Query No. 38
Subject: Accounting treatment of hedging costs incurred on External Commercial Borrowing (ECB) Loan.[1]

A. Facts of the Case

1. A Government company (hereinafter referred to as the ‘corporation’ or the ‘company’) within the meaning of section 617 of the Companies Act, 1956 is in the business of refining and marketing of petroleum products. The corporation is arranging funds through external commercial borrowings (ECB) route for its various capital project requirements. The corporation had taken ECB for a period of 5 years during the financial year 2006-07 for an amount of JPY 18,079 million (Rs. 623 crore). The allocation of the loan was for various capital projects (which, as per the querist, are qualifying assets as per Accounting Standard (AS) 16, ‘Borrowing Costs’) at the refineries of the corporation. Forward and option contracts were taken to hedge the above loan exposure, which more or less coincided with the repayment of the loans.

Above loan was hedged with the following:
a. JPY / USD Forwards,
b. USD / INR Forwards &
c. USD / INR Options.

The above loan got fully repaid on 18th July, 2012.

2. Accounting treatment followed by the corporation:

Till March 2012, the premium/discount on forward contracts were recognised over the period of such contracts and the same were treated as a part of ‘other expenses’ (exchange rate variation cost). During the year 2012-13, the premium/ discount on forward contracts has been continued to be recognised over the period of the contract (in line with the corporation’s significant accounting policies), the only difference in the treatment made during the year 2012-13 is towards the classification of such cost wherein, the amortised portion has been recognised as a part of ‘finance cost’. During the year 2012-13, total premium on forward contracts for the period 2006-07 to 2012-13 amounting to Rs. 190.90 crore was treated in the books as ‘other borrowing cost’. Out of this amount, Rs. 64.82 crore was capitalised, being the borrowing cost pertaining to qualifying assets, till the date the said qualifying assets were put to use.

The following were disclosed in this regard vide Note 28 and 36 of the annual accounts for the year 2012-13:
“Note # 28
Prior Period Expenses/ (Incomes)

Rs. in Crore

Note # 36

Hitherto, premium on forward exchange contracts entered into to hedge the liability from syndicated loans from foreign banks (repayable in foreign currency) were amortised over the period of the syndicated loans from foreign banks (repayable in foreign currency). As per AS 16, borrowing costs include costs incurred by an enterprise in connection with borrowing of funds. Accordingly, during the current financial year, the premium on forward exchange contracts entered into to hedge the liability towards syndicated loans from foreign banks (repayable in foreign currency) has been considered as borrowing cost as per AS 16. Consequently, an amount of Rs. 64.82 crore has been capitalised in the current financial year and disclosed as a part of Note #28 ‘Prior Period Expenses/ (Incomes)’. As a result, profit for the year before tax of the corporation (net of depreciation) is higher by Rs. 52.43 crore during the current financial year.”

The following are the extracts of significant accounting policies as followed in the accounting year 2012-13 in the above context:

“Construction period expenses on projects

(a) Related expenditure (including temporary facilities and crop compensation expenses) incurred during construction period in respect of plan projects and major non-plan projects are capitalised.

(b) Financing cost incurred during the construction period on loans specifically borrowed and utilised for projects is capitalised. Financing cost includes exchange rate variation in relation to borrowings denominated in foreign currency.

(c) Financing cost, if any, incurred on general borrowings used for projects during the construction period is capitalised at the weighted average cost.”

“Foreign Currency Transactions

(a) Foreign currency transactions during the year are recorded at the exchange rates prevailing on the date of transactions.

(b) All foreign currency assets, liabilities and forward contracts are restated at the rates prevailing at the year end.

(c) All exchange differences (except as stated in note #2.3 (b), 33, 34 and 35) are dealt with in the statement of profit and loss including those covered by forward contracts, where the premium/discount arising from such contracts are recognised over the period of contracts.

(d) The realized gain or loss in respect of commodity hedging contracts, the pricing period of which has expired during the year, are recognised in the statement of profit and loss along with the underlying transaction. However, in respect of contracts, the pricing period of which extends beyond the balance sheet date, suitable provision is made for likely loss, if any.”

