Query No. 15

Subject:           Applicability of AS 11 to certain transactions pertaining to recoveries of claims settled by the corporation against its credit insurance covers.[1]

A.        Facts of the Case

1. A corporation is an export credit insurer. The corporation provides insurance cover to the Indian exporters against the risk of overseas buyer’s failure to pay and/or failure by the buyer’s banks to externalize the payments to India.

2. The corporation is registered with the Insurance Regulatory and Development Authority (IRDA) as non-life insurer. The corporation follows IRDA guidelines for general insurers in preparing the financial statements. 

3. The corporation charges a premium from the policy holders in Indian rupees (INR) based on the value of the shipments made / exposure accepted by the corporation. The policy holders prepare the invoices and export documents in the specified currency as per the commercial agreements entered into with the overseas buyers. The policy holders declare the value of the shipments to the corporation  in Indian Rupees (INR) by applying the appropriate exchange rate (bank rate / reference rates as the case may be) to convert the invoice value and pay the premium thereon to the corporation in INR.

4. The querist has stated that in case the policy holders fail to receive their dues from the foreign buyers / buyer’s country, they lodge a claim with the corporation. As per the terms of the covers, the corporation covers the losses in INR. The corporation calls for the bank certified exchange rate on the date of shipment to confirm the true value of the loss suffered. The claim is considered on the lower of (a) value on which premium is paid or (b) the bank certified value. The above practice is followed, as conceptually, under an insurance contract, the insured is not supposed to gain from a misfortune suffered and on the same count, the cover offered is that which is paid for (i.e., the value on which the premium is paid). The claims thus settled are expensed out in the books of the corporation. According to the querist, as the claims are computed in INR on the basis of the shipments made, there are no foreign exchange losses or gains arising on account of payment of claims. Losses, if any, caused due to exchange rate fluctuation by default are not hedged by a foreign exchange contract.

5. As per policy terms, if subsequently, a recovery is made by the insured, he is obliged to share the recovery net of recovery expenses, in the same proportion in which the total loss was initially shared by the corporation at the time of claim settlement in INR. The querist has separately informed that the corporation's insurance policy bond (a copy of which has been provided by the querist for the perusal of the Committee) states as under:

"Upon payment of a claim under this policy by the Corporation, the insured shall take all steps which may be necessary or expedient or which the Corporation may at any time require to effect recoveries whether from the buyer or from any other person from whom such recoveries may be made including (if so required) through institution of legal or other proceedings and upon being so advised by the Corporation, shall--

(a)        assign and transfer to the Corporation his rights under the relevant contract in respect of which the loss occurred and such claim payment was made, including his right to receive any monies payable under such contract or his right to damages for any breach thereof;

(b) deliver up to the Corporation any goods in respect of which such payment has been made and any documents relating thereto and assign and transfer to the Corporation his right and interest in any such goods and documents; and

(c) assign, deliver or otherwise transfer to the Corporation any negotiable instruments, guarantees or other securities relating to such goods or contracts."

The querist has also informed that, although the corporation has subrogation rights, it exercises those rights sparingly and currently, the corporation is not exercising its right of subrogation in respect of commercial claims paid to Indian exporters and is relying on action taken by exporters for recovery.

6.         The querist has further stated that as there is generally, a time gap between the date when the shipment takes place and the time when the recovery is actually effected, recovery is realised in INR at a different exchange rate, a portion of which is shared with the corporation. As the corporation issues the policy in INR, collects premium in INR and settles claims in INR, it also adjusts the total amount realised in INR as recoveries against the claim settled. The corporation's view is that the exchange gain or loss is that of the exporters and not of the corporation. However, the joint statutory auditors of the corporation opine that the element of surplus/ deficit in recoveries due to exchange rate fluctuation should be treated as exchange gain/loss by the corporation as per Accounting Standard (AS) 11, ‘The Effects of Changes in Foreign Exchange Rates’.

