Expert Advisory Committee
ICAI-Expert Advisory Committee
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 Query No. 37

Subject:

 

Accounting for foreign exchange difference in respect of foreign currency loan restated as at the date of balance sheet but recoverable at a later date.1


A. Facts of the Case

1. A company owns and operates a Combined Cycle Power Plant in India. The plant was installed and commissioned under a turnkey engineering, procurement and construction (EPC) contract by a foreign company. The commercial operation of the company was achieved in the year 2001-02.



2. The company has entered into a Power Purchase Agreement (PPA) with a State Electricity Board (SEB) for sale of its entire power generated. As per the querist, the pricing is consistent with the standard norms as per the policy of the Government of India (GOI) in respect of Independent Power Producers (IPP) based on capacity of operation, i.e., Plant Load Factor (PLF), including fuel cost on Axiomatic Standard Efficiency including post tax return. The querist has separately supplied the summary of the components of pricing and the basis adopted for the perusal of the Committee. According to the querist, the PPA is backed by a sovereign guarantee of the State Government.



3. In view of the contractual provisions of the PPA with the SEB, foreign exchange variation income/loss arises on restatement of foreign currency loan as at the year-end, the details with regard to which, as provided by the querist, are as below:


(a) The company has borrowed foreign currency (FC) loans to part finance its capital expenditure. The principal and interest on the loans are repayable in 24 half-yearly instalments. Interest is payable at fixed rates on approximately 60% of the loan amount and at floating rates on the balance.

 


(b) The PPA provides that the foreign exchange variation in respect of the foreign currency loans is reimbursable by the SEB as part of the tariff when actually paid by the company. In other words, when the company pays an instalment of principal and interest, the difference between the Base Exchange Rate (weighted average exchange rate of the loan determined in Indian Rupees at the rates prevailing on the dates of disbursement of the FC loan) and the actual rate at which the repayment is made, is reimbursed by the SEB. Thus, the exchange variation on the FC loan is borne by the SEB as part of the tariff. (Emphasis supplied by the querist.)


(c) The structure of the tariff is such that the exact amount of exchange fluctuation, when the Indian Rupee depreciates, is reimbursed by the SEB (unlike other components of tariff that are normative, where the tariff and actual outflows do not match). As a corollary, if the Indian Rupee appreciates, the exact amount of exchange fluctuation becomes payable by the company to the SEB.


(d) A separate invoice is being raised for the same as and when a foreign exchange fluctuation loss is incurred by the company towards foreign currency loans and a credit to the SEB is given when foreign exchange fluctuation gain arises in favour of the company in respect of the foreign currency loan. This must be viewed in the light of the requirement by the PPA that the Fixed Capacity Charges (FCC) (excluding income tax) are billed once a month on fixed dates, as one-twelfth per month of the annual normative FCC. This clearly contradistinguishes the reimbursable nature of foreign exchange gain/loss as opposed to the normative nature of FCC (excluding income tax). Foreign exchange fluctuation reimbursement does not form part of FCC.


(e) The foreign currency loans outstanding at the end of the financial year are re-stated at the foreign exchange rate prevailing on the balance sheet date.

 


(f) The recoverability of forex variations in full from the SEB requires the project to achieve Plant Load Factor of 68.4932% (6,000 hours in a possible 8,740 hours per annum). As per the querist, the project does not envisage any difficulty in achieving these threshold levels in the normal course, as has been established since the first full year of operations of the project. This is also a reasonable assumption under the going concern concept.

 

4. The querist has mentioned that the underlying technical point involved in the issue relates to the matching principle of accounting. Accrual is a fundamental accounting assumption. Implicit in the concept of accrual, the focus is on matching of revenues and costs. The querist has also reproduced paragraph 2.5 of Guidance Note on Accrual Basis of Accounting, issued by the Institute of Chartered Accountants of India, which states as follows:


“The following are the essential features of accrual basis of accounting:

(i) Revenue is recognised as it is earned.

 


(ii) Costs are matched either against revenues so recognised or against the relevant time period to determine periodic income, and


(iii) Costs which are not charged to income are carried forward and are kept under continuous review. Any cost that appears to have lost its utility or its power to generate future revenue is written-off as a loss.”

