Expert Advisory Committee

1.27 Query:

Accounting for the effects of changes in foreign currency rates.

1. An engineering industrial unit is engaged in the manufacture of earthmoving equipment for supply to various core sectors of the economy. The manufacturing operations are carried at various factory units located in Karnataka State at Kolar Gold Fields, Mysore and Bangalore. Each factory unit is independent for its manufacturing activity and has its own functional departments like factory management and administration including factory personnel, administration and accounts. The overall policy making, superintendence and control are effected by the corporate office situated at Bangalore where the top management team comprising chairman, functional directors and the central marketing set-up, corporate personnel and administration, accounts department etc., are located.

2. The querist has stated that the introduction of Accounting Standard (AS) 11 on ‘Accounting for the Effects of Changes in Foreign Exchange Rates’, has given rise to practical difficulties in recognising a foreign currency transaction and translation thereof. One of the most important definitions which is at the root of the recognition of a transaction and translation thereof is the term ‘date of transaction’ which has remained undefined. With the introduction of AS 11, a transaction in a foreign currency should be recorded in the reporting currency by applying to the foreign currency amount the exchange rate between the reporting currency and the foreign currency at the date of transaction.

3. According to the querist, prior to the introduction of AS 11, all imported revenue/capital items were being accounted in the books of account at the rate of exchange prevailing on the date of inventorising the asset when the amount was crystallised by the bank and based on bank debits. However, in respect of materials imported under usance credit or deferred liabilities, the rate of exchange prevailing on the date of inventorising the inward goods was being reckoned.

4. Some of the practical difficulties encountered in respect of transactions involving receipts and payments contemplated by the querist are explained in the following paragraphs.

For payments

5. Payments made for imports are generally effected by:

(a) direct payments;

(b) letter of credit or through banks, where documents are sent on collection basis.

In any of the above cases, the exchange rate adopted by the bank as intimated by them was recognised as effective rate to recognise the transaction and translate the foreign currency to the Indian rupees.

6. According to the querist, consequent to introduction of AS 11, the following options exist to recognise the transaction date;

(a) Date of Invoice;

(b) Date of Bill of Lading;

(d) Date on which received by the Clearing Agent;

(e) Date on which cleared from customs;

(f) Date on which items received from units.

7. According to the querist, there is a lot of subjectivity which creeps in as to the date on which the transaction is recognised initially. It is also to be noted that payments under usance credit will normally materialise 6 months after the date of Bill of Lading.

8. Consequent to payment and recognition of the transaction there is a possibility that:

(a) The item is in inventory; or

(b) The item is consumed for production.

9. Where the item is consumed for production, recognition of exchange gain or loss is appreciated by the querist. However, if the item is not consumed and remains in inventory, recognising the exchange gain or loss does not seem to be prudent as per the accounting practices on recognising the revenue in the view of the querist. The querist has given an example to explain his viewpoint as below:

Value of imports Rs.10 crores (Bank Debit). Suppose Rs.1 crore is the exchange rate variation between the transaction date and the date on which the bank debits the account, then according to AS 11, only Rs. 9 crores to be accounted to inventory and Rs. 1 crore to exchange rate variation. At the year end, if the entire quantity is not issued to production, only exchange rate variation of Rs. 1 crore would get charged off and similarly in the case of favorable exchange rate variation, treating the same as income and subject the same to tax in view of adoption of AS 11 by CBDT is untenable since the purpose for which the transaction was entered is not completed. Such a situation endangers the very foundation of basic accounting concepts and provides more scope for unhealthy practices.

For receipts

10. Even when the sale transaction is effected the similar situation arises, as per the querist, as to what the date of transaction is:

(a) Date of Invoice;

(b) Date of Bill of Lading;

(d) Date on which received by the Clearing Agency;

(e) Date on which cleared from customs;

(f) Date on which items received from units.

The exchange rate adopted is also subject to debate because each bank adopts a particular mechanism.

11. The querist has mentioned that there are practical difficulties regarding the rate of exchange to be adopted because of the subjectivity involved in arriving at the date in respect of the exchange rate.

12. According to the querist, application of the guidelines stated in AS 11 also end up in:

(a) Non-availability of actual material cost;

(b) Lack of justification from accounting prudence for recognition of revenue;

13. The definition of ‘Historical Cost’ in AS 2 on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, is as under:

‘Historical Cost’ represents an appropriate combination of the:

(a) Cost of purchase

(b) Cost of conversion

(c) Other costs incurred in the normal course of business in bringing the inventories upto their present location and condition.

14. According to the querist, the adjustment arising out of forward contract when accounted on notional basis and loaded to inventory by crediting the income account contradicts the guidelines laid down in AS 2.

15. The querist has desired the opinion of the Expert Advisory Committee on the following issues:

(i) What should be the

(a) date to recognise the transaction;

(b) exchange rate to be adopted to translate the same into Indian currency.

(ii) Whether the statement of accounts relating to current assets and current liabilities is depicted with respect to the normally accepted accounting principles although it may result in payment of income taxes on income derived notionally and would consequently also affect the amount of the provision for taxation.

