Late in the day

The Institute of Chartered Accountants of India (ICAI) should have woken up sooner to the problem created by foreign exchange derivatives and how to account for them. A new accounting standard was issued in December, but its observance was made voluntary from April 2009, and mandatory only two years after that. This became a problem once it became clear that companies had lost large sums of money on derivatives, that many of them had losses on contracts that were more than their profits for the year, and in some cases more than their net worth. The existing accounting norms, which did not ask companies to fully account for such losses by "marking to market", helped companies under-state the problem and thereby under-provide for losses. In effect, shareholders would not get the complete picture. There was little doubt that this was an untenable situation, and in that sense it is just as well that ICAI has issued a new directive, asking companies to switch immediately to the new accounting standard and, failing that, to mark-to-market all their losses so that shareholders got the correct picture. The problem of course is that the directive has come on a week-end, with one working day left for the financial year to close for most companies. Saddling companies with a serious accounting change at the very end of the year has given them an unpleasant shock, and many of them will be scrambling to deal with this last-minute situation. This is not the way in which matters should be dealt with.

The new accounting directive should mean that all the facts will be known when the March accounts are reported, but shareholders may remain in the dark about the true dimensions of the potential problem. If some companies are tempted to take the view that many foreign exchange derivative contracts have maturity dates that are still in the future, and therefore they can legitimately take the view that until the stipulated date comes round, there are no losses to report. Since some of the affected companies have gone to court against the banks that sold them the derivative contracts, they will be taking legal advice on whether they have a strong case, and whether that gives them protection from "marking-to-market".

Companies will be eager to look for such escape routes as the immediate disclosure of large exposures could endanger their relationships with other bankers and suppliers, with the attendant risk of credit drying up and affecting the running of the business. However, the accounting norms that have been introduced do not leave any room for such creative thinking. There is also the possibility that banks and companies will work out arrangements whereby existing derivative contracts are unwound, and replaced by new contracts that have an even longer maturity period. But even this will not prevent full disclosure to shareholders. In any case, such "ever-greening" of loans also runs the risk of increased exposure, and a bigger problem being bought for the future.