 

5. The querist has further stated that section 211(3B) and section 211(3C) of the Companies Act, 1956 have conferred statutory status to Accounting Standards. Section 211(3B) of the Act deals with a situation where Accounting Standards may not be followed whereupon disclosure is called for in regard to the extent of deviation, the reason therefor and the financial impact. It can, therefore, be derived, according to the querist, that while a mandatory Accounting Standard (AS) is generally applicable, there could be special situations where following the same is not appropriate and the disclosure of the peculiarities is, therefore, considered appropriate. This position is to be compared with one where accrual basis is not followed. In such cases, section 209(3)(b) of the Act specifically provides that proper books shall not be deemed to have been maintained. The position is reinforced by section 217(2AA)(ii) of the Act wherein the Directors’ Responsibility Statement discloses material departures from Accounting Standards with ‘proper’ explanation for the same. According to the querist, it is, therefore, probable for a company in peculiar circumstances not to follow an Accounting Standard and not have qualification in the audit report in this regard.



6. According to the querist, Accounting Standard (AS) 11 (revised 2003), ‘The Effects of Changes in Foreign Exchange Rates’, issued by the Institute of Chartered Accountants of India (ICAI), requires that the foreign exchange gain/loss in respect of foreign exchange loan should be capitalised, following the clarification issued by the ICAI that the provisions of Schedule VI to the Companies Act, 1956 override the relevant provisions of the revised AS 11. As stated earlier, the PPA provides for reimbursement by the SEB or the payment to the SEB, as the case may be, of exchange losses/gains on foreign currency loan on actual payment.



7. The issue that is to be resolved is whether the foreign exchange gain/loss in respect of foreign exchange loan restated as at the balance sheet date but recoverable under the PPA over the period of the loan on actual payment, is to be accrued as expense/income under the matching principle, given the above facts. Thus, according to the querist, the foreign exchange variation as at the balance sheet date at best could be termed as “forex recoverable from SEB”.

 



8. The querist has suggested that the foreign exchange difference arising in respect of repayment of foreign currency loan should be treated as below:

 

(a) The foreign currency loan should be translated at the closing rates.

 


(b) (i) The differential debit or credit should be treated as recoverable/payable in the balance sheet, given the nature of the transaction and the contractual reimbursement rights provided by the PPA.

 


(ii) Alternatively, if one were to insist that such accounting practice may not be fully in line with AS 11, the differential debit or credit could be capitalised as required by AS 11 and the same being amount recoverable/payable from/to SEB, should be treated in a manner similar to discount or rebate or cost met by/payable to SEB by a matching credit/debit.

 

As per the querist, this method also finds support from the principles laid down by Accounting Standard (AS) 12, ‘Accounting for Government Grants’, issued by the Institute of Chartered Accountants of India, considering that the costs arising on account of exchange cast an obligation in the nature of grant from SEB under the PPA, backed by a sovereign guarantee. Thus, the debit or credit on account of the exchange difference would be matched by a corresponding credit or debit towards recoverable from SEB. Incidentally, even under the Income-tax Act, 1961, ‘actual cost’ is defined by section 43(1) as the actual cost of assets to the assessee, reduced by that portion of the cost thereof, if any, as has been met directly or indirectly by any other person or authority.


(c) This treatment would reflect the liability at closing rates, assets at rates net of costs met by SEB and also show a recoverable from SEB, following the provisions of the PPA.

 


(d) The methodology suggested above does not have any impact on the profits of the company and at the same time would ensure compliance with the provisions of AS 11.

 

9. The querist is of the following view:

 

(i) Given the above, the foreign exchange differences arising on account of restatement of foreign currency loans as at the balance sheet date should be matched with a corresponding receivable from SEB and reflected as “Forex recoverable from SEB” in the financial statements following the matching principle. The departure from the requirements of AS 11 to this extent has to be explained by the Board through appropriate Notes to Accounts as suggested below:

 

“The net increase / decrease in the company’s liability for repayment of loans for purchase of fixed assets, consequent upon realignments in rupee value in terms of foreign currency values have been recognised as recoverable from / payable to SEB. Hence, such increase / decrease in the company’s liability for repayment of loans is not adjusted to the carrying amount of the respective fixed assets.”

