GAPS in GAAP – Borrowing costs – PAra 4(e) of as 16

AS 16 requires borrowing costs incurred on construction of qualifying assets to be capitalised. Paragraph 4 of AS 16 contains an inclusive list of what borrowing costs may include. Sub-clause (e) of Paragraph 4 states: “exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs”. This requirement is explained in the Standard with the help of an illustration which is also reproduced below.

Illustration in AS-16 on exchange differences that are regarded as an adjustment to interest cost

XYZ Ltd. has taken a loan of $ 10,000 on 1st April, 20X3, for a specific project at an interest rate of 5% p.a., payable annually. On 1st April, 20X3, the exchange rate between the currencies was Rs. 45 per $. The exchange rate, as at 31st March, 20X4, is Rs 48 per $. The corresponding amount could have been borrowed by XYZ Ltd. in local currency at an interest rate of 11 % per annum as on 1st April, 20X3.

The following computation would be made, to determine the amount of borrowing costs for the purposes of paragraph 4(e) of AS 16:

i. Interest for the period = $ 10,000 × 5% × Rs. 48 $= Rs. 24,000.
ii. Increase in the liability towards the principal amount = $ 10,000 × (48-45) = Rs. 30,000.
iii. Interest that would have resulted if the loan was taken in Indian currency = $ 10000 × 45 × 11% = Rs. 49,500
iv. Difference between interest on local currency borrowing and foreign currency borrowing = Rs. 49,500 – Rs. 24,000 = Rs. 25,500

Therefore, out of Rs. 30,000 increase in the liability towards principal amount, only Rs. 25,500 will be considered as the borrowing cost. Thus, total borrowing cost would be Rs. 49,500 being the aggregate of interest of Rs. 24,000 on foreign currency borrowings [covered by paragraph 4(a) of AS 16] plus the exchange difference to the extent of difference between interest on local currency borrowing and interest on foreign currency borrowing of Rs. 25,500. Thus, Rs.49,500 would be considered as the borrowing cost to be accounted for as per AS 16 and the remaining Rs. 4,500 would be considered as the exchange difference to be accounted for as per Accounting Standard (AS) 11, The Effects of Changes in Foreign Exchange Rates.

In the above example, if the interest rate on local currency borrowings is assumed to be 13% instead of 11%, the entire exchange difference of Rs. 30,000 would be considered as borrowing costs, since in that case the difference between the interest on local currency borrowings and foreign currency borrowings [i.e., Rs. 34,500 (Rs. 58,500 – Rs. 24,000)] is more than the exchange difference of Rs. 30,000. Therefore, in such a case, the total borrowing cost would be Rs. 54,000 (Rs. 24,000 + Rs. 30,000) which would be accounted for under AS 16 and there would be no exchange difference to be accounted for under AS 11.

Author’s Note: As can be seen, the illustration is oversimplified and does not provide adequate guidance; for example, there is no guidance with respect to:

1. Whether an entity has a choice to assess the interest rate differential when the loan is drawn or at each reporting date? From the illustration, it appears that the interest rate differential is based on the date when the loan is drawn and not at each reporting date.
2. How is interest rate differential determined in the case of a floating rate loan?
3. Are exchange gains required to be considered as an adjustment to borrowing costs?
4. How to deal with exchange gains that follow a period of exchange losses? In such cases, should the exchange gains be treated as an adjustment to exchange losses or should it be fully recognised in the P&L?
5. Consider an example, where the interest rate differential at inception of borrowing is Rs. 1,000 and at the end of the reporting period there is exchange gain of Rs. 5,000. In this scenario, the author believes that it would be appropriate to conclude that there is no interest rate differential; rather than considering borrowing cost of Rs. 1,000 and notionally increasing the exchange gain by Rs. 1,000 to Rs. 6,000.

Why is para 4(e) a problem?
The idea of including paragraph 4(e) in AS-16 was a simple one. Indian companies borrowing in $ borrow at a much lower interest rate than borrowing in Indian Rupee. However, correspondingly because of the exchange rate movement, the $ loan liability increases, and results in the savings on account of low $ interest rates, being eroded. In a very simple world, and if IRP theory worked perfectly, then there would be a 100% offset. In other words, it is logical to see the exchange difference, as an interest cost to borrow the funds. Such 4(e) interest costs are allowed to be capitalised if they were incurred on the construction of a qualifying asset. 4(e) interest costs that are not incurred for the purposes of constructing a qualifying asset are to be charged off to the P&L account.

