ACCOUNTING FOR LIFE

This is a modified version of my article published in “Pakistan Accountant” in January 2005. Amused!!! Yes life has a profit and loss account; even a balance sheet. This new facet of accounting will be very interesting for all accountants. Giving a religious touch to a dry subject will surely be a delightful surprise.

The accounting of life, as the accounting we have studied and been doing, follows certain rules and principals. There is a balance sheet and a profit and loss account. All transactions in life are duly recorded, without any exception, through a complex double entry system. The recording system has been created by the Almighty, so it never falters, and never needs up-gradation. Each and every of our transactions is recorded, and there are no off Balance Sheet items.

Before dwelling deeper, let's first find out what are the fundamentals or conventions for the accounting of life. The basic rule is fairly simple; "all debits equal all credits". This simple rule ensures that balance sheet of our life always remain balanced. If we try to make a debit transaction (i.e. taking bribe); it will automatically create a credit transaction (i.e. medical expense, or loss of an asset).

The second rule is fairly common. Allah has predetermined Rizq for each one of us. What is Rizq? Revenues? Income? or Profits? I gave it considerable thought and came to the conclusion that Rizq means profit. But it is not the profit we are familiar with. It is the measure of utility or satisfaction.

How does this accounting work? Let’s use an example. We all know that income minus expenses is profit. Profit (Rizq) is fixed, while the income and the expenses can be varied. The bottom line will always remain same. If my Rizq is 10,000 I will always have an income minus expense balance of 10,000. If I try to increase my income, expenses will correspondingly increase. If income decreases because of any reason, expenses will also decrease. The bottom line will always be 10,000. (I am using number of 10,000 for making it understandable; Rizq is not always denoted by a number as we will see later).

Suppose I try to supplement my income by taking a bribe of 50,000. This unlawful transaction will automatically create an expense of 50,000 because the level of profit for me (Rizq) is fixed. The expense can be in any shape; I might get sick and have to pay 50,000, or burglars might barge in my house and take away goods worth 50,000.

This calculation applies similarly to a decrease in income. What happens if a pick-pocket takes away my wallet, which had 5,000? This act will be a decrease in my disposable income. It will either result in a corresponding decrease in my expenses, or a substitute source of income will arise automatically. I might get a good bargain when buying clothes for my family and save 5,000, or I might be called to present a paper in a seminar for which I will receive 5,000, or it might a combination of both of these. The end result remains the same. My Rizq will always be the amount predetermined by the Almighty. My level of satisfaction will remain the same.

In any investment you have to take risk. The return may or may not be coming. This is not the case with Sadqah. Returns are guaranteed by the Almighty. You just have to wait for a while for the investment to mature, and will definitely get returns. This is Allah's promise. You cannot lose on this one.

Economic crisis affects job market

For fourth-year students preparing to leave the ivory tower, the rising unemployment rate is a pressing concern. The current economic crisis has reshaped the financial world, and with it, the job market that many University students had been planning to enter this coming year.
Wall Street has been a major source of employment for recent College graduates. According to the University’s Career Advising and Planning Service (CAPS) exit survey data for the class of 2008, of those who had accepted full-time jobs upon graduation, about 19 percent indicated that they planned to work in banking- or finance-related fields. In 2007, 22 percent accepted jobs in banking and finance.
But many of these jobs no longer exist. In past years, major banks recruited new employees on campus, streamlining the application process for would-be financiers. And although banks that have survived the economic crisis, such as Goldman Sachs, J. P. Morgan, Credit Suisse, and UBS, will continue on-campus recruiting for their summer internship programs, they are “scaling back” hiring for full-time positions, according to Lucy Gee, associate director of employer relations at CAPS. After purchasing Bear Stearns in April, J. P. Morgan informed CAPS that it would not be conducting on-campus recruiting at any schools, as it would be busy managing the influx of new employees from Bear Sterns. Banks like Morgan Stanley and Credit Suisse, which are still recruiting, are filling fewer positions than in past years.
While past economic recessions have disproportionately affected unskilled workers, the reverse could be true in the current downturn. In a September post on The New York Times blog “Economix,” Princeton economist Alan Krueger noted that those with bachelor’s degrees or higher have been the hardest hit by the financial crisis. Citing the Bureau of Labor Statistics, Krueger pointed out that from March to August 2008, the seasonally adjusted share of employed college graduates fell by 1.6 percentage points, while the share of employed high school graduates and high school dropouts rose by 0.6 and 0.2 percentage points, respectively.
Students who had hoped to embark on careers in finance are hastily reevaluating their plans.
“The financial crisis has definitely changed the way I’m searching for jobs. I’ve realized that I need to keep my options open and not necessarily only focus on the type of jobs I had originally planned on,” fourth-year Anne Scherer wrote in an e-mail interview.
Gee noted that while job opportunities in finance still remain, job searches will become increasingly difficult and require more personal initiative than in past years. She advised interested students to consider career opportunities with smaller firms, nonprofits, and in industries that have not directly suffered repercussions from the financial crisis, like health care.
Nevertheless, many students remain worried about their job prospects and plan to compensate by casting a wide net.
“I’ve been applying for jobs since the first week of classes, and I visit the CAPS website about 15 times a day to check for interview invitations,” fourth-year Joanna Puchalski said.
Puchalski was initially interested in a career in investment banking, which she now says is “out of the question.” Instead, she is applying for jobs in consulting, wealth management, and is now considering a career in communications and public relations.
Puchalski is not alone, as many of her fellow fourth-years are similarly broadening the scope of their job searches to include consulting options in addition to more traditional finance careers. Gee said that student interest in consulting has been on the rise among students for years, and she expects that trend to continue, considering that many consulting firms have not yet scaled back hiring.
Although CAPS representatives emphasize that there is no need to panic, the job search has become increasingly trying for students who expected a relatively straightforward process.

