Accruals, provisions and fair value

ACCOUNTANCY

While reporting that the ICICI bank had taken a hit of more than Rs 1,050 crore on account of subprime losses, a newspaper reported "ICICI lost money due to depreciation in the value of securities it bought in the international markets. Due to rise in global interest rates after the subprime loan crisis, the value of these securities fell, forcing the bank to provide for the difference in its profits." Other reports also talk of "provisioning losses" suffered by ICICI. This loose use of the word "provisioning", which has a precise sense in accounting, has contributed to the popular confusion about what actually had happened at ICICI.

For accountants, 'provisions' are liabilities of uncertain amount and timing. Liabilities themselves are defined as obligations, present at the balance sheet date, settlement of which will result in outflow of economic benefits. Liabilities are recognised as creditors when the company receives the claim from the counter party and accepts it. Borrowings from individuals, institutions or market are also recognised as liabilities. Accrual accounting requires companies to recognise liabilities even if the claim is not received. Liabilities for which claims are not received at the balance sheet date are accruals or provisions. Both accruals and provisions are recognised at management's best estimates. Accruals arise when goods and services have been delivered to the firm, but a claim against them has not yet been made by the supplier.

In case of accruals, the company estimates their value based on expenditure incurred in past for receiving similar services. For example, a company recognises outstanding liabilities for travelling expenses and services already received from regular service providers. Provisions are liabilities whose amount and timing involve much greater uncertainty than that of accruals. Valuing them is correspondingly more difficult. Examples of provision are the provision for product warranty and provision for customer's claims under arbitration. Management has to make many assumptions while estimating the amount of a provision. Accounting for accruals and provisions provides significant opportunities for earnings management.

None of this, however, is applicable in the case of ICICI. The confusing use of the term 'provisioning' in that context reflects the Indian practice of using the term 'provision' to also connote a reduction in the carrying amount of some asset. For example, 'provision for doubtful debts' is a valuation allowance, which reduces the carrying amount of receivables. Valuation allowance may also be viewed as a provision for estimated loss. Provision for doubtful debts represents the estimated loss that will arise due to non-recovery of the full amount due from customers. Similarly, provision for non-performing assets (NPA) by a bank represents estimates loss due to non-recovery of loans/advances.

The 'provision' made by ICICI is also a result of a revaluation, arising in this case from the requirement that changes in the fair value of derivative instruments and securities held for trading be recognised in the profit and loss accounts. In case of 'available for sale securities', that is securities which are not included in the trading portfolio of the company, the change in the fair value is not recognised in the profit and loss account. It is recognised in the balance sheet and accumulated gain or loss is recognised in the profit and loss account when the security is actually sold. (However a company has an option to recognise the change in the fair value of 'available for sale securities' in the profit and loss account.)

Thus the 'provision' in ICICI Bank's context does not represent the management's estimate of the loss that the bank might actually suffer due to reduction in the market value of investments. Rather, here, 'provision' represents the reduction on the market value of investment portfolios, which are measured at market value at the balance sheet date (often referred as mark-to-market). The Bank will actually suffer a loss only if the market value of the portfolio does not increase in future, when the bank will sell investments in the portfolio. The loss at present is only notional. Management's estimate of loss might be much lower than Rs 1,050 crores. For example, American International Group (AIG), the world's largest insurance company which reported a loss of just under $5 billion for the months of October 2007 and November 2007 for its exposure to sub-prime related investments, estimated that in a worst case scenario the realised loss would go up to $ 900 million.

This is an instance where the measurement of financial assets, financial liabilities and derivative instruments at fair value results in volatility in operating results reported by companies, particularly financial institutions from quarter to quarter. Use of fair value requires companies to recognise these notional losses and gains in their financial statements.

Difficulties also arise in estimating fair value for financial assets and liabilities for which there is no market. In those situations, the measurement is 'mark-to-model' rather than 'mark-to-market'. Estimation of fair value using economic models is less reliable than fair value estimated using 'mark-to-market' model. AIG had to revise its estimated loss to $ 5 billion from around $ 2 billion at the insistence of PwC, the auditor of the company. PwC reported material weaknesses in AIG's internal control over financial reporting and oversight relating to the fair value valuation. An implication of 'mark-to-model' valuation is that litigation regarding valuation of financial assets and derivatives will increase in the USA and elsewhere.

Use of fair value in measurement of financial assets and derivatives will stay. In course of time, even financial liabilities will be measured at fair value. It is time that financial institutions and companies that use derivatives extensively for risk management strengthen their internal control over financial reporting. In India, banks and financial institutions are audited by mid-size audit firms, many of which do no have exposure to valuation of financial instruments. They should quickly build capabilities in valuation of securities using economic models.