Query No. 34

 

Subject:           

Adjustment of foreign currency fluctuations in the

carrying amount of fixed assets.1

 

A. Facts of the Case

 

1. A  public  sector  company  is  engaged  in  processing/marketing/ transmission of natural gas to different customers. The company operates one  of  the  largest  gas  pipeline  network  in Asia  known  as  HBJ  system having  a  capacity  of  18.2  MMSCMD  on  which  its  largest  processing facilities  are  located  and  through  the  same  pipeline  it  carries  out transmission  and  marketing  of  natural  gas  to  various  customers.  The length of the HBJ pipeline is 2500 kms. starting from gas landfall point on  seashore  at  Hazira  (Gujarat)  and  runs  through  Bijaipur  (M.P.), Jagdishpur  (U.P.)  upto  Noida  (near  Delhi).  The  HBJ  pipeline  was capitalised in the financial year 1991-92.

 

2. The company started HBJ pipeline upgradation project which was termed as Gas Rehabilitation and Expansion Project (GREP). GREP was approved by Government of India for laying of 505 kms. pipelines system from Bijaipur to Dadri and establishing/upgrading compressor stations. It expanded  the  capacity  of  HBJ  pipeline  from  18.2  MMSCMD  to  33.4 MMSCMD. This project involved the laying of an additional 505 kms. of  pipeline,  the  enhancement  of  the  compressor  stations  at  Hazira  and Jhabua and the construction of new compressor stations at Vaghodia and Khera.  The  project  also  included  cathodic  protection  of  the  additional pipeline, installation of receiving/dispatch terminals and the integration of the pipeline to the main SCADA system. The estimated cost of GREP was Rs. 23.8 billion. For financing this project a loan of US$ 260 million was taken from Asian Development Bank (ADB) by the company.

 

3.  As per the querist, the company started much later another project for setting up of gas processing facilities, which is called as Uttar Pradesh Petro-Chemical Complex (UPPC)  at Pata. The UPPC consists  of a gas sweetening  unit,  a  C2/C3  recovery  unit,  a  gas  cracker  unit  and  two downstream polyethylene units. Gas Processing Unit (GPU) is an upstream unit of this project.

 

4. The  company  raised  another  foreign  currency  Yen  loan  from the Export Import Bank of Japan (J-Exim) equivalent to US$ 80 million.The agreement for loan was entered on 20th  February, 1998. Later on the company did not draw the full amount of loan contracted as it drew only 9224 million Yen (Rs. 276 crore) equivalent to US$ 63.83 million. The loan was drawn on 29th  June, 1998.

 

5. The central statutory auditors of the company made the following observations in their report for the year ending 31st  March, 2000:  

“The  company  has  not  charged  off  to  revenue  exchange  rate difference on foreign currency loan which was disbursed after the acquisition  of  assets  which  has  resulted  in  increase  in  profits  and fixed assets by Rs. 94.85 crore”. 

6.  As  per  the  querist,  the  above  observation  was  made  taking  into consideration the following facts:

(a)        The loan was sanctioned/approved by the board of directors of the  company  as  well  as  the  Government  of  India  for  Gas Rehabilitation  and  Expansion  Project  (GREP)  which  was capitalised in March 1997. The company obtained the foreign currency loan  from J-Exim on  29.06.1998,  which  was  much later than the capitalisation of the relevant assets.

(b)        There  was  no  loan  agreement  between  the  lender  and  the company either at the time when the capital expenditure was incurred or at the time when the project itself was capitalised and the assets were put to commercial use. The agreement was signed  with  the  lender  only  on  20th February,  1998  and  the   loan agreement became effective from 12th June, 1998 as per the  mutual agreement  which  was after  three  to  five years  of the actual payments that were made to the suppliers of capital goods and services. The company placed the purchase orders for the same during the period from 1993 to 1995 and supplies started  arriving  from  1995.  Payments  to  the  suppliers  were released during the period 1995-96 to 1996-97.

