A. Facts of the Case

1. A company is a listed public limited company, promoted by a State Government. It is engaged in the business of manufacture of newsprint, and printing & writing paper.

2. During the financial year (F. Y.) 2005-06, the company embarked upon an expansion project under Mill Development Plan (MDP) at a capital outlay of Rs. 565 crore for augmenting its pulping capacity from 520 tpd to 720 tpd and the paper production capacity from 2.30 lakhs tpa to 2.45 lakhs tpa. This project was funded through borrowed funds (foreign currency/Rupee loans) and internal accruals. All the funds were used for the purpose of acquisition/construction of assets relating to the MDP.

3. During the project construction period (F.Y. 2005-06 to F.Y. 2007-08), the following exchange gains that emanated from the foreign currency borrowings and import of capital goods relating to the MDP were recognised in the books:

        (a) An exchange gain of Rs. 14.22 crore on actual repayment of foreign currency loans during the project construction period and restatement of foreign currency loan liabilities on balance sheet date.

Since this exchange gain was directly attributable to and incidental to the expansion project, the same was accounted for under ‘Capital Work-in-Progress (MDP) A/C’ during the project construction period and the exchange gain was apportioned to the cost of various qualifying assets, upon commissioning of the project, by adopting the general principles under Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’ and the Guidance Note on Treatment of Expenditure during Construction period², issued by the Institute of Chartered Accountants of India (ICAI).

        (b) Forward contracts were booked for hedging the currency risk associated with the commitments under Letter of Credit pertaining to the project imports. An exchange gain of Rs. 4.52 crore was realised on cancellation and rebooking/cancellation and settlement of project import dues covered under the forward exchange contracts. Since the exchange gain was directly attributable to MDP assets under construction, the same was also capitalised based on the principles of accounting for fixed assets under AS 10 and the Guidance Note issued by the ICAI.

4. While finalising accounts for the financial year 2007-08, the statutory auditors of the company made a qualification in their report to the shareholders that the financial statements comply with the Accounting Standards referred to in sub-section (3C) of section 211 of the Companies Act, 1956, except Accounting Standard (AS) 11, ‘The Effects of Changes in Foreign Exchange Rates’ in respect of non-recognition of the exchange fluctuation (gain) during the project construction period on foreign currency transactions to the profit and loss account, which has resulted in understatement of current year’s profit and fixed assets/capital work-in-progress to the extent of exchange gains referred to in paragraph 3(a) and (b) above. During the course of discussion, they further relied on the opinion on ‘Capitalisation/decapitalisation of exchange loss/gain’ of the Expert Advisory Committee (EAC) of the Institute of Chartered Accountants of India, published as Query No. 32 of Volume XXVII of the ‘Compendium of Opinions’, apart from other published accounts of other public sector undertakings (PSUs).

Company’s Views

5. The company is of the view that the exchange effects (losses and gains) relatable to project construction period should be capitalised under AS 10 and should not be recognised under AS 11 as income in the period in which they arose, based on the premise that the fixed assets accounting under AS 10 prevails over AS 11 and Accounting Standard (AS) 16, ‘Borrowing Costs’, in respect of accounting for fixed assets especially during construction period. According to the querist, the company’s views are based on the interpretation of relevant Accounting Standards as discussed in the paragraphs below.

Accounting for Exchange effects under AS 16

6. AS 16 deals exclusively with interest and other financial charges that can be regarded as ‘borrowing costs’ and the extent to which the same can be capitalised or recognised as an expense. As per paragraph 4(e) of AS 16, only a part of the exchange losses arising from foreign currency borrowings can be treated as ‘borrowings cost’. In the view of the company, exchange effects other than those contemplated in AS 16 are required to be recognised in books under other relevant Accounting Standards.

7. As per the querist, the following exchange effects which are not covered under AS 16 have to be dealt with under AS 10 or AS 11, as the case may be:

        (i) Exchange loss in excess of the amount regarded as interest adjustment.
        (ii) Entire exchange gain arising from foreign currency borrowings relatable to construction and post construction period of the project.
        (iii) All exchange effects arising from foreign currency transactions other than borrowings.

According to the querist, the effect of AS 16 is that exchange differences covered under (i) above (to the extent not regarded as borrowing cost) and items (ii) and (iii) are required to be recognised in books of account as ‘Other Expenses / Income’ under AS 10 or AS 11 and not as ‘borrowing cost’.