Current Economic crises and its causes

The mainstream media and Wall Street have reached the consensus that the current credit crisis is the worst since the post-war period. George Soros' statement that ”the world faces the worst finance crisis since WWII” epitomizes the collective wisdom. The crisis is currently the ultimate scapegoat for all the economic evils that currently plague the global financial system and the global economy – from collapsing stock markets of the world to food shortages in third world counties. We are repeatedly assured that the ultimate fault lies with the Credit Crisis itself; if there were no Credit Crisis, all of these terrible things would never have happened in the economy and the financial markets.

The most extraordinary thing is that the mainstream media has never attempted to compare the current economic environment to the one preceding the Great Depression. In essence, it is assumed outright that the Great Depression can never possibly happen again, ever, thus obviating the need for such a comparison. I actually believe that the macroeconomic fundamentals today are much worse, so that we are in for a protracted period of economic depression – a depression much worse than the Great Depression, a depression that would likely be remembered in history as “The Second Great Depression” or The Greater Depression , as Doug Casey has called it so aptly. Here is why I believe that this is the case.

Duplicating Mistakes from the Great Depression
At its core, the environment of the 1990s, and the response of the Fed to the tech-telecom bust has created an economic environment that has encouraged the repetition of the very same mistakes that led to the Great Depression. Here is a concise summary of widely recognized mistakes of the 1920s, without going into the details, with obvious parallels in the current environment:
Asset Bubbles – first in the stock market during the 1990s, then in real estate during the 2000s, pretty much mirroring the stock and real estate market bubbles of the 1920s.
Securitization – although not in the very “ultra-modernistic” form and shape of the 2000s, with slicing and dicing of pools and tranches of seniority, it was widely recognized in the 1930s that securitization during the 20s drove the domino effect in the U.S. financial system during the Great Depression.
Excessive Leverage – just like in 2008 the topic du jour is “deleveraging”, so the unwinding of leverage during the 1930s was the driver of forced liquidations and financial pain. Of course, it was very clear back then that the root of the problem was not deleveraging per se, but the excessive leverage that took place prior to the deleveraging process. “Investment Pools” were then instrumental in both the securitization and excessive leverage, just like the Hedge Funds of today.
Corrupt Gatekeepers – we know well that the Enrons and Worldcoms were aided and abetted by the accounting firms – those same firms that were supposedly the Gatekeepers of the financial community, yet handsomely profited from the boom while neglecting their watchdog functions. In the current financial crisis, we also know that the rating agencies were also making hay during the boom. Very similar were the issues during the 1920s that led to the establishment of the SEC and other regulatory bodies to replace the malfunctioning “gatekeepers” at the time.
Financial Engineering – we are led to believe that financial engineering is a rather recent phenomenon that flourished during the New Age Finance Era of the last 15 years, yet financial engineering was prevalent in the 1920s with very clear goals: (1) to evade restrictive regulations, (2) to increase leverage, and (3) to remove liabilities from the books, all too familiar to all of us today.
Lagging Regulations – just like the regulatory environment lagged the events of the 1920s and regulations were introduced only after the Great Depression had obliterated the U.S. financial system, so we are yet to see new regulations addressing the causes of the current crisis. Understandably, regulations should have foreseen today's financial problems and should have been introduced before the crisis.
Market Ideology – back in the 1920s, just like in the last two decades, the market ideology of “laissez faire”, which Soros quite appropriately described as “Market Fundamentalism”, has swept the financial markets. Of course, the free market knows the best, but the reality is that the money market is not really free – when the Fed determines the cost of money (interest rates), and can fix this cost for as long as it wants, then all sorts of financial imbalances can be sustained without the discipline imposed by the market. This can lead to all sorts of problems that we actually have to face today.
Non-Transparency – back in the 1930s, it was widely recognized that businesses and especially financial institutions lacked transparency, which allowed for the accumulation of significant imbalances and abuses. Today, financial markets and institutions have intentionally compromised transparency in a number of ingenious, or better disingenuous, accounting trickeries and financial gimmicks, like off-balance-sheet entities (SIVs), hard-to-understand derivatives, and opaque instruments with mind-boggling complexity. Today CEOs and Chief Risk Officers of major financial institutions cannot figure out their own risk exposures. Originally, lack of transparency was designed to fool the markets; ironically, modern-day financial executives have gotten to the point of fooling themselves.