3. Views of government auditor:

The government auditor has objected to the above accounting treatment and made the following comments:

“Statement of Profit and Loss
Prior Period Expenses/ (Incomes) :- Rs. (113.39) crore (Note-28)

This includes an amount of Rs. 64.82 crore (finance cost) in the current financial year towards reversal of premium on forward exchange contracts which was amortised over the period of the loan and charged off in the statement of profit and loss till the year 2011-12. The forward exchange contracts are entered to hedge the liability of syndicated loans from foreign banks (repayable in foreign currency).

In this regard attention is drawn to the significant accounting policies (note 2) wherein with regard to ‘Foreign Currency Transactions’ vide paragraph no. 2.6 ‘c’ it has been stated that, “All exchange differences (except as stated in note # 2.3 (b), 33, 34 and 35) are dealt with in the statement of profit and loss including those covered by forward contracts, where the premium/discount arising from such contracts are recognised over the period of contracts”. Thus, as per declared significant policy of the company relating to foreign currency transactions, the premium relating to forward exchange contracts is amortised over the period of contracts in the statement of profit and loss. Thus, the reversal of the premium on forward exchange contracts, charged off in the statement of profit and loss of the earlier years, in the current financial year contradicts the own declared policy of the company.

Moreover, as per provisions of paragraph 36 of Accounting Standard (AS) 11, ‘The Effects of Changes in Foreign Exchange Rates’, 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. Thus, the reversal of the premium, charged off in the statement of profit and loss of the earlier years, in the current financial year also contravenes the provisions of mandatory AS 11.

Thus, the reversal of the premium on forward exchange contracts, in current year is not only in contravention of corporation’s own declared accounting policy and provisions of mandatory AS 11 but also resulted in overstatement of prior period income and gross block of assets by Rs. 64.82 crore and of profit (net of depreciation) for the year by Rs. 52.43 crore.”

4. The querist has stated that the government auditor has also made the following submission for inclusion in this case for opinion:

(a) The basic underlying principle behind the provisions of AS 16, to allow capitalisation of foreign exchange losses in connection with foreign currency loan is that the amount of expenditure which an enterprise would have incurred domestically had loan in Indian rupees would have been taken instead of foreign currency loan. Thus, any cost which is incurred in connection with foreign borrowing should be incurred essentially for arranging the subject foreign currency loan as the same otherwise also would have been incurred had the loan been taken domestically.

(b) In this regard, reference is invited to paragraph 4 of AS 16 which states the items which may be considered as borrowing cost. As could be seen that there is no mention in this paragraph about hedging cost. Thus, the careful reading of paragraph 4 of AS 16 would indicate that borrowing costs are those costs which are incurred for arranging the borrowings and as the hedging costs are not incurred for arranging the borrowings, such costs are not to be considered as borrowing costs even though they might have been incurred in connection with borrowings. Had only ‘in connection with’ been the determining criteria of borrowing costs, then the mention of hedging cost would have also been included in paragraph 4 of AS 16 which states the items which may be considered as borrowing costs.

(c) In this regard, attention is also drawn to paragraph 4 (e) of AS 16, which provide 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”. Paragraph 4(e) of AS 16 covers exchange differences on the amount of principal of the foreign currency borrowings to the extent of difference between interest on local currency borrowings and interest on foreign currency borrowings. For this purpose, the interest rate for the local currency borrowings should be 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. If the difference between the interest on local currency borrowings and the interest on foreign currency borrowings is equal to or more than the exchange difference on the amount of principal of the foreign currency borrowings, the entire amount of exchange difference is covered under paragraph 4 (e) of AS 16. In this regard, attention is drawn to the example given at the end of AS 16.

(d) Moreover, the Ministry of Corporate Affairs’ (MCA’s) clarification allowing the impact of entire exchange difference relating to interest amount only (which earlier was not allowed fully) considering the ‘economic reality’ has to be seen in the context that entire exchange difference relating to interest amount was decided to be allowed for capitalisation due to constant devaluation of Indian Rupee. However, under the pretext of ‘economic consideration’, it would not be correct to consider the hedging cost incurred as borrowing cost as per AS 16 due to this clarification of MCA.