 

(c)        The  project  for  which  the  loan  was  supposedly  taken  was completed/erected by the company out of its surplus working capital  funds.  The  loan  proceeds  were  never  utilised  by  the company for financing/erection of its project.

 

(d)        At the time of the capitalisation of the project for which the loan  was  supposed  to  have  been  taken,  there  was  no commitment  from  the  lender,  i.e.,  J-Exim.  The  commitment was made from 12 th June, 1998. This is established from the fact that the company had paid the commitment charges from 12 June, 1998 to 29 June, 1998; the former date being the date of drawing of loan amount as the loan had become effective from that date only which was much after the capitalisation of the assets to which loan related. The expenditure on the project was  incurred  during  the  period  1993-94  to  1996-97.  During this period the loan agreement was not in place and there was no commitment by the lender. As such during the erection of assets as well as its capitalisation, only the mutual discussions were going on. The querist has separately informed that during the  period   1993-1997   the company   was   in   regular correspondence with ADB and  other financial institutions to draw foreign currency loans.

 

(e)        According  to  the  querist,  the  company  had  no  intention  to relate the loan taken from J-Exim to the specific fixed assets. As  stated  above,  the  loan  agreement  was  signed  on  20 February, 1998 and the sovereign guarantee of Government of India  was  also  received  on  3rd April,  1998  and  the  accounts were finalised in May 1998 but no disclosure was made by the company in the audited accounts for the financial year ending on 31st March, 1998. Had the company then claimed that the loan from J-EXIM was for reimbursement of capital expenditure already  incurred,  the  company  would  have  passed  the  entry for amount recoverable either at the time the capital expenditure was  incurred  or  at  the  time  of  signing  of  loan  agreement. According  to  the  querist,  the  drawing  of  loan  was  an independent transaction meant for replenishment of the surplus working capital.

 

(f)     The entire amount of loan proceeds was used by the company for acquisition  of fixed  deposits in  July 1998.  The company earned  interest  on  fixed  deposits,  which  was  credited  to  the statement  of  profit  and  loss  of  the  company. Therefore,  it  is clear that the drawing of the loan amount later, was only for the purpose of recouping surplus working capital funds which were  earlier  spent  by  the  company  for  project  completion. This is established from the fact that the company had surplus funds during the period 1995-96 as per the following details:

 

Year ending      Amount of Investments

 

1995                Rs. 300 crore

1996                Rs. 200 crore

 

(g)        The company had only capitalised the difference in exchange rate as on 31st March, 1999 comparing it with the rate as on 29   June, 1998 (i.e., the date of drawing of the loan amount) in the financial year 1998-99 and in the financial year 1999-2000 the difference in exchange rate as on 31st March, 2000 and as on 31

March, 1999 was capitalised. The company did not capitalise the difference in exchange rates as on 29 June, 1998 and the dates of actual incurring of capital expenditure (as  the  capital  expenditure  was  incurred  on  various  dates between 1994 to 1997). The amount of loan was much more than the amounts actually spent by the company. The project for  which  the  loan  was  supposed  to  have  been  taken  was capitalised in March 1997. The payments were mostly made in foreign currencies to Indian suppliers. The payments were made by the company out of its internal surplus working capital by purchasing the foreign currencies on the dates of payment during the period 1993-94 to 1996-97, whereas the loan was drawn  by  the  company  on  29 June,  1998,  at  the  rate  of exchange prevalent on that day. To illustrate this point, at the time of incurring the expenditure in foreign currency, e.g., on 31   March,  1994, the exchange rate  was 1 US$ =  Rs. 31.72

which meant that if the company spent 100 US$, it paid Rs. 3172, whereas at the time of drawing of the loan the exchange rate  was  1  US$  =  Rs.  41.95.  Thus,  when  it  drew  100  US$ which  it  had spent  in  1994,  it  received  Rs. 4195.  Hence  the actual loan taken was more than the amount actually spent.

