Jamal Mecklai: The tyranny of 'other income'

MARKET MANIAC

With the recent volatility of the rupee, more and more companies are seeing the "other income" component of their quarterly accounts bouncing around like tennis balls.

This is particularly true for IT companies, whose top line has very little protection from this volatility.

Equity analysts have sharpened their focus on this element of the accounts and, even though they should know better, sometimes factor this "uncertainty" into their assessment of the company's future worth.

The reality, however, is that the volatility of other income (or, more specifically, forex gain/loss) has very little to do with the actual worth of the company.

From a bottom line perspective, a business revenue of, say, Rs 1,563 crore plus other income of Rs 17 crore is exactly the same as business revenue of Rs 1,600 crore plus other income of minus Rs 20 crore!

(Of course, this point does not hold true for banks, where "other income" specifically includes trading profits, which are actually a core activity of the bank.)

The fact that a company has negative other income does not mean that it lost money on forex; correspondingly, a company that has positive other income has not gained money on forex.

Also, if the scale or sign attached to other income changes from quarter to quarter, it does not mean that the company has an ill-advised forex risk management policy.

Forex gain/loss simply clocks the difference between the rates prevailing on the date the revenue item is booked and the rates at which the company realises the revenue.

It is merely""and this word is not intended to raise the wrath of the accountancy profession, God bless them""a way for accountants to keep track of the value of the company's foreign currency-denominated receipts or payments.

As we know, accounts only report definite (and definitely valued) cash flows. Thus, they become aware of the existence of a receipt of payment only when it becomes "real"""in their terms; in other words, when there is a document defining it, in terms of amount, due date and value.

And, since they""like anybody else""do not know the value of forex flow at a future date, they simply use the spot rate on the date the exposure becomes "real" to book it and then build in the difference between that rate and the actual rate that is realised into an entry""the famed "forex gain/loss".

It is merely an accounting entry and has nothing to do with the company's business.

Trying to minimise forex gain/loss is, almost by definition, counterproductive to managing the company's forex risk. The only way to ensure that this difference is never below zero is to leave the company's entire forex risk unhedged, until each exposure crystallises.

Then, at each point of crystallisation, you would sell forward, which (assuming we are speaking of exports and that the forwards are in a premium) would ensure that there is a positive difference between the realised rate (forward rate) and the rate at which the exposure is recorded in the books (spot on the date of crystallisation).

Note that this focus requires the company to leave its forex risk unhedged ""hardly a sound prescription for risk management.

Further, it simply misunderstands the nature of risk identification.

If one is focused on ensuring that this item is never below zero, what one is, in effect, saying is that the risk on an exposure begins only when the company has registered the transaction in its books.

Under this quaint notion, a steel company that has huge capital investments and produces and exports hundreds of tonnes of steel each month would carry zero forex risk for, say, December, till it had a confirmed order to ship for December delivery""say, in October.

This is clearly a far cry from business realities, where companies have to keep trying to increase their forward visibility to be able to assess""and, hence, manage""the myriad risks facing their business.

In fact, companies need to take as long a view of their businesses as is practicable""for forex risk management, 12 months is a reasonable time line.

And they need to use some objective process to fix a target value for realisations, and then hedge in the market, as necessary, to ensure that this value was always protected.

Since markets are volatile, this process may well lead to occasions where the company's top line is protected""which is the mandate of the risk management team""but the forex gain/loss is negative.

The other""accounting-driven approach""would ensure that there was never a negative forex gain/loss, but it would have no predictability whatsoever of the company's top line.

It is, perhaps, worth recognising that this increased focus on exchange gain/loss started only about five or six years ago, when the Internet boom, made more hysterical by the "greater fool" theory of investment banking, led to a sharp focus on quarter-to-quarter results.

This was exacerbated by international accounting requirements""now also playing in India""which required changes in balance sheet values of assets and liabilities to be passed through the income statement.

Because companies had not yet figured out how to deal with translation risk, which process, in any case, was constrained by regulations in India, this volatility in the income statement was traced to the "other income", and voila!

Everyone became more and more obsessed with trying to keep this poor animal down. And, in a classic case of not seeing the forest for the trees, this obsession sometimes led to an obscuring of the real issue""which is: how do I make sure that my top line (viz. revenue plus other income) is protected at a certain value.

Accounting is necessary to create standards for assessment, but let's not focus on accounting entries at the cost of focusing on the real thing""profits.

(The author is CEO of Mecklai Financial)