1.37 Query: Foreign currency transactions and exchange fluctuations.
1. An Indian company has established an industrial undertaking in Madras Export Processing Zone (MEPZ) to manufacture electronic relays and switches in technical collaboration with a German based company. The German company (hereinafter referred to as foreign company) in addition to supplying the technical know-how, machineries etc., has also invested about 60% in the equity of the Indian company. Besides, the foreign company has also given interest free long term loans and advances in addition to the suppliers credit for supply of raw materials and stores. As per collaboration agreement, the foreign company will supply entire raw materials/stores and would be buying the entire production of the Indian company at an agreed price to be invoiced by Indian company in German currency, viz., Deutch Mark (DM). The imported raw material/stores will be around 40% of sale value of electronic relays and switches bought back by the foreign company. Thus, the entire earnings of the Indian company are in DM and major payments are also in DM. Debt service also is out of DM earnings.
2. In addition to the financial tie-up as per details above, the Indian company has also obtained foreign currency loan from IFC, Washington and rupee term loans from EXIM Bank, Indian and State Bank of India. While the IFC loan availed in US $ is repayable out of DM earnings of the company through exports, the rupee term loans from EXIM Bank and State Bank of India will also be repaid out of DM resources.
3. The foreign currency loan from IFC is equivalent in US $ to DM value of machinery. It is reflected in the Indian balance sheet in Indian rupees as per conversion rate at the time of remittance.
4. The advance received from the foreign collaborator and the suppliers credit towards raw material and stores were in ‘DM’ and are reflected in the Indian balance sheet in Indian rupee by applying the exchange rate that prevailed at the time of remittance in respect of suppliers credit by adopting the prevailing exchange parity on the bills of entry dates. The advances and the suppliers credit from the foreign collaborator are to be liquidated over a period of time out of DM resources by way of adjustment upto 40% of invoice value raised on the foreign collaborator by the Indian company. It is to be noted that the Indian company will be raising the invoice on the foreign collaborator in Deutche Mark (DM) and not in rupee. It is also to be understood that even while fixing the per unit rate for the purpose of exports, only the ‘DM’ has been used resulting in higher realisation in terms of rupee due to appreciation in ‘DM’ rate vis-à-vis Indian rupee.
5. The DM which is a dominant currency, has been appreciating continuously as against the rupee. For example, the DM-rupee parity which was at DM – Rs. 10.15 in 1988-89 was quoted at Rs. 12.35 in December, 1990 and is still appreciating. Also the ‘DM’ is appreciating against US $ continuously. One US $ which was fetching 1.808 DM – in 1988-89, is fetching only 1.507 DM in December, 1990.
6. Since the company is repaying the foreign currency loans, deferred credits towards supplies and advances only out of its ‘DM’ earnings through exports, there has not been any loss to the company due to fluctuations in DM- rupee parity. In fact the company has been able to make substantial gains out of such repayments, because of the reduction in ‘DM’ requirement consequent to the higher rupee parity it is fetching. The querist has submitted the details of the gains that have accrued/accruing to the company on this account for the perusal of the Committee.
7. The Accounting Standard (AS) 11 which has become mandatory * from 01/04/1991 deals with the effects of changes in exchange rates on account of foreign currency transactions entered into by an Indian enterprise. In accordance with the above standard, it has become obligatory on the part of Indian companies to restate the foreign currency transactions as per exchange rate prevailing as on the balance sheet date every year with reference to accounting years beginning with 01.04.1991. The loss/gain arising out of such exchange rate fluctuations have to be either absorbed in the profit and loss account or to be added/ reduced from the capital costs depending upon the nature of original transaction.
8. While the company is not likely to suffer any loss on account of such fluctuations in view of the settlement of dues in DM out of export earnings, according to the querist the company would still be required to adopt the Accounting Standard – 11. This would mean that the company would be accounting a ‘Notional Loss’ while on the contrary it would be either making substantial gains or there would not be any loss at all.
9. This booking of ‘Notional Exchange Loss’ would create great hardship to the company. It means that such ‘Notional Exchange Loss’ would absorb a major portion of its profits year after year and the company would not be in a position to declare proper dividend to its share-holders. This in turn would considerably affect its standings with the public, financial institutions and banks.
10. In the light of the above and in view of the fact that the company is not likely to incur any loss on account of exchange fluctuations, the querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) Whether it would be correct to hold that the Accounting Standard (AS) 11 would be applicable only in respect of transactions where there is likely to be a real loss on account of exchange fluctuations? Accordingly, whether the company in the case cited above would not be obliged to account for the notional loss arising out of such transactions?
(b) Whether the statutory auditor is required to make qualificatory remark in the audit report, in case the company does not account for the notional loss due to exchange fluctuations in the accounts, when it is considered as meaningless to account for the same as it will have no impact on the profitability.
