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Mohan R. Lavi

Mark Twain once remarked: “There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.”

Corporates which were enticed be the exotic derivatives that were produced before them some time back should now be feeling that they could not afford such speculation.

News reports indicate that the Ministry of Corporate Affairs (MCA) is looking into the accounts of big corporates to assess whether these firms are reflecting correctly the losses or gains arising from transactions involving foreign currency in their account books.

The Ministry has roped in the Institute of Chartered Accountants of India (ICAI) whose Financial Reporting Review Board (FRRB) is assisting the MCA in this investigation. Strict action has been promised against defaulters.

The ICAI’s Accounting Standard 11 on foreign exchange contracts was being followed in letter and spirit by most corporates vis-À-vis plain vanilla forward contracts.

Accounting Standards 30, 31 and 32 — the trilogy on Financial Instruments — brought in the concept of fair value for derivatives and hedging transactions.

Being mandatory from April 1, 2011, most corporates tended to take these standards lightly till the ICAI bowled a googly late in March 2008 through a notification which stated that 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.

It went on to state that the entity needs to disclose the policy followed with regard to accounting for derivatives in its financial statements. In case AS 30 is followed by the entity, a disclosure of the amounts recognised in the financial statements should be made. In case AS 30 is not followed, the losses provided for should be separately disclosed by the entity.

Also, the auditors should consider making appropriate disclosures in their reports if the aforesaid accounting treatment and disclosures are not made and in case of forward contracts to which AS 11, ‘The Effects of Changes in Foreign Exchange Rates’, applies, the entity needs to fully comply with the requirements of AS 11. Accordingly, this announcement does not apply to such contract. All this was applicable for the period ended 31st March 2008.

To be fair to the corporates, too much has happened too fast from them to face a carom ball from a mystery leg-spinner that the regulators are attempting. Understanding these complex instruments took time and many have also taken to the courts against the sellers of Cinderella products.

The history of accounting standards globally in general and in India in particular has been to inflict pain gradually — make them recommendatory for a few years prior to imposing them.

The trilogy on Financial Instruments were no different since most corporates were beginning to equate them with the year of transition to International Financial Reporting Standards (IFRS) — 2011. In these times of gloom and doom, a stiff penalty for non-compliance with a notification would be the final nail in the coffin for corporates.

A way out could be to ask the entities to identify the exact amount of losses and spread them over a period of time till the accounting standards on Financial Instruments become mandatory. Although the notification does permit companies to disclose such losses in the notes on accounts in case the accounting standard on financial instruments is not followed, it remains a fact that shareholders and investors would prefer small dents in the income statement over a period of time than a gaping hole after a couple of years.

The other option for the ICAI would be to make the trilogy of accounting standards on Financial Instruments mandatory from April 1, 2009, in order that there is some time to assess the entire damage and mitigate losses to the extent possible.

More Stories on : Accounting Standards | Derivatives Markets

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