Query No. 25

Subject:

Accounting for derivative contracts intended

to hedge investment in a subsidiary.¹

A. Facts of the Case

1. Company X (“X”), an Indian Company acquired an overseas Company Y (“Y”) in Canada. The acquisition was to be funded by contribution by Company X by way of an equity contribution of USD 450 mn to a Special Purpose Vehicle – Netherlands incorporated company (“SPV 1”) and the balance money was by loans drawn by this SPV and others specifically created for this purpose. The payment structure was as follows:

2. SPV 1 issued equity shares denominated in Euro to X. SPV 2 issued equity denominated in USD to SPV 1.

3. X had put in the bid for company Y during last week of January ’07 and Y communicated to X on 20th February, ’07 that they have been chosen as the preferred bidder. The transaction had to be paid for and consummated by 15th May, ’07. To protect against currency fluctuations, X entered into some forward contracts and option contracts during last week of March ’07 and early April ’07 for USD 380 mn out of the total USD 450 mn exposure. Since the exact payment dates were not known at that stage but the expectation was that the deal would be closed not later than 31st May and ideally around 15th May. Hence, X entered into derivatives maturing around the expected payment date ranging from end April to May 15th.

4. Significant portion of the derivative contracts was in the form of Zero Cost Collar options, i.e., these derivatives provide the holder a right to buy Dollars. However, instead of paying premium the holder writes a compensating sell option. In the present case, X has entered into leveraged options, i.e., where the pay off on the written sell option is higher than the bought call option. X has also entered into other variants of options.

5. The details of the derivative instruments and the activity therein are as set out in the Annexure.

6. The actual payments were made as follows:

    16-Apr-07         USD 70 mn               USD 50 mn purchased from market
                                                               USD 20 mn from early delivery from Tranche 5
     8-May-07        USD 380 mn             USD 340 mn was used by taking delivery
                                                               against the derivative contracts on 8th May
                                                               as set out in table given in the Annexure.
                                                              USD 40 mn was purchased from market

7. X has accounted for the losses incurred on various dates on cancellation of the leveraged portion of the options and roll-forward of the option contracts amounting to approximately Rs. 67 crore as expense in the profit and loss account of the relevant period.

8. The net impact of settlement of the forward contracts on May 8, 2007 was not material.

B. Query

9. The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:
         

(i) Whether the losses incurred (refer paragraph 7 above) on the derivatives contracted for hedging the cash outflow for equity investments can be considered as a direct cost of acquisition and accordingly, added to the cost of investments or would the losses have to be taken to the profit and loss account.
         

(ii) Whether the combination of call and put options can be considered as a forward exchange or another financial instrument that is in substance a forward exchange contract as in paragraph 36 of Accounting Standard (AS) 11, ‘The Effects of Changes in Foreign Exchange Rates’, and thus, be accounted for as forward contracts. In the absence of any specific guidance for accounting for option contracts what would be the primary source of technical guidance for its accounting/disclosures including the option contracts entered for hedging the forecast transaction.
         

(iii) If it is agreed that these transactions are not covered by existing Indian Accounting Standards, then whether reference can be made to International Accounting Standard (IAS) 39, ‘Financial Instruments: Recognition and Measurement’, only for these transactions, i.e., not adopt IAS 39 in its entirety, including potential for claiming hedge accounting under IAS 39.

C. Points considered by the Committee

10. The Committee notes that the company in question had entered into certain options and forward contracts to cover the foreign currency risk to purchase an investment in future. In other words, the aforesaid derivative contracts were entered into in expectation of purchase of an investment in future.

11. The Committee notes that paragraph 36 of AS 11 provides as below:
              

“36. An enterprise may enter into a forward exchange contract or another financial instrument that is in substance a forward exchange contract, which is not intended for trading or speculation purposes, to establish the amount of the reporting currency required or available at the settlement date of a transaction. The premium or discount arising at the inception of such a forward exchange contract should be amortised as expense or income over the life of the contract. Exchange differences on such a contract should be recognised in the statement of profit and loss in the reporting period in which the exchange rates change. Any profit or loss arising on cancellation or renewal of such a forward exchange contract should be recognised as income or as expense for the period.”