(e) As regards the contention that the hedging costs are necessarily to be incurred in connection with foreign currency borrowings, and are integral part of the foreign currency borrowings and thus inseparable from borrowing portfolio is not found tenable on the following grounds:

(i) Even though it may be in connection with foreign currency loan, however, such hedging costs are not for arranging the foreign currency loan but are incurred by corporation for mitigating its risk towards exchange fluctuation.
(ii) As contended, if the hedging cost would have been integral part of borrowings then without hedging cost, no ECB would have been possible. However, it is pertinent to mention that corporation itself has raised loans (ECB-3 and ECB-4) for which no hedging has been done. This proves that hedging is optional as without incurring hedging cost also the foreign currency loan could be arranged by the enterprise. Therefore, hedging cost cannot be considered as integral part and necessarily to be incurred for availing ECB.

In light of the above, hedging cost cannot be considered as borrowing cost within the ambit of provision of AS 16 even though it might have been incurred in connection with foreign borrowing.
Additionally, as per provisions of paragraph 36 of AS 11, 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. To amortise as expense means to charge off against the profit in the statement of profit and loss. Thus, in view of the above facts, the reversal of the premium, charged off in the statement of profit and loss of the earlier years, in the current financial year is not found correct.

Rationale behind treating hedging cost as borrowing cost:

(A) References of various Accounting Standards and Guidance Note:

Reference is invited to the following paragraphs of AS 16, AS 11 and of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956:

AS 16

“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:

(a) interest and commitment charges on bank borrowings and other short-term and long-term borrowings;

(b) amortisation of discounts or premiums relating to borrowings;

(c) amortisation of ancillary costs incurred in connection with the arrangement of borrowings;

(d) finance charges in respect of assets acquired under finance leases or under other similar arrangements; and

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

…” (Emphasis supplied by the querist)

“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 Standard. Other borrowing costs should be recognised as an expense in the period in which they are incurred.”

AS 11

“7.3 Exchange difference is the difference resulting from reporting the same number of units of a foreign currency in the reporting currency at different exchange rates.

7.4 Exchange rate is the ratio for exchange of two currencies.”

“7.8 Forward exchange contract means an agreement to exchange different currencies at a forward rate.”

“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.

37. The risks associated with changes in exchange rates may be mitigated by entering into forward exchange contracts. Any premium or discount arising at the inception of a forward exchange contract is accounted for separately from the exchange differences on the forward exchange contract. The premium or discount that arises on entering into the contract is measured by the difference between the exchange rate at the date of the inception of the forward exchange contract and the forward rate specified in the contract. Exchange difference on a forward exchange contract is the difference between (a) the foreign currency amount of the contract translated at the exchange rate at the reporting date, or the settlement date where the transaction is settled during the reporting period, and (b) the same foreign currency amount translated at the latter of the date of inception of the forward exchange contract and the last reporting date.”

Guidance Note on the Revised Schedule VI to the Companies Act, 1956

“9.5.5 As per Note 3 of the General Instructions for the Preparation of the Statement of Profit and Loss , disclosure of Finance costs is to be bifurcated under the following:

(A) Interest expense

(B) Other borrowing costs

(C) Applicable net gain/loss on foreign currency transactions and translation
…

B) Other borrowing costs

Other borrowing costs would include commitment charges, loan processing charges, guarantee charges, loan facilitation charges, discounts/premium on borrowings, other ancillary costs incurred in connection with borrowings, or amortization of such costs, etc.”

(B) Further contentions of the corporation are:

(i) 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 in INR and resulting exchange loss often offset, fully or partly, the anticipated savings in interest rates (foreign interest rate v/s domestic interest rate).

Nevertheless, one of the ways to ensure that the adverse effect of this likely depreciation of local currency is avoided is to carry out a hedge against the Rupee fluctuations through instruments like forwards and options. In such a scenario, the hedged portfolio becomes an integral part of the foreign currency borrowing and needs to be seen together while carrying out any cost-benefit-analysis to ascertain if the anticipated savings in interest rates (foreign loan v/s domestic loan) is safeguarded.

The above establishes the fact that the derivative transactions of forwards and options of the company are backed by a physical exposure (herein the loan portfolio). Also, this principle is as per the requirements of RBI Guidelines on derivatives transactions which entails that derivative transactions in India needs to be necessarily backed up by a physical exposure.