Companies that were constructing a qualifying asset and had borrowed in foreign currency are required to determine the 4(e) component, so that the same can be capitalised in accordance with AS 16 (4(e) component is capitalised only during the period of construction of a qualifying asset). Computing 4(e) was a problem, but was limited to situations where a qualifying asset was being constructed for which a foreign currency borrowing was used. 4(e) is now a much bigger problem, for two additional reasons.

1. AS-11 was amended to include paragraph 46 and 46A, which allowed an option of not charging foreign exchange differences on long term borrowings to the P&L a/c. The exchange differences could be amortised over the loan period, and if related to a loan for acquiring a capital asset, then the same should be capitalised as cost of the capital asset, even after the asset was put to use. The Institute of Chartered Accountants of India issued “Frequently Asked Questions on AS 11 notification – Companies (Accounting Standards) Amendment Rules, 2009 (G.S.R. 225 (E) dt. 31.3.09) issued by Ministry of Corporate Affairs”. In the said guidance, it was clarified that 4(e) interest should not be treated as foreign exchange difference. Consequently, 4(e) component is to be (a) capitalised only during the period of construction of a qualifying asset in accordance with AS-16 (b) charged to the P&L in all other cases.

2. The Ministry of Corporate Affairs issued circular no 25/2012 dated 9th August, 2012 clarifying that paragraph 4(e) of AS-16 shall not apply to a company which is applying paragraph 46A of AS-11. The circular has withdrawn 4(e) with respect to paragraph 46A, but not with respect to paragraph 46 of AS-11. There are a number of questions with respect to the circular. For example, does it have a prospective or retrospective application? Is it a clarification or a substantive amendment? Will 4(e) continue to apply to companies that were in paragraph 46?

3. Revised Schedule VI requires 4(e) component to the extent not capitalised to be separately disclosed in the P&L a/c as part of borrowing costs.

IRP Theory

How well does IRP predict Exchange Rate Movements in India?

Not so well, is the short answer. Menzie Chinn says, “Uncovered interest parity (UIP) has been almost universally rejected in studies of exchange rate movements.” Paul Krugman says, “Like stock prices, exchange rates respond strongly to ‘news’, that is to unexpected economic and political events, and like stock prices, they therefore are very difficult to forecast.”

As per the IRP theory, in countries which have higher interest rates, their currencies should depreciate. If this does not happen, there will be cases for arbitrage for foreign investors till the arbitrage opportunity disappears from the market. The reality is sometimes exactly the opposite; as higher interest rates could actually bring in higher capital inflows further appreciating the currency. In such a scenario, foreign investors earn both higher interest rates and also gain on the appreciating currency.

In reality, predicting currency movement is crystal gazing as it is affected by numerous variables, other than interest rate differential. These variables are discussed below.

Balance of Payments (BOP): BOP play’s a critical role in determining the movement of the currency. It is the aggregate of current account and capital account of a country like an external account of a country with other countries. Current account surplus means exports are more than imports and current account deficit means imports are more than exports. Eventually, import/export prices find equilibrium. Hence, the currency of a current account surplus country should appreciate. Likewise for current account deficit countries, the currency should depreciate. Growing Indian economy has led to widening of current account deficit, as imports of both oil and non-oil have risen. Gold imports have also added to the problem in India. Capital flows also play a crucial role in the BOP situation of India. Currency appreciates when there are huge capital inflows and depreciates when the capital inflows dry up and the current account deficit is also high. During the Lehman crisis, capital flows shrunk sharply from a high of $106.6 billion in 2007-8 to just $6.8 billion in 2008-09 and led to sharp depreciation of the rupee from around Rs. 39.9 per $ to Rs. 51.9 per $.

