The Central Government, vide Notification dated 31 March 2009, has amended Accounting Standard (AS) 11 The Effects of Changes in Foreign Exchange Rates, notified under the Companies (Accounting Standard) Rules, 2006. Pursuant to the amendment, a new paragraph has been inserted in AS-11 to allow amortisation/capitalisation of foreign exchange differences arising on long-term monetary items. The amendment has far-reaching consequences, than is apparent on a plain reading.
The option permitted is not in accordance with IAS-21 Effect of Changes in Foreign Exchange Rates. The Institute of Chartered Accountants of India (ICAI) and The Ministry of Corporate Affairs (MCA) have committed to adopt IFRS with effect from April 1, 2011. Availability of the option only till March 31, 2011 clearly reinforces ICAI and MCA commitment towards adopting IFRS by 2011. Companies should take serious note of this, and start preparing for IFRS, given that the IFRS conversion process is a lengthy process.
In Annexure 1, through a simple example, the author has tried to explain the practical application of the amendment when a loan is taken for working capital purposes with regards to (a) retrospective application of the standard, (b) write-off of unamortised balance at 31 March 2011 and (c) the method of amortisation. In Annexure 2, the example remains the same, except that the loan is taken for acquiring fixed assets.
The key salient features are :
1. Exchange differences on monetary items under AS-11 are required to be recognised in the P&L Account. The amendment to AS-11 allows an alternative treatment of amortising/capitalising exchange differences on long-term monetary items.
2. If a company avails the option given in the Notification, it needs to be adopted for all long-term foreign currency monetary items. In other words, cherry picking of monetary items is not permitted.
3. The alternative treatment is optional and has to be exercised in the first reporting period after the date of the Notification. The option once exercised is irrevocable.
4. The alternative treatment applies to exchange differences, i.e., both exchange gains and losses.
5. The Notification is issued by The Ministry of Corporate Affairs (MCA) as per the authority granted under the Companies Act, 1956 which is applicable to companies. For non-corporate entities, such as partnership firms, trusts and HUFs, the ICAI has clarified that the AS-11 amendment would not apply.
6. The exchange differences to the extent falling within paragraph 4(e) of AS-16 would continue to be governed by the said requirements since these do not fall within the purview of AS-11. The option given in the Notification is available only in respect of exchange differences to the extent these are governed under AS-11.
7. If the long-term foreign currency monetary item relates to other than an acquisition of a depreciable capital asset, exchange differences should be accumulated in the ‘Foreign Currency Monetary Item Translation Difference Account’ and amortised over the life of the monetary item but not beyond 31 March 2011. If the monetary item is settled, then exchange differences cannot be carried forward and will need to be recognised immediately.
8. If the long-term foreign currency monetary item relates to acquisition of a depreciable capital asset, exchange differences arising on such monetary items should be added to or deducted from the cost of the asset.
9. Capitalisation of exchange differences as cost of depreciable asset and accumulation of exchange differences in the ‘Foreign Currency Monetary Item Translation Difference Account’ are not two separate options. Thus, if a company decides to capitalise exchange differences on foreign currency loan taken for acquisition of a depreciable capital asset, it would also need to defer the exchange differences to the ‘Foreign Currency Monetary Item Translation Difference Account’ on the foreign currency loan taken for working capital.
10. Schedule VI has been amended to remove the requirement with regard to capitalisation of exchange differences. Henceforth, the requirement with regard to capitalisation of exchange difference will be dealt with only under Accounting Standards notified in the Companies (Accounting Standards) Rules.
11. Unlike pre-revised Schedule VI, the amendment does not make any distinction in respect of fixed assets acquired from outside India or otherwise. Hence the optional treatment in the Notification would have to be applied in respect of all depreciable assets, whether acquired from within or outside India.
12. A company cannot apply this amendment with prospective effect or to accounting periods commencing before 7 December 2006. The Notification is applicable to all accounting periods commencing on or after 7 December 2006. If a company follows financial year, then the Notification would apply to all long-term monetary items that existed on 1 April, 2007 and thereafter. If a company follows calendar year, then the Notification would apply to all long-term monetary items that existed on 1 January, 2007 and thereafter.
13. To the extent the adjustment relates to earlier years (for example 1-4-2007 to 31-03-2008), the same has to be effected through the general reserve account.
