Lost and Found - No truth in "Satyam"

Fatal Wednesday proved to be too fatal for Satyam today.What started in a simple merger , has blown out of proportion and has exposed India's "Enron" along with our own "Aurthur Anderson".

The Revelations and confessions made today has rocked the world along with our "already" Brittle market indicator SENSEX, which went into a free fall mode and plunged over 7% based on these.

It is an irony that Satyam was the 2008 winner of the prestigious "Golden Peacock Award for Corporate Governance". The shares of the company dipped to an all time low of Rs.30.80 today and ended at Rs.40.25.

The Great Indian Accounting Scandal

Today the 7th of Jan 2009 Mr. Ramalinga Raju of Satyam Computers resigned after admitting to an Accounting Fraud.  The ball was set in motion when the company stared at failure to Acquire Maytas Infra and after outcry from various public outfits (especially the Media) the deal was called off. This forced the management to give explanations for the gaps in the Balance Sheet and eventually things unfolded to reveal that Satyam’s balance sheet as on Sep 30, 2008,

-  Carried an non-existent(inflated) cash and bank balances of Rs.5,040Cr.

- It carried an accrued interest of Rs 376 crore which was non-existent. 

- An understated liability of Rs 1,230 crore on account of funds was arranged by Mr. Raju. 

- An over stated debtors position of Rs 490 crore.

- All together taking the tally to Rs.7,136 Crores. 

On the same BS date, the company reported a revenue of Rs.2,700Cr. when actualls were Rs.2,112Cr. and a operating Margin of around Rs.650Cr. when the actuals were Rs.61Cr.

Causality

This term denotes a necessary relationship between one event (called cause) and another event (called effect) which is the direct consequence (result) of the first. And with due reference to the above this relationship holds good with the Multi Year fraud that has been revealed. According to Mr. Raju, "What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew significantly"

Effects

Due to the above problem, the management was forced to take necessary action and thats when Maytas came into the picture. Maytas Infra is held by Mr. Raju's sons and Satyam worked out a deal where Satyam Computers would have paid at least Rs 5000 crore to acquire the Maytas companies from the promoters (Mr. Raju's Sons). The money was non-existent. So, it would have pretended to pay the money and ended up with the assets (the two Maytas companies). The promoters may have never got paid but that would have served them right.

Put in layman terms - Mr. Raju instead of making a gift deed and making things in the public,he went to do the same thing abiding all company laws. But his plans saw a dead end when the deal was forced to be called off amidst an outcry from media and analysts. This resulted in the Beginning of the End of Mr. Raju and today he has resigned and accepted his Fraud in public.

What Could have been - Mr.Raju's Point of View

If the Deal with MAYTAS had gone through then everything would have been alright - Satyam would have filled the BS with assets that it would gain from the supposed "takeover". Then real assets would appear in its books instead of non-existent cash; the Raju family would have continued to manage Satyam, even if it meant that they have to lose a few crores..and investors would have still have a chance to get their money back, Fortunately or Unfortunately That didnt happen.

To top this all off PWC - the auditors of Satyam have been aiding this from the beginning..Hats off to all you guys at PWC..You have just destroyed the life of a few million people.

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Repo Rates - Unfolded

What is it ?

The repurchase or repo rate is the interest rate at which the Reserve Bank lends money to private banks. The Reserve Bank acts as banker for private banks. Banks experience a cash shortfall or a need for liquidity on a daily basis and their lender of last resort is the Reserve Bank. A formal system is in place to guide the process through which banks borrow from the Reserve Bank and it is called the repurchase transactions system (repo system for short). The repo system of borrowing and lending involves the temporary sale of a financial asset by the borrower (bank) in exchange for the needed cash from the lender (Reserve Bank). In such a transaction, there is an explicit agreement that the borrower must repurchase the financial assets at an agreed future date – currently after one week. The repo rate is determined by the Reserve Bank at each meeting of its Monetary Policy Committee. It is expressed as a rate per annum. The repo rate serves as a benchmark for the level of short-term interest rates. 

How Does it deal with Inflation ? 

