Executive Summary
This article provides an expert-level, practitioner-oriented discussion on accounting for the effect of changes in foreign exchange rates with reference to Accounting Standard (AS) 11 — The Effect of Changes in Foreign Exchange Rates — as issued by the Institute of Chartered Accountants of India (ICAI), and its corresponding Indian Accounting Standard (Ind AS 21) — The Effects of Changes in Foreign Exchange Rates. The focus is on the fundamental accounting concepts embedded in the standards, practical implementation issues, and detailed corporate case studies and numerical illustrations. Emphasis is placed on monetary vs non-monetary items, recognition and measurement of exchange differences, translation of financial statements of foreign operations, hedge accounting issues, and disclosure requirements. Relevant judicial pronouncements, ICAI guidance, and comparisons between AS 11 and Ind AS 21 are discussed. The article includes multiple worked examples and journal entries to illustrate typical complexities encountered by auditors, CFOs, and Chartered Accountants in India.
1. Introduction
Foreign exchange risk is an integral part of global commerce. Indian corporates, banks, and financial institutions routinely enter into transactions denominated in currencies other than the functional currency. Accounting for the effect of changes in foreign exchange rates ensures that financial statements reflect the economic realities arising from currency movements and provide users with reliable, comparable information.
2. Scope and Objective of AS 11 and Ind AS 21
AS 11 and Ind AS 21 address recognition, measurement and disclosure of foreign currency transactions and translation of financial statements of foreign operations. The objective is to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency for consolidation and reporting purposes.
Key topics covered are: determination of functional currency; initial recognition of foreign currency transactions; subsequent measurement of monetary and non-monetary items; recognition of exchange differences in profit or loss or other comprehensive income; translation of results and financial position of foreign operations; and disclosure requirements.
3. Fundamental Accounting Concepts Embedded in the Standards
Both AS 11 and Ind AS 21 are rooted in basic accounting principles that guide measurement and presentation. Below, we discuss the principal concepts and how they manifest in the standards.
3.1 Accrual Concept and Matching
The accrual concept requires that economic events be recognised when they occur, not when cash is received or paid. Under AS 11/Ind AS 21, exchange differences arising on monetary items are recognised in profit or loss in the period in which they arise. This preserves the matching of costs and revenues for the period — for example, exchange losses on trade payables that finance the acquisition of inventory affect profit in the period when the related inventory is consumed or sold.
3.2 Prudence and Conservatism
Prudence influences the recognition of probable losses. Exchange differences that represent losses are recognised immediately. Under AS 11, exchange differences on long-term monetary items may be adjusted in certain circumstances in the financial statements of a foreign operation; Ind AS 21 has a different approach for translation adjustments, but prudence remains central to recognising adverse currency effects.
3.3 Substance Over Form
The standards emphasise economic substance — determining the functional currency requires assessing the currency that mainly influences sales prices, labour, and other costs. Even if contracts are denominated in a particular currency, if the economic environment indicates another currency better reflects the underlying economics, that currency may be the functional currency.
3.4 Consistency and Comparability
Consistent application of translation policies, determination of functional currency, and hedge accounting ensures comparability across periods and entities. Changes in functional currency require disclosure and justification.
3.5 Materiality and Reliability
The standards require disclosures that are material to decision-making. Disclosures about exchange differences, translation of foreign operations and hedges must be sufficiently detailed for users to understand the nature and financial effect of foreign exchange exposure.
4. Key Definitions and Classifications
A concise working knowledge of key definitions is essential.
Functional currency — the currency of the primary economic environment in which the entity operates. Presentation currency — the currency in which the financial statements are presented. Foreign currency transaction — a transaction denominated in a currency other than the functional currency. Monetary items — items which are money or claims to receive or obligations to deliver money. Non-monetary items — items other than monetary items (e.g., inventory, property, plant&equipment).
5. Recognition and Initial Measurement
On initial recognition, a foreign currency transaction is recorded by applying the spot exchange rate at the date of the transaction to translate the foreign currency amount into the functional currency. If several rates exist, the rate that actualises the transaction should be used. Where a transaction is settled over time, AS 11 requires recognition of exchange differences as they arise.
6. Monetary vs Non-monetary Items: Subsequent Measurement
Monetary items are retranslated at closing rate and exchange differences recognised in profit or loss (with limited exceptions). Non-monetary items measured at historical cost are not retranslated; their foreign currency amounts remain translated using the rate at the date of the transaction. Non-monetary items measured at fair value and denominated in a foreign currency are translated using the exchange rates at the date when the fair value was measured.
