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Should accounting be driven by economic conditions?

Adding to the list of other ongoing conflicts is the recent spat between an industry body and the accounting regulator. The hot question is whether the Institute of Chartered Accountants of India (ICAI) should enforce its book-keeping standards relating to forex losses, especially when corporate performance is already bleeding due to the unfolding economic crisis.

Proposing that the norms be reviewed to allow accounting of foreign exchange revaluation gains/losses over the remaining tenor of the underlying items of borrowings or receivables, the Confederation of Indian Industry (CII) seems to ask the Institute, `Why rub salt into our wounds?' But the bean-counting bosses on Indraprastha Marg, New Delhi, are in no mood to revise their prescription of what they consider to be the right medicine.

To find more, Business Line interacted over the email with two experts in the field of accounting, and sought their views on the subject.

"I do believe the current accounting practice of requiring current assets and liabilities to be marked to market is a logical and reasonable practice," says Mr Shankar Jaganathan, Author, Corporate Disclosures: The Origin of Financial and Business Reporting 1553-2007 AD (Routledge, 2009). He explains that this practice has evolved from the concept of `safe value' accounting required for current assets. "Safe value accounting is valuing at cost or market price whichever is lower - this concept evolved as there was a need to prevent dividend being paid out of capital."

Deferral of exchange losses over the balance period of the loan has no conceptual basis, observes Mr Jamil Khatri, Head-Accounting Advisory Services, KPMG, Bangalore. This may create further divergence in the context of India's planned convergence with IFRS (International Financial Reporting Standards), which would require mandatory expensing - similar to the current provisions of AS (Accounting Standard) 11, he adds.

"Further, there already exists significant inconsistency on accounting for exchange losses on borrowings, due to the view taken by certain companies that the Companies Act permits capitalisation of such exchange losses relating to acquisition of fixed assets."

The current proposal from CII will add to the inconsistency, fears Mr Khatri. "Lastly, a company which has borrowed in Indian rupees would need to account for the full borrowing cost on an accrual basis, while a company that raised foreign currency borrowings at relatively lower `interest' cost can defer accounting for the exchange losses (which represent costs inherent in borrowing in foreign currency) to future periods."

Moving away from the concept of mark-to-market during periods of volatility is like an astrologer predicting bad times will go away, analogises Mr Jaganathan. Rupee depreciation is profitable to exporters and now most exporters are suffering from rupee depreciation as they punted away their opportunity by betting that rupee will continuously appreciate, when it was trading in the 40s, he reminds. "I believe there is no commercial value in determining accounting policy issues based on short-term market views. The value of accounting policies is in the consistency with which they are followed. If business results are depressed so be it. The management can always highlight the impact in their Directors' Report and Management Discussion and Analysis reports," advises Mr Jaganathan.

If the regulators do want to permit this relaxation (on grounds other than accounting principles - similar to the `fair value' accounting debate in the US), Mr Khatri's suggestion is that this should be clearly stated as a divergence from acceptable accounting principles and should be for a limited period, to enable full convergence with the IFRS by April 1, 2011.

Excerpts from the double-bill interview:

Should accounting be driven by economic conditions?

Shankar Jaganathan: Historically, accounting progress has been mainly driven by stock market collapses. During bull-runs, new valuation models are invented, and in bear markets, new accounting and governance practices are initiated. The dotcom bull-run at the turn of the millennium saw `real options' as a valuation concept emerge, to explain huge market capitalisations for loss-making companies with miniscule revenue.

In the aftermath, the long-drawn multi-decade debate on accounting for the cost of stock options was settled. Likewise, even the concept of Generally Accepted Accounting Principles (GAAP) emerged in the shadows of the Great Depression of 1929.

Jamil Khatri: Accounting should continue to be driven by the underlying conceptual basis and not by economic conditions. However, economic conditions may necessitate the need for additional accounting guidance or interpretative guidance.

For example, while it would be inappropriate to eliminate `fair value' accounting on the basis of the volatile market conditions, it may be necessary to issue additional accounting guidance that assists companies and their auditors in determining what is `fair value' in these illiquid markets and given distress selling.

This is the approach that is being currently supported by the US regulators, including Bob Herz, the Chairman of the FASB (Financial Accounting Standards Board), and Ben Bernanke, the Chairman of the Federal Reserve.

Are businesses looking for accounting alternatives more in times of crisis than during growth?

SJ: Traditionally, the promoters and business managers were on one side, and the investor and the regulators, on the opposing side. This ensured that during times of crisis, the root cause of the problem was identified and its origin extinguished.

