NSEL, a case of bad book-keeping

There’s a Malayalam proverb, “ adi thettiyaal aaneyum veezhum ”, which translates as, “Even an elephant will fall with a wrong step”.

The National Spot Exchange Limited, which was considered to be an elephant for the commodity community not so long ago, is today on life support.

What started as a payment crisis at the NSEL has turned into a mind-boggling affair with everyone who had anything to do with the exchange — promoters, management, borrowers, stockbrokers — all seemingly having a role to play.

Not surprisingly, the auditors have joined in now, with the body that governs the profession — the Institute of Chartered Accountants of India — on the verge of asking auditors the right questions on what they did wrong.

NSEL Crisis

With easy money from banks consigned to history now, the dramatis personae in the NSEL crisis thought of an innovative way out — why not convert the exchange itself into a bank?

The clients of NSEL brokers had taken positions on longer-term forward contracts when the exchange was only permitted spot contracts in commodities.

Worse, the NSEL permitted 25- to 45-day forward contracts without verifying that the commodities had actually been deposited in the warehouses.

Funding may not have been restricted by the traders and processors to the core business activity.

It is eminently possible that money raised at the NSEL may have been directed to other popular investment channels such as real estate or gold.

But with both these markets depressed, it proved difficult to quickly liquidate assets and return the money — hence the default.

It is widely believed that the registered warehouses of the NSEL do not have the required amount of goods to clear the dues of investors.

The two ingredients that are apparent in any crisis or scam — sheer greed coupled with lax regulatory oversight — stand out glaringly in the NSEL saga.

A solution

It is not often that accounting standards can assist in minimising scams. And, unravelling financial crises is not the stated objective of accounting standards. However, the International Accounting Standard 2 (IAS 2) on Inventories has a solution to the situation that NSEL and its entourage find themselves in.

It states that commodity broker-traders who measure their inventories at fair value less costs to sell. Changes in fair value less costs to sell are recognised in profit or loss in the period of the change. Broker-traders are those who buy or sell commodities for others or on their own account.

The inventories they deal in are principally acquired with the purpose of selling in the near future and generating a profit from fluctuations in price.

The Indian equivalent of IAS-2 does not have this paragraph on inventory of commodity brokers, though the IFRS-equivalent has it.

Had this clause been part of our accounting standards, users of financial statements could at least have known that the borrowers in the NSEL crisis did not have any commodities as collateral to back the money they traded in.

In case they did have commodity stock and had traded in them, the gain/loss on these transactions would have been reflected in their financial statements — which could have provided indicators that they were dealing with unsustainable volumes.

Move over to IFRS

The powers that be have been pussyfooting on the adoption of International Financial Reporting Standards (IFRS) for years now. It is time the Government announces IFRS adoption — in a phased manner as was envisaged in the roadmap. This should not be stretched to eternity but should be reasonable — asking all entities to transition within a period of three years seems fair.

With their laser-like focus on fair value as the default measurement option, financial reporting and disclosures, IFRS standards could be one of the ways in which we could expect less scams.

Like the US’ GAAP and IFRS, the Ministry of Corporate Affairs should ensure that introducing ‘prior period’ items in financial statements, reflecting earlier omissions and errors, is considered a serious error.

Both, the entity that prepared them and the auditor who signed them should be called into question. Blaming changes in the financial statements on subsequent events will simply not wash.

(The author is Director, Finance, Ellucian.)

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