1.1 Query: Treatment of profit arising on cancellation of a roll-over contract. 1. A public limited company had referred a query on accounting treatment of roll-over charges where forward covers were taken for liabilities beyond six months. The opinion of the Committee has been published in the March 1992 issue of ‘The Chartered Accountant’*. The following query is related to the earlier query. PART (A) OF THE QUERY
2. The Reserve Bank of India has recently allowed cancellation of forward contracts. Previously, a forward contract, once entered into, could not be cancelled unless the underlying transaction itself fell through. Now, a company can cancel a contract and again take a forward cover. This process can be repeated any number of times till the foreign exchange transaction is settled. According to the querist, this has given a tool to the companies to speculate in the foreign exchange market with the back-up of a genuine trade transaction. The querist has explained this with the help of the following example:
- Accounting year ending on 30.9.92
- Forex loan due on 31.12.93
- Forex loan related to acquisition of fixed assets US$ 1,00,000
- Forward cover -taken on 1.1.92 -taken upto 30.6.92 -rate US$ 3.65/100 Rs - Devaluation of rupee takes place in March.
- Spot rate as on 30.6.92 US$ 3.20/100 Rs
- Spot rate as on 30.9.92 US$ 3.10/100 Rs
Normally, a company would have rolled over the liability for six months on 30/6/92 by paying the roll-over charges which would be equal to the premiums prevailing on 30/6/92 for six months. However, the company could opt for cancellation of the contracts. This would result in the following profit:
100 100
3.20 3.65
This money would be paid by the bank to the company on 30/6/1992.
3. The querist has suggested the following options with regard to the treatment of profit arising on cancellation:
(A) Forward cover is taken but not cancelled
- The loan would be valued as on 30/9/92 at the forward rate.
- The roll-over charges would be capitalised (in accordance with the opinion of the Committee referred to earlier).
- Depreciation would be charged on the cost after debiting roll-over charges.
(B) Forward cover is taken and cancelled before the close of accounting year and the profit is credited to fixed asset
- The profit on cancellation is credited to fixed assets.
- Loan is valued at the closing rate prevailing on 30/9/92. The exchange currency fluctuation (ECF) between the original rate and the closing rate is debited to the cost of the fixed assets.
- Depreciation is charged on the cost after crediting the cancellation profit and debiting the ECF. (Had there been any payment of roll-over charges, it would have been debited to the fixed assets).
(C) Forward cover is taken and cancelled before the close of accounting year and the profit is credited to the profit and loss account.
- The profit on cancellation is credited to profit and loss account.
- Loan is valued at the closing rate prevailing on 30/9/92. The exchange currency fluctuation between the original rate and the closing rate is debited to the cost of the fixed assets.
- Depreciation is charged on the cost after debiting the ECF. (Had there been any payment of roll-over charges, it would have been debited to fixed assets).
4. The querist has furnished the following arguments in favour of the above-mentioned options:
(i) The treatment given in Option (B) above is justified on the ground that the cancellation profit has arisen on account of a liability which relates to acquisition of fixed assets and is of a capital nature. Thus, this profit represents exchange currency fluctuation of a capital nature and should be capitalised.
(ii) The arguments in favour of treatment given in Option (C) are as follows:
(a) The activity of taking a forward cover involves ‘purchase’ of a foreign currency (in this case US Dollar). Foreign currency is like any other commodity that can be bought, kept and sold-off as and when desired. In Indian markets, this can be done by the companies only if a genuine trade transaction is there. In countries where the currency is fully convertible, this can be done for purely speculative purposes, i.e., buying the currency without any genuine requirement and selling to make a profit. The profit on cancellation of forward cover can be termed as profit on sale of foreign currency and should be credited to profit and loss account.
(b) There is another argument for following this treatment. Now the companies are allowed to book a forward cover and cancel and they can repeat this any number of times. Thus, even if it is done with the back-up of a genuine trade transaction, it actually represents speculative profit and should be taken to profit and loss account. A company could deliberately divide its loan portfolio into two parts:
- Loans which the company wants to keep hedged to minimise exchange liabilities. The roll-over charges to be paid would be capitalised.
- Loans which needs not be hedged. This would be a purely commercial decision based on currency involved, the date of repayment, likely roll-over charges etc.
In case of the second category, the company could take forward covers with the intention of cancelling them as and when rupee falls against the foreign currency. In this case, the profit/loss on cancellation plus the roll-over charges paid on these loans should be credited/debited to the profit and loss account. 5. The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:
(a) What should be the treatment of the profit/loss on cancellation of forward covers for the following:
(i) Liabilities relating to acquisition of fixed assets (e.g. foreign currency loans).
(ii) Liabilities other then in (a) above (e.g. import L/Cs for raw materials, royalty remittance etc.)
(iii) Current assets in foreign exchange (e.g. export receivables.)
(b) How should the profit be disclosed in the accounts?
(c) Can the profit/loss arising from cancellation of forward covers taken for liabilities relating to acquisition of fixed assets be debited/credited to the profit and loss account? Would the answer be different if the intention of taking forward covers is clearly defined and recorded, i.e., whether the intention (at the time of taking forward covers) was to speculate or to hedge the transaction?
(d) What should be the timing of recognizing profit/loss on cancellation-
- the date on which the cancellation is executed, or
- the date on which the cancellation would be effective since cancellation is done in the forward market.
(For example, a forward cover booked on 1.1.92 up to 30.6.92 may be cancelled on 15.1.92. The profit from cancellation would be crystallised on 15.1.92 itself though the actual cash would come in on 30.6.92. If the accounting year closes on 31.3.92, should the date of recognition be 15.1.92 or 30.6.92?
