Expert Advisory Committee

Query No. 16              

Subject: 

Disclosure of foreign exchange gain/loss in segment reporting.1

A. Facts of the Case

1. A company (hereinafter referred to as ‘the company’) is engaged in the business of manufacturing of plywood and laminates.  The company is reporting both businesses as separate segments in its quarterly and annual results. The main raw material for plywood is timber which is partially imported and partially domestic.  Similarly, the main raw material for laminates is paper which is also partially imported and partially domestic.  Both plywood and laminates have some common raw materials like resins and chemicals which again are partially imported and partially domestic.

2. The company imports most of its raw materials from its overseas suppliers against Letter of Credit (LC) of the periods ranging from 1 to 6 months. On the due date for payment of LC, the company arranges buyers’ credit (upto a period of 12 months) overseas to pay-off LC to beneficiary bank against Letter of Comfort (Guarantee) from its local bank.  On the date of payment of such buyers’ credit, the company pays to overseas lender through its local bank.  The main purpose of availing such credit is lowering interest cost as buyers’ credit is available at considerably lower interest cost compared to domestic interest cost (nearly 3% against 15% approx of domestic cost).

3. The querist has stated that as a matter of policy, the company keeps its foreign exchange (forex) exposure un-hedged and consequently incurs gain/loss due to foreign exchange fluctuations. Such foreign exchange gain/loss is not operational in nature and has no bearing on raw material cost, because raw material cost is determined on the basis of exchange rate prevailing on the date of import and accounting is done accordingly. Any subsequent difference, which may be gain/loss, is on account of carrying foreign exchange risk and further borrowing in the form of buyers’ credit. In view of this, the foreign exchange gain/loss is not operational but purely financial in nature.  Apart from this, as common imported raw materials are also used, the impact of gain/loss on individual segments is not ascertainable. In view of above, the company considers its foreign exchange gain/loss as un-allocable income/expense in segment reporting. The company is following this policy since inception but now its new auditors want to qualify that company is not allocating the same to specific segments. The company argues that such qualification is not needed for the obvious reasons mentioned above. 

 B. Query

4.  On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee as to whether the qualification made by the auditor of the company is needed.

C. Points considered by the Committee

5. At the outset, the Committee wishes to point out that to express opinion (qualified or otherwise) on the financial statements is the prerogative of the auditors. Accordingly, the Committee does not opine on the auditor’s qualification.  Therefore, the issue which arises in the extant case is whether the foreign exchange gain/loss should be considered as un-allocable income/expense in segment reporting.  The Committee, while expressing its opinion, has considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, recognition of foreign exchange gain/loss, determination of raw material cost, identification of reportable segments, accounting and disclosure of letter of credit and buyers’ credit, etc.

6.The Committee notes paragraphs 5.5, 5.6 and 5.7 of Accounting Standard (AS) 17, ‘Segment Reporting’, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’) which are as below:

“5.5 Segment revenue is the aggregate of

(i)    the portion of enterprise revenue that is directly attributable to a segment,
(ii)   the relevant portion of enterprise revenue that can be allocated on a reasonable basis to a segment, and

(iii)  revenue from transactions with other segments of the enterprise.

Segment revenue does not include:

(a) extraordinary items as defined in AS 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies;
(b) interest or dividend income, including interest earned on advances or loans to other segments unless the operations of the segment are primarily of a financial nature; and
(c) gains on sales of investments or on extinguishment of debt unless the operations of the segment are primarily of a financial nature.

 

5.6 Segment expense is the aggregate of

(i)    the expense resulting from the operating activities of a segment that is directly attributable to the segment, and
(ii) the relevant portion of enterprise expense that can be allocated on a reasonable basis to the segment, including expense relating to transactions with other segments of the enterprise.

Segment expense does not include:

 

(a) extraordinary items as defined in AS 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies;
(b) interest expense, including interest incurred on advances or loans from other segments, unless the operations of the segment are primarily of a financial nature;

 

Explanation:

The interest expense relating to overdrafts and other operating liabilities identified to a particular segment are not included as a part of the segment expense unless the operations of the segment are primarily of a financial nature or unless the interest is included as a part of the cost of inventories. In case interest is included as a part of the cost of inventories where it is so required as per AS 16, Borrowing Costs, read with AS 2, Valuation of Inventories, and those inventories are part of segment assets of a particular segment, such interest is considered as a segment expense. In this case, the amount of such interest and the fact that the segment result has been arrived at after considering such interest is disclosed by way of a note to the segment result.

 

 (c) losses on sales of investments or losses on extinguishment of debt unless the operations of the segment are primarily of a financial nature;
(d) income tax expense; and
(e) general administrative expenses, head-office expenses, and other expenses that arise at the enterprise level and relate to the enterprise as a whole. However, costs are sometimes incurred at the enterprise level on behalf of a segment. Such costs are part of segment expense if they relate to the operating activities of the segment and if they can be directly attributed or allocated to the segment on a reasonable basis.