Inflation: Higher inflation leads to central banks keeping interest rates high, which invites foreign capital on account of interest rate arbitrages. This could lead to further appreciation of the currency. However, one needs to make a distinction between high inflation over a short term versus a long term. If inflation is short-term, foreign investors see inflation as a temporary problem and continue to invest in that economy. If inflation is sticky, it leads to overall worsening of the economy, capital flows and exchange rate. For almost two years now, inflation in India has been very high and persistent, resulting in a highly depreciating rupee. The present situation is different from the situation in 2007-08 when despite high inflation and high interest rates, capital inflows were abundant. This was because markets believed that inflation was not a structural problem.

Fiscal Deficit: Fiscal deficits play a key role in the determination of exchange rates. Higher deficits imply that government might resort to using foreign exchange reserves to fund its deficit. This leads to lowering of the reserves followed by speculation on the currency. If the government does not have adequate reserves, fall in the currency is imminent. In India, higher fiscal deficits have also played a role in shaping expectations over the currency rate. When the fiscal deficits are high, investors become nervous, reducing the capital inflows into the country.

Global economic conditions: In times of high uncertainty as seen lately, most currencies usually depreciate against US Dollar as it is seen as a safe haven currency. The South East Asian crisis and the recent Euro crisis stand evidence to that. Currently, the markets believe that the dollar is safer than the euro, given the economic problems of the euro zone. Global economic conditions have significantly impacted exchange rates in India.

Lack of reforms: This has further made investors negative over the Indian economy and coupled with global uncertainty, has put pressure on the Indian Rupee.

Speculation: There has been a fall of 22.7 % (in value of rupee against dollar) in four months – from Rs. 44.35 in end July 2011 to Rs. 54.4 on 31st December, 2011. Importers, having been lulled into complacency by the rupee’s appreciation earlier, rush to cover their exposures, thus driving up dollar demand. Exporters hold on to their earnings in foreign currency in the hope of a further fall in the rupee.

Measures by RBI : They have also made marginal impact in terms of arresting a downslide on the rupee. However, this is a short term measure.

Hence, even over a longer term, multiple factors determine an exchange rate with each one playing an important role over time. In a calm and stable world, IRP theory may work. Unfortunately, this is never the case. Exchanges rates behave erratically, and are caused by numerous factors other than interest rate differentials. Consequentially, exchange losses may represent more or less matching interest rate differential in a few cases only. In India, experience is that, exchange losses may be far more than the interest rate differential when rupee is sliding down and in other cases, there may be a huge exchange gain in which case, the interest rate differential would have had little or no impact on the exchange rate. Much would depend on when the borrowings took place and the exchange rate movement from thereon till redemption of the loan.

Author Sarbapriya Ray in the paper “Testing the Validity of Uncovered IRP in India” concludes as follows – “One vital potential issue determining the exchange rate is the uncovered interest rate parity (UIP). Uncovered interest parity (UIP) is a typical subject of international finance, a critical building block of most theoretical models, and a miserable empirical failure. Uncovered interest rate parity (UIP) states that the nominal interest rate differential between two countries must be equal to expected change in the exchange rate. In other words, if UIP condition holds, then high yield currencies should be expected to depreciate. The article attempts to test the validity of uncovered interest rate parity based on a theoretical formulation in line with economic theory. Although KPSS test suggests that excess return series are in stationary process, excess return curve shows erratic behaviour during some months of our study period (showing negative trend) which automatically excludes the possibility for the UIP to hold. The UIP regression estimate indicates that there is no statistically significant evidence that suggests the uncovered interest rate parity to hold during January, 2006 –July, 2010 for domestic interest rate (weighted average call money rate).This indicates that interest rate spread is a very poor predictor of exchange rate yields. Thus, the UIP hypothesis fails in India.”

Position on para 4(e) under IFRS taken by global firms

Under IFRS, paragraph 6(e) of IAS 23 Borrowing Costs, has the same requirement as 4(e) of AS-16. However, the illustration contained in 4(e) and reproduced in this article is not contained in IAS 23. The global big accounting firms have different interpretation on 6(e). Interestingly, the IASB is seized of this matter but has decided not to provide guidance. The International Financial Reporting Interpretation Committee (IFRIC) acknowledges that judgment will be required in its application.

Ernst & Young¹

Borrowings in one currency may have been used to finance a development the costs of which are incurred primarily in another currency, e.g. a US dollar loan financing a Russian rouble development. This may have been done on the basis that, over the period of the development, the cost, after allowing for exchange differences, was expected to be less than the interest cost of an equivalent rouble loan.

