Derivatives and Financial Statements – International Finance For Future Managers

An insight into our training approach to Finance, by Maciej Kocon – one of our expert trainers delivering training on the Postgraduate Studies International Finance programme, Finance in Business as well as Financial Risk Management. As you can see with this introductory article to the subject, no matter what level we do not shy away from complex topics, and indeed we explain them in a straightforward manner!

Investors place their money in companies they know are managed well. That means these companies are “being looked after” and their financial health is of primary concern to management.

However, to arrive at this conclusion, the only thing that investors have at their disposal is a set of financial statements going back a number of years. By reading, understanding and analysing them they should be able to get a good feeling about the financial health of the company and of the intentions of the company’s management.

This is why Accounting Standards (nowadays called Reporting Standards) have been developed: in order to assist users of financial statements in reaching important decisions.

One of the things these standards try to eliminate is the impact of aggressive accounting, e.g. magnifying revenue and hence profits.

Managing financial risk with derivatives

Derivatives can be (and are) very useful in managing financial risk but their use needs very careful and constant scrutiny. Derivatives used to hedge an exposure can take many forms: that of a transaction or group of transactions, a firm commitment or even a probable future transaction

Companies often strike deals much in advance of the actual delivery of the product or the currency or the loan, etc. and are therefore locked into the transaction without knowing what the price of the item in question is going to be on the day of the delivery.

Consider this example:

And here this is in video format:

Risk arising from derivatives

However, hedging techniques can be complex and the derivatives used to hedge an exposure are not always easy to understand – sometimes it’s not easy to notice that they exist at all!  

A hedging agreement may often be as simple as a piece of paper and so might not even catch the attention of a financial controller! Yes, this does happen in real life, not just in books!

This gives rise to two types of risk:

• Firstly, the unauthorised use of derivatives, i.e. the construction of a derivative that company policy does not allow, and
• Secondly, the wrong use of derivatives, e.g. due to incompetence or due to a genuine mistake.

In the above simple example, the person making the decision that the company buys dollars in three months at a rate fixed today may in fact buy more dollars than needed to cover the import transaction. In other words this person may decide to gamble in an expectation to sell the excess currency at a profit!

In the same example, this person may alternatively make a mistake and sell dollars instead of buying, i.e. the hedging goes in the opposite and wrong direction. In both cases not only the risk is not covered but it actually multiplies!

A very well known example of unauthorised use of derivatives in international banking is Nick Leeson in Barings Bank and Jerome Kerviel in Societe Generale. Both situations resulted from a clear lack of supervisory controls that enabled these individuals to engage in gambling!

An example where the risk formula went down the wrong way was a German energy conglomerate that contracted to sell petroleum at prices fixed in 1992 for a maximum of ten years. The company decided to hedge its risk of rising oil prices by using derivatives, only that the hedging was by mistake done in the reverse direction. When oil prices started falling losses started accumulating fast, costing the company USD 1.5 billion.

There are therefore accounting standards whose main objective is to communicate to readers of the financial statements what risks the enterprise is facing. One constant theme is that derivatives are not just used by financial institutions but by many companies in many industries.

Calculating and showing the value of derivatives

The value of derivatives is of crucial importance. But before we even try to determine their value we need to identify that they exist and in what form. Once identified, the question then becomes how their fair value should be calculated.  

All derivatives are required to be recorded at fair value, with changes in fair value directly impacting the company’s profits. Obtaining the fair value may involve financial modelling for instruments such as for options and other complex derivatives traded “over the counter.” Sometimes it is just a question of obtaining information from the financial markets, as in the case of exchange-traded contracts. In addition, there is a significant amount of additional information required to be included in the financial statements about a company’s exposure to risk and hedging policy. This information is disclosed in notes to the financial statements, that is in addition to the figures.

Also a company may enter into contracts, which may be deemed for accounting purposes to include derivatives, known as embedded derivatives. An example is a contract in a foreign currency, which is not the currency of either party, e.g. a Polish company purchasing from an Italian company in US dollars. There is an additional exposure to foreign exchange risk and this must be separately accounted for as a derivative, i.e. it is embedded in the original contract.

Clearly, the use of derivatives is a complex issue. Companies not only need to identify derivatives and then understand how their value changes can impact performance, but they also need to ask themselves if there is a valid business reason for entering into such transactions.      

Using and assessing derivatives

Derivatives will remain in wide use by many companies and this is for very good reasons.  But companies will have to monitor their use to ensure that their risks are managed responsibly, to see if realised or unrealised losses should be shown, and, very importantly to ensure that any risks and the accounting treatments are disclosed with sufficient clarity so that shareholders can understand their potential impact on the earnings. To start the process the following questions must be taken into account:

• What are the sources of financial risks and how does the company identify, aggregate and measure those risks?
• What hedging policies and programmes are in place?
• Are derivatives being used?
• Do controls exist to protect against the abuse of derivative transactions?
• What is the worst-case scenario of using derivatives?
• Is the accounting treatment as per generally accepted accounting practices, for example IFRS?

These are the kind of questions that we discuss and resolve during our programme of International Finance.

Similarly, our case study workshops for managers in business enable you to learn theory while at the same time developing a range of vital skills. Have a look at the Finance in Business course programme.

Remember that all our training programmes are available live online! If you have any questions, please feel free to ask the relevant course coordinator.