Expert Advisory Committee

Query No. 14

Subject:

Accounting treatment of certain foreign currency transactions.^[1]

A. Facts of the Case

1. A public sector corporation, registered under the Companies Act, 1956, is functioning as a development bank with the main objective of financing power projects in India. The corporation provides term loans for power projects which include generation, transmission, urban distribution etc. to state electricity boards, state generating corporations and private power projects. The corporation has been declared a public financial institution by the central government in terms of section 4(A) of the Companies Act, 1956. Thus, the corporation functions as a development bank similar to development institutions such as IDBI, IFCI, ICICI, NABARD etc. The resources of the corporation consist of equity from the central government, market borrowings through issue of bonds, foreign currency loans, and internal generations.

2. The corporation has taken Foreign Currency Loans (FCLs) from different sources and has lent them to its borrowers in the following two ways:

(a) On back-to-back basis : The terms of borrowing of FCLs by the corporation and those of its lending are identical in all respects, with a service charge payable by the borrowers in addition to the actual cost of borrowing by the corporation. The foreign exchange risk is borne by the borrowers. The loan amount to the borrowers is established in rupee terms on the basis of exchange rate prevailing on the day when the loan is actually disbursed (called ‘book value’ of loan). In case of more than one disbursement, a weighted average rate is arrived at.

As per the agreement with the borrowers, all obligations of the corporation towards its lenders with regard to interest payment, principal repayment and other charges are to be covered by the corresponding receipt from its borrowers. The payment due dates are co-terminus for borrowing and lending by the corporation.

To meet the exchange risk on FCLs, the corporation has established an Exchange Risk Administration Fund (ERAF) which is notified for eligibility of certain tax benefits under section 10(23E) of the Income- tax Act, 1961. As the exchange variations are to be borne by the borrowers, they contribute, every half year, an amount equal to a certain percentage of loan outstanding, known as Exchange Risk Contribution. The Exchange Risk Contribution is transferred to ERAF. Any actual exchange loss incurred by the corporation on account of payment of interest and repayment of principal is immediately reimbursed by ERAF. In the event of insufficiency of fund available with ERAF, the shortfall is made good by way of further contributions by the borrowers of the corporation.

(b) Not on back-to-back basis : In such cases, the FCLs taken by the corporation are converted into rupees, merged into common pool of rupee resources and lent as rupee loans. The exchange risk on such loans is borne by the corporation. For this purpose, the corporation periodically contributes ‘exchange risk contribution’ to ERAF, which is a certain percentage of loan outstanding. Exchange loss on account of payment of interest and repayment of principal is reimbursed by ERAF to the extent the funds are available. In case of short-fall, the same is to be borne by the corporation.

3. Extracts from the Accounting Policies, insofar as they relate to foreign exchange transactions, are given below:

“3. Foreign Exchange Transactions

3.1 The following transactions are accounted for at the rates prevailing on the date of the transactions:

(i) Expenses and income in foreign exchange; and

(ii) the amounts borrowed and re-lent under foreign currency loans.

3.2 The following balances are expressed in Indian currency at the rates prevailing at the close of the accounting year:

(i) Foreign currency loans/borrowings availed of;

(ii) funds kept in foreign currency account with banks abroad;

(iii) contingent liabilities in respect of guarantees given in foreign currency; and

(iv) income earned abroad but not remitted to India.

3.3 The loans granted to sub-borrowers in foreign currency are translated at the year-end rate and any translation loss is shown as amount recoverable from the sub-borrowers.

3.4 In cases where foreign currency loan repayments have been received from sub-borrowers but not fully repaid to the lenders, translation loss on the amount not repaid is shown as recoverable from the Exchange Risk Administration Fund. If translation loss exceeds the accumulated Exchange Risk Fund, such difference is charged to the profit and loss account of the year.

3.5 In respect of the Foreign Currency Loans (FCL) re-lent in Rupees terms, the corporation periodically makes a contribution to Exchange Risk Administration Fund (ERAF) for meeting out exchange rate variation. If translation loss exceeds the accumulated Exchange Risk Fund, such difference is charged to the profit and loss account of the year.”

4. The manner of accounting for FCL transactions is as follows:

(a) In back-to-back cases : On the date of debt service, all expenses like interest, agency fees, guarantee fees, etc., are recorded in the books of the corporation at the current rate of exchange. The corresponding payments received from borrowers are at the book value (historical). The difference between the current rate of exchange and the book value, called exchange loss, is reimbursed from ERAF and is treated as income and shown under the head “Exchange Loss Recovered From Borrowers” in the profit and loss account. The repayments of FCL, however, are recorded at book value of the loan. Any exchange loss in this regard is reimbursed by ERAF and the loss thus becomes nil in the books of the corporation.