If the repo rate increases, banks have to pay more for repo funds. To maintain their existing profit margins, banks raise the interest rates at which they take deposits from and lend money to their customers. This causes a general rise in interest rates or the cost of holding money, and this eventually helps to control inflation by reducing the demand for credit to be spent on the purchase of goods and services. The actions of the Bank described here are also known as the formulation and implementation of monetary policy.

Accounting system for Derivative Losses

Recent derivative losses in India have brought the issue of accounting of derivatives into spotlight. Unfortunately, AS-30, ‘Financial Instruments – Recognition and Measurement’, which is the same as IAS 39, is mandatory only from 2011. 

As per these standards, derivatives are not treated as off-balance-sheet items, rather they are marked to market. 

The consequent gain or loss is recognised in the income statement. Alternatively, the gain or loss may be applied for purposes of hedge accounting. 

For example, an importer with April-March financial year may have a dollar obligation on January 1 to be paid after six months on purchase of raw materials. To hedge this position, a forward contract to sell rupee and purchase dollar at end of six months at a particular forward rate, is entered into. This locks the importer’s obligation to a stated rupee amount. 

Now for the March 31 year-end financial statements, the importer would have to mark to market the derivative. 

This exercise would reveal that the importer may have made an unrealised gain or loss. If hedge accounting is applied, such gain/loss need not be recognised in the income statement; rather they can be kept in a separate account, under Reserves and Surplus. 

Such gains/losses are recycled to the income statement only when the actual purchase takes place (three months later). This process ensures that financial results are not volatile, as the changes in the value of the hedged item and the hedge instrument are appropriately matched from a timing perspective. 

One of the conditions for being able to apply hedge accounting is that the hedge instrument should not have features that make it very exotic or speculative. If the hedge instrument is speculative, then the mark to market gains/losses have to be compulsorily recognised in the income statement. 

New feature 

One such exotic arrangement is the barrier option with a ‘knock-in knockout’ feature. Ordinary FX options provide the buyer with an unlimited upside and a known downside, that is, the premium. 

The knockout feature limits the upside given to the buyer and, therefore, makes the option considerably cheaper. 

When an investor purchases an ordinary FX option, the payout depends on where the spot rate closes on a particular day (the maturity). With the knockout feature, if at any time up to and including the maturity, the knockout level is reached, the option will expire worthless. 

An importer may have the view that the dollar will strengthen against the rupee over the next six months (current spot 40). They purchase an ordinary six month dollar call option at a strike of 40. This would cost 3.50 per cent. The alternative is to purchase a dollar at the money call (40) with a knockout at 44. This would reduce the premium to only 1 per cent with the following result. 

If the dollar does strengthen but trades above 44 over the life of the option, the call will expire worthless. If the dollar strengthens, but never reaches 44 over the life of the option, the call will behave like an ordinary call and the investor will exercise the call and make the same profit as the ordinary call. If the dollar does not close above the call strike (40), the option will expire worthless like an ordinary option. 

As the option buyer is giving up some upside by having the knockout feature, the premium is reduced dramatically. As the option can be knocked out at any time over the life of the option, the knockout feature is very sensitive to the volatility of the underlying instrument. It is more sensitive than an ordinary option. This explains the dramatic reduction in premium. 

However, it comes with the risk that the contract would be rendered useless. If the importer has a liability of $100 million and the dollar trades at 45 at the end of six months, the Rs 4,000 million liability will be increased to Rs 4,500 million; a loss of Rs 500 million. 

Whilst the knockout could potentially render the contract useless, a feature called knock-in makes a contract useful only if a barrier is broken. As the option is dead until it knocks in to life, the premium is reduced drastically. However if the barrier is not broken, the importer would stand exposed to a foreign exchange risk. 



Fresh currencies 

Many Indian corporates had taken positions in forex derivatives with low yielding currencies like Swiss (CHF) and Japanese Yen (JPY) as the underlying. These currencies were not only chosen because of their low yields, but also due to their perceived stability against the dollar, a phenomenon the corporates hoped to profit through participation in barrier options, despite stringent RBI policies. However, the significant appreciation of these currencies against the dollar exposed the corporates to significant losses. 

Such exoticness in derivatives is expected to have a major negative impact on the results of Indian corporates. Further as the instruments used are generally speculative, the conditions of hedge accounting are often not met, consequently, the unrealised gain/loss on the derivative position cannot be deferred to future periods to be offset against the underlying hedge item. 

