The whole point about a scale is that it remains constant. So, if something looks smaller in length than the scale, it’s because it is smaller, not because the scale got longer. This is precisely the problem with the recommendation by the National Advisory Committee on Accounting Standards (NACAS), reported in this newspaper, to postpone the compulsory implementation of Accounting Standard 11 (AS 11) to 2011 — it allows the scale to shrink and elongate at will. Since AS 11 deals with foreign exchange losses, companies that have made losses on hedges they bought, will not have to mark-them-to-market and so can declare a higher profit, or a lower loss — the same companies who, by the way, took credit for the mark-to-market gains on hedges they had bought when currencies were moving the other way! If you are an investor not looking at their accounts with a microscope, there is a pretty good chance that you will think these companies are healthier than they actually are — both when foreign exchange rates were moving in their favour and now when they are moving the other way. To its credit, the Institute of Chartered Accountants of India (ICAI) has differed on the issue, and opposed any change in the accounting norms that exist. The government will now decide, and it must be hoped that the ministry of corporate affairs will take the correct decision.
The justification being given for relaxing the accounting standard, or postponing its implementation by a year, is what is happening in the US. The Financial Accounting Standards Board (FASB), as a Bloomberg article being carried on the facing page tells you, has just come up with a proposal that allows companies to not report the long-term decline in the value of shares they own under certain conditions — that they plan to hold the financial instrument till maturity, or that the loss is not permanent. The same distinction is made in India too when it comes to banks—the Reserve Bank asks for marking-to-market only those securities that are not being held to maturity.
But banks are a special category, because they have to meet capital adequacy requirements; if capital is eroded because investments lose value, the banks have to bring in more equity. This can become a vicious cycle in a downturn as each de-rating of securities forces banks to bring in fresh capital, at lower and lower valuations—one of the problems that manifested itself in the US financial crisis. However, ordinary commercial corporations do not have this problem, and in any case they do not have the reserve requirements which force banks to hold some securities to maturity. The argument in the case of firms whose derivatives contracts have gone wrong is that the hit has to be taken over a number of years, and a swing in market trends could in fact wipe out the problem (but then again, it might not). And since the cash pay-out is not all in one year, but over the life of the derivative contract, the accounting standard should permit some leeway when it comes to valuation. The argument is not entirely without merit. And regulatory forbearance is always a tempting option when the economic cycle has swung downward; indeed, the RBI has done some of it in the current situation. But on balance, the argument for relaxing AS-11 is not convincing enough.