For balance sheet purposes, the foreign currency loan value is translated at the year-end exchange rate and any exchange loss is shown as recoverable from ERAF or the borrower, as the case may be, since either the ERAF or the borrower will bear that loss. As a result, the liabilities get translated at the year-end rate, the Loan Assets are stated at book value and exchange loss is shown under Loan Assets as recoverable from ERAF/Borrower.

(b) Non back-to-back cases : On the date of payment, all debt related expenses are recorded under the respective expense head at the current rate of exchange. The reimbursement of exchange loss from ERAF is credited under the head ‘exchange loss recovered from ERAF’. This loss is reimbursed from the ERAF only if the balance in the fund account is sufficient. Otherwise, there are no reimbursements and this loss is borne by the corporation and ultimately gets reflected in the profit and loss account for that year.

In the balance sheet, the FCL is translated at the year-end exchange rate. Any translation loss, to the extent it is in excess of fund available with ERAF, is charged to the profit and loss account. Thus, the loan liability gets translated at the year-end exchange rate.

B. Query

5. The querist has sought the opinion of the Expert Advisory Committee on the issue whether recording of interest income in Indian currency at the book value and crediting the exchange variation on account of such interest under the head “Exchange Loss Recovered From Borrowers” is in accordance with Accounting Standard (AS) 11, ‘Accounting for the Effects of Changes in Foreign Exchange Rates’.

C. Points Considered by the Committee

6. The Committee notes that the querist has sought its opinion only on the limited aspects of correctness of the accounting treatment and disclosure of interest income on foreign currency loans on back-to-back basis and exchange variation on account of such interest. The Committee, therefore, restricts itself to the above issue and does not express any opinion on the other aspects of the accounting policy followed by the company.

7. The Committee notes that paragraph 17 of Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’ recognises ‘substance over form’ as one of the major considerations governing the selection and application of accounting policies. The Standard describes ‘substance over form’ as follows:

“The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form.”

8. From the facts of the case, it is clear that the corporation is required to pay a pre-determined rate of interest on the foreign currency amounts of the loans (though they are recorded in the books of the corporation at the exchange rate prevailing on the date of remittance). Since the recording of interest (and other expenses like agency fees, guarantee fees, etc.) takes place for the first time on the date of remittance, there is no question of any exchange difference and therefore the entire amount is disclosed in the profit and loss account under the relevant expense head (e.g., interest).

9. The Committee also notes that the corporation is presently crediting the interest income at ‘book value’ to the profit and loss account. The difference between the interest paid by the corporation on FCLs at the current rate of exchange and the interest income at ‘book value’, which is reimbursed by ERAF or by the borrowers, is being shown in the profit and loss account under the head “Exchange Loss Recovered From Borrowers”. In the view of the Committee, the above disclosure does not faithfully represent the economic substance and reality of the underlying transactions. The Committee is of the view that the economic substance and reality of the transactions is that the corporation lends to its borrowers at a fluctuating rate of interest. This rate of interest is such that the interest for a period on a loan is equal to the interest payable on the same by the corporation. It is for convenience that a rate of interest on the book value has been specified. In fact, the entire interest in rupee terms payable by the corporation to its lenders is to be recovered from the borrowers.

10. In view of the above, the Committee believes that the true nature of amount reimbursed by ERAF or by borrowers, referred to in paragraph 9 above, is that of interest and should be disclosed as such in the profit and loss account. The Committee believes that a disclosure on the following lines would assist the readers in understanding the nature of the transactions clearly.

Interest on ‘book value’ of loans Rs. xxxx

Add: Exchange difference relating

to interest recovered from

borrowers Rs. xxxx

Rs. xxxx

11. The Committee also believes that it would be useful to disclose the nature of the relevant transactions in the notes to the accounts.

D. Opinion

12. Based on the above, the Committee is of the opinion that recording of interest income in Indian currency at the book value and crediting the exchange variation on account of such interest under the head “Exchange Loss Recovered From Borrowers” is not appropriate. The manner of disclosure should be based on the true nature of the underlying transactions as discussed in paragraph 10 above and the nature of the relevant transactions should be disclosed in the notes to the accounts.

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