MONEY MARKETS

In finance, the money market is the global financial market for short-term borrowing and lending. It provides short-term liquidity funding for the global financial system. The money market is where short-term obligations such as Treasury bills, commercial paper and bankers' acceptances are bought and sold.

The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months. Money market trades in short-term financial instruments commonly called "paper." This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.
The core of the money market consists of banks borrowing and lending to each other, using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency.
Finance companies, such as GMAC, typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Certain large corporations with strong credit ratings, such as General Electric, issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf via commercial paper lines.
In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the US Treasury issues Treasury bills to fund the US public debt.
Trading companies often purchase bankers' acceptances to be tendered for payment to overseas suppliers.
Retail and institutional money market funds
Banks
Central banks
Cash management programs
Arbitrage ABCP conduits, which seek to buy higher yielding paper, while themselves selling cheaper paper.

WORLD CURRENCY

In the foreign exchange market and international finance, a world currency or global currency refers to a currency in which the vast majority of international transactions take place and which serves as the world's primary reserve currency. In March 2009, as a result of the global economic crisis, China and Russia have pressed for urgent consideration of a global currency and a UN panel has proposed greatly expanding the IMF's SDRs or Special Drawing Rights.

A world currency is at one extreme of a conceptual spectrum that has local currency at the other extreme.

Currencies have many forms depending on several properties: type of issuance, type of issuer and type of backing. The particular configuration of those properties leads to different types of money. The pros and cons of a currency are strongly influenced by the type proposed. Consider, for example, the properties of a complementary currency.

Participants of Forex Market

Unlike a stock market, where all participants have access to the same prices, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the “line” (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail FX-metal market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the foreign exchange market to align currencies to their economic needs.

[edit] Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.

[edit] Commercial companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

[edit] Central banks

National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.^[7] Several scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.

[edit] Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.

[edit] Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.

[edit] Retail foreign exchange brokers

There are two types of retail brokers offering the opportunity for speculative trading: retail foreign exchange brokers and market makers. Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated by the CFTC and NFA might be subject to foreign exchange scams.^[8][9] At present, the NFA and CFTC are imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone. It is not widely understood that retail brokers and market makers typically trade against their clients and frequently take the other side of their trades. This can often create a potential conflict of interest and give rise to some of the unpleasant experiences some traders have had. A move toward NDD (No Dealing Desk) and STP (Straight Through Processing) has helped to resolve some of these concerns and restore trader confidence, but caution is still advised in ensuring that all is as it is presented.

[edit] Non-bank Foreign Exchange Companies

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account.

It is estimated that in the UK, 14% of currency transfers/payments^[10] are made via Foreign Exchange Companies.^[11] These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value servic Money Transfer/Remittance Companies

Money transfer/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally..

Foreign currency hedge

A way for companies to eliminate foreign exchange (FOREX) risk when dealing in foreign currencies. This can be done using either the cash flow or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP).

[edit] Foreign Exchange Risk

When companies conduct business across borders, they must deal in foreign currencies . Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before the currency is exchanged.

[edit] Hedge

A hedge is a type of derivative, or a Financial instrument, that derives its value from an underlying asset. This concept is important and will be discussed later. Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forwards and options. A Forward contract will lock in an exchange rate at which the transaction will occur in the future. An option sets a rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option.

[edit] Accounting for Derivatives

[edit] Under IFRS

Guidelines for accounting for financial derivatives are given under IFRS 7. Under this standard, “an entity shall group financial instruments into classes that are appropriate to the nature of the information disclosed and that take into account the characteristics of those financial instruments. An entity shall provide sufficient information to permit reconciliation to the line items presented in the balance sheet” ^[1]. Derivatives should be grouped together on the balance sheet and valuation information should be disclosed in the footnotes. This seems fairly straightforward, but IASB has issued two standards to help further explain this procedure. The International Accounting Standards IAS 32 and 39 help to give further direction for the proper accounting of derivative financial instruments. IAS 32 defines a “financial instrument” as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity” ^[2]. Therefore, a forward contract or option would create a financial asset for one entity and a financial liability for another. The entity required to pay the contract holds a liability, while the entity receiving the contract payment holds an asset. These would be recorded under the appropriate headings on the balance sheet of the respective companies. IAS 39 gives further instruction, stating that the financial derivatives be recorded at fair value on the balance sheet. IAS 39 defines two major types of hedges. The first is a cash flow hedge, defined as: “a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction, and (ii) could affect profit or loss” ^[3]. In other words, a cash flow hedge is designed to eliminate the risk associated with cash transactions that can affect the amounts recorded in net income. Below is an example of a cash flow hedge for a company purchasing Inventory items in year 1 and making the payment for them in year 2, after the exchange rate has changed.