 

(ii) Alternatively, the procedure as suggested in paragraph 8(b)(ii) above should be followed so that the letter and spirit of AS 11 is adhered to and the corresponding rights of PPA for recovery of translation difference also gets recognised.

 

10. The querist has further furnished the following information:

(i) The revenue components under the PPA could be categorised as under:


(a) Components that are pure reimbursements


(b) Components that are only normative

It would follow that while (a) insulates the business entity from certain costs, (b) provides a transparent mechanism of pricing.

(ii) Since there was clarity in respect of components that are accrued as revenue on normative basis, the treatment of components that insulate the business entity from the impact of certain costs (e.g., exchange fluctuation and specified taxes) only remained to be addressed.


(iii) The querist has separately provided the details of the components of Fixed Capacity Charges (FCC) forming part of the tariff. It has been mentioned therein also that the components, viz., debt payment, depreciation, O&M expenses, return on equity and interest on working capital are normative, and are not relatable to the actual expenditure, whilst components, viz., specified taxes and foreign exchange variation are reimbursements as enshrined in the PPA. (Emphasis supplied by the querist.)

(iv) In addition, the tariff provides for variable fuel cost (VFC) on a normative basis. (Emphasis supplied by the querist.)

(v) The purpose behind such a distinction in the PPA between the two categories (normative and pure reimbursements) is primarily to ensure efficiencies being built in on operating parameters, whilst pure reimbursements were restricted to factors outside the control of the business.

(vi) The querist has separately provided the data relating to the fixed monetary categories of tariff within the components of FCC such as debt repayment, depreciation and working capital interest and VFC to demonstrate that the aforesaid components of tariff and actual are different in each of the completed 4 years of operations.

(vii) With regard to the specific issue of depreciation, according to the querist, the income and expenditure streams are not relatable at all. Depreciation for revenue is on 90% of an artificial fixed asset base, which is lower than the actual fixed asset base and is recovered (through pricing of power) over a period of around 12 years at a rate not relatable to the useful life of the assets. Further, recovery of depreciation through tariff is not available for additions to fixed assets made after the initial start up. Depreciation (charge) as amortised in the books is of 95% of actual fixed asset costs (including additions to fixed assets over the years), over the useful life of the assets or as per the rates mandated under the Companies Act, 1956. Further, if in a year, the plant is not operated due to technical inadequacies,no revenue would accrue under depreciation, whilst the company is mandated to provide depreciation as expenditure. Hence, none of the parameters relating to depreciation is common to the revenue and expenditure (amortisation) streams.

B. Query



11. On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee on the accounting treatment of foreign exchange gain/loss in respect of foreign currency loan restated as at the date of balance sheet but recoverable at a later date.


C. Points considered by the Committee


12. The Committee notes from the ‘Facts of the Case’ that the electricity tariff comprises two parts, namely, normative and reimbursements. The Committee is, however, of the view that from the accounting point of view, there is no distinction between the two parts since these comprise the sale consideration for the power supplied to the customer. In the view of the Committee, the nature of the components of the tariff from the accounting point of view is as follows:

 

(i) In the initial years, the amount of certain expenses considered for tariff fixation purposes is higher than the expenses recognised in accordance with the generally accepted accounting principles in the financial statements and the position gets reversed in the later years. As a consequence of the aforesaid, excess revenue arises in the initial years and the position is reversed in later years.


(ii) In the initial years, the amount of expenses recognised in accordance with the generally accepted accounting principles in the financial statements is higher than the amount of expenses considered for tariff fixation purposes. As a consequence of the aforesaid, less revenue arises in the initial years and the position is reversed in the later years.


(iii) In respect of certain expenses, such as interest on working capital, the expenses are recognised in the financial statements and considered for tariff fixation purposes in the same year although the amounts for the two may be different. These do not get reversed in the subsequent years as in the case of (i) and (ii) above.