(c) Whether it would be deemed that the company has not complied with the provisions of section 205 of the Companies Act, 1956, in regard to declaration of dividend, in case it does not provide for such notional exchange loss which would have the consequential effect of providing lower depreciation in the books.
Opinion October 30, 1991
1. The Committee notes the relevant requirement of Part I of Schedule VI to the Companies Act, 1956 which states inter alia, as follows:
“Where the original cost aforesaid and additions and deductions thereto, relates to any fixed asset which has been acquired from a country outside India, and in consequence of a change in the rate of exchange at any time after the acquisition of such asset, there has been an increase or reduction in the liability of the company, as expressed in Indian currency, for making payment towards the whole or a part of the cost of the asset or for repayment of the whole or a part of moneys borrowed by the company from any person, directly or indirectly in any foreign currency specifically for the purpose of acquiring the asset (being in either case the liability existing immediately before the date on which the change in the rate of exchange takes effect) the amount by which the liability is so increased or reduced during the year, shall be added to, or as the case may be, deducted from the cost, and the amount arrived at after such addition or deduction shall be taken to the cost of the fixed asset.”
2. The Committee notes that Accounting Standard (AS) 11 on ‘Accounting for the Effects of Changes in Foreign Exchange Rates’, issued by Institute of Chartered Accountants of India, does not envisage exception to the application of the Standard. Similarly, the above mentioned requirement of Part I to Schedule VI does not envisage exception to its application. In view of the Committee, the AS-11 is applicable in the present case.
3. The Committee notes paragraphs 23 to 26 of AS-11 reproduced below:
“23. At each balance sheet date, there may be items of foreign currency assets and liabilities, i.e., items to be received or paid in foreign currency, in respect of transactions not settled within the same accounting period. An exercise should be carried out to perceive the impact of converting such items at the closing rate. This conversion process should be carried out separately for the following two categories of items – (a) Current assets and current liabilities and (b) Long-term liabilities. The results of the conversion should be dealt with in the manner described in paragraphs 24 and 25.
24. (a) In case of current assets and current liabilities (other than those related to fixed assets), if the result of conversion at the closing rate is an overall net gain, such gain should not be taken into account and the assts and liabilities should continue to appear in the books at the rates at which they were originally recorded. On the other hand, if the result is a net loss, the current assets and current liabilities should be restated and the loss should be charged in the Profit and Loss Statement.
(b) In the case of current liabilities incurred for the acquisition of fixed assets, the loss or gain, if material, should be regarded as an adjustment of cost and should be included in the carrying amount of the related fixed assets. If the amount is not material, the loss or gain may be dealt with in the manner described in sub-para (a) above.
25. (a) In the case of long-term liabilities other than those incurred for the acquisition of fixed assets, if the result of conversion at the closing rate is an overall net gain, such gain should not be taken into account and the long-term liabilities should continue to appear in the books at the rates at which they were originally recorded. On the other hand, if the result is a net loss, the long-term liabilities should be restated and the loss should be charged in the Profit and Loss Statement. However, such losses can also be deferred and recognised in the Profit and Loss Statement of current and future periods over the remaining term of the liabilities to which they relate. Such deferral is not permitted if it is reasonable to expect that recurring exchange losses will arise on that item in the future.
(b) In the case of long-term liabilities incurred for the acquisition of fixed assets, the gain or loss, if material, should be regarded as an adjustment of cost and should be included in the carrying amount of the related fixed assets. If the amount is not material, the gain or loss may be dealt with in the manner described in sub-para (a) above.
26. Gains or losses on settlement, in a subsequent period, of transactions entered into in an earlier period should be credited or charged to the Profit and Loss Statement, except in the case of exchange differences relating to amounts incurred for the acquisition of fixed assets, which should be adjusted in the carrying amount of related fixed assets.”
4. The Committee is accordingly of the following opinion in respect of the issues raised in paragraph 10 of the query:
(a) AS-11 does not envisage any exceptions to its application. The said standard is applicable in the case of the company cited in the query. Thus, the company cannot avoid accounting of the exchange loss on conversion of foreign exchange liabilities as on the current balance sheet date, on the ground that it anticipates foreign currency gains in future.
(b) In case the company does not follow AS-11, the statutory auditor should qualify his audit report to this effect.*
(c) If the company does not follow AS-11 and the relevant requirement of Part I of Schedule VI to the Companies Act, the same will have the effect of provision of lower depreciation and consequently amount to non-compliance with section 205 of the Companies Act in case the company declares dividend.
* It may be mentioned, that in view of the partial convertibility of the rupee recently announced and other related developments in the changed economic environment, the Council of the Institute of Chartered Accountants of India has decided to reconsider Accounting Standard 11. Accordingly, the Council has resolved that the mandatory application of this Accounting Standard shall stand postponed to accounts for period commencing on or after 1st April, 1993. Since the recommendatory status of the standard is still in existence, AS 11 forms the basis of this opinion. * I bid _________________________
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