Query No. 1 Accounting for gain arising on account of foreign currency fluctuations in respect of a debt outstanding.[1] A. Facts of the Case
1. A public sector consultancy and engineering company is engaged in design, procurement, and project management activities in the petroleum sector. In addition to operating petroleum refineries, the company also undertakes consultancy services in the areas of petrochemicals, oil and gas processing, pipelines, ocean engineering services, ports and harbours, metallurgy, cement, paper and power, etc. 2. The querist has informed that during the course of audit of accounts of the company for the year 1996-97, the government auditors expressed certain reservations on its accounting policy regarding foreign currency transactions which reads as below :
“Exchange difference resulting from the conversion of current assets and current liabilities at bank’s closing rates of the respective currencies and originally recorded rates is charged to profit and loss account in case there is a net loss, and in case of net gain, the same is not taken into account.” [Ref: accounting policy no.3(c)].
3. The querist has stated that the company has formulated its accounting policy based on Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, issued by the Institute of Chartered Accountants of India. The fundamental accounting assumptions as per the Standard are :
(a) going concern;
(b) consistency; and
(c) accrual.
The Standard also states that the major considerations governing the selection and application of accounting policies as below :
Financial statements should disclose all “material” items, i.e., items the knowledge of which might influence the decision of the user of the financial statements.”
4. The querist has pointed out that the company’s accounting policy on foreign currency transactions, as reproduced in paragraph 2 above, has been formulated in accordance with the consideration of prudence as explained above. 5. The querist has, however, drawn the attention of the Committee to Accounting Standard (AS) 11, ‘Accounting for the Effects of Changes in Foreign Exchange Rates’ which is mandatory with effect from 1.4.1995. As per this Standard, the exchange difference in respect of foreign currency transactions should be recognised as income or as expense in the period in which it arises except in certain situations stated in the Standard. The current assets and current liabilities at the year-end are to be converted at the closing rates as specified in paragraph 7(a) of AS 11 reproduced below and the difference, whether gain or loss, is to be taken to the profit and loss account:
“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.”
6. The querist has also drawn the attention of the Committee to Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India, which provides that where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising any claim, revenue recognition is postponed to the extent of uncertainty involved. 7. According to the querist, a sum of approximately Rs. 17 crore is due from various parties in Iran. The parties concerned are not in a position to confirm as to when they shall be able to release the payments because of the bad shape of the economy of Iran. The querist has further stated the following:
(a) The debts have been outstanding since 1992. However, the parties have never disputed the outstanding dues. The uncertainty is only as to when the debts will be realised. It may take another 2 to 3 years to recover them.
(b) The company has negotiated for release of its debt through the Ministry, Embassy in Iran and Government of Iran. Therefore, the company has not created any provision for doubtful debts against these receivables. Of late, Iran has started releasing payments and outstandings have come down.
8. According to the querist, AS 1 and AS 11 are at variance in respect of accounting of unrealised gains. The company considers that the principle of prudence should be applied in all cases and accordingly, where uncertainty exists as regards the ultimate collection, the company may defer the revenue recognition.
9. The querist has stated that the statutory auditors of the company have qualified their audit report, stating that the company has not recorded foreign exchange transactions in accordance with AS 11 and effect thereof is unascertained in view of paragraph 15(b) of Notes to Accounts (Schedule-J) which is reproduced below :
“Paragraph 15(b) - Schedule J:
As per accounting policy no. 3 regarding foreign currency transactions regularly followed by the company, current assets and current liabilities are revalued at the year-end rates. However, if there is a net loss due to exchange difference, the same is charged to profit and loss account and if there is a net gain, the same is ignored in view of the prudent accounting policy of not recording the unrealised gains due to exchange rate fluctuations.”
10. The government auditors have commented on the accounts of the company as under:
“Accounting policy no. 3(c) is not consistent with AS 11. This has resulted in the understatement of income by Rs.622.77 lakh, provision of income tax by Rs.267.79 lakh with a consequent understatement of profit by Rs.354.98 lakh.”
B. Queries
11. The opinion of the Expert Advisory Committee has been sought on the following issues:
(a) In view of the uncertainties involved in the ultimate collection of the amounts due from Iran on account of the bad shape of their economy, whether it will be prudent to recognise the exchange gain arising from translation of the debts on the balance sheet date.
(b) If the treatment adopted by the company is correct, whether any further disclosure in the accounts is required.
C. Points Considered by the Committee
12. Paragraph 7(a) of Accounting Standard (AS)11, ‘Accounting for the Effects of Changes in Foreign Exchange Rates’, clearly states that the debts due on the balance sheet date must be converted at the closing rate. The Standard further states the following in paragraph 9:
“9. Exchange differences arising on foreign currency transactions should be recognised as income or as expense in the period in which they arise......”
Therefore, the exchange difference arising due to translation on the balance sheet date, whether gain or loss, should be recognised in the profit and loss statement.
13. The exceptions mentioned in paragraph 7(a) of AS 11 do not cover the uncertainty associated with the debt in question.
14. The major considerations governing the selection and application of accounting policies are prudence, substance over form and materiality. As regards the querist’s argument as given in paragraph 8 above, the Committee notes that the accounting standards are framed after giving due consideration to these principles.
15. Since AS 11 is mandatory in respect of accounting periods commencing on or after 1.4.1995, the provisions of AS 11 will be applicable in the given situation. The querist cannot deviate from the requirements of the Standard.
16. The Committee notes the querist’s statements that a lot of money was due from Iran since 1992, that Iran has never disputed the company’s claim and lately payments have started coming in, and that no provision for bad and doubtful debts has been made against the debts. The Committee is of the opinion that these statements point to the fact that the company does not consider the debts doubtful of recovery. Moreover, even if a debt is doubtful of recovery, the plea that the gain arising on translation of the debt should not be booked as income due to the uncertainty of its recovery, does not hold good. In such a situation, a provision for bad and doubtful debts should be created against the amounts due. However, creation of a provision for doubtful debts does not change the applicability of AS 11.
17. In respect of the querist’s argument that revenue recognition should be postponed in case there is a reasonable uncertainty of ultimate collection as per AS 9, the Committee notes that AS 9 is related to revenue recognition. In the given case, revenue has already been recognised at the time when the debts were recorded in the books of account. The issue under consideration is not whether to recognise the revenue or not, rather it relates to the translation of the debts in foreign currency to Indian rupees on the balance sheet date as the reporting currency is Indian rupee. The exchange gain arising due to translation is not covered in the definition of revenue as per paragraph 3 of AS 9 and, therefore, the issue is not within its scope.
D. Opinion
18. Based on the above, the Committee is of the following opinion on the issues raised in paragraph 11:
(a) Yes, in accordance with Accounting Standard (AS) 11, ‘Accounting for the Effects of Changes in Foreign Exchange Rates’, the exchange gain should be recognised as income.
(b) The treatment adopted by the company is not correct. Therefore, this issue does not arise.
[1]Opinion finalised by the Committee on 23.6.1998.
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