Query No. 5

Subject:           

Accounting treatment of foreign exchange fluctuations.1

A. Facts of the Case

1.  A private limited company has been realising the export proceeds in foreign  currencies  and  has  been  showing  in  its  balance  sheet  and  the income statement the export income at the rate of exchange prevailing on the date of credit in the bank account of the company. The export income, in other words, is treated as sales revenue in the income statement at the rate of exchange prevailing on the date of credit in the bank account. The foreign currency so earned is either deposited in the current account or term deposit account under EEFC account permitted by RBI. As on the balance sheet date, i.e., 31st   March, 1999, no adjustments in respect of the fluctuation in the exchange rate were made.

2. The querist has invited attention of the Committee to section 211 of the Companies Act, 1956, wherein the following amendments were made with  effect  from  31st   October,  1998,  by  the  Companies  (Amendment) Act, 1999:

“(3A) Every profit and loss account and balance sheet of the company shall comply with the accounting standards.

(3B) Where the profit and loss account and the balance sheet of the company  do  not  comply  with  the  accounting  standards,  such companies shall disclose in its profit and loss account and balance sheet, the following, namely:-

(a) the deviation from the accounting standards;

 

(b) the reasons for such deviation; and

 

(c)  the financial effect, if any, arising due to such deviation.

(3C)  For  the  purposes  of  this  section,  the  expression  “accounting standards” means the standards of accounting recommended by the Institute  of  Chartered  Accountants  of  India  constituted  under  the Chartered Accountants Act, 1949 (38 of 1949), as may be prescribed by the Central Government in consultation with the National Advisory Committee on Accounting Standards established under sub-section (1) of section 210A:

Provided  that  the  standards  of  accounting  specified  by  the Institute of Chartered Accountants of India shall be deemed to be  the  Accounting  Standards,  until  the  accounting  standards are  prescribed  by  the  Central  Government  under  this  sub- section”.

3. According  to  the  querist,  pursuant  to  the  above  amendment, Accounting Standard (AS) 11, ‘Accounting for the Effects of Changes in Foreign  Exchange  Rates’,  was  specified  by  the  Institute  of  Chartered Accountants of India. The querist has referred to paragraphs 7(a), 9, 10 and 11 of AS 11 which state as below:

“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”.  

“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.

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.

11. The carrying amount of fixed assets which are carried in terms of  revalued  amounts  should  also  be  adjusted  in  the  manner described  in  paragraph  10  above.  However,  such  adjustment should not result in the net book value of a class of revalued fixed assets exceeding the recoverable amount of assets of that class, the remaining amount of the increase in liability, if any, being debited to the revaluation reserve, or to the profit and loss  statement  in  the  event  of  inadequacy  or  absence  of  the revaluation reserve”.

4. The company did not take into consideration the appreciation in US Dollar in respect of the balance sheet as at 31st  March, 1999. The statutory auditor in his report mentioned as under:

“(e)  In my opinion, the profit and loss account and balance sheet comply  with  the  Accounting  Standards  referred  to  in  sub-section (3C) of section 211 of the Companies Act, 1956.”

5. The company, under the head ‘Significant Accounting Policies’ in its balance sheet as at 31st  March, 1999, disclosed as under:

“(D) Foreign Currency Transactions:Transactions  in  foreign  currency  are  recorded  at  the  rate  of exchange in force at the time the transactions are effected.”

6. During the financial year 1999-2000, the company had EEFC account in US Dollar denomination and earned interest on the balance also. The company maintained  during the financial  year 1999-2000,  both current account and fixed deposit account, in foreign currency. The maintenance of  foreign  currency  account,  as  at  31st    March,  2000,  resulted  into appreciation in the foreign currency also but the company did not account for such appreciation in its books of account. The company contends that since the appreciation in foreign currency had not arisen till the balance sheet date, the same was not accounted for in its books of account. The company also contends that it will disclose in its significant accounting policies in the balance sheet as at 31st  March, 2000, the same accounting policy in this regard as was disclosed in the previous year and the statutory auditor should also report as was reported in the previous year.

