With the sharp depreciation of the rupee in September this year, many companies have suffered huge accounting losses, as a result of marking their export hedges to market, as required under accounting rules.

It is important to understand that the accounting entry has nothing whatsoever to do with the actual cash flows of the company. It is simply a measure of how much in or out of the money the company’s hedges are. Consider a company that had a budget rate for exports of, say, 45 to the dollar, and it hedged its exposures at a rate of, say, 46. Thus, it had protected its budget rate and, indeed, had improved its margins (as compared to budget) through hedging. However, with the rupee having fallen sharply in September to near 50 to the dollar, its quarter-end accounts would show a huge FX loss. Note, as I have mentioned, that this does not change the fact that the company has actually improved its margins by hedging.

If the rupee had strengthened to, say, 44, instead of weakening as it did the accounting entry would have shown a gain. Again, this would have nothing to do with the actual cash flows of the company.

Narayan Murthy said it best: Cash is real; profits are an opinion.

The accounting entry is merely a measure of market movements vis-a-vis the company’s hedges taken, and will always be non-zero. If the rupee weakens after the company hedges, it will be negative; if the rupee strengthens, it will be positive. The only instance in which the accounting entry would be zero is if the company doesn’t hedge at all – a highly risky approach.

In the example above, if the company had taken no hedges at all, its cash flow would have been better by a substantial amount (the amount of the FX loss); however, if the rupee had strengthened, its cash flows would have been worse, and may even have fallen below the budget levels. Note that for unhedged imports, while there is no FX loss, there is a substantial potential cash loss, if the rupee remains at current levels.

The essence of effective risk management is to ensure that budgeted margin levels are protected, even if it means giving up some upside.

The impact of the MTM of outstanding hedges on the accounts needs to be properly explained to all stakeholders – hence this note. Importantly, this quarter on quarter effect on P&L could be reduced if the company adopts AS 30. Given below are the differences in the accounting treatment of outstanding hedges under AS 11 and AS30.