Accounting for exchange effects under AS 11 read with AS 16

8. The querist has stated that AS 11 is a general Accounting Standard which deals with the exchange effects arising from the foreign currency transactions. As per paragraph 6 of AS 11, exchange differences arising from foreign currency borrowings to the extent regarded as adjustment to interest cost under paragraph 4(e) of AS 16, are to be dealt with under AS 16 and not under AS 11.

9. The querist further states that paragraphs 1 and 2 of AS 11 define its scope. But for a reference to paragraph 4(e) of AS 16 in paragraph 6, nowhere in AS 11 (including the paragraphs defining its scope) it is stated that this Accounting Standard overrides the accounting principles laid down in other Accounting Standards while dealing with the exchange differences on foreign currency transactions. AS 11 (paragraph 6) is only an exclusion clause. This paragraph does not determine the scope of AS 11. It merely conveys that the exchange difference to the extent regarded as interest is to be excluded from the purview of AS 11. Therefore, from paragraph 6, an inference can not be drawn that all other exchange effects are to be dealt with under AS 11. If the intention of paragraph 6 of AS 11 is to cover all exchange effects (except to the extent regarded as interest cost) then it should have been explicitly stated that all other Accounting Standards are not applicable for the purpose of accounting for exchange effects. (Emphasis supplied by the querist.)

10. Therefore, in the view of the querist, without taking cognisance of other relevant Accounting Standards, an inference that all exchange differences (except to the extent treated as an adjustment to interest cost) should be recognised under AS 11 as income or expenses in the period in which they arise, can not be drawn merely on the basis of paragraph 6 of AS 11.

Accounting for Fixed Assets – AS 10

11. According to the querist, AS 10 is an exclusive Accounting Standard on the Accounting for Fixed Assets which permits capitalisation of not only the direct cost of acquisition of assets (purchase price, duties, taxes, etc.,) but also other directly attributable costs incurred in bringing the asset to its working condition for its intended use (emphasis supplied by the querist). Paragraph 9.1 of AS 10 also recognises the effects of changes in foreign exchange rates as a component of cost of the asset.

12. Therefore, according to the querist, exchange effects of all foreign currency transactions, including foreign currency borrowings directly attributable and incurred in bringing the asset to its working condition, upto the commissioning of asset/project are eligible for capitalisation under AS 10, like other indirect expenditure/income incidental and related to project construction period. The transactions arise for bringing the asset to its working condition. Hence, exchange effects of all foreign currency transactions up to the date of commissioning of the asset/project is covered under AS 10. Further, nowhere in AS 10 it is stated that AS 11 overrides AS 10 as far as accounting for exchange effects related to acquisition/construction of assets is concerned.

13. The querist has also stated that when there is a mandatory requirement to deal with a particular issue under a specific AS, that particular AS will prevail over the general one. Nowhere in AS 11, it is categorically stated that all exchange effects (except to the extent regarded as interest cost) are governed by this Standard notwithstanding the accounting requirements under other Accounting Standards.

14. The Ministry of Corporate Affairs (MCA) notified AS 1 to 29 on the same date and therefore, a specific Accounting Standard – Accounting for Fixed assets can not be said to be subordinate to AS 11 in the absence of a specific provision in AS 11. It may also be noted that AS 11 is said to be overruling Schedule VI³ in view of the specific mention by way of a note in AS 11 while such exclusion is not made out for AS 10.

15. Therefore, according to the querist, in sum, on a collective reading of all the above Accounting Standards, it can reasonably be concluded that the exchange effects of foreign currency transactions relatable to project construction period are covered for capitalisation under AS 10 and only those exchange effects on foreign currency transactions, not covered under AS 10 and AS 16, are alone to be considered for accounting under AS 11.

B. Query

16. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

        (i) Whether the exchange effects, i.e., the difference between initial recognition exchange rate and exchange rate on the date of settlement or date of reporting arising from all foreign currency transactions, like loans, import payables, advances for project imports, etc., and associated forward contracts, relatable to the assets during the project construction period, can be treated as part of the cost of the assets under AS 10 as other indirect expenses / income incurred in bringing the asset to its working condition, in the absence of any specific requirement under AS 11.

