Query No. 20

Subject:

Accounting treatment on cancellation of foreign exchange forward contract. ¹

A. Facts of the Case

1. An Indian shipping company has placed an order for a new ship with a company based in Singapore and payments are to be made on the completion of various stages in Singapore Dollar (SGD). The company has entered into foreign exchange forward contract for buying SGD against the equivalent US Dollar (USD) with a maturity date as 31st March, 2006 (the company has a natural hedge as most of its revenue is USD denominated/based). This was done to cover exposure in terms of SGD/USD fluctuations at the time of installment payments becoming due to the vendor in Singapore for the new vessel, during the period vessel construction is in progress.

2. The company has cancelled the forward contract before the maturity date and the cancellation has resulted in a gain/loss. The querist has given various arguments for different accounting treatments for such gain/loss as below:

Arguments for treating the same as profit/loss:

(i) Paragraph 36 of Accounting Standard (AS) 11, ‘Changes in Foreign Exchange Rates’, issued by the Institute of Chartered Accountants of India, inter alia, states that “profit or loss arising on cancellation or renewal of a forward contract should be recognised as income or as expense for the period.

(ii) The Announcement of the Institute of Chartered Accountants of India on Treatment of exchange differences under Accounting Standard (AS) 11 (revised 2003), The Effects of Changes in Foreign Exchange Rates vis-à -vis Schedule VI to the Companies Act, 1956 and the requirement to capitalise the foreign exchange differences do not deal with paragraphs 36 to 39 of AS 11 which deal with forward contracts. The Announcement deals with paragraph 13 of AS 11 which prescribes requirements in respect of normal exchange differences.

(iii) The recent Announcement of the Institute of Chartered Accountants of India on ‘Accounting for exchange differences arising on a forward exchange contract entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction’ (published in ‘The Chartered Accountant’, January 2006 (pp.1090)), also, inter alia, states, “exchange differences arising on the forward exchange contracts entered into to hedge the foreign currency risks of a firm commitment or a highly probable forecast transaction should be recognised in the statement of profit and loss in the reporting period in which the exchange rate changes. Any profit or loss arising on renewal or cancellation of such contracts should be recognised as income or expense for the period.”

(iv) The Announcement (referred in clause (iii) above) also does not distinguish between any liabilities for capital expenditure (imports) and others.

(v) The requirement of Schedule VI relating to capitalisation of foreign exchange differences could not have contemplated such matters when it was drawn up and hence, cannot be extended to cover forward exchange transactions, etc., even if related to capital expenditure liabilities and loans.

(vi) The Exposure Draft of the proposed Accounting Standard on Financial Instruments: Presentation, also inter alia states in paragraph 56 that gains related to financial instruments should be recognised as income in the statement of profit and loss, and in the ‘definitions’ paragraph of the said Exposure Draft, derivatives are included in the definition of the term ‘financial instruments’.

(vii) Also, as the company has an Indian loan on which interest at 8.5% is paid, the requirement of Accounting Standard (AS) 16, ‘Borrowing Costs’, issued by the Institute of Chartered Accountants of India, regarding consideration of the foreign exchange differences on foreign currency loan to the extent of difference between the interest on Indian loan and interest on foreign currency loan is not relevant in the present case. Hence, interest capitalisation is not affected (if such an issue arises).

(viii) Hence, the gain, which arises because the foreign currency liability in Singapore dollars was covered for a US dollar amount (in view of natural hedge of the company) and the forward contract to hedge the loan was cancelled, should be taken to the statement of profit and loss only. Similarly, premia paid, if any, or losses incurred should also be taken to the profit and loss account only and not capitalised.

Arguments for capitalising the gain on cancellation of the forward contract:

(i) Schedule VI to the Companies Act, 1956, under the ‘Instructions in accordance with which assets should be made out’ for the head ‘Fixed Assets’, inter alia, states: “where the original cost aforesaid and additions and deductions thereto, relate to any fixed asset which has been acquired from a country outside India, and in consequence of a change in the rate of exchange at any time after the acquisition of such asset, there has been an increase or reduction in the liability of the company, as expressed in Indian currency, for making payment towards the whole or a part of the cost of the asset or for repayment of the whole or a part of moneys borrowed by the company from any person, directly or indirectly, in any foreign currency specifically for the purpose of acquiring the assets (being in either case the liability existing immediately before the date on which the change in the rate of exchange takes effect), the amount by which the liability is so increased or reduced during the year, shall be added to, or, as the case may be, deducted from the cost, and the amount arrived at after such addition or deduction shall be taken to be the cost of the fixed asset.”

