Published: October 01, 2010
Companies in India are moving towards IFRS convergence from April 1 2011. The build-up towards IFRS convergence has been both challenging and tricky, with regulatory clarity on the timelines and the exact nature of revised accounting standards being difficult to obtain. In addition, given the recent global developments relating to the replacement of IAS 39 and the issuance of IFRS 9, another layer of uncertainty appears to have been introduced into the mix. Amid all this uncertainty, there are a number of practical issues that have become more evident as companies have sought to apply IAS 39 (AS 30 in the Indian context). A significant contributor to why this change in accounting for derivative and hedging transactions is critical in India has to do with the fact that traditional accounting for derivatives in India has been based on an off-balance sheet / accrual based model and neither required on-balance sheet recognition of derivatives nor even, for that matter, disclosure of the fair values of these instruments.
Indian companies have realised that there are a number of current risk management practices that would not qualify for hedge accounting under the new accounting standards. This realisation is causing a number of companies to review the structures and transaction components used. The conflict between the objective of ensuring a less volatile income statement and of managing the economic exposures of an entity has been brought sharply into focus.
For instance, a number of organizations in India have traditionally used leveraged option structures to hedge foreign exchange exposures. For example, an Indian exporter buys a USD/INR put option for USD 1m and to finance this option writes two options for USD 1m each. This structure is used often as the strike price for this structure (all options have the same strike) is more favourable than the available forward rate. This structure does not qualify for hedge accounting (as it is determined to be a net written option), and while it may have been possible to mitigate the effects of this accounting conclusion by transacting a synthetic forward separately from a portion of the written option component, in the Indian context, regulatory restrictions do not permit this to happen.
A key area of concern for companies has been the requirement to apply the 80/125% rule relating to the ‘highly effective’ criteria for applying hedge accounting. Many Indian companies have been vocal in supporting proposals to amend the hedge accounting norms under IAS 39 and to do away with the effectiveness testing criteria whilst continuing to measure ineffectiveness. Most Indian companies do not currently use regression as a tool to test effectiveness and hence are often faced with ‘small dollar change’ effects that often preclude hedge accounting.
Another common area of consideration is the hedging time horizon that they consider while conducting their risk management activities. Many Indian entities have traditionally hedged for time periods longer than what would qualify for the purpose of determining ‘highly probable forecast transactions’. These risk management interventions have benefited entities in recent times of currency volatility but also potentially expose companies to considerably larger accounting volatility than what they have an appetite for.
Many Indian entities are therefore being forced to reconsider if they should continue with such structures given the level of accounting volatility that would ensue if they retained their current risk management activities. [[[PAGE]]]
Companies are finding that communication (or lack thereof) is fast emerging as a key consideration for them to decide on a future course of action with respect to their hedging programme. Given the historical context of accounting for derivatives as ‘off balance sheet’ items and accrual accounting, many boards of directors and audit committees may have previously been unaware of the fair values of these contracts. Under the new standards, fair value accounting is mandatory, and the variations and extent of fair values of derivatives is proving in some cases to be as expected, but in more cases to be unexpectedly high for senior management/directors of companies.
In addition, as companies are preparing for communicating these results and derivative positions more transparently to investors and other stakeholders, they are realising that certain, more aggressive derivative structures will be difficult to communicate or justify to external investors and other stakeholders.
It is also unclear as to how credit rating agencies and bankers will react to the derivative/MTM positions of corporate entities when the disclosures under the new standards are made.
Companies have been treading cautiously in this area, and the level of disclosures in this context has been muted, with most entities adopting a ‘wait and watch’ attitude, with a view to benefiting from any lessons gained from the experiences of early movers in IFRS adoption.
Applying hedge accounting in the legacy Indian standards was not difficult to achieve. Limited documentation requirements and no formal requirement for effectiveness testing or ineffectiveness measurement contributed to an environment where hedge designation or accrual accounting was perceived as neither difficult to achieve nor challenging to continue.
Under the new standards that are likely to be applied, Indian companies are finding out that they are not even able to continue the accounting treatment they are used to. It is also becoming increasingly evident that a substantial number of Indian corporates do not have the current infrastructure – IT systems, processes or controls – that is adequate to operate in a hedge accounting environment under IAS 39/ AS 30.
The key areas of lacunae include the inability to value derivative contracts on a fair value basis, separate risks for valuation purposes while applying fair value hedge accounting, modifications required to IT systems and infrastructure to track highly probable forecasted transactions and, more generally, the ability to create adequate documentation around hedge designation and effectiveness testing. The lack of easily available historical data to assist these effectiveness computations has only added another layer of complexity to the challenge at hand.
Most Indian companies are currently evaluating the adequacy of their framework and infrastructure to deal with the new accounting dispensations, but this area remains ‘work in progress’ at this stage and is often a key area of challenge and difficulty for the audit firms involved with these companies. [[[PAGE]]]
While previously applied accrual accounting suited companies and did not cause any significant tax litigations per se, the new accounting dispensation which emphasises fair value accounting is likely to pose potentially significant challenges on account of taxation related matters.
Given that tax litigation in India takes many years and sometimes decades for resolution, companies are concerned that they may be forced to pay taxes on unrealised gains on derivatives while being denied deductibility on a similar basis for unrealised losses on such contracts.
The Indian revenue authorities have yet to provide any specific guidance on what will be the taxation related position on derivative contracts and this uncertainty is not helping corporate India currently.
In conclusion, many treasurers and CFOs of companies in India are faced with very significant challenges and uncertainties as they are going about applying these new standards with regard to derivatives and hedge accounting. In the midst of these many conflicting demands, it is perhaps worth reminding oneself that the basic need and objective for risk management and hedging is a business one and not an accounting construct.
While making these key choices, it is incumbent on these treasurers and CFOs to communicate clearly and adequately with all stakeholders and to look to optimise accounting choices by utilising tools like hedge accounting where appropriate and to put in place the required infrastructure and systems to facilitate these choices.
The key driver of these activities should continue to be a business choice and view, and accounting, while undoubtedly important, should be a consequence rather than a cause of these actions.
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