        (ii) Whether it is appropriate to apply AS 11 for accounting for exchange effects arising from foreign currency transactions relatable to assets under construction when there is a specific AS 10 to deal with such items.

        (iii) In a green field project with a gestation period of 2 – 4 years, whether the exchange effects pertaining to the foreign currency transactions relatable to project construction period can be treated as pre-operative expenses and accounted for as capital work-in-progress and eventually be capitalised at the time of completion of the project. If the same is eligible for capitalisation under AS 10, whether the same treatment can be logically extended to exchange effects related to expansion project.

        (iv) Whether the exchange effects (gains/losses) arising from forward contracts booked for long delivery import of capital goods related to new project/expansion project, attributable to acquisition of specific assets with an objective to freeze the capital cost of the assets can be treated as a direct or an indirect cost related to acquisition/construction of assets for capitalisation under AS 10.

        (v) If the notional exchange gain (due to revaluation at market rate on reporting date – Mark to Market) arising during project construction period, is to be taken to the profit and loss account, whether it would be legal and proper if dividend is declared out of such gains.

C. Points considered by the Committee

17. The Committee notes that the basic issue raised by the querist relates to treatment of exchange differences (gains/losses) in respect of foreign currency borrowings arising during the project construction period. Accordingly, the Committee has not considered any other issue that may be contained in the Facts of the Case, such as, the nature of transactions in respect of which exchange differences are required to be accounted for, etc. The Committee also notes from the Facts of the Case that the construction of the project commenced in the financial year 2005-06. In the absence of 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). Accordingly, in the case under consideration, AS 11 (revised 2003) would be relevant in respect of such foreign currency transactions. The Committee further notes from the Facts of the Case that the querist has not raised the question of applicability of Schedule VI to the Companies Act, 1956 in respect of capitalisation of foreign exchange differences. Accordingly, while giving its opinion, the Committee has not dealt with that issue.

18. The Committee notes that paragraph 4(e) of AS 16, as notified by the Central Government under the Companies (Accounting Standards) Rules, 2006 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 Committee notes that with the notification of the Accounting Standards, Accounting Standards Interpretation (ASI) 10, Interpretation of paragraph 4(e) of AS 16, has been incorporated in the notified AS 16 by way of ‘Explanation’ which states as below:

        “Exchange differences arising from foreign currency borrowings and considered as borrowing costs are 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 borrowings costs to be accounted for under this Standard and the remaining exchange difference, if any, is accounted for under AS 11, The Effects of Changes in Foreign Exchange Rates. 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.”

19. From the above, the Committee notes that as per paragraph 4(e) of notified AS 16, exchange loss on foreign currency loan is capitalised to the extent it amounts to adjustment towards interest costs provided other conditions of capitalisation under AS 16 are met. However, with respect to the foreign exchange gain arising on the foreign currency borrowings, the Committee is of the view that the same should be reduced from the cost of the fixed asset to the extent the exchange loss has been capitalised as per the provisions of paragraph 4(e) of AS 16. Since borrowing costs can be capitalised only with respect to a qualifying asset as per AS 16, the Committee is further of the view that decapitalisation can be done only during the period over which the fixed asset towards which the foreign currency loan has been taken continues to be a qualifying asset.

20. With respect to the foreign exchange differences on loan liabilities or other transactions, the Committee notes the ‘Basis for Conclusions’ of Accounting Standards Interpretation (ASI) 10, ‘Interpretation of paragraph 4(e) of AS 16’ issued by the ICAI, whose consensus paragraph has been included as an ‘explanation’ to paragraph 4(e) of AS 16 notified under the Companies (Accounting Standards) Rules, 2006. Paragraphs 4 and 5 of ASI 10 are reproduced below:

 “4. Enterprises often borrow in foreign currency at a lower interest rate as an alternative to borrowing locally in rupees, at a higher rate. However, the likely currency depreciation and resulting exchange loss often offset, fully or partly, the difference in the interest rates. In such cases, the exchange difference on the foreign currency borrowings to the extent of the difference between interest on local currency borrowing and interest on foreign currency borrowing, is regarded as an adjustment to the interest costs. This exchange difference is, in substance, a borrowing cost. In case of an enterprise, which instead of borrowing locally at a higher interest rate, borrows in foreign currency on the basis that the interest cost on foreign currency borrowings as adjusted by the exchange fluctuations, is expected to be less than the interest cost of an equivalent rupee borrowing, it is not appropriate to consider only the explicit interest cost on the foreign currency borrowing as the borrowing costs. In such a case, to the extent the exchange differences are regarded as an adjustment to the interest costs, as explained above, the same should also be considered as borrowing costs and accounted for accordingly with a view to reflect economic reality. Accordingly, such an exchange difference is covered under AS 16.