12. The Committee also notes that the above paragraph of AS 11 does not apply to forward exchange contracts to cover a future transaction. In this context, the Committee notes that the Institute of Chartered Accountants of India had issued, in January 2006, an Announcement titled as ‘Accounting for exchange differences arising on a forward exchange contract entered into to hedge the foreign currency risk of a firm commitment² or a highly probable forecast transaction³’. The said Announcement is reproduced below:
               

“1. The Institute of Chartered Accountants of India (ICAI) issued an Announcement, on ‘Applicability of Accounting Standard (AS) 11 (revised 2003), The Effects of Changes in Foreign Exchange Rates, in respect of 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 (see ‘The Chartered Accountant’, July 2004 (pp. 110)). As per the Announcement, AS 11 (revised 2003) is not applicable to the exchange differences arising on forward exchange contracts entered into to hedge the foreign currency risks of a firm commitment or a highly probable forecast transaction. It is stated in the Announcement that the hedge accounting, in its entirety, including hedge of a firm commitment or a highly probable forecast transaction, is proposed to be dealt with in the Accounting Standard on ‘Financial Instruments: Recognition and Measurement’, which is under formulation.                

2. It may be noted that as per the above Announcement, AS 11 (revised 2003) is not applicable to the 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. Accordingly, the premium or discount in respect of such contracts continues to be governed by AS 11 (revised 2003), The Effects of Changes in Foreign Exchange Rates.
                

3. It has been noted that in the absence of any authoritative pronouncement of the Institute on the subject, different enterprises are accounting for exchange differences arising on such contracts in different ways which is affecting the comparability of financial statements. Keeping this in view, the matter has been reconsidered and the Institute is of the view that pending the issuance of the proposed Accounting Standard on ‘Financial Instruments: Recognition and Measurement’, which is under formulation, 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.”

13. The Committee notes that the above Announcement had been deferred by subsequent Announcements made by the ICAI in February 2006, June 2006 and July 2007.

14. With regard to whether the losses on derivatives should have been added to the cost of investments, the Committee also notes paragraph 28 of Accounting Standard (AS) 13, ‘Accounting for Investments’, which requires as follows:
           

“28. The cost of an investment should include acquisition charges such as brokerage, fees and duties.”

15. The Committee is of the view that the requirement of the above paragraph of AS 13 covers charges on acquisition and, accordingly, it does not include losses on derivative contracts as a part of cost of investments.

16. The Committee is of the view that the nature of options contracts or the combination thereof as per the facts of the case is different from the forward contacts or their combination and accordingly, the options contracts or their combination cannot be considered as a forward exchange contract or another financial instrument that is in substance a forward exchange contract for the purposes of paragraph 36 of AS 11 and the Announcements mentioned in paragraphs 12 and 13 above. The Committee is, therefore, of the view that insofar as option contracts are concerned, since there was no pronouncement of the ICAI, the company could have adopted any rational treatment. Thus, recognising losses on the options contracts was in order, keeping in view the principle of prudence. Insofar as forward contracts were concerned, although the Announcement reproduced in paragraph 12 above had been deferred, the said Announcement formed the only authoritative source of accounting for a forward transaction of a highly probable forecast transaction. Thus, in case the concerned transaction met the definition of the highly probable forecast transaction, recognition of the loss thereon in the profit and loss account was in order.

17. It may be noted that the Institute of Chartered Accountants of India has issued Accounting Standard (AS) 30, ‘Financial Instruments: Recognition and Measurement’, corresponding to IAS 39. AS 30 becomes recommendatory in respect of accounting periods beginning 1st April, 2009 and mandatory from 1st April, 2011. In view of the fact that options contracts are not forward exchange contracts or another financial instrument that is in substance a forward exchange contract as envisaged in paragraph 36 of AS 11, the company can follow AS 30 with regard to hedge accounting provisions in case the combination(s) of options taken by the company constitute(s) a hedging instrument(s), after having satisfied all the requirements related to hedge accounting, e.g., those related to hedge effectiveness, documentation, etc.

D. Opinion

18. On the basis of the above, the opinion of the Committee on the issues raised by the querist in paragraph 9 are as below:           

(i) Losses incurred on the derivative contracts for hedging the cash outflow for equity investments cannot be considered as a direct cost of acquisition thereof and accordingly, should not have been added to the cost of investments. The treatment followed by the company to recognise these losses in the profit and loss account was in order.
         

(ii) Combination of call and put options cannot be considered as a forward exchange or another financial instrument that is in substance a forward exchange contract as envisaged in paragraph 36 of AS 11. For authoritative source of technical guidance for options contracts please see (iii) below.
         

(iii) In view of the fact that options contracts are not forward exchange contracts or another financial instrument that is in substance a forward exchange contract as envisaged in paragraph 36 of AS 11, the company can follow AS 30, corresponding to IAS 39, with regard to hedge accounting provisions in case the combination(s) of options taken by the company constitute(s) a hedging instrument(s) after having satisfied all the requirements related to hedge accounting, e.g., those related to hedge effectiveness, documentation, etc.