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Currency derivatives: The happening scare in the accounting world AccountSpeak
May, 08th 2008

The extent of open derivative positions is not precisely known, but does run into billions of dollars, and the extent of losses on these contracts is still unknown. This could only increase if the currency situation were to deteriorate.


The next scary movie from Manoj Night Shyamalan is going to be The Happening, starring Mark Wahlberg as an ordinary school teacher on the run from a natural disaster of global proportions. But something scarier has been happening for sometime now in the corporate and financial circles, with ordinary accountants and bankers on the run from a disaster, again, of global proportions, but entirely manmade: currency derivatives.

The recent trend of losses is definitely part of India Inc.s learning curve on handling these kinds of instruments, observes Mr Sai Venkateshwaran, Partner, Assurance, Grant Thornton, Mumbai. These instruments can be effectively used to manage risks and companies should take a more calculated view when entering into these contracts in future. Companies will definitely be wiser when they enter the arena for the next round, he adds, during the course of a recent email interaction with Business Line.

While the accounting for these financial instruments evolves in India and internationally, Mr Venkateshwaran advises Indian companies to evaluate their MTM (mark-to-market) losses and decide on the appropriate accounting treatment, taking into consideration the challenges that exist in accounting under AS-30, the accounting standard from the Institute of Chartered Accountants of India (ICAI) on the recognition and measurement of financial instruments.

Excerpts from the interview:

First, what are currency derivatives?

Derivatives are financial contracts that derive their value from changes to the value of one or more variables also referred to as underlyings. An underlying could be a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable, including the occurrence or non-occurrence of a specified event. An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.

Today, currency derivatives are available in India as over-the-counter (OTC) instruments from banks. Derivatives available today include forwards, options, swaps and other exotic instruments involving a combination of these instruments and related underlyings. Generally, companies are required to demonstrate the underlying exposures to ensure that these instruments are used to hedge risks and not for speculative purposes. These instruments can be used effectively to manage risks and exposures and contain costs.

The need to balance risks and exposures has been growing in recent times

True. Significantly enhanced level of cross-border trade flows and investment flows has meant that currency risk plays a major role in the economics of these transactions.

With the highly volatile exchange rate situation globally, managing the currency risk is of utmost importance to even stay afloat, as companies find margins being eaten away by the unexpected currency rate fluctuations. However, balancing these risks and exposures in a turbulent market is not easy and is bound to have its casualties.

Today the global economy is shaky with the fallout of the sub-prime crisis still not completely evident. Therefore, in troubled times like this, managing these multiple risks and exposures are a serious challenge for these companies, and one in which they dont have significant prior experience. For most of these companies, their international business equations were never drawn with some of these not-so-favourable conditions in mind and, therefore, they are faced with the dark reality of unexpected losses, etc.

But there are ways to balance risks and exposures.

Thats right. World over, companies with international operations and resultant multi-currency exposures and risks tend to hedge their exposures using a mix of natural and synthetic hedges. Studies carried out in the UK suggest that most companies with foreign currency net assets hedge their exposure, by borrowing in the same currency or in addition taking foreign currency swaps, which is a mix of natural hedge and the use of hedging products. However, these strategies are also largely influenced by the cash position of the company, its current and acceptable level of gearing, and tenure of the foreign currency asset vis--vis the liability.

Certain exposures are naturally hedged, when there is a two-way exposure to the same risk, such as receivables and payables in the same currency or portion of income and expense in the same currency.

In these cases, any currency risk on the receivable/income is offset by that on the payable/expense. The residual risk, if any, is linked to the timing and quantum of these natural hedges, and is typically left uncovered or covered through use of derivative instruments, or synthetic hedging instruments. Thats where currency derivatives come into play, as these instruments, including forwards, options, swaps, etc., are useful in managing foreign currency risk.

How do these work or not work?

Companies having foreign currency exposures, say receivables or payables in a foreign currency, generally take cover using one of these derivative instruments, based on their expectation of the movement in the exchange rates. Over time, in a plain vanilla forward cover, if the currency moves in one direction, the company stands to gain, and if the currency moves in the opposite direction, the company is protected through the cover taken.

However, of late, companies in India have moved on to taking many exotic derivative products, which involve cross-currency swaps or collars, options, etc, where the profit potential is often capped while the loss potential is either seen as remote or not quantifiable. Many of these contracts are fairly complex and the interplay of the variables and the resultant inherent risks are difficult to comprehend and quantify completely.

Most companies that are now facing the heat of mounting losses on derivatives are those with complex variables including those on unrelated currencies such as Japanese yen and Swiss francs. Further, the terms of many of these complex derivative instruments are such that if a certain barrier is breached, then there is no protection at all as these are like double-edged swords.

Of course, when companies entered into these contracts, the breach of those barriers might have looked remote, but the global economic uncertainty has led to an altogether unexpected scenario.

Companies holding longer term contracts can hope to witness a reversal of some of these trends, but those holding short-term positions are faced with the reality of losses on these contracts. Apart from these losses, companies are also faced with added pressure from their bankers to either increase the margin cover on these derivatives or are faced with a squeeze on their overall limits.

The extent of open derivative positions is not precisely known, but does run into billions of dollars, and the extent of losses on these contracts is still unknown. This could only increase if the currency situation were to deteriorate.

