A. Facts of the Case
1. A listed government company is carrying on a business of
operating ships. The company does not have any subsidiary
company.
2. The company formed a joint venture company Z in March
2006 along with other five joint venture partners. As per the querist,
Z is a jointly controlled entity as described in Accounting Standard
(AS) 27, ‘Financial Reporting of Interests in Joint Ventures’, issued
by the Institute of Chartered Accountants of India. Z is incorporated
at Malta. The company holds 26% stake in company Z which has
been shown as investment. The company has also advanced US
$ 22 million to Z. Out of this advance, US $ 7 million was a
temporary finance arrangement for Z and the same was realised
by the company on 22.04.2007. The balance US $ 15 million
advanced to Z is in the nature of shareholder’s loan to be repaid
by Z. Accordingly, the same has been shown by the company
under the head ‘Amount Advanced to Joint Venture Companies’.
3. Z will construct and own one LNG tanker and the same will be
chartered under a long term ‘Time Charter Agreement 25 years’
upon delivery of the tanker in September 2009. The balance
advance of US $ 15 million will be realised by the company over
the period of operations of Z. The querist has separately informed
that the loan is in the nature of shareholder’s contribution towards
project cost for which there is no separate repayment schedule.
Repayment of loan is dependent on the net surplus cash flow
generated by the joint venture company from operation of ship
owned by it. The querist has also informed that the company has
not hedged the risks in respect of the foreign currency loans
advanced to the joint venture company, through any hedging
instruments. The company has a large number of foreign currency
receipts and payments and the amount of foreign currency
payments are more than foreign currency receipts in a year.
Therefore, as per the querist, it cannot be said that there is any
natural hedge. Meanwhile, the company is earning interest on the
amount advanced at the bank rate or LIBOR + 80 bps, whichever
is higher, on the amount advanced.
4. The exchange differences on the amount advanced to Z were
being debited by the company to the profit and loss account till
financial year 2006-07. The company has also been accounting
for interest received/receivable on the advances as income in its
books of account.
5. Apart from Z, the company has two other joint venture
companies X and Y incorporated at Malta. X and Y were formed
before 01.04.2004. The company has advanced shareholder’s loan
to these companies on terms similar to the advance to Z. These
advances were made before 01.04.2004.
6. The exchange differences on the amounts advanced to X and
Y were also being debited to the statement of profit and loss by
the company till 31st March, 2004, i.e., till the financial year 2003-
04. The company had also been accounting for interest received/
receivable on the advances as income in its books of account in
those years.
B. Query
7. The querist has sought the opinion of the Expert Advisory
Committee on the following issues in respect of accounting by the
company,
Regarding Z:
(a) What should be the accounting treatment of the exchange
differences arising on the advance of US $ 22 million to
Z?
(b) Whether this exchange difference can be recognised in
the statement of profit and loss.
(c) Whether it should be taken to foreign currency translation
reserve as per paragraphs 15 and 16 of Accounting
Standard (AS) 11, ‘The Effects of Changes in Foreign
Exchange Rates’, (revised 2003).
(d) In case of the company, there is a foreign currency loss
on the amount advanced to Z. Currently, there is no
balance in the foreign currency translation reserve. In
case, it is opined to transfer the exchange differences on
amount advanced to Z to foreign currency translation
reserve, the foreign currency translation reserve account
will have a debit balance. Whether this reserve can have
a debit balance. If so, how should it be disclosed in the
balance sheet?
(e) Whether the treatment will be different for exchange
differences on US $ 15 million and US $ 7 million as per
paragraph 16 of AS 11 (revised 2003) which distinguishes
between long-term receivables or loans and trade
receivables or trade payables (temporary finance
arrangements vis-à-vis long-term loan arrangements).
(f) Whether paragraph 24 of AS 11 (revised 2003) is
applicable to the company which deals with translating
the financial statements of non-integral foreign operations
for its incorporation in the reporting enterprise’s financial
statements.
(g) If the answer to (c) above is in the affirmative, what
could be the accounting treatment from 01.04.2007 in
the light of the fact that the company has treated such
exchange differences as revenue and charged to the
statement of profit and loss in the earlier years.
Regarding X and Y:
(h) What should be the accounting treatment for exchange
differences arising on the advance given prior to
01.04.2004 as per Accounting Standard (AS) 11,
‘Accounting for the Effects of Changes in Foreign
Exchange Rates’ (revised 1994) and after 01-04-2004,
as per AS 11, ‘The Effects of Changes in Foreign
Exchange Rates’ (revised 2003)?
(i) Whether this exchange difference can be recognised in
the statement of profit and loss.
(j) Whether it should be recognised in foreign currency
translation reserve as per paragraphs 15 and 16 of AS
11 (revised 2003).
(k) Whether paragraph 24 of AS 11 (revised 2003) is
applicable to the company.
