If the rules allow companies to book forex profits due to currency movements in a year, they can't be changed when the currency moves the other way.
Group CFO, Hinduja Group
‘In normal times, AS 11 compliance is misleading as companies will heavily debit the P&L in one year, and reverse this as the FCCBs get converted’
If the purpose of Accounting Standards (AS) is to reflect the true and fair view of the financial position of a firm, then AS 11 achieves the opposite as far as its recommendation for treatment of foreign currency (FX) liabilities are concerned. While revenues clearly need to be expensed out in the financial statement, the same rule cannot be universally applied for long-term FX borrowings — where the use of ECB or quasi-equity instruments is for fixed assets over the long-term.
- If the ECB/FCCB repayment liability is over the next 3-5 years, equitable treatment demands that the extra repayment liability should be spread over the remnant maturity period and not in one year (when the reporting currency depreciates) as it negatively skews the profit figure of that year — this denies the true profit of that year and unnecessarily increases profits in subsequent years when the currency moves the other way.
- The assets created by such loans are long-term in nature, and hence the benefits from them and the liabilities for their acquisition are both spread over a period of time. To align the assets and liabilities, it is natural that if the FX repayment liability is taken in the profit and loss (P&L), it should be taken over a matching period — which, in this case, will be the liability tenor extending to 3 to 5 years for ECB/FCCB, and to 12-14 years for ECA Credits, as assets tend to exist for more number of years.
In today’s scenario, FCCB conversion appears unlikely, but in normal times when FCCBs get converted, such compliance of AS 11 will actually be misleading as a standard — companies will debit the P&L heavily in one year of depreciation and will reverse this as the FCCBs convert.
A more balanced approach is compliance with Schedule VI of Companies Act where not only are both sides of assets and liabilities taken care of, but proportionate debit to the P&L can happen though increased depreciation. Schedule VI could be amended to ensure that the FX liability part of depreciation due to currency fluctuation is segregated and amortised over the remnant period of the particular loan which has been used to buy the assets. This ensures a proper reflection of actual debits to go to the P&L; asset values reflect the real replacement value in FX; and the Companies Act as a Law prevails over AS 11.
Schedule VI should also be amended to include Indian fixed assets, so that the accounts reflect the proper situation as FX loans are allowed today for Indian capex by the latest RBI guidelines. IAS 21, which deals with this issue at the global level, clearly allows such depreciation to be carried in the balance sheet. Since we are trying to align with the IAS by 2011, it would be prudent for us to fall in line “proactively”. The question may be raised as to whether the entire credit was taken in one year when the rupee appreciated. This should also be dealt with similarly. For such credits, where the loan has been paid off, issue is closed. For loans yet to be repaid, the extra liability needs to be amortised over the remnant tenor, and if it happens to be one year, so be it.
I don’t think the AS should be changed due to the present recessionary trend — standards can not be changed so rapidly, year after year. The fundamentals should be looked at with an unbiased mind and a decision should be taken.
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‘Financial information is only reliable when it reflects what has taken place. Changing rules for past events to help firms postpone losses is unfair’
In every economic downturn, the financial results of enterprises deteriorate and companies that are used to showing sequential growth in double digits over many quarters are suddenly faced with the reality of showing little growth, or worse still, a contraction. In such times, many companies tend to resort to practices which could be questionable in normal times, in order to show a better result than the actual one. These options are often evaluated, debated and rules pushed to the limit to meet the expected earnings. In recent times, Indian companies are also burdened by the rupee depreciating to over Rs 50 as compared with the dollar, from less than Rs 40 to a dollar not many months ago. Companies that had taken foreign exchange forward contracts or hedges even one year back were not able to predict this rapid decline in the value of rupee.
These entities could be sitting on large amounts of unrealised losses arising out of rupee volatility and if these do not qualify as accounting hedges, under the ICAI rules they need to mark them to the market price at the balance sheet date, resulting in potential losses. These are, however, unrealised losses which become actual losses only when these forward contracts mature and are settled. However, if a forward cover can be classified as an accounting hedge then the marked-to-market losses reside in the balance sheet and are released to the income statement on settlement. An accounting hedge is created when a correlation is established between the hedged item, say, a future sales in dollars and the hedging instrument, say, a forward cover taken in dollars against the volatility of realisation of the resultant debtors. Although all forward covers in India are considered economic hedges, they may not qualify as accounting hedges unless the correlation between the hedged item and the instrument is established. However, speculative foreign exchange contracts are not allowed in India.
One of the fundamental principles and assumptions of accounting embodied in the framework for preparation and presentation of financial statements issued by the Institute of Chartered Accountants of India (ICAI) is consistency. Consistency is described as “accounting policies that are followed consistently from one period to another; a change in an accounting policy is made only in exceptional circumstances.” Exceptional circumstances are not expected to recur, but a downturn is part of a business cycle which is expected to recur, and changing accounting rules to counter a downturn is against the principles of consistency. Forward contracts are financial instruments to mitigate business risks and there could be occasions when these risks are exposed, resulting in losses or gains. The debate on whether such losses should be deferred only happens when the economy is depressed but whether recognising profits in an upbeat economy should be postponed is rarely discussed.
Financial information is relevant and reliable only when it is a faithful representation of transactions as they have happened. Resorting to changing the accounting norms and rules for past events in order to achieve a short term objective of postponing losses by companies is against the basic accounting framework and principles. Our global relevance will only be enhanced when we adopt and follow global standards of derivative accounting in the letter and the spirit of these standards even in some of the most difficult financial crises that we will see.