firstly, as these exotic deals were complex, corporations may not have understood them well and did not know how to price them (how to price correctly should be an issue when they go to the court to settle). Secondly, the ability of the corporations to “Value” that trade and calculate the profit and loss. Thirdly, Corporations’ understanding of the dynamic nature of risk, when they entered into the derivative transaction (sometimes corporations ended in short position where they thought they were in a long position). These three issues increased the size of losses as speculations went wrong.

Similar losses in other countries have led to the regulations for accounting of Derivatives. Derivatives are to be reported in balance sheet as an asset or a liability and MTM (mark to market) gains and losses on them are to be reported in earnings. But, reporting of gains and losses on all derivative trades in earnings has potential of bringing volatility in earnings; which is being watched by the market. So, naturally corporations didn’t like the idea of bringing volatility in the earning statement. Regulatory bodies in various countries balanced the need for accounting for the derivatives and concerns of corporations and came up with various regulations. FAS 133 (USA), and ISA 39(Europe and rest of World) are examples of such regulations. These regulations made accounting of Derivatives mandatory for corporations and also made the accounting for a derivative depend on the purpose of the derivative. If derivative is used for trading it will be reported in balance sheet at MTM and gains and losses will be reported in earnings. If derivatives is bought for hedging (this needs to be established with documentation and also corporations have to prove that the derivative is highly effective in hedging the designated risk); it will be reported in balance sheet at MTM and for some special cases accounting rules allow the gains and losses to be reported in OCI (a subsection of Equity). This is also known as hedge accounting. With recent losses regulatory bodies in India made reporting of gains and losses in earnings mandatory. The first cut analysis of the Indian Accouting body’s(ICAI) accounting standard 30 suggests that the body is leaning towards IAS 39 standard for derivative accounting.