(ii) The asset in the present case is acquired from Singapore, a country outside India.

(iii) The liability is in Singapore dollars.

(iv) The cover is taken to protect against any adverse movement of Singapore dollars, e.g., in case it appreciates and the company needs to pay more.

(v) The cover protects the company against future liabilities; liability can be interpreted to mean future liability also; after all, it is a commitment which would have been disclosed as per Schedule VI, Part I anyway.

(vi) When the company makes the payment, it is going to capitalise the payment made actually. Hence, any such cancellation is part and parcel of the same thing and hence, whether plus or minus, is a part of cost; hence, as per Schedule VI, the amount of gain should be reduced from the cost of capital work-in-progress (WIP).

(vii) AS 11 (revised 2003) does not deal with this aspect in paragraph 36 inadvertently. If a cost is incurred to freeze the liability in Indian rupee, then that cost would logically be part of the cost of fixed assets only as these two are inseparable.

B. Query

3. In the light of the above, the opinion of the Expert Advisory Committee has been sought on how the gain/loss on cancellation of the forward contract is to be accounted for in the books of account of the company, i.e., (a) whether to be shown as an income or an expense for the period, or (b) to be deducted from/ added to the capital work-in-progress for new ship.

C. Points considered by the Committee

4. The Committee, while answering the query, has restricted itself to the query raised in paragraph 3 above and has not considered any other issue arising from the Facts of the Case.

5. The Committee notes from the Facts of the Case that the company has placed an order for purchase of a ship, the payments for which are to be made in future on completion of various stages of construction of the ship and the transaction was hedged against the foreign exchange fluctuations by entering into a forward contract by the company.

6. In this context, the Committee notes the definition of the term ‘firm commitment’, as provided in the footnote to the Announcement on ‘Accounting for exchange differences arising on a forward exchange contract entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction’, issued by the Institute of Chartered Accountants of India, which states as follows:

“A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.”

On the basis of the above, the Committee is of the view that in the present case, a forward exchange contract was entered into to hedge the foreign currency risk of a firm commitment and accordingly, the accounting treatment prescribed by the said Announcement is applicable in the present case.

7. The Committee further notes paragraph 3 of the aforesaid Announcement, which inter alia, states as follows:

 “3. ... Any profit or loss arising on renewal or cancellation of such contracts should be recognised as income or expense for the period”.

The Committee also notes that the Institute of Chartered Accountants of India, through its Announcement published in ‘The Chartered Accountant’, June 2006 (pp. 1774), deferred the applicability of its Announcement on ‘Accounting for exchange differences arising on a forward exchange contract entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction’ upto April 1, 2007 and hence, this Announcement would now be applicable in respect of accounting period(s) commencing on or after April 1, 2007. Since it represents the present view of the Council of the Institute in respect of such transactions, in the view of the Committee, the treatment prescribed by the said Announcement should be followed for such transactions.

8. Regarding the arguments set out in favour of capitalising/ deducting to/from the cost of the fixed asset as required by Schedule VI to the Companies Act, 1956, the Committee notes that the requirement of Schedule VI is in respect of capitalisation of foreign exchange variations to the cost of the fixed asset. The said requirement deals only with the increase/decrease in foreign exchange liability related to the acquisition of fixed asset from abroad and can not be extended to the profit or loss arising on cancellation of forward contract entered into to hedge a firm commitment for purchase of a fixed asset. Hence, the said requirement of Schedule VI is not applicable in the present case.

D. Opinion

9. On the basis of the above, the Committee is of the opinion on the query raised in paragraph 3 above that the gain/loss on cancellation of the forward contract should be recognised as income or expense in the statement of profit and loss for the period rather than deducting/adding the same from/to capital work-in-progress for new ship.

¹ Opinion finalised by the Committee on 18.9.2006