14. Companies need to carefully evaluate the impact of current taxes, deferred taxes and impairment. With regards to the retrospective adjustment through the general reserve (effect of earlier years), deferred tax on that component will be adjusted to (a) in the case of a ‘Foreign Currency Monetary Item Translation Difference Account’ to a reserve account, (b) in the case of capitalisation to fixed asset it is less clear, whether the same should be adjusted to the P&L account, reserve account or ignore it as a permanent difference.
15. Networth of company will increase if exchange loss is capitalised in fixed assets and vice-versa. Exchange differences on long-term monetary assets and liabilities accumulated in ‘Foreign Currency Monetary Item Translation Difference Account’ will have no effect on networth of the company when compared to the existing AS-11 requirements.
It may be noted that AS-ll does not deal with derivatives in general, other than forward exchange contractswhich are entered into to hedge assets and liabilities on the balance sheet. AS-l1 also does not cover forward contracts that are entered into to hedge highly probable transactions and firm commitments. The AS-l1 amendment applies to monetary items.Derivatives are not monetary items within the definition of AS-l1. Therefore AS-11 amendment does not apply to derivative accounting; however, because the derivatives are entered into for hedging monetary items, the amendment has significant impact in the way such derivatives are accounted for.
The existing requirements relating to (a)A5-11with regards to forward exchange contracts, (b) Announcement of the ICAI with regards to derivatives in general, (c) AS-30 Financial Instruments: Recognition and Measurement (applicable from 1-4-2009 on recommendatory basis and 1-4-2011on mandatory basis), (d) the fact that AS-30 has not yet been notified in the Companies (Accounting Standards) Rules, and (e) the current amendment to AS-l1 creates a permutation and combination of numerous situations and complexities for which there may be no answer in current Indian GAAP literature other than by conjecture. It is possible that numerous practices would emerge. This was clearly visible in the implementation by companies of the Announcement on Derivatives issued by the ICAL This amendment will only further add to that confusion.
Consider the following situation. Company has entered into an option contract to hedge foreign currency loan liability of USD 100 taken for operations. As per the amendment, exchange difference on long-term loan liability for working capital purpose should be accumulated in Foreign Currency Monetary Item Difference Account. The following accounting treatments are theoretically possible for the option contract:
a) Account for mark-to-market losses on the option contract in the profit and loss account disregarding accounting for exchange differences on the underlying hedged item. Gains, if any, may be ignored.
b) Alternatively, gains on the option contracts may be recognised if the company can demonstrate that it is complying with AS-30 principles, to the extent possible.
c) If option is an effective hedge, adjust mark-to-market changes on option contract with exchange difference on underlying loan and account for net exchange difference on loans in Foreign Currency Monetary Item Difference Account. If there is net MTM gain, then it may be ignored.
d) The treatment in (c) above could also be used for an ineffective hedge, provided it is reasonably an economic hedge.
e) The same as scenario (c), but company may recognise net MTM gains on option contract in Reserve account if the company is following principles of AS-30 for derivative contracts.
Annexure 1
How are exchange differences accumulated in the ‘Foreign Currency Monetary Item Translation Difference Account’ amortised? Consider the following scenario:
i) FXLimited’s financial year ends on 31 March.
ii) On 1 April 2006,FXhas taken foreign currency loan amounting to Euro 300,000,for use in the working capital.
iii) The loan is repayable after 6 years, i.e., on 31 March 2012.
iv) Given in a table at the top of the next column, is the amount of exchange gain/ loss arising on the loan at each reporting date
v) FX has decided to amortise exchange differences as per the option given in the Notification.
Response
In respect of exchange differences arising on restatement of long-term monetary items not pertaining to acquisition of depreciable capital assets, the Notification provides that the same should be accumulated in the ‘Foreign Currency Monetary Item Translation DifferenceAccount’ and amortised over the remaining lifeof the loan but not beyond 31 March 2011.As per the Notification, the amendment is applicable retrospectively in respect of accounting periods commencing on or after 7 December 2006. Thus, the company would adopt the following treatment:
i) Exchange difference arising during the year ended 31 March 2007 continues to be recognised in the P&L. No retrospective adjustment is allowed for these differences.
ii) FXneeds to retrospectively adjust the amount of exchange loss recognised in the year ended 31 March 2008. The amount of retrospective’ adjustment is computed as below:
iii) FX would determine amount to be amortised in each of subsequent years as shown in the table appearing at top on the following page.