7. Exchange Differences: Recognition and Presentation
Under AS 11, exchange differences arising on the settlement of monetary items, or on reporting monetary items at rates different from those at which they were initially recorded, are recognised in profit and loss for the period. Ind AS 21 broadly follows the same approach for monetary items but handles translation adjustments and presentation currency translation differently, especially for foreign operations and consolidation.
8. Numerical Illustration — Import Purchase and Settlement (Banking/Corporate Example)
Consider a Jaipur-based manufacturing company, ‘A Ltd’, which purchases raw material from a US supplier on 1 March 20X1. Invoice amount: USD 100,000. Spot exchange rate on 1 March 20X1: INR 75.00/USD. Functional currency: INR. Payment is made on 31 March 20X1. Spot exchange rate on 31 March 20X1: INR 77.50/USD. For simplicity, assume no discounts and no bank charges.
Initial recognition on 1 March 20X1 (at the transaction date rate):
USD 100,000 × 75.00 = INR 7,500,000
Journal entry on 1 March 20X1:
Inventory / Raw Material A/c Dr. 7,500,000
To Trade Payables (USD supplier translated) Cr. 7,500,000
At 31 March 20X1, company settles the payable. The functional currency INR equivalent at settlement: USD 100,000 × 77.50 = INR 7,750,000.
Exchange difference = INR 7,750,000 − INR 7,500,000 = INR 250,000 (loss).
Journal entries on settlement date:
Trade Payables Dr. 7,500,000
Exchange Loss Dr. 250,000
To Bank Cr. 7,750,000
Accounting effect: The exchange loss of INR 250,000 is recognised in profit or loss for the period, consistent with the accrual and matching concepts. If A Ltd had hedged the payable with a forward contract, the accounting treatment of the hedge (hedge accounting) would determine whether the exchange difference is taken to OCI or profit or loss under Ind AS guidance on hedge accounting.
9. Numerical Illustration — Export Sale and Receivable
Consider ‘B Bank’ (UCO Bank branch example) which provides a corporate export finance facility. A client exported goods and raised an invoice on 15 April 20X2 for USD 200,000. Spot exchange rate on 15 April 20X2 is INR 72.00/USD. On reporting date (30 June 20X2), the spot rate is INR 70.00/USD and the amount is outstanding. Assume functional currency INR.
Initial recognition on 15 April 20X2:
USD 200,000 × 72.00 = INR 14,400,000
Journal entry:
Trade Receivables Dr. 14,400,000
To Sales Cr. 14,400,000
At reporting date 30 June 20X2 (retranslation of monetary receivable):
USD 200,000 × 70.00 = INR 14,000,000
Exchange difference = INR 14,000,000 − INR 14,400,000 = INR (400,000) (gain).
Journal entry:
Exchange Gain Cr. 400,000
To Trade Receivables Cr. 400,000 (to adjust carrying amount)
Practical note: Banks and corporates should separately disclose significant exchange gains/losses and reconcile receivables in foreign currency to the INR carrying amounts.
10. Long-term Monetary Items and AS 11 Permissible Approach
AS 11 contains a specific permissive requirement: exchange differences on long-term monetary items (i.e., those that are not expected to be settled within twelve months) can, in specified circumstances, be capitalised as part of the cost of a depreciable capital asset, if they are regarded as adjustments to interest costs under AS 16 or to the cost of the asset. This treatment is subject to stringent conditions and disclosures, and must be applied consistently.
Example: An Indian company borrows a USD-denominated loan to acquire a machine. The loan term is seven years. AS 11 permits certain exchange differences relating to the loan to be adjusted to the carrying amount of the asset if they meet the definition of borrowing cost and are directly attributable to the acquisition of the asset. In contrast, Ind AS 21 requires exchange differences on foreign currency borrowings to be recognised in profit or loss unless the foreign currency borrowing is regarded as part of the cost of a qualifying asset under Ind AS 23 (Borrowing Costs). The permissive capitalisation under AS 11 is thus narrower and requires careful application.
11. Case Study — Indian IT Exporter (Revenue and Translation Exposure)
IT services companies typically invoice clients in USD, GBP, or EUR while incurring a significant portion of costs in INR. This creates a natural currency mismatch and exposes companies to translation and transaction risk. Below is a stylised example similar to an Infosys/TCS profile to demonstrate mechanics and disclosures.