Because of the potential of huge derivative losses remaining unaccounted for, the ICAI issued an Announcement requiring recognition of losses on derivatives based on “Prudence” principles of AS-1. Unfortunately, the concept of “Prudence” does not sit well with the ICAI’s other standards such as AS-11, which requires both fair value gain/loss to be recognised in respect of speculative foreign exchange forward contracts or AS-30, where both gain/loss is required to be recognised. 

Marked to what? 

Valuation of derivatives, particularly long-term derivative products, many of which could be proprietary products of banks, may be difficult to value, as they are highly illiquid instruments. The Announcement requires them to be marked to market. How can they be marked to market, when there is no market for such instruments? These instruments may have to be valued as per a model. One cannot rule out the possibility that an expert may opine that a reasonable valuation is not possible. What should be response of the companies and the auditors in such a situation? 

For an Announcement of this nature, adequate time should have been given for its implementation. Considering it took US more than a decade to develop a standard on financial instrument, it seems very unreasonable to ask Indian companies to implement these principles at such short notice. The Announcement has also not gone through the due process of law, which requires Accounting Standards to be notified in the Companies (Accounting Standards) Rules. 

Implementation issues 

There are other critical implementation issues, which companies are grappling with. Are losses to be determined based on category of instruments or on an individual contract basis? Are losses to be determined after considering the offsetting effect of the underlying hedge item? What happens if the liability is being disputed with the banks on the ground that the contract is a wager? 

Whilst the basic intent behind the Announcement is noble, the manner in which it has been executed is inappropriate. May be an appropriate approach would be to require disclosure of derivative losses only in the initial years, and simultaneously the mandatory date of applicability of AS-30 could be advanced from 2011 to 2009.

P.S - This is a copyrighted material and is posted here for the Benefit of the student Community

Differences Between UK GAAP and US GAAP

Differences between UK and US generally accepted accounting principles 

The Group prepares its financial statements in accordance with generally accepted accounting principles in the United Kingdom ('UK GAAP') which differ from those generally accepted in the United States ('US GAAP'). The following statements summarise the significant adjustments which reconcile profit on ordinary activities after taxation and equity shareholders' funds under UK GAAP to the amounts which would have been reported had US GAAP been applied.

Profit on ordinary activities after taxation	Notes	1997 £m	1996 £m	1995 £m
Profit on ordinary activities after taxation as reported in the Group profit and loss account under UK GAAP		240.8	220.8	196.1
Significant adjustments :
- pension costs	(a)	10.4	5.2	10.2
- Hyde closure provision	(b)	(1.8)	8.3	-
- capitalisation of interest (net of amortisation)	(c)	(0.3)	(0.3)	(0.2)
- deferred taxation	(d)	-	(0.2)	(1.7)
- disposal of operations		-	-	11.0
- other, net		-	-	(0.3)
Net income under US GAAP		249.1	233.8	215.1
Earnings per ordinary share under US GAAP		36.4p
Earnings per ADS under US GAAP (each ADS represents four ordinary shares)		145.6p

Equity shareholders' funds	Notes	1997 £m	1996 £m	1995 £m
Equity shareholders' funds as reported in the Group balance sheet under UK GAAP		(540.8)	295.3	826.0
Significant adjustments :
- increase in non-current pension assets	(a)	111.6	100.2	99.0
- decrease in non-current liabilities for the Hyde closure provision	(b)	9.2	12.2	-
- increase in tangible fixed assets for capitalised interest	(c)	4.5	3.5	3.7
- increase in non-current liabilities for deferred taxation :
increase in – methodology	(d)	(2.2)	(2.2)	(2.1)
increase in - on adjustments		(53.8)	(36.9)	(39.6)
- decrease in current liabilities for proposed dividend	(e)	66.4	-	-
- decrease in current liabilities for ACT on proposed dividend	(e)	16.6	-	-
- other, net		-	1.6	2.3
Equity shareholders' funds under US GAAP		(388.5)	373.7	889.3

