1.38 Query: Accounting treatment where forward covers are taken for liabilities due beyond six months.
1. A public limited company manufacturing colour picture tubes has a turnover of Rs. 200 crores p.a. It has large foreign currency exposures of the following nature:
2. Foreign currency loans taken by the company are in various currencies and forward covers have been taken upto different dates. This query relates to accounting treatment where forward covers are taken for foreign currency liabilities. Accounting Standard (AS) 11 issued by the Institute of Chartered Accountants of India has been taken into account. ‘Forward rate’ is defined in AS-11 as “the exchange rate available by the terms of an agreement for the exchange of rupee and a foreign currency at a future date.” ‘Spot rate’ is defined as “the prevailing exchange rate on a particular day for the exchange of rupee and a foreign currency of that day.”
3. In Indian foreign exchange markets, forward rates are derived by deducting ‘premium’ from the spot rates. Premium can be defined as the extra cost that has to be paid for entering into a forward contract for a future date. Spot rates as well as premiums fluctuate on a continuous basis. Premiums are determined by demand and supply and can vary between 3% p.a. to 20% p.a.
4. According to the querist, typical feature of Indian foreign exchange markets is that forward covers can be taken for a liability due in the next six months only. This is because markets are not liquid enough beyond six months and even if a company wants to take a forward cover for a liability due beyond six months, it cannot do so. The option available is a ‘Roll over’ cover. In this, a forward cover is taken for six months. The forward rate for six months is fixed as the rate at which all the liabilities covered shall be paid, even if they are due beyond six months. However, every six months, the company shall have to pay ‘Roll over’ charges to roll over the liability for another six months. Roll-overs have to be done at six monthly intervals till the date of payment comes. Roll over charges depend upon the premiums prevailing at the time of roll over. Thus, a roll over is not a perfect hedge. It is, at best, a partial hedge since the risk shifts from spot rate movements to premium movements.
5. The querist has given the following example to illustrate the above concept and to state the query:
a) Foreign currency loans (relating to acquisition of fixed assets) outstanding as on 1.1.91 US$ 3,00,000 Instalments due on 30.06.91 US$ 1,00,000 on 31.12.91 US$ 1,00,000 on 30.06.92 US$ 1,00,000
- Accounting year ending on 30.9.91
- Loan of US$ 3,00,000 recorded in accounts at the rate of 5.70
= Rs. 52,63,157
- Foreign currency rates (US $/ 100 Rs.)
- as on 1.1.91 Spot 5.50
6 months forward 5.20
- as on 30.6.91 Spot 5.00
6 months forward 4.70
- as on 30.9.91 Spot 4.90
6 months forward 4.70
- Depreciation rate 15% SLM
- Accumulated depreciation at year beginning: Rs. 20,00,000
- Gross block as on 30.9.91 (Excluding any adjustment for revaluation of loans) Rs. 75,00,000
b) The company enters into a forward cover for the entire loan of US $ 3,00,000 up to 30.6.91. Even though two instalments are due beyond 30.6.91, the company can take a forward cover only up to 30.6.91, i.e., upto six months only.
The forward rate as per the contract is US $ 5.20. Thus, all 3 instalments shall be paid at the said rate as and when these are due. In respect of second and third instalments, roll over charges shall have to be paid by the company.
c) On 30.6.91, the company pays the first instalment at the rate of US $ 5.20 (Rs. 19,23,077) even though the prevailing rate is US $ 5.00. The company rolls over the second and third instalments upto 31.12.91 by paying the roll over charges which are equivalent to the premium prevailing on 30.6.91. Roll over charges are calculated in the following manner: 200000 X 100/4.70 = Rs. 42,55,319
200000 X 100/5.00 = Rs. 40,00,000 ______________
Rs. 2,55,319 _______________
d) To understand the implications of various options suggested by the querist, relevant extracts of profit and loss account and balance sheet are given in Annexures for the following cases:
i) No forward cover is taken (Annexure-1)
ii) Forward cover is taken, and
a) roll over charges are written off to profit and loss account (Annexure 2)
b) roll over charges are added to the cost of the fixed assets (Annexure 3)
6.The querist has stated below the possible options:
i) Forward cover is taken and roll over charges are written off:
The treatment would be as under –
a) Loans/liabilities relating to acquisition of fixed assets:
- Foreign currency loans outstanding as at year end in respect of which forward covers have been taken are valued at forward rates. This is as per para 21 of AS 11. The exchange difference is added to /reduced from the cost of the fixed assets.
