Query No. 9
Subject: Accounting treatment in respect of foreign currency loans hedged by a composite cross currency interest rate swap contract and accounting therefor. 1
A. Facts of the Case
1. A company is a public limited company registered under the Companies Act, 1956. The entire equity of the company is held by the Government of India. The company is also recognised as a Public Financial Institution. The company was set up as a special purpose vehicle to provide long-term infrastructure finance as per ‘Scheme for financing viable infrastructure projects'. As per its mandate, the company provides infrastructure finance through direct lending, take out finance and refinancing in compliance with the Scheme.
2. As per the Office Memorandum of the Government of India dated 23rd April, 2007, the company was regulated directly by the Government of India under a ‘Sui-generis' regulatory regime. Accordingly, an Oversight Committee was constituted by the Government of India. Consequent upon Union Cabinet approval on 13th October, 2011 to bring the company under regulatory oversight of the Reserve Bank of India by registering it as an Non-Banking Finance Company-Infrastructure Finance Company (NBFC-IFC), the company is required to register itself as an NBFC-IFC.
3. The company is engaged in the business of providing long-term financial assistance to infrastructure projects in the country. The paid-up equity capital of the company is Rs. 2000 crore. The company has raised long-term loans from the Life Insurance Corporation (LIC) of India, National Small Saving Fund (NSSF) and bonds listed in India and foreign currency loans from bilateral and multilateral institutions. Borrowings of the company are backed by sovereign guarantee. The company has also issued long-term infrastructure bonds under section 80CCF of the Income-tax Act, 1961.
4. The details of foreign currency borrowings of the company as on 30th September, 2011 have been provided by the querist. The company has raised resources by way of foreign currency loans from multilateral institutions, viz., Asian Development Bank (ADB), Kreditanstalt fur Wiederaufbau (KFW) and the World Bank. In order to mitigate risk of losses due to changes in foreign exchange rate and floating rate of interest risk, the company undertakes hedging of loans by entering into cross currency (composite for principal repayments and coupon payments in line with loan underlying availed from multilateral and bilateral agencies) and interest rate swaps. The details of hedging transactions undertaken by the company have also been provided by the querist.
5. The querist has stated that as per Accounting Standard (AS) 11, ‘The Effects of Changes in Foreign Exchange Rates’, the company is required to report foreign currency monetary items using closing rates. Accordingly, the borrowings in foreign currency are required to be restated at the exchange rate prevailing at the reporting date and the difference is required to be taken to the profit and loss account. However, the company has not restated foreign currency borrowings to the extent hedged using closing rates and instead has restated the foreign currency borrowings at the exchange rate prevailing on the date of inception of hedging contract as on account of fluctuation of exchange rate for period from that date would be borne by respective counterparties and will not impact profitability of the company. The querist has further stated that as per RBI Circular No. MPD.BC.187/ 07.01.279/1999-2000 dated July 7, 1999, the company has also not provided mark to market losses on contracts in nature of cross currency and interest rate swaps as the underlying liability designated with swap is not carried at lower of cost or market value in the financial statements. (Emphasis supplied by the querist.)
6. The company also makes disclosure of accounting practice followed by it in the audited annual accounts in the above matters. However, auditors have qualified the accounts. Relevant extract of notes to the accounts in annual accounts and auditors’ report thereon are given as follows:
The following note was given in the notes to the accounts in annual accounts for the year ended 31st March, 2011:
7. Accordingly, the querist has approached the Expert Advisory Committee (EAC) of the Institute of the Chartered Accountants of India (ICAI) for seeking opinion regarding appropriate accounting treatment in respect of foreign currency loans to the extent hedged as per accounting standards and other applicable regulations. In this regard, the querist has sought clarification (i) on exchange rate at which foreign currency borrowings to the extent hedged, being covered by hedge contracts in nature of composite contracts, i.e., cross currency and interest rate swap contracts, (ii) on accounting treatment and disclosure requirements of mark to market losses, and (iii) on the basis for segregating the amount of gain/loss on translation of foreign currency borrowings using closing rate on the date of balance sheet on account of changes in foreign exchange rate and gain/loss due to movement in floating rate of interest.
Views of the company
8. The company has not restated the amount of foreign currency borrowings to the extent hedged using closing rate on the date of balance sheet. In view of RBI's circular dated July 7, 1999, the company has also not provided mark to market losses (MTM) on foreign currency loans to the extent hedged as the underlying liability designated with swap is not carried at lower of cost or market value in the financial statements.
B. Query
9. In view of the above, the querist has sought the opinion of the Expert Advisory Committee on the following issues:
C. Points considered by the committee
10. The Committee notes that the basic issues raised by the querist relate to accounting treatment of foreign currency borrowings/loans and MTM gains/ losses on swap contract undertaken to hedge the losses on such borrowings/ loans. The Committee has, therefore, considered only these issues and has not examined any other issue that may arise from the Facts of the Case. The Committee notes that in the extant case, the company has referred to the RBI Circular No. MPD.BC. 187/07.01.279/1999-2000 dated July 7, 1999. Accordingly, the Committee has examined the issues in the context of this circular only. Further, as the company is registered under the Companies Act, 1956, the Committee has examined the issue in the context of Accounting Standards Framework as applicable in case of companies.