We, however, consider that, as exchange rate movements are largely a function of differential interest rates, in most circumstances, the foreign exchange differences on directly attributable borrowings will be an adjustment to interest costs that can meet the definition of borrowing costs. Care will have to be taken if there is a sudden fluctuation in exchange rates that cannot be attributed to changes in interest rates. In such cases we believe that a practical approach is to cap the exchange differences taken as borrowing costs at the amount of borrowing costs on functional currency equivalent borrowings.

In theory, foreign exchange rates and interest rates are related and, as such, it is fair to assume that any changes in foreign exchange rates reflect changes in the interest rate. On this basis, all of the foreign exchange gain or loss on foreign currency borrowings would be considered as part of the borrowing costs on the borrowing. But recently, this argument has not been holding true, with many other factors impacting the relationship between foreign exchange rates and interest rates. Accordingly, it is not necessarily safe to assume that all of the foreign exchange gains or losses on foreign currency borrowings are an adjustment to income. Take the following two examples Entity A’s functional currency is euro, and it borrows £1,000 on 1st January 2009 for one year at a fixed interest rate of 5% to fund the construction of an asset. The spot exchange rate at this date is € 1.5:£1. At 31st December 2009, the exchange rate is €1.1:£1. The entity has incurred a foreign currency gain of €400, while interest costs (assuming they were paid throughout the year at the then spot rate) amount to €65. How much of the foreign exchange gain is included in the borrowing costs eligible for capitalisation?

Entity B’s functional currency is euro, and it borrows US$1,000 on 1st January 2009 for one year at a fixed interest rate of 3% to fund the construction of an asset. The spot exchange rate at this date is €1: US£1. On 31st December 2009, the exchange rate is €1.4: US$1. The entity has incurred a foreign currency loss of €400, while interest costs (assuming they were paid throughout the year at the then spot rate) amount to €36. How much of the foreign exchange loss is included in the borrowing costs eligible for capitalisation?

A number of possible approaches exist:

1.    Determine, at the date of entering into the loan, the equivalent interest rate on a local currency borrowing and use this as the borrowing cost to be capitalised. Let’s assume that, for both of the above examples, the interest rate on a €1,500 borrowing on 1st January 2009 is 7% (entity A), and the interest rate on a € 1,000 borrowing on 1st January 2009 is 4% (entity B). The amount of borrowing costs eligible to be capitalised by entity A would be €105, regardless of the movement in the foreign exchange rate. Entity B would be eligible to capitalise € 40 as borrowing costs. However, this ignores the reason for entities borrowing in a foreign currency i.e., that they expect it to be less expensive. In this case, the movement in the exchange rates has effectively generated an additional gain for entity A, which is also counter-intuitive.

2.    Establish a ‘cap and floor’ for the amount of foreign exchange gains or losses to be included in borrowing costs. The floor may be up to the amount that reduces the borrowing cost to nil. We do not believe that a net gain can be capitalised. In the above example, entity A would include €65 of foreign currency gains as an element of borrowing costs, resulting in a net nil borrowing cost. The cap may be the interest on a local currency borrowing at inception, as this reflects the relationship between foreign currency and interest at that time. In the above example, entity B would therefore include € 4 of the foreign currency losses as borrowing costs, resulting in a net borrowing cost of € 40.

3.    Determine a forward foreign exchange rate at the date of entering into the borrowing and use this to determine the amount of foreign exchange gains or losses that are eligible for capitalisation. Let’s assume in the above examples, the one year forward foreign exchange rates as on 1st January 2009 are €1.4:£1 and €1.1:US$1. The amount of foreign currency gains on the borrowing that entity A includes as borrowing costs is €10, regardless of the movement in the foreign exchange rate. Entity B includes €10 of foreign currency losses on the borrowings as borrowing costs. While this approach provides a consistent assessment of the relationship between foreign exchange rates and interest rates, it is by no means a perfect approach. There are many factors affecting the relationship between foreign exchanges rates and interest rates that cannot be adequately measured.

Management will need to carefully consider which approach they apply, to best reflect the relationship between foreign exchange rates and interest rates. However, the approach selected needs to be applied consistently and disclosed within the financial statements. Each approach also requires an appropriate information system to be in place to collect the relevant information.

