Tuesday, April 1, 2008

Accounting for Derivatives Exposure

A recent announcement by the Institute of Chartered Accounts of India (ICAI) has added to the imbroglio over derivatives. Accounting Standard 30 (AS30) that deals with accounting for derivatives was to become mandatory with effect from April 1, 2011. However, the ICAI in an emergent decision has called for an early adoption of AS30 for financial statements as on March 31, 2008. Corporates not following AS30 are required to measure unrealised losses on financial instruments using principles of prudence explained in AS1. The Business Line has a report on the implications.

This appears to be a knee-jerk reaction to recent events and is likely to cause a stir among corporates in their year-end reporting. Business Standard has an editorial today that touches upon some of the issues:

“… The problem of course is that the directive has come on a week-end, with one working day left for the financial year to close for most companies. Saddling companies with a serious accounting change at the very end of the year has given them an unpleasant shock, and many of them will be scrambling to deal with this last-minute situation. This is not the way in which matters should be dealt with.

The new accounting directive should mean that all the facts will be known when the March accounts are reported, but shareholders may remain in the dark about the true dimensions of the potential problem. If some companies are tempted to take the view that many foreign exchange derivative contracts have maturity dates that are still in the future, and therefore they can legitimately take the view that until the stipulated date comes round, there are no losses to report. Since some of the affected companies have gone to court against the banks that sold them the derivative contracts, they will be taking legal advice on whether they have a strong case, and whether that gives them protection from “marking-to-market”.

Companies will be eager to look for such escape routes as the immediate disclosure of large exposures could endanger their relationships with other bankers and suppliers, with the attendant risk of credit drying up and affecting the running of the business. However, the accounting norms that have been introduced do not leave any room for such creative thinking. There is also the possibility that banks and companies will work out arrangements whereby existing derivative contracts are unwound, and replaced by new contracts that have an even longer maturity period. But even this will not prevent full disclosure to shareholders. In any case, such “ever-greening” of loans also runs the risk of increased exposure, and a bigger problem being bought for the future.”

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