Managing the hedging risk

21 May 2010

By Elie Zabal,
senior vice-president of Treasury and Regulatory Compliance,
Triple Point Technology.

Hedge accounting is an operational problem. Getting it wrong points to failure in corporate governance and can completely erode investor confidence in a company. That makes it a real enterprise risk, and it needs to be managed as such, argues Elie Zabal, senior vice-president, Treasury and Regulatory Compliance Division at Triple Point Technology.

Deferring the financial impact of a derivative hedge transaction to smooth quarterly earnings in line with the FAS 133 and IAS 39 regulations is a perilous task. Recent corporate history provides us with plenty of examples of firms that have had to restate earnings thanks to errors in their hedge accounting practices and the consequences they have suffered -.. They have to be restated, and with that you lose the trust of the market, forfeit a good portion of your reputation for sound management and see the value of your firm drop.

Even before the credit crunch spread its malicious tentacles and froze up the markets, a company could expect to lose on average ten per cent from its share price following such a restatement, according to extensive research by accounting Professor Nicole Thorne Jenkins. In today’s climate, with the still present spectre of toxic assets looming over the markets and an almost complete breakdown in relationships between companies and their investors, firms might consider themselves lucky to escape with just a ten per cent hit on share price.

The current crisis has wiped billions of dollars off the world’s stock markets. The value of investment portfolios has plummeted. Public companies of all sizes, in all sectors and all geographies have seen their market cap shrivel, sometimes to dangerously low levels.

And yet, through all this turmoil and foment, huge numbers of firms are still trusting billions of dollars of that market capitalisation to relatively junior accountants armed with spreadsheets struggling to get to grips with the complexities of hedge accounting. If it was unadvisable before the credit crunch sparked the latest and most intense round of troubles, it is sheer insanity now.

Hedge accounting is very hard to get right. Even if you think you have it nailed, everything is open to interpretation by the company’s auditors. Errors can be costly and it seems that no company is immune from making a mistake. For example, the Ford Motor Company, Fannie Mae and Freddie Mac were all coming to terms with the effects of errors in their hedged accounts long before their current problems. Freddie took more than 18 months to recommence issuing quarterly statements on a timely basis, following the announcement of accounting distortions in early 2003. It spent hundreds of millions of dollars on the clean up operation.

The point is that hedge accounting is not simply a trading problem: the decision to hedge may be made on the trading desk, but it is the finance department that must ensure it is recorded, reported and accounted for appropriately. Managing the risks associated with it falls very much within the purview of the finance function. Nor, despite its name, is it simply an accounting issue.

Indeed, the hedge effectiveness regulations and reporting requirements touch many different aspects of your business including trading, credit, accounting and risk management. It requires adequate documentation for external auditors on an entire gamut of processes from board authorisation, the following of hedging policies, documentation and reporting. It is a major operational issue.

There are two alternatives.

The first is to abandon hedge accounting completely. But that will almost certainly result in dramatically fluctuating income statements. The markets for any number of raw materials like metals or agricultural products are now incredibly volatile.

If you are one of the rapidly growing club of firms that needs to find sophisticated ways of managing raw materials into and products out of your business, then abandoning hedge accounting is not a viable solution. A well enacted hedging program is very appealing to shareholders and market analysts – and in these highly competitive but deeply risk-averse times that is a significant benefit.

The second – and by far the more attractive option – is to abandon the spreadsheets.

If you want to manage risk across your organisation you need the tools to do it, and hedge accounting is no exception. Spreadsheets are not and have never been an effective risk management option. In fast moving, highly volatile markets they are a liability rather than a solution, and increase the chance that your junior accountants will make dangerous accounting mistakes.

But by using the right tools, you are no longer relying on manual processes or the effectiveness of self-programmed macros. Simple mistakes such as input errors, logic errors, interface errors, and wrong cell range errors can put decisions and dollars at risk. Indeed, the greatest cost of spreadsheets might be the implicit cost of poor decisions that are based on faulty data. Research suggests that 20-40 per cent of spreadsheets have errors, but recent audits by the University of Hawaii found of 54 spreadsheets, 49 (or 91 per cent) had errors.

Robust systems do now exist that automate the whole hedge accounting process. Furthermore, these systems have been real-world tested to pass scrutiny from auditors and ensure that all regulatory standards are met. So you can now make certain that your hedge accounting is compliant with the relevant accounting regulation and, just as importantly, your own risk parameters and policies on hedging.

If you want the market to have confidence in your company and if you want shareholders to have faith in your management, then they need to be sure that you have the tools to manage your risks effectively. And in today’s markets that now includes hedge accounting. Any errors in reporting and accounting for your hedges will require you to restate your earnings and breaches that trust, sending a terrible signal to the market.

Getting the right tools in place will certainly enable you to balance economic benefits, risk management and stable financial statements. But more than that it will enable you to maintain your financial well-being, retain shareholder confidence and even secure your operational future. This is the light in which hedge accounting management needs to be seen.

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