C. Points considered by the Committee
8. The Committee wishes to state that it has considered only the
issues raised in paragraph 7 of the query. Accordingly, it has not
considered the question as to whether the joint ventures in question
should be considered as jointly controlled entities within the meaning
of AS 27 since that issue has not been raised. The Committee’s
opinion is based on the presumption that the said joint ventures
are jointly controlled entities within the meaning of AS 27.
Regarding Z
9. The Committee notes that in order to determine the accounting
treatment of exchange differences arising on the amount advanced
to the joint venture, three issues need to be addressed. First:
Whether the loan advanced is monetary or non-monetary item.
Second: Whether the operations of the joint venture are integral or
non-integral to the operations of the company. Third: If operations
of the joint venture are non-integral to the operations of the
company, whether the amount advanced, in substance, forms part
of the company’s net investment in the joint venture.
10. The Committee notes the definition of the term ‘monetary
items’ given in Accounting Standard (AS) 11, ‘The Effects of
Changes in Foreign Exchange Rates’ (revised 2003), which
provides as below:
“Monetary items are money held and assets and liabilities
to be received or paid in fixed or determinable amounts
of money.”
11. On the basis of the above, the Committee is of the view that
loan advanced to the joint venture is a monetary item because
amount to be received is fixed.
12. In order to determine whether the operations of the joint venture
are integral or non-integral to the operations of the company, the
Committee notes the following definitions, and paragraphs 18 to
20 of AS 11 (revised 2003):
“Integral foreign operation is a foreign operation, the
activities of which are an integral part of those of the
reporting enterprise.”
“Non-integral foreign operation is a foreign operation that
is not an integral foreign operation.”
“18. A foreign operation that is integral to the operations of
the reporting enterprise carries on its business as if it were an
extension of the reporting enterprise’s operations. For example,
such a foreign operation might only sell goods imported from
the reporting enterprise and remit the proceeds to the reporting
enterprise. In such cases, a change in the exchange rate
between the reporting currency and the currency in the country
of foreign operation has an almost immediate effect on the
reporting enterprise’s cash flow from operations. Therefore,
the change in the exchange rate affects the individual monetary
items held by the foreign operation rather than the reporting
enterprise’s net investment in that operation.
19. In contrast, a non-integral foreign operation accumulates
cash and other monetary items, incurs expenses, generates
income and perhaps arranges borrowings, all substantially in
its local currency. It may also enter into transactions in foreign
currencies, including transactions in the reporting currency.
When there is a change in the exchange rate between the
reporting currency and the local currency, there is little or no
direct effect on the present and future cash flows from
operations of either the non-integral foreign operation or the
reporting enterprise. The change in the exchange rate affects
the reporting enterprise’s net investment in the non-integral
foreign operation rather than the individual monetary and nonmonetary
items held by the non-integral foreign operation.
20. The following are indications that a foreign operation is
a non-integral foreign operation rather than an integral foreign
operation:
(a) while the reporting enterprise may control the foreign
operation, the activities of the foreign operation are
carried out with a significant degree of autonomy
from those of the reporting enterprise;
(b) transactions with the reporting enterprise are not a
high proportion of the foreign operation’s activities;
(c) the activities of the foreign operation are financed
mainly from its own operations or local borrowings
rather than from the reporting enterprise;
(d) costs of labour, material and other components of
the foreign operation’s products or services are
primarily paid or settled in the local currency rather
than in the reporting currency;
(e) the foreign operation’s sales are mainly in currencies
other than the reporting currency;
(f) cash flows of the reporting enterprise are insulated
from the day-to-day activities of the foreign operation
rather than being directly affected by the activities
of the foreign operation;
(g) sales prices for the foreign operation’s products are
not primarily responsive on a short-term basis to
changes in exchange rates but are determined more
by local competition or local government regulation;
and
(h) there is an active local sales market for the foreign
operation’s products, although there also might be
significant amounts of exports.
The appropriate classification for each operation can, in
principle, be established from factual information related to
the indicators listed above. In some cases, the classification
of a foreign operation as either a non-integral foreign operation
or an integral foreign operation of the reporting enterprise
may not be clear, and judgement is necessary to determine
the appropriate classification.”
13. The Committee notes from the Facts of the Case that the
querist has not supplied information relevant for the above
paragraphs of AS 11 to decide whether the joint venture in question
is an integral or a non-integral foreign operation. The Committee
is, therefore, of the view that the querist/company should apply the
criteria specified in the above paragraphs to decide whether the
joint venture is integral or non-integral.
14. The Committee notes paragraphs 13, 15, and 16 of AS 11
(revised 2003), dealing with recognition of exchange differences
which are reproduced below:
“13. Exchange differences arising on the settlement of
monetary items or on reporting an enterprise’s monetary
items at rates different from those at which they were
initially recorded during the period, or reported in previous
financial statements, should be recognised as income or
as expenses in the period in which they arise, with the
exception of exchange differences dealt with in
accordance with paragraph 15.”