7.         The querist has also separately informed that a recovery provision is created in respect of a paid claim at the end of each year. The estimated recoveries in respect of all the paid claims are computed and accounted for on the basis of assessment of each individual claim case at the end of each financial year, which as per the querist, is made independent of foreign exchange fluctuations. However, the recoveries in respect of claims paid and outstanding for recovery for more than three years as on the balance sheet date are estimated at Rs.100/- per claim case even if higher recovery provision is permissible on such assessments. The estimated recoveries on account of transfer delay claim, paid or provided for, is accounted for on the basis of the corporation’s current perceptions based on the available information and past experience. This has been documented in the ‘Significant Accounting Policies’ of the company. At the commencement of the next accounting period, the corporation reverses those recovery provisions created at the end of the preceding accounting period. At the end of the financial year, estimation of each individual claim is undertaken again. Where there is no probability of recovery, the corporation ceases to make provision for recovery on the said case thereby closing the case. According to the querist, IRDA has not prescribed any regulation in this regard. In fact, the practice of making provision for recovery is prevalent only in the export credit insurance sector under the non-life insurance category. The recovery provision has two parts. The income part is shown as a reduction in the claim provisions in Schedule 2 (Claims Incurred) to the accounts. The asset part is shown as a part of other assets in Schedule 12 (Advances and Other Assets) to the accounts. As far as accounting for claims and recovery in the books of Policy Holder (PH) is concerned, the querist has stated that generally, the PH accounts for the net loss in the transaction after adjustment of claim amount settled by the corporation. Whenever the dues from the buyer are recovered, the PH would show the same as bad debt recovery and the gain/loss due to exchange rate fluctuation is required to be accounted for by the PH accordingly. The PH is further required to share the recovery proceeds {gross remittance to India less recovery expenses incurred (net recovery), if any} in the same ratio in which claim was paid by the corporation to PH.

8.         According to the querist, after a claim is paid, though it is expensed out in financial statements, record is maintained showing the amount as outstanding claim till the amount is either fully recovered or partly recovered and balance written off or fully written off as per the extant guidelines.

9.        The querist has reproduced the following extracts from AS 11:

“Objective
An enterprise may carry on activities involving foreign exchange in two ways. It may have transactions in foreign currencies or it may have foreign operations. In order to include foreign currency transactions and foreign operations in the financial statements of an enterprise, transactions must be expressed in the enterprise's reporting currency and the financial statements of foreign operations must be translated into the enterprise's reporting currency.

The principal issues in accounting for foreign currency transactions and foreign operations are to decide which exchange rate to use and how to recognise in the financial statements the financial effect of changes in exchange rates.

Scope
1. This Standard should be applied:
               (a)        in accounting for transactions in foreign currencies; and
               (b)        in translating the financial statements of foreign operations.
(Emphasis supplied by the querist.)

2.  This Standard also deals with accounting for foreign currency transactions in the nature of forward exchange contracts.”

10.      The corporation is of the view that the premiums are collected in INR, claims are settled in INR and recovery is realised in INR and there is no foreign currency element in the books of account of the corporation during the entire transaction cycle. Hence, it is considered that AS 11 is not applicable to the corporation's recovery transactions under the policies issued to the exporters.

11.      The joint statutory auditors are of the view that since the recovery of claims by the exporter is denominated in foreign currency, each instalment of recovery by the corporation has to be bifurcated into actual recovery and recovery due to exchange rate fluctuation and the amount attributable to exchange gain/ loss should be reflected accordingly. There is a possibility that, at times, the corporation may be able to recover an amount more than the claim paid amount. The surplus/deficit has to be recognised as forex gain/ loss and even when total recovery is not adequate to adjust the outstanding claim, the part of outstanding claims after adjustment of recovery not due to exchange gain/ loss should continue to be shown as outstanding claim or written off as per the extant guidelines.

12.      The querist has provided the following illustrations of adjustment of recovery in different scenarios which clearly bring out the difference between joint statutory auditors’ view  and the corporation’s view:

Illustration 1
Assumptions:

      Illustration 2:
Assumptions:

(b)   Joint statutory auditors’ view:

Illustration 3:
Assumptions:

13.       The corporation is of the view that the method of accounting for recovery as per the auditor’s view in the illustrations above totally distorts the actual recovery effected by the corporation and consequently, the ‘incurred claim’ of the corporation which is one of the major items in the revenue account of the corporation will be distorted.

14.       The joint statutory auditors are of the view that in the illustration 2 above, the corporation should book forex loss and treat the claim as fully recovered and not continue to show the recovery outstanding.

