In the name of prudence, ICAI prepones derivatives accounting
April, 07th 2008
A primer on the accounting standard, mark to market principle
The Institute of Chartered Accountants of India (ICAI) came up with an announcement, on March 29, 2008, which effectively seeks to prepone derivatives accounting standard by two years and make it applicable for the year just ended. This article explains what derivatives accounting is and the mark to market (MTM) principle, and what the implications of the ICAI announcement are.
Accounting standard for financial instruments
The standard in question is Accounting for Financial Instruments, AS 30. AS 30 is substantially the replica of international accounting standard IAS 39. While the common notion is that AS 30 is related to accounting for derivatives, it must be clear that the standard is not limited to derivatives accounting. It relates to the whole world of financial instruments, of which derivatives is only a small part.
What is a financial instrument?
Simply, every loan, every receivable, investment in financial securities, mutual funds, government securities, etc will be financial instruments. All derivatives are treated as financial instruments too. There are sometimes contracts which have derivatives embedded into it. These derivative elements inserted in non-derivative contracts require separation, and such separated derivatives shall also be a financial instrument.
What is market value?
The essential principles of accounting for financial instruments are to lay down MTM accounting for a vast array of financial instruments. Where we carry an asset or liability in books at a fair value instead of historical cost, that is MTM accounting. The asset or liability in question may not have an ascertainable market value in that case, we compute the fair value of asset/liability by applying fair valuation principles. The key concepts in arriving at fair value are discounted cashflows, adjusted for the riskiness of the cashflow in question. Hence, fair valuation involves estimating the expected cashflows, risk-adjusting the risk-free discounting rate, and computing discounted values.
For instance, if one was to fair value an unquoted bond, say which has a BBB rating, the fair value computation would require establishing the credit spreads applicable to a BBB bond, add the same to the risk-free interest rates, and compute discounted value of the expected cashflows of the bond.
What instruments require MTM accounting?
The standard classifies financial assets into four: loans and receivables, held-to-maturity (HTM) assets, held-for-sale assets, and trading assets. Derivatives are necessarily treated as trading assets or trading liabilities.
A loan originated by the entity, including a syndicated loan, not in marketable form like a bond, is included in the first category of loans and receivables. This category does not require MTM valuation. Market values are irrelevant for assets that one intends to hold to maturity. Hence, MTM is not required for HTM assets also. However, it is notable that HTM assets are almost like a Hindu marriage once acquired, one cannot sell it prior to maturity, except in very exceptional circumstances which are specified in the standard.
Held-for-sale assets require MTM valuation every reporting period. So also do trading assets. The difference between the two is while trading assets, held for short term trading intent, are MTM-ed every trading day, available-for-sale assets require MTM only at the time of financial reporting, say, every half year. The other crucial difference is that gains or losses on valuation of available-for-sale assets are not taken to P&L they are taken straight into the balance sheet.
There are additional provisions in case of derivatives. Since derivatives are treated as trading assets, they require regular MTM, and gains/losses on valuation are to be routed into current P&L. This may, however, lead to a dichotomy. A derivative may be intended as a hedge for example, if an entity has dollar receivables, to hedge against the risk of dollar depreciation, it may sell dollar short. If dollar does depreciate, the value of the receivable goes down, and that of the forward sale goes up, thus compensating the entity. However, the receivable is not marked to market, while the derivative is. To avoid the asymmetrical result where the hedged item (here, the receivable) is not marked to market, but the hedging derivative is, the principle of hedge accounting permits, on several conditions being satisfied, to treat the hedged item as well as the hedging instrument to be marked to market, such that the gains on one are neutralised by the losses on the other.
The accounting standard on financial instruments is not an easy one. Globally, both the US and international standard setters have written thousands of pages by way of interpretation and guidance on the standards. In the US, the standard setters have brought several new standards that amplify or clarify the scope or application of the original standards. IT companies have made millions writing technology to comply with the standards. Almost a decade after implementation, the standard is still every accountants nightmare. India has been going with an antiquated AS 13 for years after almost the entire world has implemented standards parallel to IAS 39. AS 30 has been given substantial time for implementation it is supposed to be applied for financial year 2009-10 on a recommendatory basis, and 2011-12 on a mandatory basis.
The Announcement brings it forward
Suddenly, however, on March 29, 2008 the ICAI came up with an announcement. Effectively, the announcement says that on grounds of prudence, though AS 30 is not mandatory just now, an entity should provide for losses on all derivatives, even for the financial year just ended.
There are several misgivings inherent in the announcement. First, accounting standards are a serious stuff, and by legislative changes in the Companies Act, they are made mandatory. AS 30 exists, but by ICAIs own choice, it is still ineffectual. Prudence cannot be the ground for making a standard effective, though it actually is not. If prudence is the reason, that is a perennial principle, and therefore, AS 30 was either not needed at all, or may be deemed to have been there always. AS 30, in fact, is a departure from the principle of prudence, as it requires not just MTM losses but even MTM gains to be brought into books.
Two, the announcement seems to be conveying the view that AS 30 is concerned with derivatives accounting only, whereas, as we have pointed out earlier, AS 30 covers a massive world of accounting for financial instruments. Three, the essential scheme of AS 30, as regards derivatives accounting, is to treat the hedging derivative and the hedged item with symmetrical changes in value, so that the impact of the two is neutralised. In India, corporates are not allowed to engage in derivatives other than for hedging purposes. If a derivative is a hedge, the losses on the derivative must be matched with gains on the hedged items, which cannot be brought on to books unless there is full implementation of AS 30.
Four, while the ICAI announcement seems to have been concerned with losses on derivatives, there are massive gains on valuation of foreign currency liabilities due to dollar values. If the ICAI announcement is taken as official preponement of the standard, entities may book huge gains as well. In short, the ICAI announcement seems to have treaded on the complex area of accounting for financial instruments in undue haste, and the announcement effectively preponing the standard may only create complications.
Vinod Kothari (The author is a chartered accountant, and consultant on securitization, structured finance and related matters)