“Net Investment in a Non-integral Foreign Operation
15. Exchange differences arising on a monetary item
that, in substance, forms part of an enterprise’s net
investment in a non-integral foreign operation should be
accumulated in a foreign currency translation reserve in
the enterprise’s financial statements until the disposal of
the net investment, at which time they should be
recognised as income or as expenses in accordance with
paragraph 31.
16. An enterprise may have a monetary item that is
receivable from, or payable to, a non-integral foreign operation.
An item for which settlement is neither planned nor likely to
occur in the foreseeable future is, in substance, an extension
to, or deduction from, the enterprise’s net investment in that
non-integral foreign operation. Such monetary items may
include long-term receivables or loans but do not include trade
receivables or trade payables.”
15. In case the operations of the joint ventures are non-integral,
the Committee is of the view that before determining accounting
treatment of exchange differences, there is a need to determine
whether the loan advanced to the joint venture, in substance,
forms part of the company’s net investment in the joint venture.
The Committee notes from the Facts of the Case that the amounts
are advanced as shareholder’s loan and though there is no separate
repayment schedule, the loan is repaid over the period of operations
of joint venture(s) out of the surplus cash flow generated from the
operations. Accordingly, it can be said that the repayment of loans
is planned and is foreseeable. Thus, such loans are not of the
nature of net investment in the joint venture. Temporary advances
in any case are not of the nature of net investment in the joint
venture. Therefore, the Committee is of the view that though
shareholder’s loan of US $ 15 million is long-term, but since its
settlement is foreseeable, in substance, it does not form part of
the company’s net investment in joint venture. The Committee is,
thus, of the view that the loan advanced is not covered by the
treatment prescribed in paragraph 15 of AS 11. Accordingly,
exchange differences arising on the loan advanced should be
recognised as income or as expense as per paragraph 13 of AS 11.
Regarding X and Y:
16. With regard to the loans advanced before 1-4-2004, the
Committee notes the applicability paragraph of AS 11 (revised
2003), reproduced below:
“Accounting Standard (AS) 11, The Effects of Changes in
Foreign Exchange Rates (revised 2003), issued by the Council
of the Institute of Chartered Accountants of India, comes into
effect in respect of accounting periods commencing on or
after 1-4-2004 and is mandatory in nature from that date. The
revised Standard supersedes Accounting Standard (AS) 11,
Accounting for the Effects of Changes in Foreign Exchange
Rates (1994), except that in respect of accounting for
transactions in foreign currencies entered into by the reporting
enterprise itself or through its branches before the date this
Standard comes into effect, AS 11 (1994) will continue to be
applicable.”
17. On the basis of the above, the Committee is of the view that
advances given to joint ventures should be considered as
‘transactions’ for the purpose of application of AS 11 (revised
2003). Accordingly, if loan was advanced before AS 11 (revised
2003) coming into effect, i.e., before 1-4-2004, provisions of AS
11 (revised 1994) would apply to the exchange differences arising
on such advances.
18. For advances given prior to 1-4-2004, the Committee notes
paragraph 9 of Accounting Standard (AS) 11, ‘Accounting for the
Effects of Changes in Foreign Exchange Rates’ (revised 1994),
which is reproduced below:
“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.”
19. On the basis of the above, the Committee is of the view that
all exchange differences arising before 1-4-2004 should be
recognised as income or as expense in the period in which that
exchange differences had arisen.
D. Opinion
20. On the basis of the above, the Committee is of the following
opinion in respect of the issues raised by the querist in paragraph
7 above:
Regarding Z
(a) The exchange differences on the advance of US $ 22
million to Z should be recognised as income or as
expense in the statement of profit and loss.
(b) This exchange difference has to be recognised
in the statement of profit and loss.
(c) No.
(d) As mentioned in (a) above, since exchange differences
should not be transferred to foreign currency translation
reserve, the question of debit balance in foreign currency
translation reserve does not arise.
(e) Treatment of exchange differences arising on both
temporary and long-term advances should be the same,
because long-term advance, in substance, does not form
part of the company’s net investment in joint venture.
(f) Paragraph 24 applies for the translation of financial
statements if the operations of the joint venture are nonintegral
to the operations of the company.
(g) Answer to (c) above is in the negative.
Regarding X and Y
(h) All exchange differences arising on advances given prior
to 1-4-2004, should be recognised as income or expense
in the statement of profit and loss as per AS 11 (revised
1994).
(i) These have to be recognised in the statement of profit
and loss.
(j) As mentioned in (h) above, all exchange differences
should be recognised as income or expense in the
statement of profit and loss. Therefore, nothing will be
transferred to foreign currency translation reserve.
(k) No, since AS 11 (revised 2003) is not applicable.
1Opinion finalised by the Committee on 30.1.2008. |