The Hindu Business Line : `Standard' lag in accounting for financial instruments

ACCOUNTING for risk management in Treasury operations in banks covers marking to market of securities, provisioning of investment fluctuation reserve and interest rate swaps. Banks follow the guidelines as provided by the regulator.

Marking to market of securities

This is nothing but valuation and accounting of securities under different categories of investments, such as `held till maturity' (HTM), `held for trading' (HFT) and `available for sale' (AFS).

HTM category: Investments under the HTM category need not be marked to market but will be carried at acquisition cost. However, if the acquisition cost is more than the face value of the security, then the premium is to be amortised over the period remaining to maturity.

In the case of investments under subsidiaries/joint ventures classified under HTM, banks should recognise and provide for any diminution in value of investments, other than temporary in nature.

AFS category: The individual scrips in the AFS category should be marked to market at quarterly or at more frequent intervals.

Net depreciation under each classification should be fully provided for while net appreciation under each classification is to be ignored.

The book value of the individual scrips will not undergo any change on account of valuation. This means, the amount of provision made is kept in a contingent fund account.

The provision required to be created on account of depreciation in the AFS category in any year should be debited to the profit and loss (P&L) account and an equivalent amount (net of tax benefit if any, and net of consequent reduction in transfer to statutory reserve) or the balance available in excess of 5 per cent of securities included under HFT and AFS categories in the investment fluctuation reserve (IFR) account, whichever is less, shall be transferred from the IFR account to the P&L account.

In the event the provisions created on account of depreciation are found to be in excess of the requirement in any year, the excess should be credited to P&L account and an equivalent amount (net of tax benefit, if any, and net of consequent reduction in transfer to statutory reserve) should be appropriated to the IFR account to meet future depreciation requirement for investments in this category. The amount of appropriation from/to the IFR is to be done below the line after determining the profit for the year.

HFT category: Individual scrip in the HFT category will be marked to market at monthly or more frequent intervals. As in the case of AFS, the book value of the security will not undergo any change on account of provision for depreciation. Also, instructions for using the IFR are the same as in AFS.

Even though extant guidelines provide for quarterly valuation for AFS securities and monthly valuation for HFT securities, some banks mark to market their portfolio more frequently, weekly/daily.

Investment fluctuation reserve

With a view to building up of adequate reserves to guard against any possible reversal of interest rate environment due to unexpected developments, banks need to build up an IFR of at least 5 per cent of the investment portfolio up to March 2006.

The IFR should be computed with reference to investments under the HFT and AFS categories. Investments under the HTM category will not be considered for building up of the IFR. However, banks are free to build up an IFR up to 10 per cent, depending up on the size and composition of the portfolio.

Accounting for derivatives

In India no standard has been prescribed for accounting of derivative contracts in the books of accounts. Recently, the Institute of Chartered Accountants of India came out with the draft of proposed `Accounting Standard on Financial Instruments: Presentation', which is still under discussion at various forums. At present, banks are disclosing their exposure in derivative transactions as off-balance-sheet items, which include currency and interest rate swaps, rupee options and forward contracts. The exposure in the financial instruments (derivatives) is disclosed in the Notes to Accounts; however, no standard practice of disclosure as such is being followed in the banks.

The off-balance-sheet exposure of banks has increased by a huge 60 per cent, standing at 119 per cent of the total liabilities in financial year 2005. Thus, there is a growing concern that the detailed and comprehensive disclosures made by banks may still be not contain a lot of information.

The method of accounting for derivatives would depend on the standard issued by the ICAI and pronouncements of other regulatory bodies such as the Securities and Exchange Board of India. However, the main issues relating to its accounting are its recognition, classification, impairment and de-recognition.

A derivative contract generally has the following features:

Initial cost like deferred discount/premium (forward contracts), option premium (options contract) and margins (futures contract).

Profit/loss and changes in assets/liabilities which arise on completion/termination/ expiration of the contract.

Marking the contract to market at the end of each trading session.

Compensating profit/loss between hedged assets and hedging instruments.

Two pronouncements issued by the ICAI offer some guidance for the accounting treatment of derivative contracts:

Guidance note on Accounting for Equity Index Futures; and

AS-11, Accounting for effects of Changes in foreign exchange rates (Revised 2003) relating to forward exchange contracts only.

