Query No. 30

Subject:

Applicability of paragraph 4(e) of AS 16 during operations stage of a project in

respect of loans transacted prior to April 1, 2004. ¹

A. Facts of the Case

1. A Government of India enterprise incorporated under the Companies Act, 1956, is engaged in the business of transmission of power from the generating units in the central sector to various State Electricity Utilities. To meet its expansion plan, funds are also borrowed in foreign currency from foreign financial institutions and banks. The company’s accounting policy regarding paragraph 4(e) of Accounting Standard (AS) 16, ‘Borrowing Costs’, is as under:

        “ Foreign exchange rate variation (FERV) (unfavourable) on foreign currency borrowing, to the extent it does not exceed the difference between the local currency borrowing cost and foreign currency borrowing cost, is treated as borrowing cost”.

2. Every year/quarter, FERV on the foreign currency loans is bifurcated into two parts, first part being the difference between the local currency borrowing cost and foreign currency borrowing cost and the second part being the amount exceeding such difference. The first part is considered as borrowing cost and accounted for as per the provisions of AS 16, i.e., included in the capital cost during construction period and charged to revenue after the project is ready for use. The other part is considered as FERV and is accounted for as per the provisions of Accounting Standard (AS) 11 (1994), ‘Accounting for the Effects of Changes in Foreign Exchange Rates’ or Accounting Standard (AS) 11 (2003), ‘The Effect of Changes in Foreign Exchange Rates’, depending upon the loan agreement date.

3. The querist has stated that the above accounting policy and practice has been followed after obtaining various opinions and clarifications from Expert Advisory Committee and Accounting Standards Board of the Institute of Chartered Accountants of India.

4. During the supplementary audit of accounts for the financial year 2008-09, the government auditors issued a ‘half margin’ stating that “the above accounting policy of the company is not in accordance with Accounting Standard issued by ICAI as paragraph 4(e) of AS 16 is applicable during construction stage only and not during operation stage”. This ‘half margin’ was in respect of loans contracted prior to April 1, 2004. The complete half margin and the reply given by the management of the company is given in Annexure I.

5. On this matter, additional sub-direction was issued to the statutory auditors asking for comment on “whether accounting of Foreign Exchange Rate Variation (FERV) in respect of foreign currency loans contracted prior to April 1, 2004 is in line with AS 16, as paragraph 4(e) of the said Standard is applicable during construction stage only”. The auditors’ reply is given in Annexure II.

6. The querist has stated that the contention of the government auditors, as revealed during the discussions, is that in the case of loans transacted prior to April 1, 2004, in respect of which AS 11 (1994) is applicable, there appears to be a contradiction in the sense that during operation period the entire FERV gain shall be adjusted to the carrying cost (capital cost of related fixed assets), whereas, a part of FERV loss (considered as borrowing cost in view of paragraph 4(e) of AS 16) shall be taken to the profit and loss account as borrowing cost. The querist has stated that the view of the Accounting Standards Board of the ICAI on this matter is that “though AS 11 (1994) did not specifically exclude foreign exchange differences covered by paragraph 4(e) of AS 16 from its scope, pursuant to the issuance of AS 16 in 2000, such foreign exchange difference automatically gets covered in AS 16 instead of AS 11 (1994), since from that date, such foreign exchange differences are considered as borrowing costs and not foreign exchange difference.” The querist has stated that as per the government auditors, the above contradiction is not there in the case of loans transacted on or after April 1, 2004 in respect of which AS 11 (2003) is applicable. In respect of such transactions, during operation period, the entire FERV loss (whether considered as borrowing cost or otherwise) as well as the FERV gain shall be charged to revenue. According to the government auditors, the contradiction in respect of loan contracted prior to April 1, 2004, can be removed if the methodology suggested by them is followed, i.e., paragraph 4(e) of AS 16 is applied during construction stage only and not during operation stage. By this method, the entire amount of FERV loss or gain shall be adjusted in the carrying cost during operations stage of the project in case of loans transacted prior to 01/04/2004. Similarly, in case of loans transacted after 01/04/2004, the entire amount of FERV loss or gain shall be taken to revenue.

7. The querist has stated the ‘half margin’ was dropped on the company’s assurance that the matter will be referred to the Expert Advisory Committee of the Institute of Chartered Accountants of India.

B. Query

8. The querist has requested the Expert Advisory Committee to examine the above mentioned accounting policy and the accounting treatment and give its opinion on whether or not paragraph 4(e) of AS 16 is applicable during the operations stage of a project.

C. Points considered by the Committee

9. The Committee notes that the basic issue raised by the querist relates to the applicability of paragraph 4(e) of AS 16 during operations stage of a project in respect of foreign currency loans transacted prior to April 1, 2004. Therefore, the Committee has considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, treatment of FERV gain, treatment of FERV loss on loans transacted after April 1, 2004, applicability of paragraph 4(e) of AS 16 to foreign currency loans transacted after April 1, 2004, etc.

10. The Committee notes that AS 11, as notified by the Central Government under the Companies (Accounting Standards) Rules, 2006, carries, inter alia, the following footnote:

        “In respect of accounting for transactions in foreign currencies entered into by the reporting enterprise itself or through its branches before the effective date of the notification prescribing this Standard under Section 211 of the Companies Act, 1956, the applicability of this Standard would be determined on the basis of the Accounting Standard (AS) 11 revised by the ICAI in 2003.”