 

According to the querist, if the argument of the company that the loan proceeds were related to the acquisition of the relevant assets  was  to  be  accepted,  then  the  company  ought  to  have capitalised  the  exchange  variation  arising  out  of  the  time difference of 2-5 years between the actual expenditure and the drawing of loan. This might lead to increase in capitalisation of the project by more than 30% at the time of drawing of the loan itself. It might also lead to the conclusion that even if the loan  was  taken  4  years  after  the  capitalisation  and  if  in  the agreement it was mentioned that loan was for reimbursement of project cost then the exchange difference on this loan will have to be capitalised even if the loan was not actually used for the acquisition of the assets and was actually used by the company for replenishment/recoupment of working capital.

 

(h)        The  company  did  not  raise  any  bridge  loan  at  the  time  of erection of assets as it had ample surplus working capital funds as stated above which were used by the company for the project.

 

(i)         The entire GREP of Rs. 2376 crore was financed from other sources and not out of the loan proceeds of J-Exim Bank. As entire proceeds from J-Exim Bank were utilised for recoupment of  surplus  working  capital,  it  did  not  finance  acquisition  of any asset directly or indirectly.

7. According to the querist, the additional factors which were considered by the auditors in forming their opinion are as under:

 

(a) GREP  is  a  separate  and  distinct  project  than  UPPC  at  Pata. The company had stated that its loan agreement with J-Exim stipulated the specific items to be financed for the GREP as follows:            

Line Materials               US$     6.00 million

Cathodic Protection      US$     4.00 million

Terminals                      US$     0.70 million

Telecom/SCADA         US$     3.10 million

Pressure upgradation    US$     0.20 million

Gas Processing Unit     US$     66.00 million

Total                            US$     80.00 million

 

The  last  item for  which  the  company maintained  that  it  had reached a loan agreement with J-Exim for financing GPU at Pata  for  66  million  US  dollars  and  that  it  is  a  part  of  the GREP, is contrary to the facts as GPU is a part of the UPPC at Pata  as  this  is  its  upstream  unit  and  not  a  part  of  GREP  in view of the following facts:

 

(i)  The  company  had  issued  a  report  dated  16th    January, 1999, for the purpose of providing information to Non- Domestic  Financial  Institutions,  banks,  mutual  funds registered with SEBI and Foreign Institutional Investors for the purpose of offering shares of Government of India (out of the shares owned by the Government) to the above clients  by way of  negotiated  private sale  which  clearly states the following details about GREP:

 

“In March 1994, the Government of India approved the Gas  Rehabilitation  and  Expansion  Project,  which  has expanded  the  capacity  of  HBJ  Pipeline  from  18.2 MMSCM  to  33.4  MMSCM.  This  project  involved  the laying  of  an  additional  505  kms.  of  pipeline,  the enhancement  of  the  compressor  stations  at  Hazira  and Jhabua and the construction of new compressor stations at Vaghodia and Khera. The project also includes cathodic protection  of  the  additional  pipeline,  installation  of receiving/dispatch  terminals  and  the  integration  of  the pipeline  to  the  main  SCADA system.  The  project,  at  a total  estimated  cost  of  Rs.  23.8  billion,  has  been substantially completed with the pipeline, compressor and various  terminals  commissioned  in  July  1998.  The SCADA  system  is  under  execution  and  pending  the commissioning  of  new  SCADA  system,  the  existing system  has  been  extended  to  monitor  the  operating parameters.”

 

Similarly,  the  same  report  specifically  described  GPU (an upstream unit) at Pata as a separate project, which is  a  part  of  Uttar  Pradesh  Petrochemical  Complex  of  the company.

 

Further,  the  same  report  emphatically  stated:  “The company  accepts  responsibility  for  the  information contained  in  this  document.  To  the  best  of  knowledge and belief of the company (which has taken all reasonable care  to  ensure  that  such  is  the  case),  the  information contained herein is in accordance with the facts and does not  omit  anything  likely  to  affect  the  import  of  such information.”  

(ii) Further, published 12th  annual report and annual accounts for the year 1995-96 and 13th  annual report for the year 1996-97 described GREP as a project which was accorded approval in March 1994 by the Government of India and was for the  purpose of laying pipeline of 505 kms. and also  for  enhancement  of  compressor  stations  and  for establishing two new compressor stations at Khera and Vaghodia.

