Query No. 29

Subject:           (i) Accounting for Principal only Currency Swaps.

                        (ii) Hedge accounting as per AS 30.[1]

A.        Facts of the Case

1.         The main business of a company is refining crude and marketing petroleum products manufactured out of it. These products are sold both in India and abroad. The querist imports majority of its crude from abroad and sources a small portion indigenously. The payment for the indigenously procured crude is made in USD and USD linked rupees. Hence, it can be said that the entire crude payments are in USD/USD linked rupees. The company sells substantial quantity of its products in the export market at internationally quoted prices and balance in the domestic market at internationally linked product prices. The formula for conversion is as per the practice consistently followed in the Indian oil industry. The Reserve Bank of India (RBI) reference exchange rate is used for conversion of dollars into rupees which is also the industry practice.

2.         The querist has stated that, in nutshell, the entire revenue and crude cost of the company is either in USD or USD linked rupees. The company’s debt profile consists mainly of Rupee (INR) debts from Indian banks/financial institutions. The majority of the company’s expenses (other than crude), including interest cost and repayment of term loans, are in INR resulting into an economic exposure for the company as mentioned below:

• Since the refining revenues are receivable in USD/USD linked rupees, any fluctuation in the USD-INR rate can have an impact on its cash flows and/or profitability. (Economic risk associated)

• As the company is having INR debt profile, the company has a risk on USD rate movement, e.g., if Rupee appreciates, revenue in INR will decrease whereas quantum of INR debt servicing (principal and interest) will remain the same. So the company will require more USD to pay for same Rupee expenditure/repayment of loan, thus, affecting the cash flows, profitability and vice versa.                                                                                      

• To mitigate this risk, the company had taken principal only swap (POS)/cross currency swap (CCS) to effectively replace the INR term loans (liabilities) with USD liability. This has been permitted by RBI. Reference has been drawn by the querist to circular no. RBI/2013-14/5 dated July 1, 2013 (Paragraph A, Section I A1(iv)) in this regard.

3.         Substance of the Swap transactions:

• With a view to reduce the volatility in the cash flows/profitability of the company, it entered into INR/USD swaps whereby INR term loans effectively got converted into USD liabilities. The quantum/notional value of the swaps were derived based on repayment schedule of the term loans.

• The swaps provided income from positive interest carry but have the associated foreign exchange fluctuations risk. However, the company’s revenues being predominantly in USD or USD linked rupee, a natural hedge is available.

In the final analysis, the Swaps provide two fold benefits –

• Positive interest carry.

• Fluctuation in the profitability/ cash flow caused by USD-INR rate movement is mitigated/reduced.

By virtue of the above, in substance, as on date of contract, the querist has paid rupee loan liabilities outstanding and converted rupee loan into foreign currency loans at a predetermined exchange rate. In consonance with the principle of economic substance over form, accounting treatment as under has been accorded to this transaction (emphasis supplied by the querist):

Swap Notional Receivable (Receivable in INR)               Dr. Rs. ...
To Swap Notional Payable (Payable in USD)                            Rs. ...

The USD Swap notional payable is treated as a monetary item and revalued at every closing date and the forex fluctuation amount is taken to Foreign Currency Monetary Item Translation Difference Account (FCMITDA) and amortised in accordance with paragraph 46/46A of Accounting Standard (AS) 11, ‘The Effects of Changes in Foreign Exchange Rates’.

The querist has stated that an earlier opinion of the Expert Advisory Committee (EAC), which was published in the February, 2014 issue of the Institute’s Journal, states that the POS/ CCS does not fall under AS 11. However, the company believes that the opinion has not considered the ‘substance over form’ aspect for this transaction and hence, there is a need to clarify that so long as the economic substance as stated above can be demonstrated, this accounting treatment should be applied.

