The preparation of a financial statement in conformity with IFRS, or US GAAP, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, as well as of contingent asset and liabilities at financial statement date. Therefore, actual results could differ from those estimates, even in regulatory financial reporting and certainly in virtual consolidated financial statement (VCFS) of financial condition, which include the accounts of a company and its subsidiaries.
- Material intercompany balances and transactions are eliminated in consolidation.
- But client transactions are recorded on a settlement date basis, as with a financial statement for regulatory reasons.
Securities borrowed and securities loaned are recorded at the amount of cash collateral advanced or received. Adjustments that result from translating foreign currency financial statements are reported as a separate component of stockholder’s equity. A general form of a consolidated statement of financial condition is shown in table below:
General Lines Characterizing A Consolidated Statement Of Financial Condition
- Cash and cash equivalents
- Cash and securities segregated under prevailing regulations
- Securities purchased under agreements to resell
- Receivables from brokers and dealers
- Receivables from clients
Liabilities and stockholder’s equity
- Drafts payable
- Loans payable
- Securities sold under agreements to repurchase
- Payable to brokers and dealers
- Payable to clients
- Securities sold but not yet purchased
- Accounts payable, accrued expenses
- Other liabilities
- Preferred stock
- Common stock and additional paid-in capital
- Accumulated deficit
- Cumulative foreign currency translation adjustments
The level of leverage embedded in these positions can be appreciated through different indices that are not difficult to interpret. For instance: securities sold under agreement to repurchase may be nearly half the total liabilities, and the repos alone may represent seven times or more stockholder equity [This example about ‘seven times’ comes from an analysis of the statement of a highly geared company].
Securities purchased under agreements to resell and securities sold under agreements to repurchase, are collateralized financing transactions. They are carried at their contract amounts, plus accrued interest; and they are subject to both credit risk and market risk – an exposure that may be fairly significant and of which the board, CEO, and senior management must be steadily updated through virtual consolidated financial statement [VCFS]:
- Assets recorded at market or fair value include cash, securities owned, and cash & securities segregated under prevailing regulations.
- Liabilities recorded at market or fair value include securities sold but not yet purchased.
In the virtual (as in the regulatory) consolidated financial statement, instruments recorded at amounts that approximate market value generally have variable interest rates or short-term maturities. Accordingly, their market values are not materially affected by changes in interest rates. Assets that are recorded at amounts approximating market value:
- Consist primarily of short-term financial instruments, and
- They include agreements to resell securities borrowed, and certain other receivables.
Short-term liabilities, which include agreements to repurchase, loans payable, securities loaned and certain other payables and accrued interest, are also recorded at amounts that approximate fair value. Because with IAMIS management should not lie to itself, it would be a false belief to think that market risk is mitigated by:
- Hedging transactions, or
- Static trading limits.
The most important contribution of virtual consolidated financial statement [VCFS] is to bring home the point that the company faces an outstanding exposure even if it thinks its positions are hedged.
Because derivatives risk can turn the most carefully prepared financial plan on its head, good governance also suggests the wisdom of preparing interactively, on request, a report with both:
- Notional principal amounts (NPA), and
- Demodulated NPA to the level of assumed risk [also known as credit equivalent amounts].
Because nothing is static in business, hedge effectiveness must be measured steadily by comparing the change in fair value of each hedged position at applicable market rate. This continuous monitoring is as necessary for currency risk as it is for interest-rate risk, and the price of every other commodity.
The fact that a company enters into interest-rate swap agreements to manage its risk between fixed and variable interest rates, does not mean that the positions it has assumed are free of risk. The same reference is valid about hedging the future value of our produce:
- Theoretically forward sales protect from price pressure.
- Practically, if the market turns around, forward sales become a drag to profits, and sometime a serious one.
In the 1990s, gold mines got into the habit of selling forward their produce every time the price of gold, which had long been stagnant, edged up a bit. This worked well for a number of years, but those gold companies who were ‘star hedgers’ got burned when in 2005 the price per ounce soared. Whether upward or downward, a trend in the price of a commodity holds many surprises. In the last week of November 2005, for example, the gold price jumped $10 per ounce to $496, continuing to build upon its gains. December 7 took bullion to a 28-year high at $514 per ounce. Prior to that spark, bullion had peaked at $503 on 14 December 1987 – 18 years earlier.
The irony is that gold producers who were ‘best hedged’ in an environment of depressed price per ounce were precisely those who felt the most pain when the good news came. A December 2005, study by Merrill Lynch identified Bema Gold Corp, Northgate Minerals, and Buonaventura as the companies with most exposure to the price hike in terms of lost profits. They lost money precisely because of their hedging.
The pattern of income that went down the drain is different by company:
- Bema Gold had ‘hedged’ nearly 50% of its 2005 forecast production, but ‘only’ 7% of its reserves.
- Buonaventura had hedged over 30% of its 2005 production, and a whopping 18% of its reserves.
It needs no explaining that hedging proved a disaster to the companies, which found themselves so deeply committed that they could not benefit from price upswings. Their shareholders were unhappy. Boards, CEOs, and senior managers should not be found sleeping when it comes to hedging risk, and a virtual consolidated financial statement available in real time is the best way to keep them steadily awake.
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