- Roll over charges are written off/carried forward as prepaid expenses based on the period to which they relate. This is because roll over charges are in the nature of bank charges. On the roll over date, the bank executes the earlier forward contract entered into and enters into a fresh forward contract for six months later. In the process, the bank incurs certain costs (depending upon the premiums prevailing) which it recovers from the company as roll over charges.
- Foreign currency loans in respect of which no forward covers have been taken would be valued at exchange rates prevailing at the year end and exchange difference would be added to/ reduced from the cost of fixed assets.
b) Loans/liabilities not relating to acquisition of fixed assets.
- Foreign currency loans outstanding as at year end in respect of which forward covers have been taken are valued at forward rates. This is as per para 21 of AS 11. The exchange difference is recognised in profit and loss account.
- Roll over charges are written off/carried forward as prepaid expenses based on the period to which they relate.
- Foreign currency loans in respect of which no forward covers have been taken would be valued at exchange rates prevailing at the year end and exchange difference would be charged to the profit & loss account.
ii) Forward cover is taken and roll over charges are capitalised:
The treatment would be as under –
a) Loans/liabilities relating to acquisition of fixed assets:
- Foreign currency loans outstanding as at year end in respect of which forward covers have been taken are valued at forward rates. This is as per para 21 of AS 11. The exchange difference is added to /reduced from the cost of the fixed assets.
- Roll over charges are added to the cost of fixed assets. This is because the charges relate to a liability of a capital nature which has been incurred for acquisition of fixed assets.
- Foreign currency loans in respect of which no forward covers have been taken would be valued at exchange rates prevailing at the year end and exchange difference would be added to/ reduced from the cost of fixed assets.
b) Loans/liabilities not relating to acquisition of fixed assets:
- Foreign currency loans outstanding as at year end in respect of which forward covers have been taken are valued at forward rates. This is as per para 21 of AS 11. The exchange difference is recognised in profit and loss account.
- Roll over charges are written off/carried forward as expenses based on the period to which they relate.
- Foreign currency loans in respect of which no forward covers have been taken would be valued at exchange rates prevailing at the year end and exchange difference would be charged to the profit and loss account.
7. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
a) What should be the treatment of roll over charges in the accounts?
b) What should be the treatment of roll over charges for taxation? Can roll over charges be treated as an allowable business expenditure or as capital expenditure?
Opinion November 7, 1991
1. The Committee notes that roll over charges to be paid at the end of six months is the difference between the forward rate and the spot rate prevailing at the end of sixth month. In case, the forward rate at the end of six months is lower than the spot rate prevailing on that date, the roll over charges would be received by the person taking the forward cover. For example, on 1st January, 1990, the spot rate and forward rate of one US $ are Rs. 18.18 and Rs. 19.23 respectively. On 1st July, 1990, the spot rate and forward rate of one US $ are Rs. 20.00 and 21.27 respectively. On 1st January, 1991, the spot rate and forward rate of one US $ are Rs. 20.40 and 20.00 respectively. If a person takes a forward cover on 1st January, 1990, he will be assured of one US $ at Rs. 19.23 at any time upto 30th June, 1990. If he wants to extend the forward cover, he shall pay roll over charges of Rs. 1.27, i.e., the difference between the forward rate and spot rate as on 1stJuly, 1990. If he further wants to extend the forward cover, he will receive roll over charges of Re. 0.40, i.e., the difference between the spot rate and forward rate as on 1st January, 1991.
2.The Committee is of the view that the roll over charges are indicative of the increase or decrease in the liability of the company in the next six months. The Committee is of the view that roll charges represent the difference arising on account of change in foreign exchange rates.
3. The Committee is also of the view that once the forward cover is taken and the related liabilities are recorded at the forward rates, the liability of the person taking the cover will not change during the period of cover and also the period for which roll over charges are paid/ received. In other words, the liabilities once recorded at forward rates would not be again converted at the forward rates prevailing at the end of six months when roll over charges are paid/received since the roll over charges represent the revision in rate. The Committee is of the view that if roll over charges are paid, they are paid on account of increase in the liability of the company and the payment is on account of revision in rates after six months. Similar is the case when roll over charges are received by the company.
