Derivs accounting unfit for purpose
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People and MarketsCommentLeader

Derivs accounting unfit for purpose

The skies look dark as you head off for a walk on the beach, so you buy an umbrella. If it turns out sunny, you’ll get a few smirks from people you meet. But you’re unlikely to be abused as an idiot.

Yet abuse, even punishment, is what the accounting system metes out to companies that prudently hedge against risks to their cashflows, when the risks do not materialise.

On Tuesday, Rolls-Royce declared a £4.6bn annual loss, mainly due to a £4.4bn mark-to-market revaluation of derivatives, which dwarfed the £700m charge for bribery litigation.

The stock lost 4%. There is a lot going on at Rolls-Royce, so it’s hard to say what difference the derivatives news made.

But at MetLife a fortnight ago, it was the main news item. The US life assurer’s shares fell 5.8% when it lost $2.1bn in the fourth quarter after a $3.2bn derivatives hit.

Both companies have huge financial market exposure. MetLife had hedged against low interest rates, FX, and equity market threats to its investments. Rolls-Royce has a $38bn hedge book against the risk that its dollar revenues dwindle in value relative to sterling costs.

In late 2016, US rates, equities and the dollar suddenly rose and sterling crashed. The rainy days both had hedged against became less likely. None of this costs them a penny — it will help their underlying businesses. But the non-cash derivative revaluations blew huge holes in their results.

Derivatives have to be accounted for. But the value of Rolls-Royce and MetLife does not lie in their hedge books. It is perverse for a change in their theoretical value to overwhelm the companies’ real performance. Reform is needed.