Jamal Mecklai: Welcome to the new, improved as 11

MARKET MANIAC

Funny how important accounting has become, isn't it? Ever since Enron brought Andersen down, the accounting profession has been thrust into the limelight""T-shirts saying "Accountants do it by numbers" and the like have been seen at cricket matches and softball games all over the world.

And while glacial change is often seen by accountants as swift, the speed with which we are seeing changes in accounting standards all over the world is nothing short of revolutionary.

Even our own Institute of Chartered Accountants has got into the act and the recent revision of AS 11 on the "Effects of Changes in Foreign Exchange Rates" will dramatically change the reported""and, hence, actual""profitability picture of many companies.

Under the new rule, the entire change in the value of assets and liabilities as a result of changes in the exchange rate feeds directly to the income statement. The change is stark and the impact can be dramatic.

Consider a company with unhedged foreign currency borrowings of $25 million as on March 31, 2004. With the rupee closing the April-to-June quarter at 46.08, the entire Rs 5.2-crore increase in the value of the liability (the rupee was at 44.00 on March 31) will have to go as a direct hit to its bottom line.

Earlier, the increase in the value of the liability would be offset by increasing the value of the asset created by that liability, which would then be written off through the impact of depreciation on the P&L.

Given that the total ECBs on corporate books in India are of the order of $12 billion and assuming that the bulk of these were used to purchase fixed assets, this new version of AS11 would require around nearly Rs 2,500 crore to be written down against corporate profits during this past quarter!

It is not very clear as yet as to how many companies have built the impact of this new AS 11 into their quarterly accounts. Considering how strong profits were this past quarter, it is possible that most companies have still not factored in the impact.

To be fair, AS11 makes implementation mandatory only for accounting periods beginning April 1, 2004, and, in the arcanespeak of accountants, quarters are not "accounting periods."

So, it is likely we will see the full impact only at the end of the fiscal. It is also, of course, possible that some companies, particularly those with a strong reporting focus, may have actually hedged out their translation risk for this past quarter, which may help to explain the sharp demand for rupees in the second half of June.

This suggests that once companies fully appreciate the impact of this new accounting standard, they will need to become far more sophisticated in their use of the forex market.

For instance, one approach""which, incidentally, I feel makes the most sense""would be to try to treat all assets (or liabilities), whether rupee or foreign currency, in the same way from a net value standpoint. To do this, companies would have to use options to "fix" the valuation exchange rate for a foreign currency asset (or liability) at the same value, as on the preceding balance sheet date.

Returning to the earlier example, the rupee value of that $25-million liability as on March 31, 2004, was Rs 110 crore (at the spot exchange rate of 44 to the dollar).

To ensure that the liability value remains the same on June 30 (assuming there are no intervening repayments), the company would need to buy a call option to fix the price of its dollars at 44 on June 30. The price of that option was 20 paise per dollar, or a total of 50 lakh on the $ 25 million liability.

In the event, on June 30, the dollar was at 46.08 rupees, which would push the value of the liability up to Rs 115.20 crore. However, this loss (of Rs 5.2 crore, as earlier) would be offset by the gain the company would make by exercising the option and sell the resulting dollars in the market, registering a profit (and positive cash flow) of Rs 4.70 crore.

The net loss on the company's books would be only Rs 50 lakh, which was the cost of the option in the first place. (Note that if the company did nothing, it would simply have to carry the entire depreciation of the rupee as a loss, taking a hit of Rs 5.20 crore on its P&L.)

Clearly, as companies begin to appreciate the impact of the new rule, volumes in the options market will rise. Further, volumes in the cash market will also rise, as banks will need to hedge their option sales by buying (or selling) forwards.

While this is excellent""one of the key needs of the hour is to increase market volumes""there is still a lot of cloudiness from a regulatory standpoint.

Currently, regulations permit companies to hedge the risk on foreign currency liabilities and certain foreign currency assets""for example, loans to subsidiaries. However, the risk on balance sheet items, which do not result in cash flows""e.g. equity investments overseas or cash balances held in subsidiary accounts""may not be directly hedged.

Companies may hedge up to 25 per cent of the previous year's forex turnover on a non-deliverable basis, but this is a roundabout way to comply with a real, defined risk on the P&L.

The RBI needs to provide clearer guidance on how companies can manage their risks in the face of this new accounting rule.

(The author is CEO, Mecklai Financial)