Assumptions for a quarter:
– Revenue billed in USD: USD 50,000,000
– Average INR/USD during the quarter (realised billing rate): INR 74.00
– Closing INR/USD rate at quarter-end: INR 76.50
– Operating costs in INR: INR 2,500,000,000
Revenue recognised (at transaction dates using spot or average as appropriate): USD 50,000,000 × INR 74 = INR 3,700,000,000.
At quarter-end, outstanding receivables of USD 5,000,000 remain uncollected. Their INR carrying amount at recognition: USD 5,000,000 × 74 = INR 370,000,000. If closing rate is 76.50, retranslated INR amount: USD 5,000,000 × 76.50 = INR 382,500,000. Exchange gain on retranslation = INR 12,500,000 (credit to profit or loss).
Impact on margins: If the INR appreciates or depreciates materially between billing and collection, reported margins can be volatile. Many IT companies use hedging strategies — natural hedges (matching costs in foreign currency), forward contracts, and options — to reduce outcome volatility. Under Ind AS 21 and Ind AS 109 (financial instruments), hedge accounting can be applied if strict criteria are met, reducing profit or loss volatility by recognising effective hedge gains/losses in OCI.
12. Case Study — Capital Import for Oil&Gas Project
A capital-intensive entity such as an oil and gas explorer may import major equipment invoiced in USD and fund the purchase with a foreign currency loan. Key considerations include treatment of exchange differences, borrowing costs, and whether exchange differences are capitalised under AS 11 or recognised in profit or loss under Ind AS 21/Ind AS 23.
Example: Company ‘C Petroleum’ orders offshore equipment priced at USD 10,000,000. Contract date rate: INR 72.50/USD. Import logistics result in payment spread over 24 months; company borrows USD 10,000,000 with repayment over 10 years. Under AS 11, certain exchange differences on long-term monetary items may be capitalised if they relate to the cost of the qualifying asset and meet AS 16/AS 11 conditions. Under Ind AS, IAS/Ind AS 23 indicates borrowing costs that are directly attributable to the acquisition of a qualifying asset should be capitalised; exchange differences on foreign currency borrowings are accounted depending on whether they are regarded as part of the borrowing cost.
13. Hedging and Derivatives: Practical Considerations
Hedge accounting is outside AS 11 but critically interacts with foreign currency accounting. Ind AS 109 (Financial Instruments) sets out hedge accounting requirements, eligibility, designation, effectiveness assessment and presentation. Common hedging instruments include forwards, futures, options, and cross-currency swaps.
Practical issues:
– Documentation: Formal documentation of hedge relationships at inception is mandatory under Ind AS 109.
– Effectiveness testing: Ongoing assessments are required and may involve regression analysis or other statistical measures.
– Ineffectiveness: Any ineffective portion of hedge gains or losses must be recognised in profit or loss immediately.
– Designation choices: Fair value hedge vs cash flow hedge vs net investment in a foreign operation have different accounting and presentation impacts.
14. Numerical Illustration — Forward Hedge of a Payable (Detailed)
Company ‘D Ltd’ has an obligation to pay USD 2,000,000 in six months for imported machinery. Spot rate at inception: INR 80.00/USD. To hedge, D Ltd enters into a six-month forward contract to buy USD 2,000,000 at INR 81.50/USD. Ignore transaction costs for clarity.
Accounting under Ind AS (if hedge accounting is applied as a cash flow hedge and qualifies):
1) At inception, forward contract has zero cost (assuming fair value zero). No entry other than disclosure/documentation.
2) At reporting dates, the fair value of the forward will change. Effective portion of gain/loss on the forward is recognised in OCI; ineffective portion in profit or loss.
Suppose at reporting date after three months, spot = INR 82.00/USD and the fair value loss on the forward (mark-to-market) is INR 1,000,000 (i.e., this represents an adverse movement). If hedge is fully effective, the INR 1,000,000 is recorded in OCI (Other Comprehensive Income) as loss, with offsetting entry to derivative liability. On settlement of the hedged payable and forward contract, the amount in OCI is reclassified to profit or loss or adjusts the cost of the hedged item depending on the type of hedge and its effectiveness.
Journal entries at reporting date (simplified):
Loss on forward (OCI) Dr. 1,000,000
To Derivative Liability Cr. 1,000,000
On settlement, derivative settled at loss of 1,200,000 (further movement) and payable settled at INR 164,000,000 (USD 2,000,000 × 82.00). The cumulative OCI amount is reclassified appropriately.