4.      Alternative accounting treatment:

When the company initiated the aforesaid POS/CCS transactions as a part of its risk management strategy, it had done an evaluation and concluded that as an alternate accounting treatment, Accounting Standard (AS) 30 ‘Financial Instruments: Recognition and measurement’, (application of hedge accounting) could also be applied, in which case, the impact would have been taken to cash flow hedge reserve and/or profit and loss account, as applicable. However, with the introduction of paragraph 46/ 46A of AS 11, it was concluded that by and large the same accounting is achieved in as much as the cash flow hedge reserve or FCMITDA is treated as ‘other comprehensive income’ rather than fully impacting profit and loss account. Hence, the company applied AS 11 despite having all the ingredients as on that date to follow ‘Hedge Accounting’ by applying the principles of AS 30. These requirements are summarised below for ready reference:

The querist has stated that as per the Announcement on Application of AS 30, Financial Instruments: Recognition and Measurement, issued by the Institute of Chartered Accountants of India (ICAI) published in the April 2011, issue of ICAI’s Journal, the status of AS 30 would be as below:

“(i)        To the extent of accounting treatments covered by any of the existing notified accounting standards (for eg. AS 11, AS 13, etc.) the existing accounting standards would continue to prevail over AS 30.

(ii) In cases where a relevant regulatory authority has prescribed specific regulatory requirements (eg. Loan impairment, investment classification or accounting for securitizations by the RBI, etc.), the prescribed regulatory requirements would continue to prevail over AS 30.

(iii) The preparers of the financial statements are encouraged to follow the principles enunciated in the accounting treatments contained in AS 30. The aforesaid is, however, subject to (i) and (ii) above.”

Since the company firmly believed that the POS/CCS transactions were covered under AS 11, a notified Standard, the accounting treatment was done accordingly. However, in view of the opinion of the EAC, the company proposes to follow AS 30 on POS and CCS from inception since all conditions needed for hedge accounting as per AS 30 existed as of that date.

B.        Query

5.         Based on the above facts, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(i) In the case of the company, with the facts and circumstances under which POS/CCS were taken having been explained, could the accounting treatment followed be considered as appropriate in view of the overarching principle of economic substance of the transaction and not merely by the legal form?

(ii) If no, then whether the querist can follow hedge accounting following the principles of AS 30 since inception i.e., from the day the hedge designation took place.

C.        Points considered by the Committee

6.         The Committee notes that the basic issue raised by the querist relate to appropriateness of accounting for Principal Only Swap (POS) transaction as per the principles of AS 11, viz., recognising notional USD liability in respect of Rupee loan liability as monetary item and recognising restatement gains/losses on such monetary item as per paragraphs 46 and 46A of AS 11, notified under the Companies (Accounting Standards) Rules, 2006 and whether such transactions can be accounted for as per AS 30. The Committee has, therefore, considered only these issues and has not examined any other issue that may arise from the Facts of the Case, such as, measurement of MTM gains/ losses on POS contracts, accounting for interest on Rupee loan, validity of POS/Cross Currency Swap (CCS) taken with respect to circular of RBI, assessing hedge effectiveness as per the principles of AS 30, correctness of using RBI rate for translating foreign currency balances, etc. The Committee also wishes to mention that since the Facts of the Case are based only in respect of the POS transactions, the Committee has presumed that CCS in the extant case are of the nature of POS only and accordingly, the Committee has examined the issue from that perspective only. Further, the Committee presumes that in the extant case, INR is the functional currency of the company.

7.         The Committee notes from the Facts of the Case that the company has debts and loans (liabilities) in INR. However, since its revenues are in USD/USD linked Rupee, the company has effectively converted the INR liability to USD liability by entering into Principal Only Swap (POS). In this regard, the issue to be examined is whether the Rupee liability becomes a foreign currency liability by the existence of POS transaction or whether it should, in substance, be treated as a foreign currency liability by the existence of POS transaction.