PWC²

16.96 Capitalisation of borrowing costs includes capitalising foreign exchange differences relating to borrowings to the extent, that they are regarded as an adjustment to interest costs. The gains and losses that are an adjustment to interest costs include the interest rate differential between borrowing costs that would be incurred if the entity borrowed funds in its functional currency, and borrowing costs actually incurred on foreign currency borrowings. Other differences that are not adjustments to interest cost may include, for example, changes in foreign currency rates as a result of changes in other economic indicators, such as employment or productivity, or a change in government.

16.97 IAS 23 does not prescribe which method should be used to estimate the amount of foreign exchange differences that may be included in borrowing costs. IFRIC has considered this issue, but has not issued any guidance. There were two methods considered by the IFRIC:

•     The portion of the foreign exchange movement may be estimated based on forward currency rates at the inception of the loan.

•     The portion of the foreign exchange movement may be estimated based on interest rates on similar borrowings in the entity’s functional currency.

Other methods might be possible. Management has to use judgment to assess which foreign exchange differences can be capitalised. The method used to determine the amount that is an adjustment to borrowings costs is an accounting policy choice. The method should be applied consistently to foreign exchange differences whether they are gains or losses.

Deloitte³

2.1    Exchange differences to be included in borrowing costs.

IAS 23 includes no further clarification as to what is meant by the inclusion of exchange differences ‘to the extent that they are regarded as an adjustment to interest costs’.

It is clear that, not all exchange differences arising from foreign currency borrowings can be regarded as an adjustment to interest costs; otherwise, there would be no requirement for the qualifying terminology used in IAS 23:6(e). The extent to which exchange differences can be so considered depends on the terms and conditions of the foreign currency borrowing.

Qualifying interest costs denominated in the foreign currency, translated at the actual exchange rate on the date on which the expense is incurred, should be classified as borrowing costs. Although exchange rate fluctuations may mean that this amount is substantially higher or lower than the interest costs contemplated when the original financing decision was made, the full amount is appropriately treated as borrowing costs.

Some exchange differences relating to the principal may be regarded as an adjustment to interest costs (and, therefore, taken into account in determining the amount of borrowing costs capitalised) but only to the extent that the adjustment does not decrease or increase the interest costs to an amount below or above a notional borrowing cost, based on commercial interest rates prevailing in the functional currency at the date of initial recognition of the borrowing. In other words, the amount of borrowing costs that may be capitalised should lie between the following two amounts:

(1)    actual interest costs denominated in the foreign currency, translated at the actual exchange rate on the date on which the expense is incurred; and

(2)    notional borrowing costs based on commercial interest rates prevailing in the functional currency at the date of initial recognition of the borrowing.

Whether any adjustments for exchange differences are made to the amount determined under (1) above is an accounting policy choice and should be applied consistently.

KPMG⁴

4.6.420 Foreign exchange difference.

4.6.420.10 Borrowing costs may include foreign exchange differences to the extent that these differences are regarded as an adjustment to interest costs. There is no further guidance on the conditions under which foreign exchange difference may be capitalised and in practice, there are different views about what is acceptable.

4.6.420.20 In our view, foreign exchange differences on borrowings can be regarded as an adjustment to interest costs only in very limited circumstances. Exchange differences should not be capitalised, if a borrowing in a foreign currency is entered into to offset another currency exposure. Interest determined in a foreign currency already reflects the exposure to that currency. Therefore, the foreign exchange differences to be capitalised should be limited to the difference between interest accrued at the contractual rate and the interest that would apply to borrowing with identical terms in the entity’s functional currency. Any foreign exchange differences arising from the notional amount of the loan should be recognised in profit or loss.

4.6.420.30 When exchange differences qualify for capitalisation, in our view both exchange gains and losses should be considered in determining the amount to capitalise.

GT⁵

Exchange differences.
If an entity has foreign currency borrowings, to what extent are foreign exchange gains and losses eligible for capitalisation?

IAS 23.6(e) states that borrowing costs may include exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs. The standard offers no detailed guidance on how to interpret this. Accordingly, entities should develop their own detailed policy. As with any other accounting policy, the chosen method should be applied consistently and disclosed if significant.