B. Queries

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

(a) Whether the accounting treatment followed by the company is in accordance with the applicable laws and if not, what is the correct  treatment  of  interest  and  appreciation  in  foreign currency.

 

(b) In the event of the company not accounting for, for the balance in foreign currency at the closing rate of exchange, what is the disclosure to be made by the company and the statutory auditor?

 

C. Points considered by the Committee

8. The Committee notes that paragraph 5 of AS 11 provides as below:  

“5. A transaction in a foreign currency should be recorded in the reporting currency by applying to the foreign currency amount the exchange  rate  between  the  reporting  currency  and  the  foreign currency at the date of the transaction....”

9. The Committee also notes the requirements of paragraphs 7(a), 9,10 and 11 of AS 11 as reproduced in paragraph 3 above.

10. From the above, the Committee is of the view that the accounting treatment followed by the company is not as per AS 11. The transactions in foreign currency should be recorded at the exchange rate prevailing on the date of transaction and not at the rate prevailing on the date of credit in the bank account. Also, monies held in foreign currency bank accounts as on the date of the balance sheet should be reported using the closing rate since it is a monetary item. The resulting gain should be recognised in the profit and loss account of the relevant period. The Committee is also of the view that the present wording of the accounting policy followed by the company reproduced in paragraph 5 above is not clear. It should be changed to the effect that the foreign currency transactions are reported at the rate prevailing on the date of transaction.

11. The Committee notes from the facts that the accounting treatment followed by the company in respect of interest on EEFC Account is not clear.  The  Committee  is  of  the  view  that  ‘accrual’  being  one  of  the fundamental accounting assumptions, interest earned should be recorded in the books of account on accrual basis.

12. The  Committee  notes  that  paragraph  23  of  Accounting  Standard (AS)  1,  ‘Disclosure  of  Accounting Policies’,  issued  by  the  Institute  of Chartered Accountants of India, provides as below:  

“23. Disclosure of accounting policies or of changes therein cannot remedy  a  wrong  or  inappropriate  treatment  of  the  item  in  the accounts.”

Therefore, the Committee is of the view that the company has to follow AS  11  and  no  disclosure  can  remedy  non-compliance  of  Accounting Standards.

13. The Committee notes that the querist has not taken into consideration the  fluctuations  in  the  exchange  rate,  viz.,  appreciation  in  the  foreign currency kept in EEFC account as on the date of the balance sheet, i.e., 31st  March, 1999, which is in violation of AS 11. Accordingly, the auditor should have qualified his report.

14. The Committee is of the view that in respect of the current year, the statutory auditor should qualify his report regarding non-compliance of AS 11 as explained above pursuant to the requirements of section 227(3)(d) of  the  Companies  Act,  1956,  and  its  impact  on  the  true  and  fair  view under section 227(2). The auditor should also quantify the effect of his qualification  on  profit  or  loss  and/or  state  of  affairs  in  a  clear  and unambiguous manner in accordance with paragraph 3.10 of the ‘Statement on Qualifications in Auditor’s Report’ issued by the Institute of Chartered Accountants of India.

D. Opinion

15. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 7:

(a) The accounting treatment followed by the company is not in accordance with AS 11, and therefore, not in accordance with the requirements of the applicable laws, i.e., Companies Act,1956.  The  correct  treatment  of  interest  and  appreciation  in foreign currency would be as explained in paragraphs 10 and 11 above.

 

(b) The  company  should  report  the  balances  held  in  foreign currency at the closing rate. In case it is not done, no disclosure by the company will rectify the wrong treatment. Even if any disclosure  is  made,  the  auditor  should  qualify  his  report  as explained in paragraph 14 above.

 

1  Opinion finalised by the Committee on 5.3.2001.