Query No. 28

Subject:

Accounting for foreign exchange variation prior to

commencement of commercial operation.¹

A. Facts of the Case

1. A company is in the process of setting up a refinery in the State of Madhya Pradesh. The said refinery will have an installed capacity of 6 million metric tonnes per annum (MMTPA).

2. The querist has informed that since the company is yet to commence its commercial operations, no profit and loss account has been prepared by the company and only the necessary details as per Part II of Schedule VI² to the Companies Act, 1956 have been disclosed in schedule F to the financial statements as ‘pre-operative expenditure pending capitalisation’. The expenditure incurred during the construction period is classified as ‘pre-operative expenditure pending capitalisation’ and income earned during the construction period has been applied to reduce the capital cost of the project.

3. The company is procuring items relating to plant and machinery for construction of refinery from foreign vendors. The transaction is recorded in ‘Systems, Applications & Products’ (SAP) on despatch of the material (FOB basis) at the rate prevailing on the transaction date. Subsequently, the payment is settled in foreign currency through bank (letter of credit) which is normally a date later than the transaction date. The difference in foreign exchange variation between the transaction date and the settlement date is presently booked under ‘pre-operative expenditure pending capitalisation’.

4. The querist has reproduced paragraph 13 of Accounting Standard (AS) 11 (revised 2003), ‘The Effects of Changes in Foreign Exchange Rates’, issued by the Institute of Chartered Accountants of India (ICAI), which states that “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”. As per the querist, since paragraph 15 of AS 11 (revised 2003) deals with ‘Net Investment in a Non-integral Foreign Operation’, the same is outside the scope of reference of this query. The querist has also reproduced paragraph 9.1 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, which, inter alia, states that “the cost of an item of fixed asset comprises its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price. … The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, changes in duties or similar factors”.

B. Query

5. Based on the above facts, the querist has sought the opinion of the Expert Advisory Committee regarding accounting treatment of foreign exchange variation as to:

     (i) whether the foreign exchange variation is to be accumulated till the commencement of production and then written off to the profit and loss account in terms of AS 11, or,

     (ii) whether the foreign exchange variation being directly related to procurement of fixed asset is to be capitalised along with the cost of the same asset in terms of AS 10, or,

     (iii) whether the foreign exchange variation is to be treated as indirect expenses relating to project and accumulated as pre-operative expenditure pending capitalisation and allocated over the assets of the refinery.

C. Points considered by the Committee

6. The Committee notes that the basic issue raised in the query relates to accounting for foreign exchange differences arising on settlement of liability for procurement of items of plant and machinery from abroad prior to the commencement of commercial operation. The Committee has, therefore, examined only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, accounting for income and expenditures other than the above-mentioned foreign exchange variation during the construction period before commencement of commercial operation, appropriateness of recording of transactions on despatch of materials, etc. Keeping in view the fact that the querist has referred to AS 11 (revised 2003) and in the absence of any information to the contrary, the Committee presumes that the foreign exchange transactions were entered into after 1.4.2004 by the company, i.e., the date of applicability of AS 11 (revised 2003). It is also presumed that the financial year is the accounting year of the company. It is further presumed that as is the normal practice in case of letters of credit, the period of credit is less than 12 months.

7. The Committee notes paragraph 13 of AS 11 (revised 2003), issued by the Institute of Chartered Accountants of India, reproduced by the querist in paragraph 4 above, which requires that in respect of transactions in foreign currency entered into on or after 1.4.2004, the exchange differences arising on the settlement of monetary items should be recognised as income or as expense in the period in which they arise. The Committee notes that the said Standard was notified by the Central Government under the Companies (Accounting Standards) Rules, 2006, which came into effect in respect of accounting periods commencing on or after 7th December, 2006. The notified AS 11 contains a footnote that ‘the accounting treatment of exchange differences contained in this Standard is required to be followed irrespective of the relevant provisions of Schedule VI to the Companies Act, 1956’. In this respect, the Committee notes that the relevant provisions of Schedule VI, as aforesaid, were contained in the second paragraph³ of ‘Instructions in accordance with which assets should be made out’ in Part I of Schedule VI to the Companies Act, 1956, which is reproduced below:

        “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.”

