Query No. 13

Subject:    

  Treatment of exchange fluctuations relating to advance

received in foreign currency for export of goods.^[1]

A. Facts of the Case

1.  ABC Limited (hereinafter referred to as ‘the company’) is engaged in the business of manufacture of steel. The company has set up a fully integrated steel plant. The company’s plant is mainly financed through the following:

(a) Equity share capital (including share premium).

 

(b) Non-convertible debentures issued to financial institutions and others.

 

(c) Floating rate notes.

 

(d) Foreign currency loans from banks and financial institutions.

 

(e) Rupee loans from banks and financial institutions.

 

(f)  Foreign suppliers of capital goods.

 

(g) Indian suppliers of capital goods.

2. The company has entered into an ‘advance payment and steel supply contact’ with a Foreign Customer (FC) for supply of steel over a period of three years for an aggregate value of approximately US $  190 million.

3. In terms of the contract, the company has received an interest-bearing advance of US $ 134.50 million from FC. The advance has been received in the year 1997-98 and converted into Indian Rupees at the rate of exchange prevailing on the date of receipt of advance. The advance is repayable out of the sale proceeds in 12 equal quarterly instalments. Such repayment commenced after eight months from the date of receipt of advance.

4. The products have to be sold to FC or to other buyers as mutually agreed. The sale proceeds have to be deposited in an ‘Escrow’ account with a Designated Foreign Bank (DFB). At the end of each quarter, DFB has to pay an instalment of US $ 11.21 million plus interest for the quarter to FC; the surplus sale proceeds, if any, have to be remitted to the company. In terms of the approval obtained by the company from the Reserve Bank of India (RBI), the company can keep the surplus sale proceeds outside India for the purpose of payment of instalments (including interest) falling due in subsequent quarters.

5. In the event that the company is unable to supply in a quarter the products of a value which is equivalent to the quarterly instalment of US $ 11.21 million plus interest, the shortfall has to be made good in subsequent quarters.

6. In its approval, RBI has also stipulated that the company cannot remit any funds towards repayment of the advance but it must adjust the advance only against supply of goods. It is only in extreme circumstances, i.e., force majeure that the company can approach RBI for obtaining approval for repayment of the advance otherwise than through supply of products.

7. The advance received has been utilised for the following purposes:

(a) Redemption of non-convertible debentures.

 

(b) Repayment of foreign currency loans from banks and financial institutions.

 

(c) Repayment of rupee loans from banks and financial institutions.

 

(d) Payments to foreign suppliers of capital goods.

 

(e) Payments to Indian suppliers of capital goods.

 

(f) Other payments.

8. The company has revalued the outstanding balance of the advance as at March 31, 1998 at the closing rate of exchange and charged the resultant loss to the profit and loss account.

B. Queries

9. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) The ‘settlement date’ has been defined in paragraph 2 of Accounting Standard (AS) 11, ‘Accounting for the Effects of Changes in Foreign Exchange Rates’, as “the date at which a receivable is due to be collected or a payable is due to be paid”. At other places in the Standard, the expressions such as ‘the amount which is likely to be realised from, or required to disburse’ (paragraph 7 of the Standard) have been used.  In view of this, whether the company is right in contending that the Standard is not applicable to the transaction of supply of products where money has already been received in advance and converted into Indian Rupees.  The company is of the view that such types of transactions are not specifically covered in the Standard.

 

(b) Monetary items have been defined in paragraph 2 of AS 11 as “money held and assets and liabilities to be received or paid in fixed or determinable amounts of money, e.g., cash, receivables, payables”. The company contends that the advance received is not a monetary item since it is to be serviced by export of goods. Whether the company’s contention is right.

 

(c) Inter-related transactions have been described in paragraph 4 of AS 11 as below:

         “For the purpose of this Statement, two or more transactions are considered inter-related if, by virtue of being set off against one another or otherwise, they affect the net amount of reporting currency that will be available on, or required for, the settlement of those transactions.  Although the exchange rates applicable to realisations and disbursements in a foreign currency may be different, an enterprise may, where legally permissible, partly use the receivables to settle the payables directly, in which case the payables and receivables are reported at the exchange rate as applicable to the net amount of receivable or payable.”

         In view of this, whether the company is right in contending that the transactions enunciated in paragraphs 2 to 5 above are inter-related transactions.  The company is of the view that all these transactions, being inter-related transactions, should be recorded at the rate of exchange prevailing on the date of receipt of advance and, accordingly, the unsettled advance should not be revalued at the rate of exchange prevailing on the balance sheet date.

(d) In view of sub-paragraphs (a) to (c) above, whether the outstanding balance of FC advance needs to be revalued at the end of each financial year at the closing rate of exchange. The company is of the view that in case the advance is revalued, the company’s profit before taxation for the respective financial years will not show a correct view.  Assuming hypothetical figures, the company has worked out that in the event the advance is revalued, its profit (loss) for the financial years 1997-98, 1998-99, 1999-2000 and 2000-01 will be Rs. (32.14) crore, Rs. 19.65 crore, Rs. 55.51 crore and Rs. 41.21 crore respectively instead of Rs. 14.04 crore, Rs. 28.07 crore, Rs. 28.07 crore and Rs. 14.04 crore.

 

(e) Paragraphs 9 and 10 of AS 11 state as below:

                (i) “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.”

