Accounting for foreign currency translations

1.A Government of India undertaking deals with import of metals, industrial raw materials, fertilizers and export of mineral ores and other finished products. Such purchases/sales, settlement of despatch/demurrage and claims recoverable/payable involve lot of foreign exchange. According to the existing procedure, the unsettled/outstanding transactions in foreign currency relating to the particular financial year are being converted into Indian rupees at the rate of exchange prevailing on 31^st March of the respective year i.e. close of financial year. The procedure is an accordance with the accounting policy incorporated by the company from the earlier years which forms part of the annual report. The accounting policy states as under: -

“Amounts recoverable and payable as at the close of the year in foreign currency are accounted for at the rate of exchange prevailing on 31^st March of the respective year”.

2.In terms of the accounting policy, all transactions outstanding as on 31^st March and relating to the particular financial year for which the accounts are being finalized are converted into Rupees at the rate of exchange prevailing on 31^st March of that particular year. In respect of transactions which continue to be outstanding from the earlier years, the same are taken at the value at which these were converted in that particular year i.e. the financial year in which these arose. In other words, the impact of fluctuations in the rates of exchange is not taken in to account for the outstanding transactions year after year, as sometimes the transactions are settled after expiry of two or more years. On actual realizations/payments, the variations between the amounts which have been originally booked in the accounts and amounts actually realized/paid are debited/credited to profit and loss account in the year of settlement.

3. This procedure and the accounting policy were accepted both by statutory and Government audit but during the course of audit for the year 1984-85, statutory auditors and Government auditors commented on the procedure being followed for conversion of transactions in foreign currencies. Auditors were of the view that all outstanding items relating to previous years should also be reconverted into rupee equivalent at the prevailing rate of exchange every year and any excess/shortfall be taken to profit and loss account through “gain/loss in exchange A/c”. The Management’s view was that since these transactions relate to previous years and are outstanding (precisely it is not certain as to when settlements will take place) it will not be appropriate to inflate/deflate the working results every year since the impact of variations in exchange are being taken care of on realization basis and any excess/shortfall on realisation is taken to profit and loss account in the year of realization. Further in the opinion of the querist it will not be correct to account for the variations year after year in profit and loss account without actual settlement.

4.The querist has further informed that the volume of transactions relating to foreign currencies are quite large and are being carried forward for a number of years and in some of the case the items are over five year. This is normal feature as despatch/demurrage cases take long time for settlement. In addition to despatch/ demurrage cases, claims for short landings etc., get settled very late by the foreign suppliers. According to the querist, it will not be prudent in view of huge transactions to convert them every year at the prevailing rate of exchange particularly when it is not certain whether the claims/despatch/demurrage will be admitted at figures communicated by the company. The profit and loss account and balance sheet will merely be reflecting inflated/deflated view of the profitability if all the transactions are required to be converted at the current rate of exchange, without any relevance to actuals. The querists feels that this may also create taxation problems for unrealised gains/losses.

5. In view of the above facts, the opinion of the Expert Advisory Committee of the Institute has been sought by the querist on the following points:

i) Whether the procedure being followed by the company for conversion of foreign currency transactions at the rate of exchange prevailing as on 31^st March of the year in which the transactions arose is in order.

ii) If not, whether it will be advisable to convert the transactions every year at the prevailing rate of exchange and inflate/ deflate the profits of the particular year without any relevance to the actuals, which will be a subsequent event unknown at the particular time.

iii) Since this will involve lot of problems of taxation as Income-tax may be applicable on unearned profit whereas no credit may be afforded for unaccounted losses, whether it would be appropriate to transfer the entire amount of such variations to a specific reserve account without calling for any comments from the taxation authorities, and if so, the procedure for its treatment.

Opinion May 15, 1986

1.The Committee notes that para 16 of the ‘Statement on Accounting for Foreign Currency Translation’ issued by the Institute of Chartered Accountants of India, states that “current assets (both monetary and non-monetary) and short term liabilities are normally translated at the current rate. When however the exchange risk has been eliminated by a forward exchange contract, the translation should be at the rate mentioned in the contract.”