 

In view of the aforesaid, GREP is a separate and distinct project  and  it  does  not  include  GPU. GPU  is  only  an upstream unit and only one of the various units of UPPC at Pata and is a separate unit altogether.

 

(b) The  company  had  sought  permission  from  the  government/ RBI for financing imports of capital goods and services only for  GREP  and  not  for  GPU  at  Pata  as  is  evident  from  the following documents:

 

(i)  The application of the company dated 14.2.1996 which sought permission of the government for sanction to its proposal for raising foreign currency loan from J-Exim was only for GREP and not for GPU. The Government of India conveyed its sanction vide letter dated 29.3.1996 of which the basic conditions were as follows:

 

(1) The  foreign  currency  loan  sanctioned  was  for  US dollar 80 million  and specifically for the  import of capital  goods  and  services  required  for  GREP. The sanction was given only for the purpose of financing the  capital  goods  and  services  and  not  for  the reimbursement  of  expenditure  already  incurred  by the  company  out  of  its  surplus  internal  resources. Sanction letter also stated that the Reserve Bank of India would be advised to allow the company to draw the  loan  and  effect  the  advance  payment/down payment  only  after  the  company’s  agreement  with the lender was taken on record by this department.

 

(2) The company was required to submit semi-annually a certified copy of the auditor’s report that the loan/ credit was utilised only for import of capital goods and/or  for  purposes  for  which  approval  was  given. Such reports  could be  submitted till  the loan/credit was fully drawn.  

(ii)  After receipt of the sanction of the Government of India, the Bank of India on behalf of the company applied to RBI for its sanction  vide application dated 16.12.1996.

 

The  application  clearly  stated  that  the  loan  would  be raised strictly for the purpose of import of capital goods and services for GREP.

 

(iii) Reserve Bank of India conveyed its approval vide their sanction letter dated 2.1.1997 for loan of US$135 million as per the following terms and conditions:

 

(1)  The loan would be specifically for financing of import of capital goods and services for GREP.

 

(2)  The  company’s  request  for  opening  of  foreign currency account with Bank of India, Tokyo branch would be entertained only when the loan agreement was  signed  and  taken  on  record  by  Ministry  of Finance.  

(iv) The Bank of India’s application on behalf of the company to RBI dated 6.4.1998 was for the request of opening of bank account with Bank of India, Tokyo branch, where it had maintained that the account was being opened only for financing of capital goods and services for GREP. It did not mention that the bank account was being opened for the purpose of reimbursement of capital expenditure already  incurred.  The  Reserve  Bank  of  India,  vide  its permission  dated  April  22,  1998,  for  opening  of  bank account with Bank of India, Tokyo branch, clearly stated that the permission was being given for the purpose of financing of all imports only and not for reimbursement of expenditure incurred earlier out of working capital by the company.

 

(c) Even the GPU was capitalised in March 1998, i.e., much before drawing of the loan amount, i.e., in June 1998.

 

8. According to the querist, a perusal of the above facts clearly brings out that the Government of India permission and RBI permission were meant  only  for  financing  of  imports  of  capital  goods  and  services  for GREP and  not  for  any  other  project  such  as  GPU.  Similarly,  this  was meant for the purpose of financing of import and not for the purpose of recoupment of working capital.

 

9. According to the querist, out of the total loan of US$ 80.00 million, US$ 66.00 million relates to GPU at Pata and US$ 14.00 million relates to GREP. Further, as the actual loan taken from J-Exim was only for US$ 63.83 million approximately, the portion claimed to be related to GREP would  be  much  lesser.  Even  for  US$  66.00  million  loan  there  was apparently no Government of India and RBI approval.

 

10. According  to  the  querist,  keeping  in  view  the  above  facts,  it  is evident  that  there  was  no  loan  agreement  with  the  lender  at  the  time capital expenditure was incurred. As per RBI approval the loan was for financing of GREP only and not GPU and the government approval also clearly  stated  that  the  expenditure  should  be  incurred  only  out  of  the loan.  Nowhere  in  the  government  approval  and  RBI  approval  it  was mentioned that the loan was for recoupment of capital expenditure already incurred by the company. Thus, the company only recouped its working capital which was spent by it on the completion of the project.

