The Un-Faithful Representation of Financial Statements: Issues in Accounting for Financial Instruments

Abstract

Both the International Financial Reporting Standard (IFRS) and accounting standards for the US GAAP categorize hedging relationships as falling into several buckets. Two of these buckets are of relevance in this paper: (a) hedging the volatility of fair values, and (b) hedging the volatility of future cash flow. In this paper, I argue that at least five accounting treatments lead to reporting information that distort the true transactions. The four treatments relate to (a) the Hypothetical Derivatives Method, (b) using CVA and DVA as valuation adjustments of the values of derivative assets and liabilities, (c) hedging unrecognized firm commitment and (d) separation of embedded derivatives and (e) failure to disclose that hedging is essential a substitution of risk exposure. To remedy these resulting violations of faithful representation of actual and true transactions, both standards-setting boards need to undertake significant revisions of accounting for financial instruments to allow for effective adherence to the principle of “faithful representation.”