The Hindu Business Line : The standard makes hedge accounting difficult

AS-30 has a whole set of rules on hedge accounting. The rules are pretty stringent and in many cases it may be impossible to apply hedge accounting because the rules cannot be complied with. This may be so, even if there was a perfect economic hedge.

MR DOLPHY D’SOUZA, PARTNER, E&Y.

AS-30? Derivatives? MTM? If you are a keen reader of business news, a lot of these accounting hieroglyphics have been appearing in the past few weeks.

There has been so much noise about accounting policies, but none of it has been music to either companies or investors in listed entities. Business Line attempted to get in touch with tax and accounting giant Ernst and Young (E& amp;Y) to present facts as they are. Mr Dolphy D’Souza, Partner, E&Y, gives us a few important answers taking help from the firm’s knowledge repository.

What is AS-30?

AS-30 (Accounting Standard 30 titled ‘Financial Instruments: Recognition and Measurement’) of the ICAI (Institute of Chartered Accountants of India) is excruciatingly complex, and is pretty much rule driven.

Essentially the rules relate to classification of financial instruments in one of the four prescribed categories to which different valuation rules apply. The other important aspect of the standard is the application of hedge accounting.

What types of financial instruments are we talking about here?

The four categories of financial assets are Fair value through Profit and Loss Account (FVTP), Available for Sale (AFS) instruments, Held to Maturity (HTM) instruments and Loans and Receivables (L&R).

The FVTP classification is used in case of financial assets that are traded or managed as a portfolio or a derivative. In the FVTP classification, the fair value changes in each reporting period are taken to the income statement. The FVTP classification is not used for unquoted equity investments, for which fair value cannot be reliably measured. These instruments would be valued at cost with a provision made for impairment.

AFS category is a residual category, and would apply to instruments that do no fall in any of the other three categories, for example, an equity investment in a listed company, which is not held with the intention of trading. The fair value changes in the AFS-categorised financial instruments are taken to the retained earnings, and recognised in the profit and loss (P&L) account only when they are sold.

The HTM classification can be only used for assets that have a maturity period and there is intention to hold the asset to its maturity.

The accounting is done to reflect the inherent IRR (internal rate of return) in the instrument. A breach of the intention subjects an entity to a tainting provision that precludes any further HTM classification for a period of two years.

L&R classification would be applicable for debtors, advances, deposits, etc. In the case of debtors that are receivable on demand, there is no discounting. However there would be discounting, if the payments to be received from a debtor are scheduled and are not on demand.

There are various other detailed rules, for example, on impairment, classification of financial liabilities, recognition and de-recognition of financial instruments, securitisation, restructuring of loans, etc in AS-30.

With such instruments, is it easy to do both accounting and hedging?

AS-30 has a whole set of rules on hedge accounting. These rules relate to the hedged item, hedge instrument, hedging documentation, hedge effectiveness, etc. The rules are pretty stringent and in many cases it may be impossible to apply hedge accounting because the rules cannot be complied with. This may be so, even if there was a perfect economic hedge.

Give us an example of hedging effectiveness…

To give an example, the rules require hedge effectiveness in the bounds of 80-125 per cent. Airline companies may have a need to protect themselves from future fuel price increases.

Since there is no futures market in jet fuel, they may hedge themselves for oil price changes. Now, generally the oil prices changes should move in tandem with the jet fuel.

However, some ineffectiveness could creep in because oil needs considerable processing before it can be converted to jet fuel.

The ineffectiveness could be beyond the 80-125 per cent bound and therefore consequently the airline company may not be successful in applying hedge accounting.

What happens in case the hedging activity fails?

When hedging fails, the hedge instrument (in the above case it is the forward purchase of oil) is marked to market at each reporting period and the effect is taken to the income statement, which could cause considerable volatility in the income statement.

Coming back to the standard, tell us what impact it could have on different parties.

Banks and other financial institutions (example, NBFCs or non-banking financial companies) would be severely affected by the standard. Almost everything contained in the standard will impact these entities.

It is however too early or difficult to say whether those impacts would be positive or negative to the net worth. In fact, no generalisation can be made, and the effect would depend on a case-by-case basis. Any severe negative effect could cause capital adequacy problems.

Off-balance-sheet items such as various types of derivatives will now have to be fully accounted for.

What about the effect on companies?

Companies that have issued FCCBs (foreign currency convertible bonds) will have to take an interest charge to the income statement, even if the FCCBs are presumably zero coupon bonds. FCCBs will also be subjected to split accounting, which requires splitting of a debt component and the option derivative at fair value.

What would be the problems in implementation?

Generally hedge accounting would be difficult to apply, and hence the underlying hedge instrument (example, a derivative such as a forward foreign exchange contract) would have to be marked to market (MTM) at each reporting period with the effect being taken to the income statement.

Right now, under AS-11 (on the effects of changes in foreign exchange rates), there are no strict hedge rules, and for hedging to be applied it is enough to demonstrate that the forward was not for speculation purposes.

What are the challenges?

The standard would need to be aligned and approved by the regulators, particularly NACAS (National Advisory Committee on Accounting Standards) and the RBI (Reserve Bank of India). The standard would also need to be aligned with the Companies Act, particularly relating to treatment of preference capital and the use of securities premium (Section 78).

Given that Indian markets are not deep enough, determining fair valuation could be a challenge (example, debt markets). As far as auditing is concerned, considerable amount of training would be required before the standard is implemented. Many valuation experts would be required for arriving at a fair value for financial instruments.

D. MURALI

KUMAR SHANKAR ROY

http://InterviewsInsights.blogspot.com

More Stories on : Interview | Accounting Standards | Derivatives Markets

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
When lobbies clash…

Testing the limits of market economy

AS-30 imbroglio: The lag and ragtag effects

The Kaladan Corridor and north-eastern security

The standard makes hedge accounting difficult

Today the airline pricing system is a black box to the passenger

Bribe engineering

IITs and IIMs

Indiscriminate expansion

Preserving exclusivity