Is it appropriate to treat all exchange differences on foreign currency borrowings as an adjustment to interest costs?

No. In our view, not all such exchange differences are adjustments to interest costs. Exchange rate movements depend in part on current and expected differences in local currency and foreign currency interest rates (the interest rate differential). However, other factors also contribute to exchange rate changes: a currency will tend to lose value relative to other currencies if a country’s level of inflation is higher, or if the country’s level of output is expected to decline or if a country is troubled by political uncertainty (for example).

Moreover, although exchange gains and losses relate to an entity’s foreign currency borrowings, such gains and losses are different in character to interest costs on those borrowings. In particular, it is difficult to argue that exchange gains and losses on the principal amount of a loan is an adjustment to interest costs. Exchange gains and losses on the accrued interest portion of the loan’s carrying value may more readily be considered an adjustment to interest costs (see below).

What is an appropriate accounting policy for exchange differences?

One acceptable and straightforward approach is not to include any exchange differences as adjustments to interest costs. IAS 23.6(e) states that borrowing costs may include exchange differences to the extent they are regarded as an adjustment to interest costs – it does not therefore require such an adjustment. Applying this approach, interest costs on foreign currency borrowings include only the foreign currency interest expense converted into the entity’s functional currency in accordance with IAS 21 The Effects of Changes in Foreign Currency Exchange Rates.

Should an entity wish to take account of exchange differences, the challenge is to identify the portion of overall exchange differences that are adjustments to interest costs. A reasonable and practical approach is to treat only exchange differences arising on current period accrued interest as an adjustment to interest costs. This approach considers the adjustment to interest costs as the difference between:

•     the amount of interest cost initially recognised in the entity’s functional currency using the spot exchange rate at the date of the transaction; and

•     the amount the entity has to pay on settlement translated into the entity’s functional currency using the spot exchange rate at the date of payment.

Using this approach, exchange differences on the principal amount of the loan are not included in the calculation of borrowing costs to capitalise.

Are any other methods available?
Yes, an entity might develop other models and techniques to determine the exchange differences to include in the calculation of borrowing costs to capitalise. However, in our view any such method should:

•    be consistent with the objective of IAS 23 to include borrowing costs that are directly attributable to a qualifying asset. Borrowing costs are considered to be directly attributable, if they would have been avoided had the expenditure on the qualifying asset not been made (IAS 23.10);

•    not result in negative interest costs; and

In our view it is not acceptable to:

•    include exchange gains in excess of the interest expenses incurred (i.e. to capitalise a negative amount); or

•    Capitalise only exchange losses, but credit all exchange gains to the income statement.

One alternative approach is to determine a notional borrowing cost based on the interest cost that would have been incurred, had the entity borrowed an equivalent amount in its functional currency. In effect, this approach treats a foreign currency loan as a functional currency loan with an embedded foreign currency exchange contract. The IAS 23 calculation is based on the notional functional currency loan.

Applicability of para 4(e) in different scenarios under AS 16

It would be fair to comment that the global practices being followed with respect to 4(e) are disparate. Even the guidance provided by the large firms is not consistent. A few of the large firms have debunked the theory of IRP, but most others show sympathy towards the determination of 4(e) component. Though sometimes the same terminology used by the large firms such as a “cap” and “floor”, have been used in different contexts and can be confusing. Fortunately or unfortunately, a large part of the debate in the large firms may be purely academic under AS-16, since unlike IAS-23 an illustration is included in AS-16. This resolves a lot of issues. Nonetheless, the illustration in paragraph 4(e) of AS 16 deals with computation of 4(e) adjustment in a scenario where the company takes foreign currency (FC) loan at a lower interest rate and incurs exchange loss on the FC borrowing. However, it does not deal with many other scenarios which the author has described in the foot note under the illustration.

Consider the following example. The company takes a FC loan at a lower interest rate and has exchange gain on restatement on FC loan. In this scenario, theoretically there should have been an exchange loss, but because the IRP theory does not work because of unusual factors, there is an exchange gain in certain periods. The question is whether one would notionally increase exchange gain so that a 4(e) component can be artificially determined. In this situation, the author believes that it may not be appropriate to further increase the exchange gain to consider a notional 4(e) charge. This is explained in the illustration below.