Opinion January 15, 1997

1. The Committee wishes to point out at the outset that it has not gone into the question of taxation aspects of exchange rate differences since it involves interpretation of legal provisions of taxation laws and the Committee is prohibited from answering queries involving interpretation of law as per the Rules framed in this regard. Thus, the opinion of the Committee, given hereinafter, is primarily from the point of view of normally accepted accounting principles as laid down in Accounting Standard (AS) 11 (Revised) on ‘Accounting for the Effects of Changes in Foreign Exchange Rates’, issued by the Institute of Chartered Accountants of India.

2. The Committee notes that para 5 of AS 11 (Revised) requires that “a transaction in a foreign currency should be recorded in the reporting currency by applying to the foreign currency amount the exchange rate between the reporting currency and the foreign currency at the date of the transaction.” The Committee is of the view that ‘the date of transaction’, in accounting, is that date on which a transaction (whether payment or receipt) becomes eligible to be recognised in the books of account of the enterprise as per the relevant normally accepted accounting principles. For instance, revenue from sale of goods and services is required to be recognised in the books of account of the seller in accordance with the principles laid down in this regard in Accounting Standard (AS) 9 on ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India. Thus, it has to be ascertained that on which of the dates mentioned by the querist in para 10 (or any other date), revenue from sale of goods should be recognised in the books of account keeping in view the principles laid down in AS 9, e.g., on which date the risks and rewards of ownership in the goods are transferred to the buyer. Similarly, the relevant dates of recognition of other receipts and those of payments in the books of account have to be ascertained. The rates of exchange prevailing on such dates would be the relevant rates for translating the foreign currency into the Indian currency.

3. The Committee notes paras 7, 9, 10, 11 and 13 of AS 11, as reproduced below:

“7. At each balance sheet date:

(a) monetary items denominated in a foreign currency (e.g. foreign currency notes, balances in bank accounts denominated in a foreign currency, and receivables, payables and loans denominated in a foreign currency) should be reported using the closing rate. However, in certain circumstances, the closing rate may not reflect with reasonable accuracy the amount in reporting currency that is likely to be realised from, or required to disburse, a foreign currency monetary item at the balance sheet date, e.g., where there are restrictions on remittances or where the closing rate is unrealistic and it is not possible to effect an exchange of currencies at that rate at the balance sheet date. In such circumstances, the relevant monetary item should be reported in the reporting currency at the amount which is likely to be realised from, or required to disburse, such item at the balance sheet date;

(b) non-monetary items other than fixed assets, which are carried in terms of historical cost denominated in a foreign currency should be reported using the exchange rate at the date of transaction;

(c) non-monetary items other than fixed assets, which are carried in terms of fair value or other similar valuation, e.g. net realisable value, denominated in a foreign currency should be reported using the exchange rates that existed when the values were determined (e.g. if the fair value is determined as on the balance sheet date, the exchange rate on the balance sheet date may be used); and

(d) the carrying amount of fixed assets should be adjusted as stated in paragraphs 10 and 11 below:

9. Exchange differences arising on foreign currency transactions should be recognised as income or as expense in the period in which they arise, except as stated in paragraphs 10 and 11 below.

10. Exchange differences arising on repayment of liabilities incurred for the purpose of acquiring fixed assets, which are carried in terms of historical cost, should be adjusted in the carrying amount of the respective fixed assets. The carrying amount of such fixed assets should, to the extent not already so adjusted or otherwise accounted for, also be adjusted to account for any increase or decrease in the liability of the enterprise, as expressed in the reporting currency by applying the closing rate, for making payment towards the whole or a part of the cost of the assets or for repayment of the whole or a part of the monies borrowed by the enterprise from any person, directly or indirectly, in foreign currency specifically for the purpose of acquiring those assets.

11.The carrying amount of fixed assets which are carried in terms of revalued amounts should also be adjusted in the manner described in paragraph 10 above. However, such adjustment should not result in the net book value of a class of revalued fixed assets exceeding the recoverable amount of assets of that class, the remaining amount of the increase in liability, if any, being debited to the revaluation reserve, or to the profit and loss statement in the event of inadequacy of absence of the revaluation reserve.

13.An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract, to establish the amount of the reporting currency required or available at the settlement date of a transaction. The difference between the forward rate and the exchange rate at date of the transaction should be recognised as income or expense over the life of the contract, except in respect of liabilities incurred for acquiring fixed assets in which case, such difference should be adjusted in the carrying amount of the respective fixed assets.”

4. The Committee notes from the above that it has nowhere been stated in para 13 of AS 11 that adjustment arising out of forward contract should be loaded to inventory as mentioned by the querist in para 14 of the query. Similarly, monetary assets and liabilities (not ‘current’ assets and liabilities as stated by the querist) are required to be converted at the balance sheet date and the difference to be recorded as gain or loss as per the normally accepted accounting principles in India as well as in other countries, as per the requirements stated above.

5. On the basis of the above, the opinion of the Committee on the issues raised by the querist is as below:

(i)(a) The date for the relevant rate of exchange would be the date on and

(b) which the relevant items of revenues and expenses are recognised in the books of account of the enterprise in accordance with the relevant normally accepted accounting principles.

(ii) The amounts of monetary assets and liabilities reflected in the balance sheet on the basis of principles laid down in AS 11 are as per the normally accepted accounting principles in India. With regard to taxation, please refer para 1 of opinion.

______________________________