11. The Committee notes from the Facts of the Case that the swap in the extant case is a composite contract for principal repayments as well as coupon (interest) payments in line with the underlying loans (refer paragraph 4 above) and that mark-to-market loss relating only to interest rate swap cannot be computed separately as the company had entered into a contract for hedging both the risks of interest rate and exchange fluctuations (refer paragraph 6 above). Thus, the Committee is of the view that the swap in the extant case is a composite cross currency interest rate swap, which hedges both foreign currency risk and interest rate risk.
12. The Committee notes that the foreign currency loan is denominated in USD/Euro and is also repayable in the same currency. The fact that the company has swapped the USD/Euro currency exposure of the foreign currency loan into INR exposure using a swap does not alter this position. The swap does not mean that the company has incurred INR liability to the lender as the swap and the loans are separate contracts. Under the swap agreement, the company gives INR to the counterparty of the swap and that party actually remits USD/Euro to the company as per the agreed rate under the swap contract. Further, the company uses USD/Euro, so received, to settle its liability against foreign currency loans. Thus, the company has the obligation to repay the loan in USD/Euro currency to the lender. The Committee further notes that AS 11 requires separate accounting for forward exchange transactions considering it as a transaction separate from the underlying transaction. Accordingly, the Committee is of the view that the foreign currency loan, which is an underlying transaction, and the swap contract to hedge against any loss arising on the aforesaid loans should be treated as two separate transactions.
13. Accordingly, the Committee is of the view that the foreign currency loan should be accounted for in accordance with AS 11. In this regard, the Committee notes paragraph 13 of AS 11, notified under the Companies (Accounting Standard) Rules, 2006 (hereinafter referred to as the ‘Rules'), which provides as follows:
From the above, the Committee is of the view that at each reporting date, foreign currency loans should be restated at the exchange rate prevailing on that date and exchange differences should be charged to the profit and loss account. In this regard, the Committee notes that the company in the extant case has not restated the foreign currency loans as per the above-mentioned requirements of AS 11 and therefore, is an accounting error, that should be rectified in the current reporting period treating it as a ‘prior period item' as per the requirements of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies', notified under the Rules.
14. As regards accounting treatment of swap contract, the Committee notes that paragraph 36 of AS 11 deals with accounting for 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. Thus, AS 11 covers forward exchange contracts and other financial instruments of similar nature. However, as discussed in paragraph 11 above, the swap, in the extant case, is a composite cross currency interest rate swap which hedges not only exchange rate risk but also interest rate risk. Accordingly, the Committee is of the view that such swap is not within the scope of AS 11.
15. The Committee further notes that recently, in May 2015, the ICAI has issued a Guidance Note on Accounting for Derivative Contracts, which becomes applicable for accounting periods beginning on or after 1st April, 2016; however, its early application from the date of issuance of this Guidance Note is encouraged. The Committee further notes that on the Guidance Note becoming effective, in respect of the accounting periods, for which accounts are not yet closed, the company should recognize and measure the outstanding swap contracts in the extant case at their fair value with the corresponding impact recognised in the reserves as a transition adjustment and disclosed separately as per the requirements of the Guidance Note. However, the company is not permitted to follow the hedge accounting as recommended in the Guidance Note retrospectively. Further, in the future, the company should account for the swaps at fair value with changes in the fair value being recognised in accordance with the requirements of the Guidance Note. In this regard, the Committee notes the following paragraphs of the Guidance Note:
With regard to the disclosure requirements, the company should follow the disclosure requirements as prescribed in AS 11 and the Guidance Note.
16. The Committee notes that before the issuance of the Guidance Note, the company had the option either to follow the Announcement on Application of AS 30, Financial Instruments: Recognition and Measurement, issued by the ICAI, as per which, AS 30 can be adopted by an entity to the extent that it does not contradict the requirements of existing notified accounting standards or it could follow the Announcement on Accounting for Derivatives, as per which, in case the company does not wish to follow the requirements of AS 30, it should have provided for mark-to-market losses in respect of all the outstanding derivative contracts at each reporting date. However, considering the principle of prudence, mark-to-market profits could have been recognised only when realized. Further, the company should also have disclosed the accounting policy for derivative contracts as adopted by it along with a separate disclosure in respect of losses incurred on such contracts in its financial statements. The Committee notes that in the extant case, the company has neither followed the requirements of the Announcement on Accounting for Derivatives nor the requirements of AS 30. Therefore, it is an accounting error and the same should be rectified by adopting one of the afore-mentioned options for prior periods in the current reporting period treating it as a ‘prior period item’ as per the requirements of AS 5, notified under the ‘Rules’.
17. With regard to application of RBI Circular, the Committee notes that the said Circular is applicable in respect of interest rate swap (IRS). The Circular defines interest rate swap and prescribes accounting in respect thereof as follows:
Since, in the extant case, the swap is a composite cross currency interest rate swap, which is to hedge both foreign currency risk and interest rate risk, as discussed above, the Committee is of the view that the accounting prescribed by the Circular in respect of only interest rate swap is not applicable on such composite contracts. Accordingly, the question of ascertainment/segregation of mark to market gains or losses on interest rate swap (IRS) in composite contracts (in view of RBI Circular) does not arise.
D. Opinion
18. On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 9 above:
___________ 1 Opinion finalised by the Committee on 3.6.2015. |