ACCOUNTING STANDARD, FINANCIAL INSTRUMENTS - AS 30:
Derivatives have, on occasion, been termed weapons of mass destruction and at times, they have behaved as such. However, when used judiciously, they can hedge against those risks that a company does not want to carry.
Similarly, judicious use of accounting policy choices can also mitigate the havoc that could be wrecked by mark-to-market accounting of derivative instruments. Mark-to-market accounting, or fair-value accounting, requires that all derivative instruments are carried in the financial statements at their fair values, with changes in the values being recognised in the profit and loss account.
What further aggravates matters is that under Indian Generally Accepted Accounting Principles (GAAP), one has to recognise losses arising from such derivative instruments, but not the gains on grounds of prudence, unless of course one considers AS 30 the standard on financial instruments.
ADVANTAGES OF AS 30
This has a number of advantages. First and foremost, it allows both gains and losses arising from derivative instruments to be recognised in the profit andr loss account.
Although this removes asymmetric accounting, the real benefit for companies comes from the hedge accounting provisions in AS 30. This has been the reason why a significant number of our blue-chip companies have already early adopted the standard, and I expect this trend to continue.
Unless and until a company is using derivatives for speculative purposes, the provisions in AS 30 allow it to reflect the economic reality of its hedging programme in its financial statements, or in other words eliminate from the profit or loss account the mark-to-market volatility arising from hedging. This is achieved using the hedge accounting provisions in AS 30. These provisions allow for the matching of the gains or losses arising from the derivative with that of the transaction that the derivative is hedging. As a result changes in fair value of the derivative instrument are recognised in reserves and released to the profit and loss account when the transaction that is being hedged impacts profit or loss.
HEDGE ACCOUNTING
This is best illustrated through an example.Let us consider a company that expects to receive a certain amount of foreign exchange in the near future from export sales. As a policy, it does not want to expose itself to the volatility arising from movements in foreign exchange rates, and therefore enters into a forward contract to lock in the rate exchange at which it will receive payment.
In the absence of hedge accounting, the changes in fair value of the forward contract will be recognised in the profit and loss account thereby causing volatility in reported results, although the economic reason behind the transaction was just the reverse.
Using hedge accounting, the volatility arising from changes in fair value of the forward contract is recognised in reserves, and not in the profit and loss account. The gains or losses accumulated in reserves are released to the profit and loss account when the actual payment is received.
As with all good things, this comes at a price. Being an exception to the normal accounting, AS 30 imposes stringent conditions on companies regarding compliance if it wants to apply hedge accounting. These requirements can be onerous and need to be followed diligently. However, the benefits are significant as well.
I would like to end, however, on a note of caution. The above solution is an accounting solution only, and will not turn lead into gold, and losses won't become gains – a formula for that alchemy is yet to be discovered.
For managing their business under the current volatile economic scenario, companies need to consider the above in conjunction with their risk-management practices and policies.
Source : Business Line ,2 July 2012
Derivatives have, on occasion, been termed weapons of mass destruction and at times, they have behaved as such. However, when used judiciously, they can hedge against those risks that a company does not want to carry.
Similarly, judicious use of accounting policy choices can also mitigate the havoc that could be wrecked by mark-to-market accounting of derivative instruments. Mark-to-market accounting, or fair-value accounting, requires that all derivative instruments are carried in the financial statements at their fair values, with changes in the values being recognised in the profit and loss account.
What further aggravates matters is that under Indian Generally Accepted Accounting Principles (GAAP), one has to recognise losses arising from such derivative instruments, but not the gains on grounds of prudence, unless of course one considers AS 30 the standard on financial instruments.
ADVANTAGES OF AS 30
This has a number of advantages. First and foremost, it allows both gains and losses arising from derivative instruments to be recognised in the profit andr loss account.
Although this removes asymmetric accounting, the real benefit for companies comes from the hedge accounting provisions in AS 30. This has been the reason why a significant number of our blue-chip companies have already early adopted the standard, and I expect this trend to continue.
Unless and until a company is using derivatives for speculative purposes, the provisions in AS 30 allow it to reflect the economic reality of its hedging programme in its financial statements, or in other words eliminate from the profit or loss account the mark-to-market volatility arising from hedging. This is achieved using the hedge accounting provisions in AS 30. These provisions allow for the matching of the gains or losses arising from the derivative with that of the transaction that the derivative is hedging. As a result changes in fair value of the derivative instrument are recognised in reserves and released to the profit and loss account when the transaction that is being hedged impacts profit or loss.
HEDGE ACCOUNTING
This is best illustrated through an example.Let us consider a company that expects to receive a certain amount of foreign exchange in the near future from export sales. As a policy, it does not want to expose itself to the volatility arising from movements in foreign exchange rates, and therefore enters into a forward contract to lock in the rate exchange at which it will receive payment.
In the absence of hedge accounting, the changes in fair value of the forward contract will be recognised in the profit and loss account thereby causing volatility in reported results, although the economic reason behind the transaction was just the reverse.
Using hedge accounting, the volatility arising from changes in fair value of the forward contract is recognised in reserves, and not in the profit and loss account. The gains or losses accumulated in reserves are released to the profit and loss account when the actual payment is received.
As with all good things, this comes at a price. Being an exception to the normal accounting, AS 30 imposes stringent conditions on companies regarding compliance if it wants to apply hedge accounting. These requirements can be onerous and need to be followed diligently. However, the benefits are significant as well.
I would like to end, however, on a note of caution. The above solution is an accounting solution only, and will not turn lead into gold, and losses won't become gains – a formula for that alchemy is yet to be discovered.
For managing their business under the current volatile economic scenario, companies need to consider the above in conjunction with their risk-management practices and policies.
Source : Business Line ,2 July 2012
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