(ii)The Institute of Chartered Accountants of India (ICAI), while issuing clarification on foreign exchange transactions in November 2003 vide Accounting Standards Interpretation (ASI) 10[2], ‘Interpretation of paragraph 4(e) of AS 16’, has, inter alia, stated-

“it is not appropriate to consider only the explicit interest cost on the foreign currency borrowing as the borrowing costs” and that exchange differences are to be considered as borrowing cost and accounted for accordingly “with a view to reflect economic reality.”

It may be noted that the above clarification was issued by the ICAI subsequent to the issuance and publication of Accounting Standard (AS) 11 (Revised 2003), ‘The Effects of Changes in Foreign Exchange Rates’ in March 2003 journal.

Attention is also drawn to a more comprehensive paragraph included in the ICAI’s pronouncement, ‘Framework for the Preparation and Presentation of Financial Statements’ which is reproduced below:

“35. If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form.”

The economic reality with respect to cost incurred towards premium / discount is that when an organisation finds the long-term foreign currency borrowing costs lower, on a fully-hedged basis, than comparable Rupee borrowing costs, then only such foreign currency borrowing options are undertaken. This signifies that the implied interest cost (herein referred to as the premium on forward / option contracts) also needs to be considered as a part of the borrowing costs and treated accordingly as per the relevant Accounting Standard.

(iii) The ECB has been taken for various capital projects as stated above and hence, the same is directly attributable to the acquisition, construction or production of qualifying assets as per paragraph 6 of AS 16. Hence, hedging cost (after establishing the fact that hedged portfolio is an integral part of the foreign currency borrowing as per (i) above) is also attributable to acquisition, construction or production of a qualifying asset.

(iv) As per paragraph 37 of AS 11, the premium or discount on entering into forward or option contracts are to be separately accounted from the exchange differences on such contracts. Hence, hedging cost is separately accounted as borrowing cost and not considered as a part of exchange rate variation.

(v) Hedging cost is considered to be in nature of ancillary costs in connection with the arrangement of borrowings as indicated in paragraphs 3.1 and 4 (c) of AS 16 and paragraph 9.5.5 of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956.

(vi) Paragraph 6 of AS 16 does not state that only ‘mandatory’ costs need to be capitalised. It only states that borrowing cost that are “directly attributable to the…” should be capitalised.

(vii) Had the corporation not entered into any forward contract, the entire exchange rate variation would have been capitalised as per paragraph 46 of AS 11, without any amount being charged to the statement of profit and loss.

(viii) Interest Rate Parity theory states that ‘the size of the forward premium (or discount) should be equal to the interest rate differential of the two countries of concern’ [ICAI - Foreign Exchange and Risk Management]. When interest rate parity exists, interest arbitrage is not feasible, because any interest rate advantage in the foreign country will be offset by the discount on the forward rate.

Thus, forward premium is directly dependent upon the interest rate differential of the two countries and can be construed as corollary to paragraph 4 (e) of AS 16.

Based on the above referred paragraphs of Accounting Standards/Guidance Note and the rationale given above, the corporation has considered premium/ discount on forward/ option contract (i.e. hedging cost) on the ECB as finance costs. This accounting treatment has been concurred by the statutory auditors and is also supported by an independent opinion taken from a reputed Chartered Accountant firm.

B. Query

5. On the basis of the above, opinion of the EAC is sought by the querist on the following issues:

(i) Whether the hedging cost incurred in connection with external commercial borrowings can be considered as ‘borrowing cost’ under provisions of AS 16.

(ii) If answer to query (i) is negative then what should be the correct accounting treatment for hedging cost in connection with ECB in the light of various notified accounting standards and notifications/clarifications of MCA issued so far.