The Committee notes that the preamble to AS 11 (revised 2003) states as follows:

         “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.”

From the above, the Committee is of the view that in respect of foreign exchange differences arising on loans transacted prior to April 1, 2004, the provisions of AS 11 (1994) will be applicable.

11. The Committee notes that AS 16 came into effect in respect of accounting periods commencing on or after April 1, 2000, i.e., after the date AS 11 (1994) became applicable, i.e., April 1, 1995. The Committee also notes that the ‘Clarification on Status of Accounting Standards and Guidance Notes’ issued by the Council of the ICAI states, inter alia, 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.”

Thus, in the view of the Committee, requirements of AS 16 would supersede the requirements of AS 11 (1994) wherever applicable.

12. The Committee notes that paragraph 4(e) of AS 16 provides that borrowing costs include “exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs”. The said paragraph applies to those exchange differences which arise on the amount of principal of the foreign currency borrowings to the extent of the difference between interest on local currency borrowings and interest on foreign currency borrowings. Thus, the amount of exchange difference not exceeding the difference between interest on local currency borrowings and interest on foreign currency borrowings is considered as borrowing costs to be accounted for under this Standard and the remaining exchange difference (arising on loans transacted prior to April 1, 2004), if any, is accounted for under AS 11 (1994) irrespective of the stage of completion of the relevant assets. For this purpose, the interest rate for the local currency borrowings is considered as that rate at which the enterprise would have raised the borrowings locally had the enterprise not decided to raise the foreign currency borrowings.

13. With respect to the treatment of borrowing costs, the Committee notes that paragraph 6 of AS 16 provides as below:

        “6. Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset should be capitalised as part of the cost of that asset. The amount of borrowing costs eligible for capitalisation should be determined in accordance with this Statement. Other borrowing costs should be recognised as an expense in the period in which they are incurred.”

The Committee notes that the requirements with respect to cessation of capitalisation of borrowing costs are contained in paragraph 19 of AS 16, which provides as under:

        “19. Capitalisation of borrowing costs should cease when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.”

14. From the above, the Committee is of the view that in respect of a project, capitalisation of borrowing costs should cease in respect of various qualifying assets under that project when substantially all the activities necessary to prepare the respective qualifying assets for their intended use are complete. Accordingly, the Committee is of the view that borrowing costs, covered under paragraph 4(e) of AS 16, cannot be capitalised after the commencement of operations.

D. Opinion

15. On the basis of the above, in respect of the issue raised by the querist regarding FERV arising on foreign currency loans transacted prior to April 1, 2004 after the commencement of commercial operations, the Committee is of the opinion that the FERV loss to the extent covered under paragraph 4(e) of AS 16 should be treated as borrowing cost which should be expensed in the period in which the same is incurred.

Annexure - I

Replies to Government Audit Observations on the Annual Accounts for the year 2008-09 :

Annexure - II

Reply of the Statutory Auditor

The provisions of AS 11 (revised 1994) ‘Accounting for the Effects of Changes in Foreign Exchange Rates’ shall be applied in accounting for transactions in foreign currency. The said Accounting Standard specifies about

* Recording of transactions on initial recognition
 *Reporting effects of changes in exchange rates subsequent to initial recognition
 *Recognition of exchange differences with respect to transactions entered in foreign currency on or after 1-4-1995 to 31-03-2004.

Under the said provisions of AS 11 (revised 1994), exchange differences arising on repayment of liabilities which were incurred for acquisition of fixed assets shall be adjusted to the carrying cost of the assets incurred for the purpose of accounting for fixed assets.

Accounting Standard (AS) 16 ‘Borrowing Costs’ came into effect for accounting periods commencing on or after 01-04-2000. As per the said standard ‘Borrowing costs are interest and other costs incurred by an enterprise in connection with the borrowing of funds’.

As per Para 4(e) Borrowing Costs includes ‘exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.’

Subsequently, ASI 10 interpreted paragraph 4(e) of AS 16 in November 2003. Based on the said ASI 10 the FERV (unfavourable) on foreign currency (FC) borrowings, to the extent it does not exceed the difference between the local currency borrowing cost and foreign currency borrowing cost is treated as borrowing cost by the company vide Accounting policy 8.3.

Nowhere in AS 16, it is mentioned that the provisions are not applicable to operations stage. As per the generally accepted accounting principles, the borrowing cost on the loans (be it INR loan or FC Loans) during operations stage is charged to the P&L Account. Therefore the company has rightly accounted for the borrowing costs (including the component of 4(e) of AS 16).

Further the Accounting Standards Board vide their letter dated 4th April 2005 on the subject matter clarified the position beyond doubt and the relevant portion of the said letter is as under:

“The Board was of the view that though AS 11 (1994) did not specifically exclude foreign exchange differences covered by paragraph 4 (e) of AS 16 from its scope; pursuant to the issuance of AS 16 in 2000, such foreign exchange difference automatically gets covered in AS 16 instead of AS 11 (1994), since from that date, such foreign exchange differences are considered as borrowing costs and not foreign exchange difference.” We are also informed by the company that they are referring this matter to the Institute of Chartered Accountants of India for their Expert opinion.

The company’s accounting policies on foreign currency transaction including Accounting policy No. 8.3 in our opinion, are in tune with AS 11 (Revised 1994), AS 16 read with ASI 10; AS 11 (revised 2003) and the clarifications issued by the EAC of ICAI from time to time.

¹Opinion finalised by the Committee on 15.12.2009