Entity A’s reporting currency is rupees, and it borrows US$100 million on 16th December 2011 for one year at a fixed interest rate of 2% to fund the construction of an asset. The spot exchange rate at this date is $1: Rs. 53.65. On 31st March 2012, the exchange rate is $1: Rs. 50.87. The entity has incurred a foreign currency gain of Rs. 278 million, while interest costs (translated using the average rate) amount to Rs. 30.48 million (Rs. 100 million

*    2% * 52.26 * 3.5/ 12). How much of the foreign exchange gain is included in the borrowing costs eligible for capitalisation?

A number of possible approaches exist:
1.    Determine, at the date of entering into the loan, the equivalent interest rate on a local currency borrowing and use this as the borrowing cost to be capitalised, regardless of the movement in the foreign exchange rate. Let’s assume that, the interest rate on a Rs. 5,365 million borrowing on 16th December 2011 is 9%. Hence, the amount of borrowing costs eligible to be capitalised by entity A would be Rs. 140.83 million (Rs. 5,365 million * 9% * 3.5/ 12). In this approach, the movement in the exchange rates has effectively generated an additional exchange gain of Rs. 110.35 million (i.e., interest capitalised of Rs. 140.83 million minus actual interest of Rs. 30.48 million) for entity A, which is counter-intuitive.

2.    To recognise interest cost of Rs. 30.48 million and FC gain of Rs. 278 million. The FC gain is not notionally increased by Rs. 110.35 million to determine the 4(e) component.

3.    Establish a ‘cap and floor’ for the amount of foreign exchange gains or losses to be included in borrowing costs. The floor may be up to the amount that reduces the borrowing cost to nil because borrowing costs cannot be negative. It may not be appropriate to capitalise a net gain. In the above example, entity A would include Rs. 30.48 million of foreign currency gains as an element of borrowing costs, resulting in a net nil borrowing cost. The FC gain would be Rs. 247.52 million (Rs. 278 million – Rs. 30.48 million).

4.    There are other acceptable methods which are not discussed here.

The conclusion on the above illustration can be summarised as below.

Discrete vs. Cumulative Approach

Paragraph 4(e) of AS 16 and explanation thereto explains computation of 4(e) adjustment for one year. However, it does not deal with a scenario where FC loan extends for more than one year and there is loss/gain in one accounting period and gain/ loss in the subsequent periods. Two methods seem possible for dealing with this issue.

Method A – The discrete period approach

4(e) adjustment is determined for each period separately. FC gains/losses that did not meet the criteria for treatment as borrowing cost in the previous year cannot be treated as 4(e) adjustment in the subsequent years and vice versa.

Method B – The cumulative approach
4(e) adjustment are assessed/identified on a cumulative basis, after considering the cumulative amount of interest expense that is likely to have been incurred, had the company borrowed in local currency. The amount of 4(e) adjustment cannot exceed the amount of FC losses incurred on a cumulative basis at the end of the reporting period. The cumulative approach looks at the project as a whole as the unit of account, ignoring the occurrence of reporting dates. Consequently, the amount of the FC differences eligible for identification as 4(e) adjustment in the period is an estimate, which can change as the exchange rates changes over periods.

Example
An illustrative calculation of the amount of FC differences that may be regarded as borrowing cost under method A and method B is set out below.

Method
A – Discrete Approach

Method
B – Cumulative Approach

If a company is also preparing quarterly financial information, a related issue will arise regarding the approach that should be adopted while preparing quarterly financial statements.

Ind-AS 23 provides additional guidance on this subject as follows.

“6A. With regard to exchange difference required to be treated as borrowing costs in accordance with paragraph 6(e), the manner of arriving at the adjustments stated therein shall be as follows:

(i)    the adjustment should be of an amount which is equivalent to the extent to which the exchange loss does not exceed the difference between the cost of borrowing in functional currency when compared to the cost of borrowing in a foreign currency.

(ii)    where there is an unrealised exchange loss which is treated as an adjustment to interest and subsequently there is a realised or unrealised gain in respect of the settlement or translation of the same borrowing, the gain to the extent of the loss previously recognised as an adjustment should also be recognised as an adjustment to interest.”