        5. The explicit interest cost, including exchange difference thereon, if any, is covered under paragraph 4 (a) of AS 16, which provides that borrowing costs may include interest and commitment charges on bank borrowing and other short term and long term borrowings. Accordingly, the intention of paragraph 4(e) of AS 16 is to cover exchange differences on the amount of the principal of the foreign currency borrowings. Further, since paragraph 4(e) uses the words ‘to the extent that they are regarded as an adjustment to interest costs’, the entire exchange difference on principal amount is not covered by paragraph 4 (e). Since, the difference between interest on local currency borrowings and interest on foreign currency borrowings, is regarded as an adjustment to the interest costs, only the exchange difference to the extent of such difference is covered by paragraph 4 (e) of AS 16. The entire exchange difference on the principal amount is regarded as an adjustment to the interest cost only in a situation where the difference between interest on local currency borrowings and interest on foreign currency borrowings is equal to or more than the exchange difference.”

Accordingly, from the above, the Committee is of the view that the foreign exchange loss over and above that covered under paragraph 4(e) of AS 16 is a cost that is not regarded as a borrowing cost. Such cost would not have been incurred had the entity borrowed the funds domestically. Thus, this cost cannot be attributed to the cost of construction of the project and should be expensed when incurred. Similarly, any exchange gain over and above the exchange gain adjusted to the cost of the fixed cost, as discussed in paragraph 19 above, should be accounted for as income for the year in which the same arises.

21. With respect to the applicability of AS 10 vis-à-vis AS 11 and AS 16, the Committee notes that while dealing with a particular item of expenditure, certain Accounting Standards require expensing thereof when incurred unless otherwise required under another Accounting Standard. For example, Accounting Standard (AS) 15, ‘Employees Benefits’, requires in paragraph 10(b) that short-term employee benefits should be recognised “as an expense, unless another Accounting Standard requires or permits the inclusion of the benefits in the cost of an asset (see, for example, AS 10, Accounting for Fixed Assets)”. AS 16 requires the borrowing costs to be capitalised in case of a qualifying asset in accordance with the requirements of the Standard including the foreign exchange differences covered under paragraph 4(e) of AS 16. Other borrowing costs are required to be recognised as an expense in the period in which they are incurred. AS 11, however, requires all foreign exchange differences to be recognised as income or as expenses in the period in which they arise with the exception of those exchange differences that are required to be capitalised under paragraph 4(e) of AS 16. AS 11, thus, does not require capitalisation of any other exchange fluctuation by making reference to any other Accounting Standard such as, AS 10.

22. With respect to the argument forwarded by the querist in paragraph 11 of the Facts of the Case in 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 Council of the Institute of Chartered Accountants of India (published in the Journal of the Institute, ‘The Chartered Accountant’, April 2002, page 1242), 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 further notes that AS 10 became mandatory in respect of accounting period 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. The Committee is of the view that though both the Standards were notified by the Ministry of Corporate Affairs on the same day, the Standards were applicable even prior to that date under the proviso to section 211(3C) of the Companies Act, 1956.

23. With respect to the accounting for forward exchange contracts, the Committee notes that AS 11 (revised 2003) provides in paragraph 36 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.”

Accordingly, the exchange effects (gains/losses) arising from forward contracts in the case of the company should be treated as per the provisions of the above paragraph.

D. Opinion

24. On the basis of the existing Accounting Standards, including AS 11, and other pronouncements, as discussed above, the Committee is of the following opinion on the issues raised by the querist in paragraph 16 above:

 

(i) No, the exchange effects arising from the foreign currency transactions relatable to assets during the project construction period cannot be treated as part of the cost of the asset under AS 10 as other indirect expenses/income incurred/earned in bringing the asset to its working condition, except for those foreign exchange differences which are covered under paragraph 4(e) of AS 16.