March 31, 2009

Fantasy accounting

I recently read the news on suspending AS11 accounting standards for the next 2 years in view of the dramatic changes in international markets. In the last one year, the rupee has suddenly depreciated from 40s level to 50s declining by more than 20% during this period. Most of the companies were caught by surprise as they did not expect the rupee to depreciate so sharply and hence are facing MTM (mark to market) losses for the current year.

AS11 is a standard for recognizing impact of forex changes on the company’s accounts. I have the discussed impact of forex changes in my discussion of NIIT tech. I have said the following in the past

The current quarter results show a bottom line drop of around 50%, mainly due to forex losses. I do not consider them as core losses (just as forex gains are not permanent gains). I have seen a lot of people get all worked up about forex losses, which does not make sense to me.

Unless the company is speculating on forex (via non effective hedges), I think the forex gains and losses should even out over the period of few years and hence one should be concentrating on the core profits to value the company.
As an example look at the results of the airlines such as southwest (in the US). Southwest airlines has been consistently profitable for the last 20+ years. They have had 2-3 quarters of hedging related losses due to oil price volatility. Do you think they have a problem in their core operations?

So if I have considered these losses to be temporary, akin to a bad bet, then why am I not applauding this temporary suspension of the standards?

The reason is simple – I want my companies to give me the true picture. Don’t fudge, whitewash or hide information from me (as an investor). Please tell me the whole truth and leave it to me to judge the impact of it. As investors we are smart enough (as a group) to judge the impact of forex changes on the long term economics of the companies and don’t need the companies to whitewash this information for me.

Now that we are in the territory of fantasy accounting, I have a few more proposals

- Ignore cost increases of raw material when they become too high. When steel prices increase sharply, all auto and other companies should be allowed to ignore price increases
- Ignore manpower costs and salary hikes. Allow all IT companies to ignore salary hikes in excess of 5%.
- Ignore depreciation after a huge capex. Whenever the company puts up a new plant or makes a big accquisition, allow it to ignore depreciation and amortization expenses

I could go on and on. The above change is self serving and will only muddy up the numbers. It allows the companies to present the numbers in a good light and ignore reality. Is it a given that the rupee will appreciate to 40s level in 2 years and all will be great in the fantasy land?

I personally don’t care what companies report by suspending AR 11 for 2 years. I will personally adjust the numbers of the companies I have invested in or plan to, based on the forex changes.

I really wish I had this flexibility when I was studying !! I would have asked the examiners to ignore all the question I got wrong and I would have always got 100% in all my exams :) . Life would have been good !!


mkd said...

Keeping the ethical angle aside of AS 11, I wonder if we are not postponing a smaller problem today for a much bigger problem tomorrow.

With government deficits running high, and international markets unpredictable and risk-averse - tomorrow's currency is anyone's guess.

More people seem to be guessing towards a much more weaker rupee unless the government mends its way (is it really possible?)

Now, one of the first revisits to do in a portfolio is forex exposure. Everyone seems to be obsessed with forex earning companies (IT et al) while focus should equally be on forex debt companies (FCCB candidates?)

Puneet Kapoor said...

I agree with your assessment of the change in accounting standard. Well written. However, you have referred to a previous post on NIIT Tech which I couldnt locate. You may like to insert a link when referring back in such a manner.

VISHNU said...


Mark to Market per se is not dangerous since its just a number. Those who worry about CASH flows doesn't bother about Mark to Market.

But it can be lethal for institution like Banks which depends on Trust. A simple mark to market losses in a quarter (again a number) is enough to drive out depositors and it can wipe out the bank in turn the whole banking system collapses.

What I dont understand is why not people abolish the whole exotic derivatives in the first place ?. Its better for lot of companies if they dont involve in derivatives. In long term effect of derivatives on the profit & loss will be neglible (negative if you include the cost to hold the instrument)


Anonymous said...

In fact Rohit its worse than just ignoring the facts by suspending AS11.
1. Corporates have lobbied hard to transfer P&L mark-to-market losses from their income statements to the balance sheet. This fudges their quarterly earnings numbers which we all know tie up with salary hikes, bonuses and the like.
2. Firstly lets invert - would these same corporates have lobbied for the scrapping of AS11 if they had made M-to-M forex gains - NO! Like you said their logic is to count the profits when they occur and ignore the losses by changing the rules. Sounds like heads I win, tails you lose.
3. By reducing their balance sheets and inflating their profits commonly used metrics in valuations are boosted. By reducing the capital base through a neat balance sheet transfer of losses, watch how the numerator in ROE/ROIC goes up and the denominator Equity/Invested Capital goes down creating an artifically inflated ROE/ROIC number.
4. Would be curious to know which financial wizards are "cheating" their investors of the true pictures. I would be skeptical in fact of these companies who will use AS11 suspension to their advantage. Let that list be published by SEBI for investors.


Anonymous said...

आपके विचार बहोत उत्तम है

Anonymous said...

In fact yesterday they approved same thing in US Congress for US Corporates too ! Let's wait for another bigger market doom after the coming Bull Run !!!

Rohit Chauhan said...

Hi mkd
I think the problem will exist irrespective of whether corporates recognize them on the books or not. this suspension of AR11 is just fudge the numbers. this especially due to some companies which have large forex based loans and could be forced to take losses on their annual results


Rohit Chauhan said...

Hi puneet
you can do a search for NIIT tech on the blog. however i will add a link when i refer to such posts.

i dont think MTM losses are book entries alone. they are cash losses. In the interimn MTM losses are book entry, however when the hedge expires, the contracts have to be squared and the losses paid or gains recieved.
so i would say MTM losses do represent losses if they have to be closed immediately.
I will not read too much into an MTM loss, but if excessive they add to the risk. look at the case wockhardt ..their high debt and MTM losses have put them in trouble. so i would say MTM losses are a risk for non banks too


Rohit Chauhan said...

Hi khali_pili_lafda
you hit the nail on the head. there were no complaints and lobyying when these corporates were making money on these hedges when the bets have turned bad, they want AR11 to be suspended.
also i was surprised to read that some companies such as reliance dont even follow AR 11. did not know that this was voluntary of corporate governance standards !!

Rohit Chauhan said...

Hi anon2
not sure if suspending MTM accounting will create another bull run. i think investors are not wisening up and will read between the lines and not pay for such hidden losses


VISHNU said...

Hi Rohit,

Thats correct. But If they square off contracts , then it should be losses correct ? (why they are calling it mark to market losses ?)

In wockhard case it is not currency forward contracts , it is FCCB, in this case they really needs to pay interest in foreign currency ( I am still dont know why they are calling this as Mark to Market)

Another interesting point here is shifting of losses to balance sheet from P&L. Whenever the currency flucuation works in their favour they put it in P&L (higher salary for CEOs bases on Profit) and when they hit with losses they put it in Balance sheet (No need to reduce the salary)

If you look at the paper trail of past actions of Insiders (not to count intrinsic value) you will find different kind of personalities.

(I have changed my style to look at footnotes first before looking at AR)