PART (B) OF THE QUERY
6. A forward cover can be taken for a liability due beyond the accounting year of the company. The company has taken forward cover for interest due after close of accounting year. This part of the query relates to the treatment of profit/loss on cancellation of forward cover relating to interest (or, for that matter, any revenue item) due after the close of accounting year.
7. According to the querist, the nature of this liability is different from that of the loans. Loans are recorded in the balance sheet as a liability. However, interest payable in future (i.e., after the close of the accounting year) is not recorded in the accounts. Thus, any forward cover taken for such interest liability would also not get reflected in the accounts. In case of loans, the valuation is done at the forward rate and, therefore, any profit due to depreciation of rupee on forward cover taken is indirectly recognised (by valuing the loan at a lower amount). However, in case of interest payable in future, the profit is not recognised unless the forward contract is cancelled. The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:
(a) Should the profit on cancellation of such a forward cover be recognised in the profit and loss account of
- the year in which forward cover is cancelled, or
- the year in which the interest amount is to fall due.
(b) How should it be disclosed? Should it be shown as income or reduced from the interest paid during the year?
8. The querist feels that it should be recognised in the year of cancellation. This is because the moment the forward cover is cancelled, the profit accrues to the company. The actual realisation may take place immediately or even after the close of accounting year when the interest is due. On the other hand, it can be argued that if the forward cover had not been cancelled, the profit would have accrued on the date of payment in the form of reduced payment. Thus, it would have been accounted for in the year of payment of interest. Further, taking of forward cover is not separate transaction by itself- it is linked to the transaction of payment of interest and any profit should be accounted for in the year of interest payment.
Opinion* November 11, 1993
1. The Committee notes para 14 of the Exposure Draft of revised Accounting Standard (AS) 11, on ‘Accounting for the Effects of Changes in Foreign Exchange Rates’, issued by the Accounting Standards Board of the Institute of Chartered Accountants of India, which reads as follows:
“14. Any profit or loss rising on cancellation of a forward exchange contract should be recognised as income or as expense for the period, except in case of a forward exchange contract relating to liabilities incurred for acquiring fixed assets, in which case, such profit or loss should be adjusted in the cost of the respective fixed assets.”
2. The Committee notes paras 3.2 and 10 of Accounting Standard (AS) 5 on ‘Prior Period and Extraordinary Items and Changes in Accounting Policies’, issued by the Institute of Chartered Accountants of India, which read as follows:
“3.2 ‘Extraordinary items’ are gains or losses which arise from events or transactions that are distinct from the ordinary activities of the business and which are both material and expected not to recur frequently or regularly. These would also include material adjustments necessitated by circumstances, which though related to previous periods are determined in the current period.”
“10. Extraordinary items of the enterprise during the period should be disclosed in the statement of profit and loss as part of net income. The nature and amount of each such items should be separately disclosed in a manner that their relative significance and effects on the current operating results of the period can be perceived.”
3. The Committee is of the view, on the basis of the above, that the profit or loss arising on the cancellation of a roll-over contract is an extraordinary item, except where the normal business of a company involves dealings in foreign exchange, e.g., banking companies etc. Therefore, it should be accounted for and disclosed as recommended in para 10 of Accounting Standard (AS) 5, reproduced at para 2 above.
4. On the basis of the above, the Committee is of the following opinion in respect of the issues raised at paras 5 and 7 of the query, respectively:
Part (A) of the query
(a) The profit/loss arising on cancellation of a forward exchange contract, in case the forward contract relates to the liabilities relating to acquisition of fixed assets, should be adjusted in the cost of the respective fixed assets. In all other cases, it should be recognised as income or expense, as the case may be, in the profit and loss account for the period.
(b) The profit or loss, as the case may be, on cancellation of a roll-over contract, in case it is to be adjusted in the cost of the relevant fixed asset, as per (a) above, should be shown as an addition/deduction to the cost of fixed asset in the balance sheet with adequate disclosure in the notes to accounts. In other cases it should be accounted for and disclosed as an extraordinary item, as per para 3 above.
(c) No. Notwithstanding the intention of taking the forward contract, the profit/loss on cancellation of forward contracts relating to the liabilities incurred for acquisition of fixed assets cannot be credited/debited to the profit and loss account.
(d) The profit/loss on cancellation of a roll-over contract should be recognised on the date when the cancellation is executed, provided, in case of profit it should not be recognised unless-
(i) The amount of such profit can be reasonably measured;
(ii) It is not unreasonable to expect its ultimate collection.
Part (B) of the query
(a) The profit or loss, as the case may be, on cancellation of the forward cover taken for a future interest liability should be recognised in the year in which such forward contract is cancelled, provided the conditions stated in (d) above are satisfied.
(b) The accounting treatment and disclosure of the profit, or loss, as the case may be, on cancellation of a forward cover relating to the interest, that will be due and payable in future years, should be as follows:
(i) In case the interest relates to a liability incurred for acquisition of fixed asset and the relevant asset is not ready for being put to use, it should be adjusted in the cost of acquisition of such asset.
(ii) In other cases, not covered by (i) above, it should be recognised in the profit and loss account as an extraordinary item, as per para 3 above. __________________________ * Published in Compendium of Opinions, Volume XI, page XI-106. * The Committee wishes to draw attention to the fact that the opinion is based on the recommendations made in Exposure Draft of Revised Accounting Standard (AS) 11, issued by the Accounting Standards Board of the Institute of Chartered Accountants of India, published in ‘The Chartered Accountant’, August, 1993. It is, thus, possible that this opinion may change upon issuance of revised Accounting Standard (AS) 11. |
