Accounting Standards
Application of AS-30, Financial Instruments: Recognition and
Measurement is recommendatory from 1-4-2009 and mandatory from 1-4-2011.
However, in the meanwhile various regulatory authorities were concerned about
the manner in which derivative losses were being accounted for. To ensure that
losses on account of exposure to derivatives are duly provided in financial
statements, the ICAI has recently issued an Announcement on accounting of
derivatives. The Announcement is applicable to all derivatives except for
forward exchange contracts covered under AS-11, The Effects of Changes in
Foreign Exchange Rates. The Announcement applies to financial statements for the
period ending on or after 31 March, 2008. The Announcement prescribes following
accounting guidance for derivatives :
• Entities should do accounting for all derivatives in
accordance with AS-30. In case AS-30 is followed by the entity, a disclosure
of the amounts recognised in the financial statements should be made.
• In case an entity does not follow AS-30, the entity
should mark-to-market all the outstanding derivative contracts on the balance
sheet date. The resulting mark-to-market losses should be provided for keeping
in view the principle of prudence as enunciated in AS-1, Disclosure of
Accounting Policies.
• The entity should disclose the policy followed with
regard to accounting for derivatives in its financial statements.
• In case AS-30 is not followed, the losses provided for
should be separately disclosed by the entity.
• In case of derivatives covered under AS-11, that standard
would apply.
• The auditors should consider making appropriate
disclosures in their reports if the aforesaid accounting treatment and
disclosures are not made.
The objective of ICAI in providing clarification on
accounting for derivative is to ensure that financial statements reflect a true
and fair picture of the financial position. The Announcement comes at the fag
end of the financial year and leaves very little time for corporates to
implement it. Derivative deals are complex and companies will require time to
ensure proper fair valuation of such contracts.
Accounting Standards are required to be notified under the
Companies (Accounting Standard) Rules, 2006. In the absence of the Announcement
being notified under the Act, the question of its legal validity arises.
Companies may argue that they are not bound to comply with accounting treatment
prescribed in the Announcements. However, auditors are required to qualify the
accounts, if an ICAI Announcement is not followed. Companies wanting to avoid a
qualification from the auditor are indirectly forced to comply. The Announcement
therefore creates a surrogate rather than a legal requirement for companies to
follow. The author believes that due process of law has been by-passed.
The Announcement prescribes that accounting for derivatives
can be done in accordance with AS-30. Should AS-30 be early adopted in its
entirety or is the early adoption limited to accounting principles relating to
derivatives and hedge accounting ? AS-30 is not yet notified in the Companies
(Accounting Standard) Rules, 2006. If AS-30 has to be adopted in its entirety,
it will conflict with some existing accounting standards notified in the
Companies (Accounting Standards) Rules, 2006, such as accounting for investments
under AS-13 and accounting for forward contracts under AS-11. On the other hand,
AS-30 cannot be applied selectively for derivative and hedges, since it
contradicts the requirement of the Indian GAAP framework which prohibits
selective application of standards. This dichotomy is insoluble.
The Announcement is based on the framework of ‘Prudence’. If
prudence is all that it takes to make financial statements true and fair, then
it begs the question, why does one need any other accounting standards ? AS-30
requires recognition of unrealised gains on derivatives as well. So also, under
AS-11, speculative contracts are marked to market and both gains and losses are
recognised. Therefore as can be seen ‘Prudence’ has been overtaken by the
framework of ‘fair valuation’. If fair value is the framework that is the
cornerstone of future accounting standards, it is illogical to issue an
Announcement based on the concept of ‘Prudence’.
The Announcement is not applicable to forward exchange
contracts covered under AS-11. To determine whether a particular derivative
contract is covered under scope of AS-11 or the announcement, it is crucial to
decide whether such derivative contract is in substance a forward exchange
contract. AS-11 defines forward exchange contract as ‘an agreement to exchange
different currencies at a forward rate’. Forward rate is defined as ‘the
specified exchange rate for exchange of two currencies at a forward rate’.
Paragraph 36 of AS-11 also states “An enterprise may enter into a forward
exchange contract or another financial instrument that is in substance a forward
contract, which is not intended for trading or speculation purposes, to
establish the amount of the reporting currency required or available at the
settlement date of a transaction”. Considering the definition of forward
contracts, it would be easy to conclude in case of derivative instruments like
plain vanilla USD-INR forward contract undertaken to hedge USD receivable is
covered under AS-11. However, whether a purchase option, written option or
option with exotic features such as knock-in-knock-out, range options, etc.
would be within the scope of AS-11 is a question mark.
The Announcement states “In case an entity does not follow
AS-30, keeping in view the principle of prudence as enunciated in AS-1 the
entity is required to provide for losses in respect of all outstanding
derivative contracts at the balance sheet date by marking them to market”. There
is no guidance given in the Announcement regarding how such losses should be
computed. Theoretically, following options are possible : (a) losses can be
computed on each contract basis (b) losses can be computed based on portfolio
basis — net loss is determined for each category of derivatives such as option
contracts or commodity contracts (c) losses can be computed on global-company
basis — net loss on entire portfolio of derivatives taken together. Guidance is
also needed on whether losses should be calculated considering fair value
changes in the derivatives only or whether offsetting gain on the hedged item
can be considered for determining net losses.
The Announcement does not clarify whether losses on embedded derivatives need to be provided or not. A corporate may incorporate a stand-alone derivative in another host contract and try to avoid recognition of losses on the derivatives.
The Announcement requires provision for mark-to-market losses. Many of the derivative instruments are proprietary products of banks, which do not have any ready market. Therefore such derivatives are rather marked to a model, which is usually bank-specific, rather than marked-to-market. Fair valuation of derivatives, particularly long-term derivatives, is likely to be highly subjective, since it would involve considerable extrapolation. In many cases such long-term judgments do not match with the actual situation that emerges later. Hence fair valuation of illiquid instruments tends to be very unreliable. In a survey done by Ernst & Young, it was found that stock option expense as a percentage of reported results could vary as much as 40% to 155% by just tinkering with the assumptions, but within the boundaries of the Standard.
The whole issue of whether these contracts are wagering contracts is something that will be eventually settled in the court of law. It is probably too early to say if the liability will eventually devolve on the corp orates or on the bank. Neither does the Announcement cover these uncertainties, nor does it clearly state if what is being dealt with are only foreign exchange derivatives or all types of derivatives.
From the above it is evident that there are various complex issues in the implementation of the Announcement, which ICAI needs to clarify. Unless clarity is provided on the above issues, various companies will follow different accounting policies to compute losses on derivative contracts. This will hamper comparability and result in subjectivity and inconsistency in accounting for derivatives. The ICAI should defer the applicability of the Announcement till the time clarity on the above-mentioned issues is provided to the Industry. In the meanwhile, the requirement should be restricted to disclosure of derivative losses only. ICAI may also consider advancing the 2011 mandatory date for AS-30 to 2009.