Consolidated statement of cash flows	Notes	1997 £m	1996 £m	1995 £m
Set out below is a summary consolidated statement of cash flows under US GAAP :	(f)
- cash inflow from operating activities		307.0	132.5	218.3
- cash (outflow) / inflow from investing activities		(44.9)	(28.1)	68.8
- cash outflow from financing activities		(284.2)	(32.4)	(426.3)
(Decrease) / increase in cash and cash equivalents		(22.1)	72.0	(139.2)

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Notes to differences between UK and US generally accepted accounting principles :

(a) Pension costs

Under UK GAAP, pension costs are determined in accordance with the UK statement of standard accounting practice ('SSAP') no. 24, with costs being expensed over employees' working lives. Under US GAAP, pension costs are determined in accordance with the requirements of the statements of financial accounting standards ('FAS') nos. 87 and 88. US GAAP requires valuation of plan assets and obligations based on the fair value of plan assets and assumed discount rates in measurement of plan objectives. UK GAAP requires valuation based on actuarial long-term assumptions of both asset values and expected rate of return on liabilities. Gains and losses under US GAAP are amortised on a straight-line basis whereas under UK GAAP these items are amortised as a level percentage of pensionable pay.

(b) Hyde closure provision

Under UK GAAP, the Hyde closure provision included an amount for additional depreciation as permitted by SSAP no. 12 (revised). Under US GAAP there is no impairment as described under FAS no. 121.

(c) Capitalisation of interest

Under US GAAP, interest incurred as part of the cost of constructing fixed assets is capitalised and amortised over the life of the qualifying assets in accordance with FAS no. 34. In accordance with common UK practice, Gallaher does not capitalise such interest in its financial statements.

(d) Deferred taxation

Under UK GAAP, deferred taxation is only accounted for to the extent that it is probable that taxation liabilities or assets will crystallise in the foreseeable future. Under US GAAP deferred taxation is accounted for on all temporary differences and a valuation allowance is established in respect of those deferred taxation assets where it is more likely than not that some portion will not be realised.

(e) Ordinary dividends

Under UK GAAP, the final ordinary dividends and related ACT are provided in the financial statements in the year in which they are proposed by the board for approval by the shareholders. Under US GAAP, dividends and related ACT are not provided for until declared.

(f) Cash flows

The consolidated statement of cash flows presented under UK and US GAAP present substantially the same information but may differ, however, with regard to classification of items within the statements and as regards the definition of cash and cash equivalents.

Under US GAAP, cash and cash equivalents do not include bank overdrafts and borrowings with initial maturities of less than three months. Under UK GAAP, cash flows are presented separately for operating activities, returns on investments and servicing of finance, taxation, capital expenditure and financial investment, acquisitions, equity dividends and management of liquid resources and financing. Under US GAAP, however, only three categories of cash flow activity are reported: operating, investing and financing. Cash flows from taxation and returns on investments and servicing of finance shown under UK GAAP are included as operating activities under US GAAP. Capital expenditure and financial investment and acquisitions and disposals are included as investing activities under US GAAP. Under US GAAP, capitalised interest is treated as part of the cost of the asset to which it relates and is thus included as part of investing cash flows. Under UK GAAP, all interest is treated as part of returns on investments and servicing of finance. The payment of dividends and cash flows associated with bank overdrafts and short-term borrowings are included under financing activities and changes arising from the management of liquid resources are treated as either financing activities, investing activities or as an activity within cash and cash equivalents under US GAAP.

P.S - This is a copyrighted material and is posted here considering the benefit of the fellow students.No offence is intended towards anyone.

The Great Financial Fiasco

This is what has happened in our global markets guys..more so in the US than any where in the world..All the faith in the reporting standards has been shattered and i pray that the so called "growth" in our country-INDIA is not based on such a accounting and reporting systems!!!
We have basically built our foundation on BPOs and KPOs,the orders for which have been consistently copming in from the US again and when the recession has hit them,so it will hit us..Im not indicating that there will be a negative growth rate but the fact remains that our growth rate is slowing down as im updating this blog..im sure that it will hover somewhere around 6% to 7% this year but we have to keep in mind that the we are yet to face repercussions of the recession that the US is going through...
we are just starting to face this problem of shortage of income and i do pray that our fundamentals are strong enough and the reporting systems arent being misused for making book profits rather than actuals.