 

11. The  querist  has  referred  to  paragraph  10  of  Accounting  Standard (AS)  11,  ‘Accounting for  the  Effects  of  Changes  in  Foreign  Exchange Rates’, issued by the Institute of Chartered Accountants of India, which states as 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.”

 

 

12. In  the  context  of  the  above  paragraph  of  AS  11,  the  querist  has stated as below:

(a)        The  loan  in  question  was  disbursed  after  the  assets  were capitalised and the concerned assets were created/acquired by the company out of surplus working capital funds and the loan proceeds  were  neither  used  for  the  construction  of  the  fixed assets nor for repayment of any bridge loan. In fact the loan was  utilised  for  creating  short-term  deposits  whose  interest was credited to the profit and loss account.

 

(b)        The loan amount was neither directly nor indirectly used for acquisition  of  fixed  assets,  therefore,  the  company  was  not right in adjusting the exchange difference as on 31.3.1999 and 31.3.2000 in the carrying amount of fixed assets. The exchange difference should have been charged to revenue in the periods in which these arose.

B. Queries

 

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

 

(a) Whether the  company was  right in  considering that  the loan received  from  Export  Import  Bank  of  Japan  (J-Exim)  was directly  or  indirectly  utilised  for  the  acquisition/erection  of specific and relevant assets.

(b) Whether the company was right in adjusting the exchange rate difference  as  on  31.03.1999  and  31.03.2000  in  the  carrying amount of the respective fixed assets claiming that loan received from Export Import Bank of Japan was directly or indirectly connected with the acquisition of specific assets and thus the company’s right to adjust the exchange rate difference in the carrying amount of fixed assets under AS 11 was not affected on any or all of the following grounds:

 

(i)         The company had not taken any bridge loan for acquiring the fixed assets under financing from J-Exim.

 

(ii)        The projects, to the extent of loan proceeds, were financed through  own  temporary  working  capital  funds  till  the loan proceeds were received.

 

(iii)   The  loan  proceeds  were  received  after  the  date  of acquisition  of  specific  assets  or  capitalisation  of  these projects.

 

(iv)   The loan proceeds were not paid directly to the vendors/ contractors  for  the  acquisition  of  the  fixed  assets  but loan proceeds were parked as short term fixed deposits with  banks  by  the  company  as  there  were  no  pending bills of vendors/contractors towards capital expenditure already incurred.

 

(v)        The  loan  proceeds  were  not  retained  in  non-interest bearing current account of a bank as directed by RBI to be used for payments to vendors/contractors but deposited in  interest  bearing short  term deposits  bank account  as per  the  company’s  policy  of  maintaining  temporary internal working capital funds.

 

(vi)   There  was  no  loan  agreement  with  the  lender  either  at the  time  the  capital  expenditure  was  incurred  or  when the relevant projects were capitalised and the assets were put to commercial use.

 

(vii)  As  per  RBI’s  approval  the  loan  was  for  financing  of GREP only and not GPU and the government approval also clearly stated that the expenditure should be incurred only out  of  the  loan  fund.  Nowhere  in  the  government approval  and  RBI  approval  it  was  mentioned  that  the loan was for recoupment of capital expenditure already incurred by the company.  

(c) Whether the company was right in not passing any entry in the books of account with regard to the foreign exchange variation on  loan  taken  from  J-Exim  related  to  the  period  from  the actual dates of incurring of capital expenditure to the date of drawing of the loan amount.

 

C. Points considered by the Committee

 

14. The Committee notes from paragraph 10  of AS 11, reproduced in paragraph  11  above,  that  the  exchange  differences  are  required  to  be capitalised as a part of the cost of the fixed assets if the liabilities were incurred  for  the  purpose  of  acquiring  the  fixed  assets.  The  Committee notes that it is the purpose for which the loan was raised that is of prime significance,  i.e.,  whether  the  purpose  of  the  loan  was  to  finance  the fixed assets or the working capital.