               (ii) “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.”

(f) If the answer to sub-paragraph (d) above is in the affirmative, whether, based on paragraph 9(e)(ii) above, the exchange difference arising on revaluation of advance at the closing rate of exchange can be adjusted to the cost of fixed assets to the extent the advance is utilised towards payments stated in sub-paragraphs 7(a) to 7(e) above.

 

(g) If the answer to sub-paragraph (d) above is in the affirmative, alternatively, in view of paragraph 9(e)(i) above, whether the exchange difference on revaluation of advance at the closing rate of exchange can be treated as deferred revenue expenditure to be written off in subsequent periods when and to the extent the advance is serviced by export of goods.

 

(h) If the answer to sub-paragraphs (f) and/or (g) above is in the affirmative, whether the loss on revaluation of outstanding balance of FC advance, charged off to the profit and loss account for the year ended 31st March, 1998, can be reversed and adjusted to the cost of fixed assets and/or treated as deferred revenue expenditure. If so, in what manner should such an adjustment be disclosed in the accounts for the year ending 31st March, 1999.

(i) In case there is a moratorium period of two years for servicing the advance by export of goods, whether the answers to sub-paragraphs (a) to (d) and (f) to (h) above would differ.

C. Points Considered by the Committee

10. The Committee notes the arguments put forth by the querist in paragraph 9(a) above. The Committee, however, does not agree with the contention that AS 11 is not applicable to the transaction of supply of products where money has already been received in advance and converted into Indian rupees.  The Committee is of the view that in the present case, the effect of the transaction of export is to give rise to a debt (a monetary asset) which is adjusted against the advance taken by the company from the foreign customer (a monetary liability).

11. The Committee also notes that paragraph 2 of AS 11 defines ‘monetary items’ as “money held and assets and liabilities to be received or paid in fixed or determinable amounts of money, e.g., cash, receivables, payables”.  The Committee is of the view that the words ‘received or paid’ do not necessarily envisage receipt or payment in cash. What is of the essence of the definition of monetary items is that the value of the asset or liability should be fixed or determinable in monetary terms.  In the present case, the liability of the company in respect of the advance taken from the foreign customer is fixed in monetary terms, though it will be discharged through exports rather than through payment in cash.  As such, the Committee is of the view that the advance received from the foreign customer is a monetary liability.

12. The Committee notes paragraph 4 of AS 11.  The Committee is of the view that the aforesaid paragraph refers to those transactions whose restatement at different rates of exchange would fail to portray the economic reality.  For example, where a foreign party owes certain amounts to an enterprise and the enterprise also owes certain amounts to such party and the two parties intend to settle these amounts only through a net payment, it is obvious that separate restatement of the two amounts in the books of the enterprise at two different rates of exchange would not give a correct picture of economic reality. In such a case, the appropriate course of action would be to translate the net amount receivable or payable at the applicable exchange rate.  The Committee is of the view that transactions referred to in the query are not of the nature contemplated in paragraph 4 of AS 11 and cannot therefore be treated as inter-related transactions.

13. In view of what has been stated in paragraph 11 above, the Committee is of the view that the outstanding balance of FC advance represents a monetary liability.  The Committee notes that paragraph 7(a) of AS 11 requires that monetary items denominated in a foreign currency should be reported in the financial statements using the closing rate.

14. The Committee notes that as per paragraphs 9 and 10 of AS 11, the exchange differences arising on restatement of liabilities incurred for repayment of monies borrowed for acquiring fixed assets are to be included in the carrying amount of the related fixed assets only if the monies have been borrowed by the enterprise in foreign currency “specifically for acquiring those assets”.  In the instant case, this criterion is not met.  Accordingly, in the view of the Committee, the aforesaid exchange difference cannot be capitalised and should be expensed in the year in which it arises.

15. The Committee notes that paragraphs 9 and 10 of AS 11 do not in any case permit the treatment of exchange differences as deferred revenue expenditure.

D. Opinion

16. Based on the above, the Committee is of the following opinion on the issues raised in paragraph 9 of the query, seriatim:

(a) The company is not right in contending that AS 11 is not applicable to the transaction of supply of products where money has already been received in advance in foreign currency and converted into Indian rupees.

 

(b) The company is not right in contending that the advance which is to be serviced by export of goods is not a monetary item.

 

(c) The company’s contention that the transactions referred to in the query are inter-related transactions is not correct.  Accordingly, the Committee does not agree with the company’s view that all these transactions should be recorded at the rate of exchange prevailing on the date of receipt of the advance and that the unsettled advance should not be restated at the rate of exchange prevailing on the balance sheet date.

 

(d) Since the FC advance is a monetary item, it should be restated at the end of each financial year at the closing rate in accordance with paragraph 7(a) of AS 11.

 

(e) No issue has been raised in this sub-paragraph.

 

(f) The exchange difference arising on restatement of advance at the closing rate cannot be adjusted in the cost of the fixed assets and should be expensed in the year in which it arises.

 

(g) In view of what has been stated at (f) above, the exchange difference on revaluation of FC advance at the closing rate cannot be treated as deferred revenue expenditure.

 

(h) Not applicable in view of (f) and (g) above.

(i) No.

___________

^[1] Opinion finalised by the Committee on 4.3.1999.