8.         The Committee notes from the Facts of the Case that the company has taken Rupee liability which has been swapped into USD. The Committee also notes that the liability of the company (viz., Rupee loan) is denominated in Rupee and is also repayable in the same currency. The fact that the company has swapped the Rupee liability exposure into USD currency exposure using the POS does not alter this position. The POS does not mean that the company has incurred USD liability to the lending bank. Thus, entering into the POS transaction does not alter the fact that the company has the obligation to repay the loan in Rupees to the lending bank. Further, the POS can be cancelled by the company (though it may not have the intention to cancel). Accordingly, the Committee is of the view that the Rupee liability does not become a foreign currency liability solely by the existence of POS transaction. The Committee is further of the view that the combination of the Rupee loan and the POS cannot be treated as a single transaction enabling treatment of the Rupee loan as a USD loan. This is because AS 11 does not recognise such ‘synthetic accounting’. Further, the legal effect of the terms of the Rupee loan (which is denominated in Rupee) and POS (which is cancellable) cannot be ignored. Hence, Rupee loan and POS transactions should be treated as two separate transactions.

9.         The Committee further examines whether POS can be considered to be a foreign currency transaction within the scope of AS 11. Accordingly, the Committee notes the following paragraphs of AS 11, notified under the Companies (Accounting Standards) Rules, 2006:

“1.       This Standard should be applied:

(a)        in accounting for transactions in foreign currencies; and

(b)        in translating the financial statements of foreign operations.

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

“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) buys or sells goods or services whose price is denominated in a foreign currency;

(b) borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency;

(c) becomes a party to an unperformed forward exchange contract; or

(d)  otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency.”

The Committee notes that POS does not result in borrowing of USD funds. It is simply a derivative which requires performance and settlement in future and is also cancellable. Hence, in the extant case, a foreign currency transaction within the scope of AS 11 may occur only if the POS transaction undertaken by the company can be considered to be an unperformed forward exchange contract, which is examined in paragraph 10 below.

10.       The Committee notes the definitions of forward exchange contract and forward rate given in paragraphs 7.8 and 7.9 respectively of AS 11, which are reproduced below:

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

 7.9 Forward rate is the specified exchange rate for exchange of two currencies at a specified future date.”

The Committee notes that the POS may be argued to be a forward exchange contract as per the definition reproduced above. However, as per footnote 1 appended to paragraph 2 of AS 11, not all forward exchange contracts fall within the scope of AS 11, which reads as below:

“This Standard is applicable to exchange differences on all forward exchange contracts including those entered into to hedge the foreign currency risk of existing assets and liabilities and is not applicable to the exchange difference arising on forward exchange contracts entered into to hedge the foreign currency risks of future transactions in respect of which firm commitments are made or which are highly probable forecast transactions. A ‘firm commitment’ is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates and a ‘forecast transaction’ is an uncommitted but anticipated future transaction.”

From the above, it might appear that with the exceptions mentioned in the above-mentioned footnote, all forward exchange contracts are within the scope of AS 11. However, the Committee notes that accounting treatment of forward exchange contracts is prescribed in paragraphs 36-39 of AS 11 and is of the view that if a forward exchange contract is not of the nature dealt with in those paragraphs, it is outside the scope of AS 11, even though it does not fall within the exceptions mentioned in the above-mentioned footnote. The Committee notes that a combined reading of paragraphs 36-39 of AS 11 indicates that those paragraphs prescribe accounting treatment for only those forward exchange contracts which are entered into for hedging foreign currency risk where the underlying transaction  is denominated in a foreign currency, or for trading or speculation purposes. The Committee notes from the Facts of the Case that the underlying transaction is a Rupee loan that does not give rise to any foreign currency risk. It is the POS transaction in the extant case that exposes the company to foreign currency risk rather than mitigating the same. The Committee further notes that in the extant case, the querist has argued that by virtue of POS transaction, the INR liability would effectively be converted into a liability denominated in USD which would be the currency of the forecasted future revenues of the company and due to this, an effective natural hedge would be available. Thus, the purpose of entering into POS is to take the benefit of this natural hedge and not to hedge foreign currency risks on the existing liability undertaken, viz., the Rupee loan, etc. Accordingly, the Committee is of the view that since AS 11 covers only the forward contracts entered into for hedging the foreign currency risks of existing assets and liabilities, the POS in the extant case cannot be considered to be a forward contract entered into to hedge the foreign currency risk covered under the scope of AS 11. The Committee also notes that the POS is also not held for trading as the company is not a trader/dealer in foreign exchange. Further, the intention of entering into POS transaction does not appear to be speculative as there is an underlying INR loan and the company has initiated the POS transaction as a part of its risk management strategy and also intends to apply hedge accounting as per AS 30. Hence, in the extant case, the POS is not a forward exchange contract within the scope of AS 11 and therefore, is not a foreign currency transaction within the scope of AS 11. Accordingly, the Committee is of the view that the question of application of paragraphs 46 and 46A of AS 11 does not arise.