There is also the Employee Stock Option Scheme and Employee Stock Purchase Scheme Guidelines, 1999 issued by SEBI. Globally, stringent accounting practices are being followed for presentation and accounting of financial instruments and derivative contracts. The International Accounting Standards Committee has issued International Accounting Standard (IAS) 39, Financial Instruments: Recognition and Measurement, effective since January 1, 2001. Similarly, the Financial Accounting Standard Board (US) has issued FABS 133, Accounting for Derivative Instruments and Hedging Activities, applicable to companies since January 1, 2001.

IAS 39 and FAS 133 require all derivatives, including hedges, to be recognised on the balance-sheet at their fair value. Internationally, fair value is considered to be the most relevant measure for financial instruments and the only relevant measure for derivative instruments. Fair value can be defined as: "Value at which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm's length transaction."

Fair value is computed as the actual amounts give a wrong picture, while the total exposure of the system may sound huge, whereas for a single bank, presentation on net basis could be much lower because of offsetting trades.

The accounting for changes in fair value of a derivative contract is depended on the intended use of such contract. Broadly, derivative contract is classified into hedging and speculation.

The accounting treatment of derivatives varies under the two classifications. FAS 133 requires the following treatment of derivative contracts:

Fair value hedge: For a derivative contract which is entered into as a hedge against possible change in value of a recognised asset or liability, the gain or loss is recognised in the earning in the period of change together with the offsetting gain or loss on the hedged item attributable to risk hedged. The final effect on the earning is to the extent hedge is not effective.

Cash flow hedge: For a derivative contract which is entered into as a hedge against a variable cash flow of a forecasted transaction, the gain or loss is initially reported outside the P&L account and subsequently it is reclassified into earnings when the forecasted transaction affects the earnings. The portion of probable loss which is not covered by the hedge is immediately recognised.

A hedging contract entered into to cover the foreign currency exposure of a net operation in foreign operation, the gain or loss is reported outside the P&L account.

For a contract which is not designated as hedging, gain or loss is recognised in the period of change.

The entity that applies the hedge accounting standard is required to establish at the inception of the contract, the method it will use to assess the effectiveness and ineffectiveness of the hedging derivative instrument. The method adopted should be consistent with the entity's approach to managing risk. Whereas in India such transactions are shown as off-balance-sheet items which fail to present a complete picture of the exposure of a banking institution in the derivatives market. The proposed `Accounting Standard on Financial Instruments: Presentation' deals with only the presentation aspect of the financial instruments in the balance-sheet of such instruments. A separate standard may be issued for disclosure requirements regarding financial instruments.

Until comprehensive standards for accounting of derivative contracts are devised and implemented in India, banks need to devise there own methods of presenting and disclosing information relating to derivative contracts entered into by them. Banks can take clue for the international standards in effect. Also, with the deadline for implementation of the new capital accord (Basel II) closing in, the risk exposure of the banking institutions in the off-balance-sheet items are required to be properly evaluated and considered to be presented in more transparent manner.

Thus, there is a dire need of a standard on accounting practice to be followed for financial instruments considering the financial implication and destructive power of derivative instruments witnessed by the financial world in: collapse of Barings, an investment bank; bail-out of hedge fund Long-Term Capital Management by the US Federal Reserve in 1995, and the Enron debacle.

The swap that is entered for hedging purposes should be accounted on accrual basis, except the swap designated with an asset or liability that is carried at lower of the cost or market value in the financial statements. In that case, the swap should be marked to market with the resulting gain/loss recorded as an adjustment to market value of the designated asset/liability.

Gains or losses on termination of swaps should be recognised when the offsetting gain/loss is recognised on the designated asset/liability. This implies that any gain or loss on terminated swap would be deferred and recognised over the shorter of the remaining contractual life of the swap or remaining life of the asset/liability.

Accounting for trading purpose

Trading swaps should be marked to market with changes recorded in the income statement.

Income and expenditure relating to these swaps should be recognised on settlement dates.

Fee should be recognised as immediate income or expenditure.

Gains or losses on the termination of swaps should be recorded as immediate income or expenses.

(Edited-excerpts from the D. Rangaswamy Memorial Endowment Lecture delivered by K. C. Chakrabarty, CMD, Indian Bank, on December 19, 2005.)