15. Translation of Financial Statements of Foreign Operations
Ind AS 21 provides detailed guidance on translation of foreign operations. The functional currency of the foreign operation must be determined first. An entity’s financial statements are translated into the presentation currency as follows (summary):
– Assets and liabilities are translated at the closing rate at the reporting date.
– Income and expenses are translated at exchange rates at the dates of the transactions (often approximated by average rates for the period if rates do not fluctuate significantly).
– All resulting exchange differences are recognised in other comprehensive income and accumulated in a separate component of equity (a foreign currency translation reserve).
When a foreign operation is disposed of, the cumulative translation differences are reclassified to profit or loss as part of the profit or loss on disposal.
16. Numerical Illustration — Consolidation Translation
Parent ‘P Ltd’ (functional currency INR) has a wholly-owned subsidiary ‘S Ltd’ whose functional currency is USD. At reporting date:
– S Ltd’s statement of financial position shows USD 10,000,000 assets and USD 4,000,000 liabilities (net assets USD 6,000,000).
– During the year, S Ltd reported profit of USD 1,200,000.
– Closing rate USD:INR = 75.00. Average rate for the year USD:INR = 73.50.
Translation for consolidation under Ind AS 21:
– Translate assets and liabilities at closing rate: Net assets USD 6,000,000 × 75.00 = INR 450,000,000.
– Translate profit at average rate: USD 1,200,000 × 73.50 = INR 88,200,000.
If the parent’s investment in subsidiary (carrying amount) is not adjusted for translation differences, the difference between translating net assets at closing and translating profit at average rates creates a translation reserve.
17. Comparative Analysis — AS 11 versus Ind AS 21
While AS 11 and Ind AS 21 share the core objective of reflecting currency effects, there are important differences due to alignment of Ind AS with IAS 21 and interaction with Ind AS 109 and Ind AS 23:
1. Translation differences: Ind AS 21 requires translation differences arising on consolidation to be recognised in OCI and accumulated in a currency translation reserve. AS 11 did not explicitly require this presentation, leading to differences in equity presentation.
2. Capitalisation of exchange differences: AS 11 permits in certain cases capitalisation of exchange differences on long-term monetary items as part of the cost of an asset; Ind AS generally requires recognition in profit or loss unless qualifying as borrowing costs under Ind AS 23.
3. Interaction with hedge accounting and financial instruments: Ind AS 21’s interactions with Ind AS 109 mean hedge accounting is more rigorously defined and documented; AS 11 has less prescriptive interaction with derivative accounting frameworks.
4. Terminology and alignment: Ind AS 21 aligns with IAS 21’s terminology and presentation, making it more consistent with IFRS-based consolidated financial statements and cross-border comparability.
18. Selected Regulatory and Judicial Guidance
Over time, Indian courts and regulators have provided clarifications on treatment of exchange differences, particularly in banking and capital-intensive industries. The ICAI has issued guidance notes and educational materials addressing common issues such as determination of functional currency, disclosure norms, and treatment of long-term monetary items. Practitioners should consult the latest ICAI technical updates, Ind AS transition FAQs, and RBI circulars for banks when addressing foreign currency accounting.
19. Practical Complexities and Common Pitfalls
Several implementation issues frequently trouble practitioners:
– Determination of functional currency: entities may have mixed indicators; commercial judgment must be exercised and documented.
– Treatment of embedded derivatives: contracts with foreign currency clauses may contain embedded derivatives requiring separation and measurement under Ind AS 109.
– Tax implications: timing differences between tax and accounting recognition of exchange differences can be complex and require careful deferred tax computation.
– Intercompany loans: classification and forbearance on consolidation may produce foreign exchange volatility in group statements.
– Disclosures: incomplete or inconsistent disclosures about currency risk, hedges and translation differences undermine transparency.
20. Detailed Worked Example — Manufacturing Exporter with Hedging and Consolidation Impact
This composite example brings together many threads: transactional exposure, hedging, consolidation, and presentation.
Facts:
– Parent ‘X Ltd’ (INR functional currency) has a 100% subsidiary ‘Y Inc’ (USD functional currency).
– X Ltd exports goods; during the year sells USD 5,000,000 of goods. Average realised rate = INR 75.00. Closing rate = INR 78.00. Outstanding receivable at year end = USD 1,000,000.
– X Ltd has costs mostly in INR.
