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Query No. 36
Subject:
Accounting
treatment of swap transaction entered
to hedge foreign exchange risk.1
A. Facts of the
Case
1. A public
sector company is engaged in transmission, processing and marketing of Natural
Gas. The company owns about 4000 kms. of pipeline and transports
about 59 MMSCM
per day of
Natural Gas. During
the financial year 1998-99, the company commissioned a petrochemical
plant
at a cost of about Rs. 2400 crore to manufacture polymers.
2. For the
purpose of financing the cost of various capital projects of the company, in addition to loans in Indian currency, the company has also taken foreign currency
loans. The liability of the company for payment
of interest on the loan fluctuates not only because of
floating interest rate but also because of exchange rate fluctuations. During
the financial year 2000-01, in order to hedge against the foreign currency
fluctuations, the company has
partly swapped Asian
Development Bank (ADB)
loan to the extent of US$ 29.39
million. According to the swap deal entered by the company with HDFC Bank, the
exchange rate for a part of foreign exchange liability incurred for acquiring
the capital asset has been fixed at 1 US$
= Rs. 44.6925.
In addition, the
payment of interest
on each repayment date, which was
hitherto fluctuating inter-alia on account of exchange rate variations and
floating interest rate, has also become fixed to the extent
of fluctuating exchange
rate (1 US$
= Rs. 44.6925).
For this, the company has to incur additional interest cost @ 3.66% on
each repayment date, the principal and interest repayment date being the same,
i.e., 15th December and 15th June. The main highlights of the swap deal
are as under:
• ADB loan of
US $ 145.73 million partly swapped into rupees, to the extent of US $ 29.39
million (notional principal).
• Swap
exchange rate was fixed at Rs. 44.6925 per dollar.
• Interest @ 9.96% to be paid by the company on rupee equivalent amount of principal, on
reducing balance, against interest of 6.30% payable on ADB Loan to be received
from HDFC Bank. The additional interest is only to cover the foreign currency
fluctuations risk. As far as the risk of floating interest rate is concerned,
the company has to pay the difference on its own accord, i.e., the difference is not covered by the swap transaction.
• Necessary dollars for principal repayment to ADB to be
received from HDFC Bank, along with interest @ 6.30% on reducing notional
principal, at each repayment date (15th June/15th Dec.), converted
into rupees at the spot rate on that date.
Rupee equivalent of instalment @ Rs. 44.6925 per US$ along-
with interest @ 9.96% to be paid by the company to HDFC Bank.
3. As per the
querist, the issues that require consideration are relating to the accounting
treatment in respect of the following:
(a) Difference between
exchange rate at
which the loan
amount has been accounted for (year-end rate) and the swap exchange
rate.
(b) Additional interest expense of 3.66% to be incurred by the company on each repayment date (i.e., difference between interest of 9.96% to be paid to HDFC
against interest of 6.30% payable to ADB) for hedging against the fluctuating
exchange rate relating to:
• principal
repayment of the liability in the form of loan taken for acquiring fixed asset;
and
• interest
payment on the above loan.
4. As per the
querist, Accounting Standard (AS) 11, ‘Accounting for the Effects of Changes in
Foreign Exchange Rates’, issued by the Institute
of Chartered Accountants of India, does not specifically
deal with swap transactions.
However, paragraph 13
of the said
Standard deals with forward exchange contracts and appears to be similar to the
swap deal entered into by
the company. Paragraph
13 on ‘Forward
Exchange Contracts’ states as under:
“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.”
5. As per the
querist, Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’,
as well as
Accounting Standard (AS)
16, ‘Borrowing Costs’, specify
the treatment in
case of financing
cost. The relevant portions of both the Standards are
as under:
(i) Paragraph
9.2 of AS 10 states as under:
“Financing costs relating to deferred credits or to borrowed funds attributable to construction or
acquisition of fixed assets for the period up to the completion of construction or acquisition of fixed assets are also sometimes included in the gross
book value of the asset to which they relate. However, financing costs
(including interest) on fixed assets purchased on a deferred credit basis or on monies borrowed for construction or
acquisition of fixed assets are not capitalised to the extent that such costs
relate to periods after such assets are ready to be put to use.”
(ii) Paragraph
19 of AS 16 states as under:
“Capitalisation of borrowing costs should cease when substantially all the activities
necessary to prepare the qualifying asset for its intended use or sale are
complete.”
6. The querist
is of the view that in accordance with paragraph 13 of
AS 11, the following accounting treatment should be given:
(a) The
difference between the exchange rate at which transaction relating to the
principal portion of the loan has already been recorded and
the swap rate
should be adjusted
in carrying
amount of fixed assets, as it relates to the liabilities
incurred foracquisition of fixed assets.
(b) The
additional amount to be incurred by the company in the form of additional interest cost of 3.66% at each repayment date:
• should be
adjusted in the carrying amount of respective fixed assets to the extent it
relates to hedging the liability incurred for acquisition of fixed asset
(because a part of this additional amount is being incurred to hedge the exchange rate in respect of liabilities incurred by the company for acquiring
fixed assets);
• should be
recognised as expense to the extent it relates to hedging the liability
incurred for payment of interest
(because a part of this additional amount is being incurred
to hedge the exchange rate in respect of liabilities incurred by the company
for payment of interest on the loan).