4. The Committee notes paragraphs 21, 23, 24, 25 and 26 of the Accounting Standard (AS) 11 on ‘Accounting for the Effects of Changes in Foreign Exchange Rates’, issued by Institute of Chartered Accountants of India, which are reproduced below:
“21. When forward exchange contracts are entered into to establish the amounts of rupees required or available at the settlement dates of the foreign currency transactions, the forward rates specified in the related foreign exchange contracts may be used as the basis for measuring and reporting the transactions.
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 assets 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 sup-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.”
5. The Committee notes that Part I of Schedule VI to the Companies Act, 1956, inter alia, prescribes as below:
“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.” (Emphasis supplied by the Committee).
6. The Committee also notes section 43 A of the Income-tax Act, 1961, which states as under:
“Special provisions consequential to changes in rate of exchange of currency.
43A. (1) Notwithstanding anything contained in any other provision of this Act, where an assessee has acquired any asset from a country outside India for the purposes of his business or profession and, in consequence of a change in the rate of exchange at any time after the acquisition of such asset, there is an increase or reduction in the liability of the assessee 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 the moneys borrowed by him 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 aforesaid is so increased or reduced during the previous year shall be added to, or as the case may be, deducted from, the actual cost of the asset as defined in clause (1) of section 43 or the amount of expenditure of a capital nature referred to in clause (iv) of sub-section (1) of section 35 or in section 35A or in clause (ix) of sub-section (1) of section 36, or, in the case of a capital asset (not being a capital asset referred to in section 50), the cost of acquisition thereof for the purposes of section 48, and the amount arrived at after such addition or deduction shall be taken to be the actual cost of the asset or the amount of expenditure of a capital nature or, as the case may be, the cost of acquisition of the capital asset as aforesaid……………
Explanation 2: Where the whole or any part of the liability aforesaid is met, not by the assessee, but, directly or indirectly, by any other person or authority, the liability so met shall not be taken into account for the purposes of this sub-section.
Explanation 3: Where the assessee has entered into a contract with an authorised dealer as defined in section 2 of the Foreign Exchange Regulation Act, 1947 (7 of 1947), for providing him with a specified sum in a foreign currency on or after a stipulated future date at the rate of exchange specified in the contract to enable him to meet the whole or any part of the liability aforesaid, the amount, if any, to be added to, or deducted from, the actual cost of the asset or the amount of expenditure of a capital nature or, as the case may be, the cost of acquisition of the capital asset under this sub-section shall, in respect of so much of the sum specified in the contract as is available for discharging the liability aforesaid be computed with reference to the rate of exchange specified therein………”.
7. The Committee is of the view that as per the requirements of the Schedule VI to the Companies Act, 1956, section 43A of the Income-tax Act, 1961 and AS 11, the increase or decrease in the liability relating to acquisition of fixed assets, should be debited or credited, as the case may be, to the fixed asset to which such liability relates. Since the roll over charges are on account of increase or decrease in the liability of the company, these should be adjusted to the fixed assets to which the liability relates.
8. The Committee is of the view that the treatment suggested by the querist in para 6(ii)(a) of the query is correct. The treatment suggested by the querist in respect of liabilities not relating to acquisition of fixed assets in para 6(ii)(b) of the query is correct except the treatment of roll over charges. The roll over charges in respect of liabilities other than those pertaining to acquisition of fixed assets should be expensed in the period in which such roll over charges are incurred and should not be carried forward.
9. The Committee is accordingly of the following opinion:
(a) Roll over charges paid/received in respect of the liabilities relating to the acquisition of fixed assets should be debited/credited to the asset in respect of which liability was incurred. Roll over charges in respect of the liabilities not relating to the acquisition of fixed assets should be charged to the profit and loss account of the period in which such roll over charges become due.
(b) The above treatment shall apply for Income-tax purposes also.
Annexure 1
No forward cover is taken
a) Calculation of gross block/outstanding loans
b) Profit & loss account for the year ended on 30.9.91 (relevant extracts only):
Rs.
c) Balance Sheet (relevant extracts only)
Annexure 2
Forward cover is taken and roll over charges are written off
a) Calculation of gross block/outstanding loans
b) Profit & loss account for the year ended on 30.9.91 (relevant extracts only):
c) Balance Sheet (relevant extracts only)
Annexure 3
Forward cover is taken and roll over charges are capitalised
a) Calculation of gross block/outstanding loans
b) Profit & loss account for the year ended on 30.9.91 (relevant extracts only):
c) Balance Sheet (relevant extracts only)
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