 

13. The consequence of the above peculiarities of tariff fixation in the electricity companies is that there would be a divergence between the accounting income, i.e., the income computed by applying the generally accepted accounting principles and the income computed by applying the tariff fixation requirements, including those laid down in a PPA. With a view to reflect a true and fair view of the profit (loss) for the period, the revenues and expenses need to be matched. The Committee is of the view that the matching can be achieved in respect of the situations mentioned at paragraph 12(i) above, i.e., where excess revenue arises in the initial years because higher costs are considered for tariff purposes as compared to those recognised in the financial statements, by recognising a deferred liability which gets reversed in the later years when the expenses for tariff purposes become lower as compared to those recognised in the financial statements. Similarly, the matching can be achieved in respect of the situations mentioned at paragraph 12(ii) above, i.e., where an expense is recognised earlier in the financial statements as compared to that for tariff purposes, by recognising a deferred asset subject to the consideration of prudence, i.e., the realisability of the asset is reasonably certain or where the company has a history of business losses, the realisability of the asset is virtually certain, also keeping in view the achievement of the required Plant Load Factor as per paragraph 3(f) above. In respect of the situations mentioned at paragraph 12(iii) above, where the differences between the expenses/revenue do not get reversed in the subsequent years, no effect is required to be given.



14. Regarding the issue raised by the querist in the present case related to accounting for foreign exchange difference in respect of the foreign currency loan which is recognised in the financial statements on the balance sheet date for accounting purposes in one year but is recovered in a later year for tariff purposes, the opinion given by the Committee hereafter is based on the above principles as well as the relevant accounting standards.



15. The Committee does not agree with the argument advanced by the querist as stated in paragraph 5 above that the accounting standards may not be followed where appropriate in view of the fact that the disclosures of departures from accounting standards are required by the Companies Act, 1956. The Committee is of the view that section 211(3A) of the Companies Act, 1956, is absolutely clear in requiring compliance with the accounting standards as it states “every profit and loss account and balance sheet of the company shall comply with the accounting standards” (emphasis supplied by the Committee). The Committee is of the view that this is an unfettered requirement of law; and a ‘duty’ to disclose departures from the accounting standards as required by section 211(3B) of the Act does not confer a ‘right’ of departure to a company where in its own wisdom it considers it appropriate to depart. Such a disclosure requirement under section 217(2AA) of the Act, also does not confer such a right. In other words, in the view of the Committee, the requirement to disclose departure from the accounting standards cannot be construed to provide a license to a company to depart from the accounting standards merely because a disclosure from departure is required. In view of this, the company will have to comply with the requirements of AS 11 and other accounting standards.



16. On the basis of the above, accounting for foreign exchange fluctuations in the context of the tariff fixation for electricity companies, in the view of the Committee, should be as follows:

 

(i) Foreign currency variation on the foreign currency outstanding loan as on the balance sheet date should be arrived at by applying the closing rate as per the requirements of AS 11. The said variation should be adjusted in the cost of the fixed asset in case the foreign currency loan has been acquired for the purpose of acquisition of the fixed asset from abroad in view of the requirements of Schedule VI to the Companies Act, 1956, and also keeping in view the Announcement in this regard issued by the Institute of Chartered Accountants of India. (Considering paragraph 8(b)(ii) of the ‘Facts of the Case’, the Committee presumes that the foreign currency loans have been raised to acquire fixed assets from abroad.)

 

(ii) The company should create a ‘deferred foreign currency fluctuation asset’, subject to the consideration of prudence as discussed in paragraph 13 above, with a corresponding credit to ‘deferred income from foreign currency fluctuation’ which should be shown on the assets side and liabilities sides of the balance sheet respectively.

 


(iii) An amount equivalent to the depreciation on the foreign currency variation component of the cost of the fixed asset should be transferred from the ‘deferred income from foreign currency fluctuation’ to the credit of the profit and loss account of the relevant year to achieve matching of cost with the revenue.

 


(iv) ‘Deferred foreign currency fluctuation asset’ should be credited when amount in this regard is received from the SEB. Any balance in the said asset account should be transferred to the relevant profit and loss account.

 

17. The Committee is of the view that the above treatment meets the requirements of accrual basis of accounting including the matching principle while recognising the peculiarities of the electricity companies in respect of tariff fixation.


D. Opinion



18. On the basis of the above, the Committee is of the opinion that the accounting treatment of foreign exchange gain/loss in respect of foreign currency loan, raised for the purpose of acquiring a fixed asset from abroad, restated at the balance sheet date but recoverable at a later date should be in accordance with the recommendations contained in paragraph 16 above.

 


1 Opinion finalised by the Committee on 25.1.2006