Ind-AS seems to be taking a cumulative approach when exchange gain follows exchange loss that were treated as an adjustment to interest cost. However, Ind-AS provides no guidance when there is a reverse situation, ie exchange gains precede exchange losses. In the latter situation, it is possible to recognise the exchange gain in the P&L account and the exchange loss could be split into a 4(e) component; the remaining being accounted as a pure exchange loss. It may be noted that, Ind-AS cannot be applied mandatorily with respect to interpreting Indian GAAP, though in the author’s view it could be applied voluntarily.

To cut the long story short

•    The present AS-16 standard includes a clear illustration of how the interest rate differential will be determined. Therefore, entities will need to follow the same. However, as discussed in this article, the illustration does not deal with numerous situations, which are causing the problem.

•    Consider an example, where the interest rate differential at inception of borrowing is Rs. 1,000 and the exchange loss in scenario 1 is Rs. 5,000 and in scenario 2 is Rs. 800. There should not be a debate that interest rate differential in scenario 1 is Rs. 1,000 and in scenario 2 is Rs. 800. Given that 4(e) is clearly explained in the standard by way of an illustration, it seems highly inappropriate not to consider Rs. 1,000 in scenario 1 and Rs. 800 in scenario 2 as interest rate differential (4(e) component).

•    Consider a third scenario where at the first year end after taking the FC loan there is exchange gain of Rs. 5,000 (but the interest rate differential at inception of borrowing is Rs. 1,000). In this scenario, the author believes that it would be appropriate to conclude that there is no interest rate differential; rather than considering an interest rate differential of Rs. 1,000 and notionally increasing the exchange gain by Rs. 1,000 to Rs. 6,000.

•    In the reporting period after the first reporting period, there seems to be a choice of either using the discrete approach or the cumulative approach. For example, the exchange loss in one period is followed by exchange gain in the following period. In the absence of any guidance under AS-16, either the discrete or cumulative approach is valid. Ind-AS seems to be suggesting a cumulative approach in some situations. That guidance is not mandatory with respect to interpretation of 4(e), but could be applied voluntarily.

•    All companies should disclose in the financial statements the policy followed to determine the 4(e) component, and this policy should be applied consistently.

Should para 4(e) under Indian GAAP be withdrawn because IRP theory does not hold good?

•    Para 4(e) is an issue of significance to India because of large volume of FC borrowings and high exchange rate volatility.

•    It is quite clear from the many research papers that the uncovered IRP theory does not hold good.

•    The global guidance and practices followed are inconsistent and disparate and many have debunked the IRP theory. IFRIC has refused to provide any guidance, citing that it is a judgmental matter.

•    Capitalisation of borrowing cost on qualifying asset itself is not a good idea, because it is a consequence of how the asset is funded (whether from equity or borrowing?) and therefore provides an unnecessary arbitrage.
By adding 4(e) component to the definition of borrowing cost, is like adding one disputed theory on top of another disputed theory. That makes matters worse.

•    Paragraph 46 and 46A of AS-11 were founded on the belief that exchange rates will either revert back to the original or will, in the medium to long term, reflect interest rate differential (stable forward points reflecting interest differences between two countries). By allowing amortisation of exchange differences, what is achieved is a smoothing of the exchange differences that would be similar to recognising interest rate differentials over the period of the FC loan.

•    On account of various arguments made in this paper, the author believes that 4(e) should be withdrawn. Along with 4(e); paragraph 46 & 46A of AS-11 should also be withdrawn, as they are founded on similar belief. The belief that exchange rates will either revert back to the original or will reflect the interest rate differential for the medium to long term, is a preposterous assumption and unproven by empirical evidence. If one were to do a backward testing, the assumption may hold good in a few cases, as a matter of co-incidence, rather than on the basis of a proven theory. The world nor India, is or ever will be calm and stable. If we agree to this then we should withdraw 4(e) and paragraph 46 and 46A of AS-11.

•    The Ministry of Corporate Affairs has issued has Circular No 25/2012 dated 9th August 2012 with-drawing 4(e) with respect to paragraph 46A, but not with respect to paragraph 46. The author’s suggestion is that 4(e) should be fully withdrawn along with paragraph 46 and 46A of AS-11.