C. Points considered by the Committee

6. The Committee notes that the basic issue raised by the querist relates to accounting treatment of hedging cost, viz., premium/ discount on forward/ option contract undertaken in connection with external commercial borrowings (ECB) (which are repayable in foreign currency) as per the provisions of AS 11 and AS 16, notified under the Companies (Accounting Standards) Rules, 2006. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, accounting for interest on ECB, accounting for exchange differences arising on ECB, accounting for foreign currency transactions and commodity hedging contracts, correctness of accounting policy of the company in respect of finance/borrowing cost and other accounting policies in general, accounting for expenditure incurred during construction period apart from hedging cost, accounting treatment of exchange differences arising on forward contracts as at the reporting date or the settlement date, correctness of treating the hedging cost as prior period item when there is a change in accounting policy, etc. The Committee presumes from the Facts of the Case that the option under paragraphs 46 and 46 A of AS 11 for capitalisation of foreign exchange differences in respect of ECBs, is not exercised by the company.

7. The Committee notes from the Facts of the Case that the querist has argued the hedging cost to be other/ancillary borrowing costs as per paragraph 4(c) of AS 16. In this regard, the Committee notes the following paragraphs of AS 16, notified under the Companies (Accounting Standards) Rules, 2006:

“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:

(a) interest and commitment charges on bank borrowings and other short-term and long-term borrowings;

(b) amortisation of discounts or premiums relating to borrowings;

(c) amortisation of ancillary costs incurred in connection with the arrangement of borrowings;
…”

From the above, the Committee notes that other/ancillary borrowing costs are the costs incurred in connection with the arrangement of borrowings, viz., for obtaining the borrowings whereas hedging costs, viz., the discount or premium on forward contracts are the costs incurred to enter into forward contracts for hedging or mitigating the risks associated with adverse movement of foreign exchange rate variations on foreign currency borrowed through ECBs and not for arranging the borrowings itself. Further, the Committee is of the view that it is not necessary to hedge risk against foreign currency movement to obtain the borrowings. In other words, ECBs are not received with a pre-condition to hedge its foreign currency risks. Therefore, hedging costs cannot be considered to be an anciliary cost incurred for arrangement of borrowings. Thus, hedging costs cannot be considered as a type of borrowing costs.

8. As far as the querist’s argument that derivative transactions in India need to be necessarily backed by physical exposures as per the RBI guidelines, the Committee is of the view that this requirement does not mandate that all physical exposures, viz., foreign currency loans and borrowings necessarily need to be covered by hedging instruments. Thus, the hedging costs are avoidable and not an integral or necessary part of the borrowings and, therefore, cannot also be considered as directly attributable cost. Further, in the view of the Committee, the forward exchange contracts are independent from underlying transactions and therefore, AS 11 prescribes separate accounting for forward exchange contracts. Accordingly, in the extant case, foreign currency borrowings and hedging instruments are two separate transactions and that hedged portfolio is not an integral part of the foreign currency borrowings, as being argued by the querist.

9. With respect to the accounting for hedging costs, the Committee notes that AS 11, notified under the Rules explicitly provides its accounting principles in paragraphs 36 and 37 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.

37. The risks associated with changes in exchange rates may be mitigated by entering into forward exchange contracts. Any premium or discount arising at the inception of a forward exchange contract is accounted for separately from the exchange differences on the forward exchange contract. The premium or discount that arises on entering into the contract is measured by the difference between the exchange rate at the date of the inception of the forward exchange contract and the forward rate specified in the contract. Exchange difference on a forward exchange contract is the difference between (a) the foreign currency amount of the contract translated at the exchange rate at the reporting date, or the settlement date where the transaction is settled during the reporting period, and (b) the same foreign currency amount translated at the latter of the date of inception of the forward exchange contract and the last reporting date.”

The Committee notes from the Facts of the Case that in the extant case, the company has taken forward/option contracts for hedging the ECB loan only and are not intended for trading or speculation purposes. Therefore, as per the above-reproduced provisions of AS 11, 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.

D. Opinion
10. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 5 above:

(i) No, the hedging cost incurred in connection with external commercial borrowings cannot be considered as ‘borrowing cost’ under the provisions of AS 16, as discussed in paragraphs 7 and 8 above.
(ii) 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, as discussed in paragraph 9 above.

_________

[1]Opinion finalised by the Committee on 22.1.2014 and 23.1.2014.

[2]The ASI has been withdrawn by the Council of the Institute of Chartered Accountants of India and the consensus portion thereof has been added as ‘Explanation’ to the paragraph 4(e) of Accounting Standard (AS) 16, ‘Borrowing Costs’.