Acounting of Foreign Currency Fluctuations

Facts
Force India Ltd. (FIL) is a public company having two divisions:

(a) Manufacturing Division where high-tech products are manufactured for the IT sector. This division has two plants employing more than 500 employees. Exports constitute more than 50% earnings for this division. Most of the manufacturing equipment required for the two plants are imported;

(b) ITES Division where medical transcription and medical billing services are rendered. This division is spread over three locations and employs more than 700 employees. The entire billing of this division (on monthly basis) is to customers located outside India and in most cases, there are long-term contracts entered into with these customers.

Transactions of imports/exports of the manufacturing division are predominantly denominated in USD, whereas for the ITES division entirely denominated in Euros.

In view of the multi-currency exposure, the recent volatility in the exchange rates and since the CFO of FIL had a deep understanding of the forex markets, FIL has entered into the following contracts:

(i) Forward contracts for USD for the net exposure of the manufacturing division for the next 18 months. These contracts mature on a monthly basis and have no co-relation to the payments to be made for imports or export realisations.

(ii) Forward contracts for Euros for the receivables of the ITES division (including projected receivables for future billings). These contracts mature on a monthly basis.

(iii) Contracts at the MCX for USD.

FIL closes its financial statements on 31st December every year. As at 31st December 2011, the following information is available:

(a) Net realised and unrealised loss on forward contracts in USD Rs.15 lakh and Rs.160 lakh respectively;

(b) Net realised and unrealised loss of forward contracts in Euros Rs.5 lakh and Rs.75 lakh, respectively;

(c) MTM loss on open contracts at the MCX Rs.20 lakh.

Discuss the treatment of the aforesaid losses as well as the foreign currency exposures for receivables/ payables of FIL in the financial statements for the year 2011.

Discussion and solution

1. An entity can have exposure to foreign currency fluctuations in the following situations:

(a) Long-term or short-term forex loans taken for acquisition of fixed assets — whether from India or outside India;

(b) For sales/purchases in forex;

(c) On forward contracts entered into by the entity for hedging its exposure to forex fluctuations;

(d) On forward contracts entered into for speculative purposes.

2. In the given case, the company has exposure to foreign currency fluctuations on account of the following:

(a) Sales from manufacturing division and services rendered from ITES division;

(b) Imports of equipment for the manufacturing division;

(c) Forward contracts entered into in USD for the manufacturing division;

(d) Forward contracts entered into in Euros for the ITES division;

(e) Contracts entered into at MCX.

3. In each of the above cases, the company has realised gains/losses during the year 2011 as well as unrealised or mark-to-market (MTM) losses as at 31st December 2011.

4. Accounting treatment of forex exposures is primarily determined by the following:

(a) Accounting Standard (AS) 11 ‘The Effects of Changes in Foreign Exchange Rates’ as notified by the Companies (Accounting Standards) Rules, 2006;

(b) Amendments thereto by Notifications issued in March 2009, May 2011 and December 2011;

(c) Announcement by ICAI in March 2008 on ‘Accounting for Derivatives’.

(d) Accounting Standard 30 ‘Financial Instruments: Recognition and Measurement’ issued by ICAI. Though AS-30 is not yet notified under the Companies (Accounting Standards) Rules, 2006, the same can be voluntarily adopted so far as it does not conflict with any other notified accounting standard or any existing regulatory and statutory requirement.

5. The amendments to AS-11 as referred to in 4(b) above relate to accounting for forex fluctuations for loans (other than short-term) in foreign currency for acquisition fixed assets. In the given case study, there are no such loans obtained by FIL and hence these amendments are not applicable.

6. Monetary items are defined by para 7.11 of AS-11 as ‘money held and assets and liabilities to be received or paid in fixed or determinable amounts of money’. In the given case, debtors arising from export sales as well as rendering of services and creditors arising from imports would be monetary items since they would be received or paid in fixed or determinable amounts of money.

7. As per para 13 of AS-11, ‘exchange differences arising on the settlement of monetary items or on reporting an enterprise’s monetary items at rates different from those at which they were initially recorded during the period, or reported in previous financial statements, should be recognised as income or as expenses in the period in which they arise’.

8. The above-referred para 13 of AS-11 would be applicable to foreign currency fluctuations as referred to in para 2(a) and 2(b) in the case above. All exchange differences on settlement of these items or on restatement at the year-end would thus need to be transferred to the statement of profit and loss.

9. Accounting treatment for forward contracts in foreign currency entered into by an entity is to be done as per paras 36 and 37 of AS-11. The said paras are as under:

37. The risks associated with changes in exchange rates may be mitigated by entering into forward exchange contracts. Any premium or discount arising at the inception of a forward exchange contract is accounted for separately from the exchange differences on the forward exchange contract. The premium or discount that arises on entering into the contract is measured by the difference between the exchange rate at the date of the inception of the forward exchange contract and the forward rate specified in the contract. Exchange difference on a forward exchange contract is the difference between (a) the foreign currency amount of the contract translated at the exchange rate at the reporting date, or the settlement date where the transaction is settled during the reporting period, and (b) the same foreign currency amount translated at the latter of the date of inception of the forward exchange contract and the last reporting date.”

11.    Paras 38 and 39 of AS-11 further state as under:

“38. A gain or loss on a forward exchange contract to which paragraph 36 does not apply should be computed by multiplying the foreign currency amount of the forward exchange contract by the difference between the forward rate available at the reporting date for the remaining maturity of the contract and the contracted forward rate (or the forward rate last used to measure a gain or loss on that contract for an earlier period). The gain or loss so computed should be recognised in the statement of profit and loss for the period. The premium or discount on the forward exchange contract is not recognised separately.