The corporation’s view

15.       As per the querist, as mentioned in paragraph 9 above, AS 11 is applicable to foreign transactions and foreign operations. The corporation's credit insurance policies issued in INR cannot be construed as forex transactions just because the quantum of recoveries is affected by exchange rate fluctuations. The corporation is of the opinion that the basic transaction in foreign currency is of the exporter only and any such exchange gain/loss is to be recognised only in its books of account as per AS 11.

16.       The querist has also stated that as there are not many organisations, undertaking similar business of significant volume, common accounting procedure at industry level is not available.

B. Query

17.       The querist has sought the opinion of the Expert Advisory Committee on the appropriateness of the method of accounting for recovery, currently followed by the corporation.

C.        Points considered by the Committee

18.       The Committee notes that the basic issue raised in the query relates to whether the accounting treatment followed by the corporation of not recognising any foreign exchange gains / losses on the amount recovered from the third party to the contract of insurance is correct or not. The Committee has, therefore, considered only this issue and has not examined any other issue arising from the Facts of the Case, including disclosures of risks, accounting for transactions in the books of the insured/ policy holder, accounting for insurance premium, measurement of provision for recoveries or any asset arising therefrom, recognising foreign exchange gain/loss on estimated recoveries, adjustment of recoveries against claim settled, etc. Further, the Committee wishes to point out that the opinion expressed hereinafter is purely from accounting perspective and not from legal perspective, for example, from the perspective of examining the legal relationship between the corporation and the insured, etc.

19.       The Committee notes from the Facts of the Case (paragraph 5 above) that the corporation has the right of subrogation, although it is relying on action taken by exporters for recovery. The Committee is of the view that once the claim is settled by the enterprise, it steps into the position of insured against the third party who may have caused the damage. Thus, even though the exporter recovers the amount but it is done on behalf of the corporation and primarily the right to recover remains with the corporation. Moreover, as per clause 25 of the Insurance Policy (reproduce below), the Committee notes that the corporation has a right to recover greater sum than the amount of claim paid by it.

“25.     Any sums recovered by the Insured or by the Corporation after the date at which the loss is ascertained, from the buyer or from any other source shall be divided between the Corporation and the Insured in the proportion in which the amount of loss was borne by each of them respectively according to the terms of this Policy, whether or not such division results in the retention by the Corporation of a greater or lesser sum than the amount paid by the Corporation under this policy in connection with the amount of loss, whatever be the cause, circumstance or reason for such retention. The Insured shall pay to the Corporation all sums so recovered forthwith upon being received by him or by any person on his behalf, the Insured hereby acknowledges and declaring that until such payment is made to the Corporation he receives and holds such sums in trust for the Corporation.”

Thus, in the view of the Committee, on payment of claim, the right to recover gives rise to a resource controlled by the corporation from which future economic benefits are expected to flow, which is an ‘asset’ as per paragraph 49(a) of the Framework for Preparation and Presentation of Financial Statements as reproduced below:

“An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.”

20.       The Committee further notes paragraph 8 of AS 11, which provides as follows:

“8. A foreign currency transaction is a transaction which is denominated in or requires settlement in a foreign currency, including transactions arising when an enterprise either:
(a)        …
(d)       otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency.”

From the above, the Committee is of the view that on payment of claim, the corporation acquires an asset, viz, right to recover from the foreign buyer which is denominated in foreign currency. This acquisition of asset is a foreign currency transaction as per AS 11. Thus, the Committee is of the view that although, in the extant case, the premiums collected and claims settled are denominated in INRs but the asset acquired for recovery (viz., right to recover from the foreign buyer) is denominated in foreign currency which involves foreign currency risk as is also clear from the Illustration provided by the querist. Accordingly, the Committee is of the view that the company should recognise the exchange gain or loss, if any, thereon due to foreign currency fluctuations as foreign exchange gain or loss and therefore, the contentions of the company in this regard are not correct.

D.        Opinion

21.       On the basis of the above, the Committee is of the view that the accounting treatment followed by the corporation of not recognising foreign currency gains/losses on the amount recoverable from the third party to the contract of insurance is not correct.

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[1]Opinion finalised by the Committee on 16.7.2013.