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Accounting of derivative losses
April, 17th 2008

Recent derivative losses in India have brought the issue of accounting of derivatives into spotlight. Unfortunately, AS-30, Financial Instruments Recognition and Measurement, which is the same as IAS 39, is mandatory only from 2011.

As per these standards, derivatives are not treated as off-balance-sheet items, rather they are marked to market.

The consequent gain or loss is recognised in the income statement. Alternatively, the gain or loss may be applied for purposes of hedge accounting.

For example, an importer with April-March financial year may have a dollar obligation on January 1 to be paid after six months on purchase of raw materials. To hedge this position, a forward contract to sell rupee and purchase dollar at end of six months at a particular forward rate, is entered into. This locks the importers obligation to a stated rupee amount.

Now for the March 31 year-end financial statements, the importer would have to mark to market the derivative.

This exercise would reveal that the importer may have made an unrealised gain or loss. If hedge accounting is applied, such gain/loss need not be recognised in the income statement; rather they can be kept in a separate account, under Reserves and Surplus.

Such gains/losses are recycled to the income statement only when the actual purchase takes place (three months later). This process ensures that financial results are not volatile, as the changes in the value of the hedged item and the hedge instrument are appropriately matched from a timing perspective.

One of the conditions for being able to apply hedge accounting is that the hedge instrument should not have features that make it very exotic or speculative. If the hedge instrument is speculative, then the mark to market gains/losses have to be compulsorily recognised in the income statement.

New feature

One such exotic arrangement is the barrier option with a knock-in knockout feature. Ordinary FX options provide the buyer with an unlimited upside and a known downside, that is, the premium.

The knockout feature limits the upside given to the buyer and, therefore, makes the option considerably cheaper.

When an investor purchases an ordinary FX option, the payout depends on where the spot rate closes on a particular day (the maturity). With the knockout feature, if at any time up to and including the maturity, the knockout level is reached, the option will expire worthless.

An importer may have the view that the dollar will strengthen against the rupee over the next six months (current spot 40). They purchase an ordinary six month dollar call option at a strike of 40. This would cost 3.50 per cent. The alternative is to purchase a dollar at the money call (40) with a knockout at 44. This would reduce the premium to only 1 per cent with the following result.

If the dollar does strengthen but trades above 44 over the life of the option, the call will expire worthless. If the dollar strengthens, but never reaches 44 over the life of the option, the call will behave like an ordinary call and the investor will exercise the call and make the same profit as the ordinary call. If the dollar does not close above the call strike (40), the option will expire worthless like an ordinary option.

As the option buyer is giving up some upside by having the knockout feature, the premium is reduced dramatically. As the option can be knocked out at any time over the life of the option, the knockout feature is very sensitive to the volatility of the underlying instrument. It is more sensitive than an ordinary option. This explains the dramatic reduction in premium.

However, it comes with the risk that the contract would be rendered useless. If the importer has a liability of $100 million and the dollar trades at 45 at the end of six months, the Rs 4,000 million liability will be increased to Rs 4,500 million; a loss of Rs 500 million.

Whilst the knockout could potentially render the contract useless, a feature called knock-in makes a contract useful only if a barrier is broken. As the option is dead until it knocks in to life, the premium is reduced drastically. However if the barrier is not broken, the importer would stand exposed to a foreign exchange risk.

Fresh currencies

Many Indian corporates had taken positions in forex derivatives with low yielding currencies like Swiss (CHF) and Japanese Yen (JPY) as the underlying. These currencies were not only chosen because of their low yields, but also due to their perceived stability against the dollar, a phenomenon the corporates hoped to profit through participation in barrier options, despite stringent RBI policies. However, the significant appreciation of these currencies against the dollar exposed the corporates to significant losses.

Such exoticness in derivatives is expected to have a major negative impact on the results of Indian corporates. Further as the instruments used are generally speculative, the conditions of hedge accounting are often not met, consequently, the unrealised gain/loss on the derivative position cannot be deferred to future periods to be offset against the underlying hedge item.

Because of the potential of huge derivative losses remaining unaccounted for, the ICAI issued an Announcement requiring recognition of losses on derivatives based on Prudence principles of AS-1. Unfortunately, the concept of Prudence does not sit well with the ICAIs other standards such as AS-11, which requires both fair value gain/loss to be recognised in respect of speculative foreign exchange forward contracts or AS-30, where both gain/loss is required to be recognised.

Marked to what?

Valuation of derivatives, particularly long-term derivative products, many of which could be proprietary products of banks, may be difficult to value, as they are highly illiquid instruments. The Announcement requires them to be marked to market. How can they be marked to market, when there is no market for such instruments? These instruments may have to be valued as per a model. One cannot rule out the possibility that an expert may opine that a reasonable valuation is not possible. What should be response of the companies and the auditors in such a situation?

For an Announcement of this nature, adequate time should have been given for its implementation. Considering it took US more than a decade to develop a standard on financial instrument, it seems very unreasonable to ask Indian companies to implement these principles at such short notice. The Announcement has also not gone through the due process of law, which requires Accounting Standards to be notified in the Companies (Accounting Standards) Rules.

Implementation issues

There are other critical implementation issues, which companies are grappling with. Are losses to be determined based on category of instruments or on an individual contract basis? Are losses to be determined after considering the offsetting effect of the underlying hedge item? What happens if the liability is being disputed with the banks on the ground that the contract is a wager?

Whilst the basic intent behind the Announcement is noble, the manner in which it has been executed is inappropriate. May be an appropriate approach would be to require disclosure of derivative losses only in the initial years, and simultaneously the mandatory date of applicability of AS-30 could be advanced from 2011 to 2009.

Dolphy DSouza
(The author is Partner, Ernst & Young. The views are personal.)

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