The Committee further notes that the ICAI issued an announcement in November 2003, ‘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’, stating that a company adopting the treatment prescribed in Schedule VI will be considered to be complying with AS 11 for the purposes of section 211 of the Companies Act. This announcement has been withdrawn by the ICAI in view of the above-mentioned footnote to the notified AS 11. Accordingly, the accounting treatment of exchange differences contained in the notified AS 11 (and not the requirements of Schedule VI) are applicable in respect of accounting periods commencing on or after 7th December, 2006.

8. From the above, the Committee is of the view that in respect of the transactions in foreign currencies entered into on or after 1.4.2004, the exchange differences arising on settlement of liabilities (on account of items of plant and machinery procured from abroad),

     (i) during the period 1.4.2004 to 31.3.2007 (presuming that financial year is the accounting year), requirements of Schedule VI would be applicable, and

     (ii) during the accounting periods commencing on or after 1.4.2007, the requirements of notified AS 11 (i.e., AS 11 (revised 2003)) would be applicable.

Accordingly, in respect of transactions in foreign currencies entered into on or after 1.4.2004, the exchange differences arising during the period 1.4.2004 to 31.3.2007 on settlement of monetary liability (letter of credit) incurred for procurement of items of plant and machinery from abroad should be adjusted to the cost of the related fixed assets. However, in accordance with AS 11 (revised 2003), the foreign exchange differences arising on or after 1.4.2007, should be charged/credited to the profit and loss account in the period in which the same arise. The Committee is of the view that for this purpose profit and loss account will have to be prepared by the company even during the construction phase.

9. The Committee is further of the view that while applying the above accounting treatment, paragraph 4(e) (read with its Explanation) of Accounting Standard (AS) 16, ‘Borrowing Costs’, notified under the Companies (Accounting Standards) Rules, 2006, which states that borrowing costs may include exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs, needs to be duly considered.

10. With respect to the argument forwarded by the querist with regard to paragraph 9.1 of AS 10, the Committee notes that the Announcement, ‘Clarification on Status of Accounting Standards and Guidance Notes’, issued by the Institute of Chartered Accountants of India, inter alia, states as below:

        “In a situation where certain matters are covered by a mandatory Accounting Standard and subsequently, an Accounting Standard is issued which also covers those matters, the earlier Accounting Standard or the relevant portion thereof will be considered as superseded from the date of the new Accounting Standard becoming mandatory, unless otherwise specified in the new Accounting Standard.”

The Committee notes that AS 10 became mandatory in respect of accounting periods commencing on or after 1.4.1991, whereas, AS 11 (revised 2003) became mandatory with effect from 1.4.2004. Keeping in view the above Announcement, the Committee is of the view that the provisions of AS 11 (revised 2003) would prevail over the provisions of AS 10, wherever relevant.

D. Opinion

11. On the basis of the above, in respect of transactions in foreign currencies entered into on or after 1.4.2004, regarding the foreign exchange differences arising on settlement of letter of credit for import of items of plant and machinery, the Committee is of the following opinion on the issues raised by the querist in paragraph 5 above:

    (i) The foreign exchange differences should not be accumulated till the commencement of production for writing off to the profit and loss account in terms of AS 11.

    (ii) The foreign exchange differences arising

        (a) during the period 1.4.2004 to 31.3.2007 should be adjusted to the cost of the relevant fixed asset, and

        (b) during the accounting periods commencing on or after 1.4.2007, should be charged (/credited, as the case may be,) to the profit and loss account, in the period in which the same arise.

While applying the above accounting treatment, the requirements of paragraph 4(e) (read with its Explanation) of AS 16 should also be taken into consideration.

    (iii) The foreign exchange differences should not be treated as indirect expenses relating to project and, therefore, should not be accumulated as pre-operative expenditure pending capitalisation for allocation over the assets of the refinery.

¹Opinion finalised by the Committee on 15.12.2009. Subsequent to the issuance of this opinion, Notifications No. G.S.R. 225 (E) dated 31st March, 2009, G.S.R. 913 (E) and G.S.R. 914 (E) dated 29th December, 2011 issued by the Ministry of Corporate Affairs (MCA) came into effect, which may affect the opinion expressed herein.

²Schedule VI has since been revised. Revised Schedule VI came into force for the Balance Sheet and Profit and Loss Account for the financial year commencing on or after 01.04.2011.

³The said paragraph of Schedule VI has subsequently been omitted vide Notification No. G.S.R. 226(E) dated 31st March, 2009 issued by the Ministry of Corporate Affairs.