With unaccustomed high drama, the Institute of Chartered Accountants of India (Icai) strode into the sunset of 2007-08, and pulling its revolver from its holster, shot at the market with a silver bullet.
Accounting Standard 30 (AS-30) will be applicable from the fiscal year ending 31 March 2008, it said, which gave companies all of one day to restructure their accounts to build in this requirement.
And what a requirement it is! With hundreds of companies huddled in bunkers and/or firing legal salvos at banks, there is little clarity as to the fate of several thousand crores of derivatives contracts. Who is responsible? Who has to make a provision? And, equally contentious, what is the genuine mark to market (MTM) of a particular contract?
I suppose that while the answer to the first question remains in doubt — some cases are sub judice; and in many cases, companies and banks are engaged in discussions/battles — auditors will have little doubt about the answer to the second one. Given the nature of auditors, they will require both parties to at least make a provision. Certainly, companies will need to provide or disclose potential MTM losses and, where there are disagreements, banks may be required to provide for credit losses as well.
And then, of course, there’s the third question — who is to determine what is the real MTM value of a particular contract? And, here’s where Icai’s silver bullet turns to smoke (and mirrors).
Derivatives valuation is a specialized subject and most audit firms in India do not have the necessary skills to value many of the complex-structured products that have been doing the rounds. Equally, given the volatility of markets and the complexity of some of the derivatives on companies’ books, different valuers can come up with totally different numbers for the same derivatives. Since many of these are not liquid products, the values cannot be double-checked with a market price, which would mean that the auditors may be hard-pressed to require a certain provision or write-down.
As an example, we are currently doing a valuation exercise for a large IT company. While the company does not have any complex products, it does have some option contracts that run out to five years to hedge its long-term US dollar receivables. In some cases, we found substantial differences between our valuation and the valuations provided by the company’s bank; we analysed our processes from first principles and ultimately found that the only possible reason for this variation could be that we used different long-term forward rates than the bank did. Now, given that there is no liquid long-term forward market, the calculated forward rates would depend, among other things, on the bid-asked spread used by the bank, which is, again, a non-market number — i.e., different banks would use different spreads, resulting in different forward rates and different valuations, which, indeed, is what we found.
After considerable explanation, the company’s auditors accepted our valuation methodology and agreed to permit the company to use our valuations for their accounts, even though they differed — in some cases, substantially — from valuations provided by the banks.
This raises an important structural issue for auditors: how to — or, indeed, whether to — use valuations provided by banks.
In most instances, auditors look to an outside source to confirm a value (of an asset or liability) asserted by the company. Where the company asserted a lower value for a liability than an outside source, most auditors would be inclined to question it and, often, require a larger provision.
However, in the case of derivatives valuations, banks are the counter-parties to these transactions. Thus, it would be in the banks’ interest to show a higher liability value (since they would, of course, like to square the transaction at a larger gain to themselves); thus, their valuations — without ascribing any villainy whatsoever — would suffer from a structural conflict of interest and, in my view, should not be used to determine provisions or write-downs.
I am pleased that the auditor in the current case has agreed with us, although this example points up the complexities of the issue, particularly since the situation can get much more complicated when there are structured products in the portfolio. While there are black box models that can be used to value some of these — swaps with knock-outs, knock-ins, tarns, snowballs, etc. — valuing some structures could take as much as two or three hours; again, there are some structures which even the most highly skilled derivatives banks have to send overseas for valuations. And again, since there are always a lot of assumptions in the modelling — notably on market liquidity — there can often be huge variations in valuations from different sources.
Clearly, one of the lessons for auditors (and investors and rating agencies) is that understanding derivatives valuations can often be crucial to understanding value.
Jamal Mecklai is chief executive officer of Mecklai Financial and Commercial Services Ltd. Comment at firstname.lastname@example.org