The amortisation is based on the remaining life of the loan and period to 31 March 2011, whichever is earlier. In this case,31March2011 is earlier; thus amortisation is one-third, one-half and one for years ending 31 March 2009, 31 March 2010 and 31 March 2011, respectively.
iv) No exchange differences can be carried beyond 31 March 2011 and exchange differences arising in the year ended 31 March 2012 need to be recognised immediately. In any case, FX should have adopted IFRS from 1 April 2011 and application of IAS-21 would also require exchange differences on monetary items to be recognised immediately.
An interesting observation is that since the amendment has a retrospective effect, previous exchange differences that were recognised in profit or loss would be transferred to the ‘Foreign Currency Monetary Item Translation Difference Account’ through general reserve. As this account is amortised to profit or loss of FX, there would be a double recording of the exchange difference in the profit or loss; once in previous years’ profit or loss and once going ahead by way of amortisation in future profit or loss.
Note 1
There can be various methods of determining amortisation. For example, one may argue on the following possible methods of amortisation:
i) The loan repayment is after 5 years from the date of retrospective application, i.e., 1 April 2007. Thus, amortisation for the year ended 31 March 200S is 1/ 5th of the exchange differences for the year. Since the Notification does not allow carry forward beyond 31 March 2011, any amount remaining at 31 March 2011 is written off at the said date.
ii) Year ended 31 March 200S is the 2nd year of the loan and the total period of the loan is 6 years. Thus, appropriate amortisation for the year is 2/ 6th of exchange differences for the year ended 31 March 200S.
iii) Year ended 31 March 200S is the 2nd year of the loan and the Notification allows carry forward only up to 31 March 2011. Thus, appropriate amortisation for the year is 2/5th of exchange differences for the year ended 31 March 200S.
iv) As per the Notification, FX can apply the amendment from 1 April 2007 and it is allowed to amortise exchange differences arising on the loan up to 31 March 2011. Thus, maximum deferral period for exchange differences arising and accumulated on the loan during the year ended 31 March 200S is 4 years. Accordingly, 1/4th of exchange differences is appropriate amortisation for the exchange differences.
The author is of the view that method (iv) is the most appropriate method for amortising exchange differences. Thus, the calculation is based on this method.
Annexure 2
Capitalisation of Exchange Difference
Consider the following scenario:
i) FX Limited’s financial year ends on 31 March.
ii) On 1 April 2006, FX has taken foreign currency loan amounting to Euro 300,000, for acquiring plant. At the date of loan, exchange rate was Euro 1 = INR 60.
iii) FX purchased the plant amounting to INR lS,OOO,OOOusing loan amount.
iv) The useful life of the plant is 10 years and depreciation is based on the straight-line method. The loan is repayable after 6 years, i.e., on 31 March 2012.
v) Given at top on the next page in a table is the amount of exchange gain/ loss arising on the loan at each reporting date
vi) FX has decided to capitalise exchange differences as per the option given in the Notification.
Response
In respect of exchange differences arising on restatement of long-term monetary items pertaining to acquisition of depreciable capital assets, the Notification provides that the same should be adjusted to the cost of the asset and should be depreciated over the balance life of the asset (as against the life of the loan). As per the Notification, the amendment is applicable retrospectively in respect of accounting periods commencing on or after 7 December 2006. Thus, the company would adopt the following treatment:
(i) Exchange difference arising during the year ended 31 March 2007 continues to be recognised. No retrospective adjustment is required/ allowed for these differences.
(ii) FXneeds to retrospectively adjust the amount of exchange loss recognised in the year ended 31 March 2008. For exchange differences capitalised in a year, it is assumed that the same arises evenly during the year. Accordingly, the company charges 50% depreciation on such addition. On this basis, the amount to be capitalised for previous periods is determined as shown in the table alongside.
(iii) FX passes the following entry to apply the option retrospectively (at 1 April 2008)
Debit Plant INR…………….. 850,000
Credit General Reserve……………. INR 850,000
(iv) For subsequent years, FX determines capitalisation and depreciation as shown in the table below:
(v) Exchange differences arising in the year ended 31 March 2012 need to be recognised as income/ expense immediately and cannot be capitalised. In any case, FX should have adopted IFRS from 1 April 2011 and application of IAS-21 would also require exchange differences on monetary items to be recognised immediately. Also, carrying amount of plant would be determined based on IAS-16/ IFRS 1 principles.
