Query No. 23

Subject:           Whether amortisation of premium paid on foreign currency (USD) buy forward covers can be treated as borrowing cost.[1]

A.  Facts of the Case

1.         A company (hereinafter referred to as the ‘company’) manufactures copper cathode, gold, silver and Di-ammonium phosphate (DAP). The main raw material for manufacture of copper is the Copper Concentrate (CC) and it contains various metals primarily being copper, gold and silver.

2.         The company sources its raw materials almost entirely from outside India. The prices are settled in USD at the benchmark international rate. As per the normal trade practice, 90% of payment is to be made within 3-4 days of the arrival of the material. This is because the rates and quality are settled later on. Balance 10% is paid upon finalisation of quality and quantity.  The company has two options to make the payment to the supplier either from internal resources/accruals or by way of short-term borrowings from bank. The company mainly borrows from banks. For this purpose, the company has an option either to borrow in Indian Rupee (INR) or in USD in the form of buyer’s credit for a period of 3-6 months. The company borrows mainly in USD in the form of buyer’s credit as the rate of interest is linked to LIBOR plus spread ranging between 100-200 bps. However, borrowings in USD have some associated costs like withholding tax under section 195 of the Income-tax Act, 1961 and also the cost of hedging (premium) for taking the forward cover for repayment of the loan. However, even after considering these costs, i.e., LIBOR plus spread and the premium paid for taking the forward cover, the cost of borrowings in USD are cheaper than the cost of borrowings in INR.

3.         Entire sales of copper, gold and silver are denominated in USD whether it is exported or sold in the domestic market. As such, the business model works as natural hedge wherein the borrowings in USD are repaid in USD by selling the products. However, in this natural hedge scenario there is always a timing mismatch between the date of repayment of loan and the sales realisations. In order to take care of this timing mismatch, which is almost 10-15 days, the company takes forward buy covers to hedge the risk for any currency fluctuation between the realisation of sales and the repayment of the borrowing. These forward covers are provided by the bank at current spot rate plus a premium which is based on the market condition proportionately for the period of the cover.

Present accounting treatment:

4.         The querist has stated that as required by Accounting Standard (AS) 11, ‘The Effects of Changes in Foreign Exchange Rates’, the premium paid on forward covers is amortised over life of the contract and is charged to the statement of profit and loss of the company as  exchange rate difference which is included under the head ‘other expenses’. This is considered as a part of segment result (defined as earnings before interest and tax). At the same time, since the borrowings are monetary items as per AS 11, the same are restated at the month-end spot rate and such restatements are part of segment result.

Proposed accounting treatment:

5.         With a view to align accounting for premium on related forward covers with risk management objectives, it is considered more appropriate to include amortisation of forward premium as part of borrowing cost. According to the querist, this will only lead to change in presentation while reported net result from operation of the company will not undergo any change.

B.        Query

6.         On the basis of the above, the company seeks the opinion of the Expert Advisory Committee on the following issues:

(i) Whether amortisation of premium on forward covers can henceforth be treated as ‘other borrowing cost’ under the head ‘finance cost’ under Schedule III to the Companies Act, 2013 as per Accounting Standard (AS) 16, ‘Borrowing Costs’.

(ii) If the answer to (i) is yes, whether it can be excluded for the purpose of disclosing segment result.

(iii) If the answers to (i) and (ii) above are in affirmative, whether it is necessary to effect such change from the beginning of financial year.

C.        Points considered by the Committee
           
7.         The Committee notes that the basic issue raised by the querist relates to whether amortisation of  premium on forward contract undertaken in connection with short-term foreign currency borrowings/buyers’ credit (which are repayable in foreign currency) can be treated as a part of the borrowing cost as per the provisions of AS 16, notified under the Companies (Accounting Standards) Rules, 2006 and therefore, whether it can be disclosed  as ‘other borrowing costs’ under the head ‘finance cost’ under Schedule III to the Companies Act, 2013 and excluded under segment results. 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 the short-term borrowings/buyers’ credit, accounting for exchange differences arising on borrowings/buyers’ credit, accounting for buyers’ credit, accounting for foreign currency transactions and hedging contracts, accounting treatment of exchange differences arising on forward contracts as at the reporting date or the settlement date, applicability of paragraph 4(e) of AS 16, computation and presentation of segment results, etc.

8.         The Committee notes from the Facts of the Case that the company wishes to treat the premium on forward cover as a part of borrowing costs as per 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;

 …”

(Emphasis supplied by the Committee.)

From the above, the Committee notes that other costs/ancillary costs included in the definition of borrowing costs are the costs incurred in connection with the arrangement of borrowings, viz., for obtaining the borrowings whereas the premium on forward cover is a hedging cost, incurred to enter into forward contracts, for hedging or mitigating the risks associated with adverse movement of foreign exchange rate variations on foreign currency borrowings and not for arranging the borrowings themselves. Therefore, premium on forward covers cannot be considered as ancillary costs incurred for arrangement of borrowings.

9.         With regard to presentation of amortisation of premium on forward covers as ‘other borrowing costs’ under the head ‘finance cost’ under Schedule III to the Companies Act, 2013, the Committee notes paragraphs 9.5.5 and 9.5.7 of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956 and paragraphs 5.6 and 5.7 of Accounting Standard (AS) 17, ‘Segment Reporting’, notified under the Companies (Accounting Standards) Rules, 2006, as follows:

   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:
…

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.”

            “9.5.7  Other Expenses

All other expenses not classified under other heads will be classified here. …”

 AS 17

“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.”

From the above, the Committee is of the view that since the requirements of Schedule III to the Companies Act, 2013 are similar to the requirements of Revised Schedule VI to the Companies Act, 1956, the above-reproduced requirements of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956, are equally applicable. Further, since the premium on forward covers cannot be considered as ancillary costs in connection with arrangement of borrowings, as discussed in paragraph 8 above, the Committee is of the view that such premium cost cannot also be considered as ‘other ancillary costs incurred in connection with borrowings’ for the purposes of paragraph 9.5.5, ‘other borrowing costs’ of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956.  The Committee further notes that the amortisation of premium on forward covers is not covered by any other item as mentioned in paragraph 9.5.5 of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956, reproduced above. Accordingly, the Committee is of the view that amortisation of premium on forward covers cannot be presented and disclosed as ‘other borrowing costs’ under the head ‘finance cost’ under Schedule III to the Companies Act, 2013. Instead, it should be disclosed under the head ‘other expenses’ as it cannot be classified under any other head specified under Schedule III. Further, for similar reasons, the Committee is of the view that the premium on forward covers should not be excluded from the segment results considering it as an interest expense. The Committee is also of the view that since in the extant case, premium on forward covers relates to liabilities in respect of purchase of raw materials which are attributable or allocable to segments, it should be included in the segment expenses for determination of segment result for segment reporting as per AS 17.

D.        Opinion

10.       On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 6 above:

(i)         No, premium on forward covers cannot be considered as a ‘borrowing cost’ under the provisions of AS 16, as discussed in paragraph 8 above.  Amortisation of premium on forward covers cannot be presented and disclosed as ‘other borrowing costs’ under the head ‘finance cost’ under Schedule III to the Companies Act, 2013. Instead, it should be disclosed under the head ‘other expenses’.
(ii)        The premium on forward covers should not be excluded from the segment results considering it as an interest expense, as discussed in paragraph 9 above.
(iii)       In view of (i) and (ii) above, answer to this question does not arise.

_________

[1]Opinion finalised by the Committee on 24.7.2014.