7. According to
the querist, however, as per the provisions of AS 10 and AS 16, all interest
expenses incurred by the company after the date the asset is ready to be put to
use is not to be capitalised and should be charged to the profit and loss
account.
B. Queries
8. The querist
has sought the opinion of the Expert Advisory Committee on the following
issues:
(a) Accounting
treatment for the difference between the prevailing exchange rate and the swap
rate.
(b) Accounting treatment for the additional cost of interest (of
3.66% to be incurred by the company on each repayment date)
for hedging against the exchange fluctuations relating to:
• principal
amount of loan drawn for acquiring fixed asset; and
• for
interest payment.
(c) As the total
additional interest cost of the swap deal is known as on the date of the swap
deal, the payment whereof would accrue on due dates, whether the total
additional interest cost should be loaded to the cost of the fixed asset pertaining
to the fixed asset and that pertaining to the interest be charged to revenue on the date of
the swap deal or accounting has to be done only on each due date.
C. Points
considered by the Committee
9. The Committee
notes that the company has entered into a swap deal to partly hedge foreign currency liability incurred for
purchase of fixed assets. According to the querist, under the swap deal, only
the risk relating to foreign currency fluctuations in
loan and interest
payment has been hedged. The Committee further notes that
the company would continue to bear the risk relating to fluctuations in interest
payment that may take place due to reasons other than fluctuations in exchange
rate, i.e., due to the floating interest rate. As the latter aspect has not
been raised by the querist, the Committee has not addressed the issue in its
opinion.
10. The Committee
notes paragraph 13
of Accounting Standard
(AS)
11, ‘Accounting for the Effects of Changes in Foreign
Exchange Rates’, as reproduced by the querist in paragraph 4 above.
11. The Committee
is of the
view that a
swap deal is
in substance a forward exchange contract entered into by
the company to establish the amount
of reporting currency
required to settle
the liability. Since
the foreign currency liability was incurred by the company for
acquisition of
a fixed asset, the difference between the swap rate and the
exchange rate at the date of the transaction should be adjusted in the
carrying amount of the respective fixed asset.
12. The Committee
notes from the facts of the case that the additional interest cost
is incurred for
hedging the risk
of foreign currency fluctuations. In the absence of such
an arrangement, the company would have been exposed to the risk of foreign
currency fluctuations and would have had to incur a loss on account of foreign
currency fluctuation. The Committee is, accordingly, of the view that the
additional interest should be treated in the same manner as the forward
exchange contract. In view
of this, the
additional interest cost incurred
to hedge foreign
exchange risk should be
apportioned between the
amount incurred to
hedge risk relating to the
principal amount of loan and to the interest thereon. The portion incurred to
hedge the risk related to the principal amount, to the extent it relates to
fixed assets, should be adjusted to the carrying amount of the relevant fixed assets.
13. The Committee
notes that paragraph
9.2 of Accounting
Standard
(AS) 10, ‘Accounting for Fixed Assets’, as reproduced by the
querist in paragraph 5 above,
has been withdrawn
pursuant to the
issuance of Accounting Standard
(AS) 16, ‘Borrowing Costs’, which came into effect in respect of accounting periods commencing on or after
1st April, 2000.
14. The Committee
notes that the
term ‘borrowing costs’
has been defined by AS 16 as follows:
“Borrowing costs are interest and other costs incurred by an
enterprise in connection with the borrowing of funds.”
15. The Committee
also notes that
as per paragraph
4(e) of AS 16,
borrowing costs also include “exchange differences arising from foreign-
currency borrowings to the extent that they are regarded as an adjustment to interest costs”.
16. In view
of the above,
the portion of
the additional interest
cost incurred to hedge foreign exchange risk to the extent it relates to
interest payment, should be treated as a borrowing cost.
17. With regard
to the question
whether the additional
interest cost related to the
fixed asset should be loaded to the cost of the fixed asset on the date of swap
deal, the Committee is of the view that, on the basis
of the requirements of paragraph 13 of AS 11 reproduced in
paragraph 4 above and the nature of the additional interest as described
in paragraph 12 above, the
additional interest cost
related to the
principal portion should be
charged to the cost of the fixed asset as on the date of the swap deal. However,
since the additional
interest cost related
to the interest portion is a borrowing cost of
revenue nature, it should be expensed in the year to which it relates since it
appears that the commercial production in respect of the project has already started.
D. Opinion
18. On the basis of
the above, the Committee is of the following opinion on the issues raised in
paragraph 8:
(a) The
difference between the prevailing exchange rate and the swap rate
should be adjusted
to the carrying
amount of the relevant fixed assets for which the loan
was taken.
(b) The
additional interest cost incurred to hedge against foreign exchange risk should be apportioned between the amount incurred to hedge the risk relating to the principal amount
of loan and the interest thereon. The portion incurred to hedge the risk related to principal amount, to the extent it relates to
the fixed assets, should be adjusted to the carrying amount of the relevant
fixed assets whereas the portion incurred to hedge the risk related to interest should be treated as a part of borrowing cost and expensed in the year to which its relates.
(c) Refer to
paragraph 17 above.
1Opinion finalised
by the Committee on 28.9.2001. |