 

15. The Committee is of the view that in order to ascertain the purpose for which the loan was raised, the facts and circumstances of the case, including the relevant loan agreement and the correspondence between the  parties  concerned  need  to  be  considered.  For  instance,  the  loan agreement may indicate whether the loan was being raised to finance the fixed  assets.  Similarly,  the  correspondence  between  the  lender  and  the company, which according to the querist, was regular might be examined to determine whether there was a prior understanding between the lender and the company that the assets could be purchased even before the loan agreement was signed.  In other words, whether there  was a stipulation that the lender would treat the acquisition of assets prior to the signing of the loan agreement as the assets in respect of which the loan was being raised. That would provide an indication that as per the terms of the loan as well as the correspondence between the lender and the company whether the loan was a reimbursement of the expenditure already incurred towards acquisition of the fixed assets. It may also be useful to consider whether the delay in obtaining the loan was caused by the procedural factors of obtaining the government approvals.

 

16. The  Committee  is  of  the  view  that in  case  the  loan  is  not  for  the purpose of the acquisition of the fixed assets as indicated by the factors stated  in  the  above  paragraph,  it  would  mean  that  the  loan  is  for  a purpose other than the acquisition of fixed assets. If that be so, foreign currency  differences  in  respect  of  the  loan  liability  should  not  be capitalised as a part of the cost of the fixed assets and should be recognised in the profit and loss account. However, in case it is clearly established, based on the above factors, that the loan was raised for the purpose of acquisition of fixed assets, the foreign currency differences in respect of the loan should be capitalised as a part of the cost of the fixed assets in the manner specified in the following paragraph.

 

17. In respect of capitalisation of the foreign exchange differences on the  loan  amount,  the  Committee  is  of  the  view  that  only  the  foreign exchange differences related to the loan equivalent to the actual amount spent in Rupees on the relevant fixed assets should be capitalised. Thus, in  case  the  loan  amount  is  equal  to  the  amount  actually  spent  on  the relevant fixed assets, the entire amount of foreign exchange differences in this regard should be capitalised. On the other hand, if the loan amount received  is  in excess  of  the  actual  amount  spent, the  foreign  exchange differences arising in repayment of such excess loan amount should not be capitalised, since the said excess cannot be considered to be for the purpose  of  acquisition  of  the  relevant  fixed  assets.  The  Committee  is further of the view that only those foreign exchange differences should be  capitalised  which  relate  to  the  period  after  the  drawing  of  the  loan since, prior to that, the company was not exposed to the risk of changes in foreign currency rates.

 

18. The Committee notes from the facts of the case that the querist has stated that the foreign currency loan in question is related to acquisition of fixed assets for GREP and not for GPU. The Committee is of the view that the  project to  which the loan  is related  is a question  of fact  to be determined on perusal of the relevant loan agreement and the other relevant documents. The Committee has, therefore, not touched upon the issue as to the project to which the loan pertains.

 

D. Opinion

 

19. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 13:

 

(a)        The company was right in considering that the loan received from Export Import Bank Japan was raised for the purpose of acquiring/erecting specific assets provided the factors stated in paragraph 15 above indicate the same.

(b)        In view of paragraph 18 above, the Committee has not touched upon  the  issue  as  to  the  project  to  which  the  loan  actually pertains since it is a question of fact. The question as to whether the  company  was  right  in  adjusting  the  exchange  rate differences in the carrying amount of the respective fixed assets would depend on whether the loan can be considered to be for the purpose of acquisition of fixed assets based on the factors stated in paragraph 15 above. The extent to which the exchange differences  can  be  capitalised  should  be  determined  in accordance with paragraph 17 above.

 

(c)        The company was right in not passing the entry in the books of  account  with  regard  to  the  foreign  exchange  variation  on loan taken from J-EXIM related to the period from the actual dates of incurring capital expenditure to the date of drawing of the loan amount in view of paragraph 17 above.

1Opinion finalised by the Committee on 19.8.2001