39.    In recording a forward exchange contract intended for trading or speculation purposes, the premium or discount on the contract is ignored and at each balance sheet date, the value of the contract is marked to its current market value and the gain or loss on the contract is recognised.”

12.    As can be seen from the above, paras 38 and 39 of AS-11 prescribe the treatment for forward contracts which are intended for trading or speculation purpose. Thus, in all cases where paras 38 and 39 are applicable, the gain/loss computed in terms of these paras would need to be recognised in the statement of profit and loss.

13.    Besides contracts covered by paras 36, 37, 38 and 39 of AS-11, there could be other forward con-tracts which a company may enter into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction. Accounting treatment for such contracts is not covered by AS-11 since these are neither backed by actual transactions, nor intended for trading or speculation.

14.    Accounting of such contracts which are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction would be covered by the ICAI announcement of March 2008. The said announcement lays down 2 options which can be followed by a company to account for such contracts. The 2 options are:

(a)    The mark-to-market (MTM) loss in case of such transactions should be provided for in the statement of profit and loss following the principle of prudence as enunciated in AS-1 ‘Disclosure of Accounting Policies’ — the gains arising on MTM, however, need not be provided;
(b)    Adopt AS-30 on a voluntary basis. Paras 80 to 113 of AS-30 provide for recognition and measurement of forward contracts intended for hedging and which are not covered by AS-11. These paras provide that in case the forward contracts fall within the definition of an ‘effective hedge’ within the meaning of AS-30, the MTM gains/losses on such contracts can be transferred to a ‘Hedging Reserve Account’ and carried forward in the balance sheet rather than recognise them in the statement of profit and loss account. To qualify as an ‘effective hedge’, however, there has to be close relationship between the date of maturity of the forward contract and the realisation of the underlying ‘hedged item’ i.e., the export receivables. There are also stringent documentation requirements laid down by AS-30 to prove the effectiveness of a hedge. On settlement or cancellation of these contracts, the eventual gains/losses would need to be transferred to the statement of profit and loss account.

15.    The ICAI announcement also mentions that in case one of the above 2 options is not followed and there is a MTM loss as at the year-end on such contracts, appropriate disclosures should be made by the auditor in his report. Since the announcement only mentions ‘appropriate disclosures’, such disclosures may not amount to a qualification in the report of the auditors.

16.    In the given case, in the situation mentioned in para 2(c) above, the company has entered into contracts to cover its exposure in USD for exports of goods and import of equipment. As per the information available, these contracts do not have any co-relation with the receivables/payables, but they are backed by actual transactions of exports/imports since these are entered into in respect of the net exposure of the manufacturing division. In such a case, the accounting treatment would need to be as per paras 36 and 37 of AS-11 (as discussed in paras 9 and 10 above). Thus, the realised as well as unrealised losses on such contracts would need to be accounted for in the statement of profit and loss.

17.    In the given case, in the situation mentioned in para 2(d) above, the company has entered into contracts to cover its exposure in Euros for exports of services. As per the information available, some of these contracts are backed by actual export receivables, but the remaining contracts are to cover future exports of services. Since these contracts mature on a monthly basis, there seems to be a co-relation between the receivables (as in most cases of export of ITES services the billings are on regular pre-determined intervals).

18.    The accounting treatment for contracts which are backed by receivables would be covered by para 36/37 of AS-11 and would be as discussed in para 16 above. However, in case of contracts which are for future billings, these would be in the nature of hedge for the foreign currency risk of a firm commitment or a highly probable forecast transaction. These would be accounted as per the ICAI announcement (as discussed in paras 14 and 15 above). Thus, FIL would have an option to either provide the MTM loss on such contracts or adopt AS-30 and transfer the loss to a ‘Hedging Reserve’.

19.    In the given case, in the situation mentioned in para 2(e) above, the company has entered into contracts at the MCX for USD. These contracts, though apparently, entered into for trading or speculative purposes, in this case, seem to be entered into for hedging the forex exposures of FIL. If the contracts were entered into for trading or specula-tive purposes, the accounting treatment would be as per paras 38/39 of AS-11. However the contracts seem to be backed by actual transactions of exports/imports. In such a case, the accounting treatment would be as per paras 36/37 of AS-11. In either case, the realised as well the unrealised (or MTM) losses would need to be transferred to the statement of profit and loss.

20.    The duty of the statutory auditor in the above case would be as under:

(a)    For situations in 2(a) and 2(b) above, verification whether appropriate closing rates are considered for determining the forex fluctuations and whether the same are accounted in the statement of profit and loss;

(b)    For situation mentioned in 2(c) above, verification of open forward contracts in USD and whether the same are clearly backed by actual transactions of exports/imports on a net basis;

(c)    For situation mentioned in 2(d) above:

(i)    Verification and adequate documentation whether AS-11 or AS-30 would be applicable to the forward contracts entered into;

(ii)    verification of open forward contracts in Euros and whether they constitute an ‘effective hedge’ vis-à-vis the receivables/ future receivables as envisaged by AS-30 and whether the company had adequate internal documentation at the time of entering into these contracts so as to constitute an ‘effective hedge’;

(d)    For situation mentioned in 2(e) above, verification of whether the contracts entered into at MCX were towards hedging of open exposures in USD or whether these were for trading or speculation;

(e)    Adequate audit documentation for all the above with reasoning and supporting to be kept as part of audit working papers.

Editor’s Note: The case study is based on the case studies presented by the author at the Residential Refresher Course of BCA.