– X Ltd entered into a forward contract to sell USD 1,000,000 at INR 77.00 (cash flow hedge) to hedge the receivable.
– Y Inc reports net profit USD 300,000 for the year.
Accounting outcomes:
1) Revenue recognised by X Ltd: USD 5,000,000 × INR 75.00 = INR 375,000,000.
2) Receivable carrying amount (for outstanding USD 1,000,000): INR 75,000,000 at recognition. At closing rate INR 78.00, retranslation gives INR 78,000,000 -> exchange gain INR 3,000,000 recognised in profit or loss unless hedge accounting changes classification.
3) Forward contract: if cash flow hedge qualifies, effective portion of gain/loss (difference between forward contracted INR 77.00 and current forward/spot valuations) is taken to OCI. Suppose the forward has a fair value loss of INR 2,000,000 at year end and is fully effective; recognise Loss (OCI) INR 2,000,000, Derivative Liab. INR 2,000,000.
4) On consolidation: Y Inc’s net profit USD 300,000 translated at average = assume USD 300,000 × 76.00 = INR 22,800,000. Net assets translated at closing create a translation reserve. The parent’s consolidation eliminates intra-group receivables if any and recognises translation reserve in OCI.
21. Disclosures and Presentation Requirements
Both AS 11 and Ind AS 21 require entities to disclose significant exchange differences and the methods used to translate foreign operations. Under Ind AS, entities must disclose:
– The amount of exchange differences recognised in profit or loss;
– The amount of exchange differences recognised in OCI and the components of the reserve;
– Nature and extent of risks arising from financial instruments in foreign currencies and how they are managed.
For banks, RBI circulars add further disclosure expectations about forex contracts, open positions, and capital requirements.
22. Taxation and Deferred Tax Implications
Tax authorities may treat exchange gains and losses differently for tax purposes. Timing mismatches between accounting recognition and taxable events create deferred tax assets or liabilities. Deferred tax computation should consider the tax base of monetary items denominated in foreign currency and the accounting carrying amounts after translation. In India, practitioners should refer to relevant provisions of the Income Tax Act, CBDT notifications, and judicial precedents for specific treatments.
23. Audit and Internal Controls
Auditors should evaluate controls over foreign currency transactions, including:
– Controls for identification and classification of monetary vs non-monetary items.
– Controls over determining and documenting functional currency.
– Controls for valuation of derivatives and effectiveness testing where hedge accounting is applied.
– Reconciliations of foreign currency balances and review of forward/futures contracts, including confirmations with counterparties.
24. Practical Checklist for Chartered Accountants
– Document determination of functional currency with supporting evidence.
– Maintain detailed schedules of foreign currency monetary items and apply closing rates consistently.
– For non-monetary items measured at fair value, ensure exchange rate used corresponds to fair value measurement date.
– Evaluate whether foreign currency borrowings qualify for capitalisation as borrowing costs under Ind AS 23 or AS 11 permissive guidance.
– When applying hedge accounting, ensure robust documentation and periodic effectiveness testing.
– Consider tax implications and compute deferred tax for timing differences due to exchange differences.
– Disclose exposure, hedging strategy, and translation reserve movements comprehensively in notes to accounts.
– For banks, follow RBI circulars and ensure currency position reporting and limits are adhered to.
25. Conclusion
Accounting for the effect of changes in foreign exchange rates is complex and requires careful application of fundamental accounting principles — accrual, prudence, substance over form, and consistency. AS 11 and Ind AS 21 provide the framework, but interaction with other standards (Ind AS 109, Ind AS 23) and local regulatory requirements (RBI, ICAI guidance) adds layers of practical complexity. Chartered Accountants must combine technical knowledge with professional judgement, robust documentation, and clear disclosures to present financial statements that faithfully represent the entity’s financial position and performance in the presence of foreign exchange volatility.
26. References and Further Reading
1.Accounting Standard (AS) 11 — The Effect of Changes in Foreign Exchange Rates, ICAI.
2. Ind AS 21 — The Effects of Changes in Foreign Exchange Rates.
3. Ind AS 109 — Financial Instruments.
4. Ind AS 23 — Borrowing Costs.
5. ICAI Guidance Notes and Technical FAQs on Foreign Exchange Accounting.
6. Reserve Bank of India circulars and guidelines for banks on forex exposures and reporting.
7. Selected judicial pronouncements and case law relevant to foreign exchange accounting in India.
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