Education

Dodging the derivatives

Mohan R Lavi | Updated on February 16, 2011 Published on February 16, 2011

ICAI's recent clarification on financial instruments has the effect of postponing applying AS 30, 31 and 32 to most entities apart from the ones that are in the select list to move over to IFRS from April 2011.

The tagline of the book “Traders, Guns and Money” by Satyajit Das is “ knowns and unknowns in the dazzling world of derivatives”. It commences by chronicling the tale of an Indonesian noodle-maker who lost millions trusting an investment bank that sold him a double swap — an exotic financial instrument which the noodle-maker had no clue about.

The wonderland of derivatives consists primarily of traders and investment banks making millions using others' money. Yet, entities consider forward contracts, derivatives, hedges and swaps an investment activity that can, not only act as an insurance against risks but also bring in mega-bucks if all goes well.

International Accounting Standard 39 on Financial Instruments was ridiculed when announced as it directed all derivatives to be marked-to-market. The International Accounting Standards Board (IASB) did not flinch as it touted its policy of financial statements reflecting realistic values annually. It later embarked on a project to simplify IAS 39 in four stages with IFRS-9 that altered recognition criteria but retained most of the measurement criteria.

Following the IASB's footsteps, the Institute of Chartered Accountants of India (ICAI) notified in March 2008 marking to market all derivative transactions or embracing Accounting Standards 30, 31 and 32 on Financial Instruments which were notified in 2007, recommendatory from April 2009 and mandatory from April 2011.

The notification had to be quickly withdrawn as it generated more legal tussles between entities and banks than accounting issues. Akin to the noodle-makers in Indonesia, garment exporters from a garment town were up in arms against their bankers since a reality check of the financial effect of the contracts they had entered into reflected a mass of red ink.

Three years on, ICAI has recently issued another Clarification which has the effect of postponing applying AS 30, 31 and 32 to most entities, apart from the ones that are in the select list to move over to IFRS from April 2011.

ICAI Clarification

The clarification issued by the ICAI notes that the financial crisis forced regulators back to the drawing board on standards for financial instruments. It says that the present Indian Accounting Standards 11 on Foreign Exchange Contracts and 13 on Investments would prevail over AS 30 and in instances where specific regulatory requirements on loan impairment, asset classification, accounting for securitisations etc have been laid out, these would prevail over AS 30.

Subject to the above, it encourages entities to prepare financial statements are per the requirements of AS 30 which could be as rare as a scam-free environment.

The Reserve Bank of India is expected to issue IFRS-compliant accounting standards for banks and financial institutions when they move over to IFRS. Entities that are covered in the first set of entities to move over to IFRS are required to follow Ind-AS39 and Ind –AS 107.

Financial Instruments

Financial Instruments are no longer restricted to forward contracts and investments which present accounting standards in India cover. There are significant conceptual differences between the present AS 13 on Investments and AS 30 on Financial Instruments. While the financial instruments issued by banks and financial institutions would follow RBI norms for recognition and measurement, those issued by corporate entities would be left direction-less. A financial instrument traded between a bank and an issuing entity could be valued differently in each other's books. It is normal for large entities to have spun-off subsidiaries for their investment and trading purposes to whom the standard on financial instruments would not apply as they may not meet the criteria specified in the road-map. Nigeria is the latest nation to jump onto the IFRS band-wagon. Unlike India, their road-map covers small and medium enterprises from 2014. We seem to be considering IFRS as a necessary evil for select entities. This has resulted in a slow-and-steady approach to convert to IFRS, but it would appear we have already lost the race.

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Published on February 16, 2011
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