 

5.7 Segment result is segment revenue less segment expense.”

7. From the above, the Committee notes that the definitions of segment revenue and segment expense include amounts of such items that are directly attributable to a segment, as well as amounts that can be allocated to a segment on a reasonable basis. The Committee also notes that foreign exchange gain/loss is not explicitly excluded from the definition of segment revenue/segment expense. However, interest expense is explicitly excluded from the definition of segment revenue/segment expense. With regard to interest expense, the Committee notes paragraphs 3.1 and 4 of Accounting Standard (AS) 16, ‘Borrowing Costs’, notified under the ‘Rules’, which provide as follows:

“3.1   Borrowing costs are interest and other costs incurred by an enterprise in connection with the borrowing of funds.”

“4.Borrowing costs may include:

...

(e) exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.

Explanation:

 

Exchange differences arising from foreign currency borrowing 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 cost to be accounted for under this Standard and the remaining exchange difference, if any, is accounted for under AS 11, The Effect 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.
…”

From the above, the Committee is of the view that the exchange differences in the extant case to the extent covered under paragraph 4 (e) of AS 16, viz., difference between interest on local currency borrowings and interest on foreign currency borrowings should be regarded as an adjustment to interest cost and therefore, should be treated as interest cost for the purposes of AS 17. Accordingly, as per the definitions of ‘segment expense’ and ‘segment revenue’, such exchange difference should not be included as a part of segment expense/revenue. With regard to the remaining portion of the exchange difference, the Committee is of the view that it is arising on the liabilities relating to purchase of raw materials which are attributable or allocable to segments and, therefore, should be included in the segment expenses/revenue for determination of segment result for segment reporting subject to the discussion given hereinafter.

8.As regards the querist’s argument regarding non-ascertainability of the impact of gain/loss on individual segments as imported raw materials are used as common raw materials for different segments, the Committee notes paragraphs 13, 14 and 37 of AS 17, notified under the ‘Rules’, which provide as follows:

“13. The definitions of segment revenue, segment expense, segment assets and segment liabilities include amounts of such items that are directly attributable to a segment and amounts of such items that can be allocated to a segment on a reasonable basis. An enterprise looks to its internal financial reporting system as the starting point for identifying those items that can be directly attributed, or reasonably allocated, to segments. There is thus a presumption that amounts that have been identified with segments for internal financial reporting purposes are directly attributable or reasonably allocable to segments for the purpose of measuring the segment revenue, segment expense, segment assets, and segment liabilities of reportable segments.

 

14. In some cases, however, a revenue, expense, asset or liability may have been allocated to segments for internal financial reporting purposes on a basis that is understood by enterprise management but that could be deemed arbitrary in the perception of external users of financial statements. Such an allocation would not constitute a reasonable basis under the definitions of segment revenue, segment expense, segment assets, and segment liabilities in this Standard. Conversely, an enterprise may choose not to allocate some item of revenue, expense, asset or liability for internal financial reporting purposes, even though a reasonable basis for doing so exists. Such an item is allocated pursuant to the definitions of segment revenue, segment expense, segment assets, and segment liabilities in this Standard.”

 

“36. Assets and liabilities that relate jointly to two or more segments should be allocated to segments if, and only if, their related revenues and expenses also are allocated to those segments.

 

37. The way in which asset, liability, revenue, and expense items are allocated to segments depends on such factors as the nature of those items, the activities conducted by the segment, and the relative autonomy of that segment. It is not possible or appropriate to specify a single basis of allocation that should be adopted by all enterprises; nor is it appropriate to force allocation of enterprise asset, liability, revenue, and expense items that relate jointly to two or more segments, if the only basis for making those allocations is arbitrary. At the same time, the definitions of segment revenue, segment expense, segment assets, and segment liabilities are interrelated, and the resulting allocations should be consistent. Therefore, jointly used assets and liabilities are allocated to segments if, and only if, their related revenues and expenses also are allocated to those segments. For example, an asset is included in segment assets if, and only if, the related depreciation or amortisation is included in segment expense.”

On the basis of the above, the Committee is of the view that the exchange gain/loss related to raw materials which are purchased specifically for separate segments (for example, paper and timber) would be directly attributable to the segments and, therefore, can be included in segment revenue/expense. Further, as regards exchange gain/loss on common raw material purchases, the Committee is of the view that if it can be allocated to different segments on a reasonable basis, the company should allocate it as per the requirements of the Standard. If, however, such foreign exchange gain/loss can not be allocated due to limitation of related information, the company should develop an appropriate system, as non-availability of requisite information is not sufficient reason to classify an item as an unallocated reconciling item, if a reasonable basis for allocation can be arrived at. The Committee is also of the view that in case allocation cannot be made on a reasonable basis, it should be included as an unallocated reconciling item.

D. Opinion

9. On the basis of the above, the Committee is of opinion that to express opinion (qualified or otherwise) on the financial statements is the prerogative of the auditors and accordingly, the Committee has not opined on this issue as discussed above. The foreign exchange difference to the extent covered by paragraph 4(e) of AS 16 should be regarded as an adjustment to interest cost and therefore, should be treated as interest cost for the purposes of AS 17. Accordingly, it should not be included as a part of segment expense/revenue, as discussed in paragraph 7 above.  The remaining portion of the foreign exchange gain/loss should be attributed/allocated to different segments, in case it can be allocated to segments on a reasonable basis, as discussed in paragraph 8 above.

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¹Opinion finalised by the Committee on 31.7.2012.