The last two decades of prosperity has made all concerned believe that `economic growth is our heritage and bull-run our birthright.' With the advent of large institutional investors and market-friendly regulators, the distinction between the two sides has evaporated. The single-minded focus now seems to be to find an avenue for growth, and if growth is missing, to see if we can show growth.

JK: This is partially true. For example, while the current resistance to fair value accounting (globally) or accounting for foreign exchange losses on derivatives and borrowings (in India) is reflective of the adverse market and business conditions, businesses have also resisted accounting in times of growth.

During the technology boom, for instance, as companies doled out large amount of stock options to employees, businesses in the US lobbied hard to ensure that the intrinsic value of accounting for stock options was available as an alternative, and was not replaced by the fair value accounting (which the FASB believed was the right accounting answer).

Do you foresee a relaxation of norms in India, similar to the way the IASB (International Accounting Standards Board) recently reacted to the demands of financial institutions?

SJ: Asian Development Bank estimates that in calendar year 2008, $50 trillion was lost in global financial assets. Between 2007 and March 2009, about $35.3 trillion of global stock market value evaporated. This has made regulators behave in an unconventional manner, fearing a recession and its implications. In India, I do not see the situation as bad as it is in Europe and America. This makes me believe that our regulators will act keeping in mind the long-term implications of their decision.

JK: The IASB's decision to permit transfer of financial instruments between categories, while a relaxation, is still based on certain accounting principles (for example, these principles of transfer are accepted under the US GAAP). While this has sent a confusing message for other standard-setters, this relaxation is not as significant as what is being sought by banks in the US (for not requiring fair value accounting) and the relaxation being sought by certain groups of Indian companies for deferral of exchange losses on borrowings.

As the ICAI has publicly stated, they are in the process of considering views of various stakeholders and it is possible that some form of relaxation may be granted. However, this is not currently certain.

Can changes to accounting requirements, even if for a brief period, make statements non-comparable intra period?

SJ: An accounting result is not only a historical measure but also a future performance indicator. Just as cricket scores in New Zealand are not predictive of the scores in Australia, likewise accounting results based on the `altered' boundary line lose their predictive value and can only adorn the record books.

JK: Most international standards (IFRS, US GAAP) require that if an accounting policy is changed, the new accounting policy should be retroactively applied to ensure that results are made comparable. While this works well in the case of changes from one acceptable policy to another, it would be very difficult to apply this in situations that involve exemption from certain mandatory requirements (such as fair value accounting or recognition of exchange losses).

Results are often made incomparable under the Indian GAAP, because the Indian accounting standards do not permit revision of previous financial statements (except in the limited case of changes in accounting policies at the time of an IPO or initial public offering).

Any examples of successful businesses that could tide over the problems through managerial acumen and so are not looking for any accounting relaxations?

SJ: Recently, a distinguished group of 35 management thinkers, practitioners and investors came together in California to identify the top 25 management challenges. The number one challenge according to them was: `Ensure that the work of management serves a higher purpose: Management both in theory and practice, must orient itself to the achievement of noble, socially significant goals.'

I believe all successful businesses will attempt to live up to this challenge. To these businesses, failure is not the absence of success, but loss of belief in future success. The management acumen required is in the belief of their `noble, socially significant goals.'

This belief will provide them with the resilience to withstand downturns, as any business will have to face both ups and downs in its long lifespan. The required maturity is more often seen in businesses that do not chase financial goals. For them, financial goals are a by-product.

JK: Entities can use the existing accounting rules to ensure that the accounting matches the business objectives without seeking relaxations. For example, several companies that had large foreign exchange derivatives, which were taken to hedge forecasted sales, purchases, borrowings and investments, have effectively used the principles of AS 30 (by adopting the principles early) to ensure that gains/losses on these derivatives do not immediately impact the profit and loss account and are recorded in the P&L account, only along with the underlying hedged transaction (sales, purchases etc.).

This requires a few things from management:

Ensure that they think through the policy choices available (AS 30, in this case) and work with their auditors and audit committees to ensure early adoption.

Ensure that the derivatives are structured in the right manner to achieve the hedge accounting (for example, certain leveraged option contracts do not qualify for hedge accounting - hence the need for simple forward contracts).

Ensure that internal processes and documentation are streamlined to meet the requirements of hedge accounting (designation of hedges, effectiveness testing, etc).

This is just one example of how an entity can achieve its economic and business objectives - without seeking accounting relaxations. Careful planning is essential, in such cases.

D. MURALI

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