Meanwhile the accounting body came up with its guidance

In the absence of specific accounting guidance, companies in India accounted for derivative contracts only when the actual gains or losses were realised. However, in the current scenario of mounting losses, the ICAI mandated companies and their auditors to report the losses on derivative contracts, either through early adoption of AS-30 or application of the principle of prudence. The ICAI directive was in response to a live problem; but the problem is rather complex, that it requires extensive deliberation and interpretation before it can be applied practically.

AS-30 requires companies to value all derivative instruments at fair value or MTM at each reporting date. This is in line with the fair-value-based concept towards accounting for gains and losses. Accordingly, unrealised losses and gains are recorded on a periodic basis, which are at times offset and reverse over a period up to the time of settlement, when the ultimate gains or losses are realised. Therefore, technically speaking, a loss at a period end could entirely reverse and result in a realised gain on the contract, depending on the movements of the related currency, etc. The periodic unrealised gains and losses are typically notional, unless it is a definitive trend leading to the build up of the realised loss, which is what the case with many Indian companies is.

On the other hand, accounting for these losses based on prudence, is more an extension of the historical cost basis of accounting, where known losses are provided for. Therefore, if the losses are not likely to reverse, the principle of prudence would require that these losses be recorded at the reporting date.

How have companies and their bankers responded to the situation?

In response to mounting losses and the ICAI directive, a few companies decided to go to court and seek relief, stating these contracts are void ab initio, thereby buying time to account for and settle these losses. Other companies have decided to account for these losses, however, with varying interpretations of the standards.

Companies are today looking to use extremely liberal interpretations of complex concepts such as hedge accounting in accounting for these losses. Adoption of hedge accounting helps to match the losses with the gains, and route the unrealised gains and losses on cash flow hedges through equity (balance sheet) till the losses or gains are realised.

However, criteria to be met to qualify for hedge accounting are quite onerous. While hedges can be effective from an economic perspective, they very rarely are seen as effective hedges from an accounting perspective. Internationally, companies adopting US and international standards have struggled to meet the strict hedge accounting criteria. Further, to meet the hedging accounting criteria, the designation of the hedge, related documentation, and the evaluation and related criteria should have been established as at the inception of the hedge and the standard does not permit retrospective designation of hedges.

Banks, on the other hand, are also working with companies, to restructure the losses on these instruments and convert them into other instruments with cash flows spread over a period of time. However, from an accounting perspective, these would only have a marginal impact on the MTM losses to the extent of the interest on deferred payments, if any.

Can you explain the challenges in accounting for these losses?

Early adoption of AS-30 is clearly a big challenge. AS-30 is a complex rules-based standard, and the application of this standard would require significant amount of expertise. AS-30 covers not only derivatives but all financial assets and liabilities, including cash, receivables, loans, debt, derivatives, other financial contracts, etc.

Also, AS-30 involves significant use of fair values, a lot of which needs to be captured on a real-time basis. Early adoption would mean applying this standard and measuring all relevant elements at fair value as at the beginning of the year, which would be the transition date. However, availability of fair value information for all these elements as of a year back will remain a challenge.

Further, companies looking to adopt hedge accounting wouldnt be able to unless the hedges were so designated and relevant documentation maintained since inception of the hedge, as the standard does not permit retrospectively hedge designation. Accordingly, most companies would end up reporting hedges as ineffective from an accounting perspective.

The decision to record the losses is only one step. The second and more critical step is in the determination of fair value. The application of fair valuation principles in a consistent manner is easier said than done. India neither has strong guidelines on valuation nor a large pool of valuation specialists.

How is the international accounting scene in this regard?

Internationally, there were mixed practices on fair valuation. To bring in consistency in the application of fair valuation principles, the FASB, the US standard-setter, released a standard on fair valuation last year.

International standard-setters are still working on the guidance on fair valuation. In the US, there is still lack of clarity on the application of the issued guidance, especially on determining fair values when there is no active market.

Its interesting that while companies in India answers the big question of whether or not to account for these MTM losses, their counterparts in US and Europe are faced with a bigger question, which is being debated by the FASB and SEC on how to account for these assets and liabilities. The FASB last year issued guidance on fair valuation, and now the challenge is in the practical application of that guidance, specifically when there is no active market for these assets and liabilities.

And this doesnt seem to be the end to the issues around accounting for financial instruments. Internationally, American Bankers Association and its international counterpart, the International Banking Federation, are recommending to the FASB and IASB that they should look at a mixed-attribute financial reporting model as against a strict fair-value regime for financial instruments. A mixed-attribute model is one that uses both fair value and historical cost calculations and is expected to result in a lower level of income statement volatility as compared to the fair value model.

Bio: Sai Venkateshwaran, a chartered accountant with experience in some of the Big 4 firms, is the engagement partner on several IFRS and US GAAP advisory and US GAAS assurance assignments to Indian, US and multinational clients. Also actively involved in providing transaction support services to several of these clients, he leads several Sarbanes Oxley compliance assignments, SAS-70 certification, and IT controls and security review. Sai was involved in the drafting of ICAIs guidance on Accounting for Oil & Gas Producing Activities and Accounting for Demergers. He co-authored background material for publication by the ICAI on AS-18 (Related Party Disclosures), AS-24 (Discontinuing Operations), and AS-26 (Intangible Assets).


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