Further, the Committee is of the view that since AS 11 is not applicable to the exchange difference arising on forward exchange contracts entered into to hedge the foreign currency risks of highly probable forecast transactions, POS, even if it is argued to be  undertaken to hedge the foreign currency risks of future sales transactions, will not be covered under AS 11.

11.       With regard to application of hedge accounting as per AS 30 in the extant case, the Committee notes the following paragraphs of AS 30 as stated below:

“8.17 A hedging instrument is (a) a designated derivative or (b) for a hedge of the risk of changes in foreign currency exchange rates only, a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item (paragraphs 81-86 and Appendix A paragraphs A114-A117 elaborate on the definition  of a hedging instrument).        

  8.18 A hedged item is an asset, liability, firm commitment, highly probable forecast        transaction or net investment in a foreign operation that (a) exposes the entity to risk  of changes in fair value or future cash flows and (b) is designated as being hedged (paragraphs 87-94 and Appendix A paragraphs A118-A125 elaborate on the definition of hedged items).

8.19 Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument (see Appendix A paragraphs A129-A138).”

  “Hedging

80. If there is a designated hedging relationship between a hedging instrument and a hedged item as described in paragraphs 95-98 and Appendix A paragraphs A126-A128, accounting for the gain or loss on the hedging instrument and the hedged item should follow paragraphs 99-113.”

“87. A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a highly probable forecast transaction or a net investment in a foreign operation. The hedged item can be (a) a single asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation, (b) a group of assets, liabilities, firm commitments, highly probable forecast transactions or net investments in foreign operations with similar risk characteristics or (c) in a portfolio hedge of interest rate risk only, a portion of the portfolio of financial assets or financial liabilities that share the risk being hedged.”

“98. A hedging relationship qualifies for hedge accounting under paragraphs 99-113 if, and only if, all of the following conditions are met.

(a) At the inception of the hedge there is formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge. That documentation should include identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged and how the entity will assess the hedging instrument's effectiveness in offsetting the exposure to changes in the hedged item’s fair value or cash flows attributable to the hedged risk. 

  (b) The hedge is expected to be highly effective (see Appendix A paragraphs A129- A138) in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistently with the originally documented risk management strategy for that particular hedging relationship.

(c) For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash  flows that could ultimately affect profit or loss. 

(d) The effectiveness of the hedge can be reliably measured, i.e., the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument can be reliably measured (see paragraphs 51 and 52 and Appendix A paragraphs A100 and A101 for guidance on determining fair value).

(e) The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the  hedge was designated.”

From the above, the Committee is of the view that in the extant case, the transactions in the extant case would qualify for hedge accounting as per AS 30 provided the conditions as prescribed in paragraph 98 of AS 30 including hedge effectiveness, such as, matching of cash flows of forecasted future sales realisations with the repayment schedule of term loans, etc. are fulfilled.

D.        Opinion 

12.       On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 5 above:  

                                                                                               
(a)        POS taken against INR liability, does not fall within the scope of AS 11, even in substance, as discussed in paragraphs 9 and 10 above and accordingly, the question of applying paragraphs 46 and 46A of AS 11 does not arise. Therefore, the accounting treatment followed by the company in the extant case is not appropriate.

(b)        The company can follow hedge accounting following the principles of AS 30 since inception, provided the conditions of AS 30 including hedge effectiveness, as discussed in paragraph 11 above are fulfilled.

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[1]Opinion finalised by the Committee on 7.11.2014.