2. The aforesaid Statement defines the various terms as below:

“Current asset: Asset which is held for the purpose of conversion into cash within a relatively short period of time or within a normal operating cycle, for example, stocks, current receivables etc.”

“Non-current asset : Asset which is not held for the purpose of conversion into cash within a relatively short period of time or within a normal operating cycle, for example, fixed assets, non-current receivables etc.

“Long-term liability : The whole or part of a liability which is not due for repayment within one year from the end of the accounting period.”

“Short-term liability : The whole or part of a liability which is due for repayment within one year from the end of the accounting period.”

“Current rate : The exchange rate in force at the end of the accounting period.”

3.The Committee is of the view that the outstanding in respect of purchases/sales of commodities dealt with by the company and various types of claims arising in connection with these transactions are basically on account of trading activities of the company. Therefore, such balances should be treated as current assets/short-term liabilities even though, in certain cases, they may remain outstanding for more than one accounting period. In view of this, such balances should be translated at the current rate, i.e., the exchange rate prevailing at the end of the accounting period.

4.Regarding the treatment of translation differences, the Committee notes that the abovementioned Statement recommends as below:

“21.A major problem connected with accounting foreign currency translation is the appropriate treatment of translation differences. These problems broadly require consideration of (a) whether all translation differences should be adjusted in the profit and loss account (b) whether the adjustment should be in the year of change or deferred and (c) whether any part of the difference can be treated as a capital expenditure.

22.Those who advocate the adjustment of all differences in the profit and loss account argue that changes in exchange rates result in a loss or gain which does not in any way affect the cost of the assets. However, while such a practice would have the merit of simplicity there are several reasons why it cannot be adopted in all cases. Firstly, translation adjustments are related to assets and liabilities which will be liquidated over varying periods of time and not necessarily within the accounting periods, Secondly, in respect of certain assets and liabilities, though the asset or liability may be liquidated within the accounting period, the realization of the gain or the reimbursement of the loss will be deferred beyond the accounting period and will be subject to changes in foreign exchange regulations from time to time. Finally, in an area of fluctuating exchange rates and general exchange instability, the gain or loss may be reversed before it can be realized or reimbursed.

23. At the same time, deferment of the charge to the profit and loss account in all cases till the actual gain or loss is realized on conversion of the foreign currency would result in accounting on a “cash basis” and would be contrary to the “accrual” concept of accounting. It therefore becomes necessary to distinguish between translation differences which arise on translation of current assets and short-term liabilities and translation differences which arise on translation of non-current assets and long-term liabilities.

24. The translation difference arising on the translation of current assets and short-term liabilities should be charged to the profit and loss account of the year in which the difference arises. However, if the difference arises in respect of assets and liabilities in a country from which remittance of profits or funds is not possible, the charge to the profit and loss account if a net gain, should be deferred and transferred to a separate reserve account. Any loss arising on the subsequent translation of the assets or liabilities in the same currency can be debited to this reserve. If the difference is a net loss, it must be charged to the profit and loss account in all cases.”

5.The Committee notes that Section 145(1) of the Income-tax Act 1961 lays down that “Income chargeable under the head “profits and gains of business or profession” or “Income from other sources” shall be computed in accordance with the method of accounting regularly employed by the assessee”. The Committee is of the view that since the company is already accruing the exchange gain/loss at the close of the year in which the relevant transaction takes place, it is possible to accrue such gain/loss in respect of the same outstanding in subsequent years also. The Committee is of the view that this will be in accordance with the method of accounting being followed by the company.

6 On the basis of the above, the opinion of the Committee on the issues raised by the querist in para 5 of the query is as below:

(i) The procedure being followed by the company for translation of foreign currency transactions at the rate of exchange prevailing as on 31^st March of the year in which the transactions arose is not in order.

(ii) The outstandings of the nature mentioned in the query which continue for more than one year should be translated at the relevant current rate. The resulting foreign exchange gain/loss should be transferred to the profit and loss account.

(iii) From the taxation point of view, since the treatment suggested at (ii) above is in accordance with the method of accounting being followed by the company, it can be argued that the resulting gain/loss is treated, in the relevant year, as income or deduction therefrom, as the case may be.

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