On 31 March 2009, the Central Government added a new transitional provision in AS 11 The Effects of Changes in Foreign Exchange Rates, notified under the Companies (Accounting Standard) Rules, 2006 (as amended), to allow amortization/ capitalization of foreign exchange differences arising on long-term monetary items. In accordance with the provision, companies were given an irrevocable option to adopt the following treatment as an alternate to the immediate recognition of exchange differences arising on long-term foreign currency monetary items:
(i) If the long-term foreign currency monetary item was related to the acquisition of a depreciable capital asset, exchange differences arising on such items should be added to or deducted from the cost of the asset and depreciated over the life of the asset.
(ii) If the long-term foreign currency monetary item was related to other than an acquisition of a depreciable capital asset, exchange differences thereon should be accumulated in the “Foreign Currency Monetary Item Translation Difference Account” and amortized over the life of the monetary item, but not beyond 31 March 2011.
The transition provisions in AS 11 restricted this option to accounting periods ending on or before 31 March 2011. This was because the Ministry of Corporate Affairs (MCA) and the Institute of Chartered Accountants of India (ICAI) had a commitment to converge with IFRS from 1 April 2011 and IAS 21 The Effect of Changes in Foreign Exchange Rates does not give this option.
Inconsistency with Ind-AS
The MCA recently notified “Indian IFRS” standards (known as “Ind-AS”). Unlike IAS 21, the notified Ind-AS 21 The Effect of Changes in Foreign Exchange Rates does not mandate a company to immediately recognize gains/losses arising on long-term foreign currency monetary items. Rather, it gives companies an irrevocable option to be excercised at the transition date or the date when exchange difference on long-term monetary item arise for the first time. According to this option, companies can choose to recognize and accumulate exchange differences arising on the restatement of such items, directly in equity. The amount so accumulated in equity will be transferred to profit or loss over the period of maturity of the item in an appropriate manner. The option, once selected, is irrevocable and needs to be applied to all such items.
From the above, it is clear that a company following the current Indian GAAP will, going forward, need to recognize gains/losses arising on long-term foreign currency monetary items immediately in profit or loss. However, the companies following Ind-AS can still use an irrevocable option to recognize these gains/losses in equity and amortize them over the period till maturity.
How can the inconsistency be resolved?
We believe that the immediate recognition of gains/losses arising on all foreign currency monetary items, including long-term items, is more appropriate for the following key reasons:
(i) A company may typically apply this option to smoothen the impact of exchange differences on its profit or loss (P&L).
However, in certain situations, it may lead to back-loading of the charge. To illustrate, let us consider an example where a company had taken a loan of US$100 in 1999-2000 repayable after three years, when the exchange rate was 1 US$ = Z43. The exchange rates at the end of years 1999-2000, 2000-2001 and 2001-2002 were 43.63, 46.46 and 48.89, respectively. If the company does not avail this option, it will charge exchange loss of Z63, 2283, 2243, respectively, in each year. With the use of option, the charge to P&L in each year will be Z21, 2163 and 2406, respectively.
(ii) If a company recognizes full foreign exchange gains/losses immediately rather than amortizing the same, its financial statements would carry more credibility in the eyes of the investor community. Ernst & Young recently conducted a survey – IFRS convergence: an investor’s perspective. Among the survey participants, 65% were in favor of immediate P&L recognition of gains/losses arising on the translation of these items. While smoothening exchange differences in P&L may be a preferred option for some preparers of financial statements, the investor community and analysts are more interested in knowing the financial position of a company as at the reporting date. The option to amortize foreign exchange gains/losses is expected to distort the presentation of financial position at the reporting date. This may impact the earnings per share (EPS) and market valuation of companies.
Keeping Ind-AS financial statements as close to IFRS as possible will help companies to draw more appropriate peer comparison on a global basis.
By taking foreign currency loans, a company exposes itself to currency risk and recognition of gain/loss arising on restatement in P&L reflects the same risk. If a company does not want these gains/losses to impact its P&L, it should not take foreign currency loans or use an appropriate hedging strategy to cover this risk. We do not believe that changes made in Ind-AS accounting are an appropriate solution to the issue. Further, it may be too presumptuous to consider that gains/losses arising on a long-term foreign currency monetary item will even out over the life of the item and, therefore, the company need not recognize those gains/losses immediately.
(v) When regulators amended AS 11 to allow amortization/ capitalization of exchange differences arising on long-term monetary items, it was understood that this was an exception to normal accounting requirements. Hence, the transitional relief was given to companies only till 31 March 2011. It was also clear that once India converges with IFRS from 1 April 2011, all companies will need to recognize these exchange differences immediately in P&L.
Therefore, we believe that Ind-AS 21 should not give an option to defer and amortize exchange differences. However, if this option is given in Ind-AS, then it appears illogical to not give the same under AS 11. While giving an option under AS 11, the following additional considerations may apply:
(i) The current option in AS 11 is not the same as that under Ind-AS 21. For example, Ind-AS 21 does not differentiate between long-term foreign currency monetary items related to the acquisition of depreciable assets and other long-term items. Rather, it states that a company using this option will recognize and accumulate exchange differences arising on the restatement of all long-term foreign currency monetary items, directly in equity, and then amortize the same over the life of the item, in an appropriate manner.
(ii) Whether the option to be given in AS 11 will be the continuation of the existing option in AS 11, but with an extension of the sunset date beyond 31 March 2011 or will it be a new irrevocable option? For example, if a company has not used the existing option given in AS 11, can it use the new option to be given in AS 11 and vice versa?
(iii) Ind-AS allows a first-time adopter to apply the option given either prospectively or retrospectively. Whether the option to be given in AS 11 can also be used either prospectively or retrospectively. If retrospective application is allowed, how will the resulting impact be adjusted? For example, if a company has earlier adjusted these differences to the carrying value of fixed assets, it will need to restate those assets to apply the exemption retrospectively (if it is a new exemption similar to Ind-AS 21, which does not allow the carrying value of fixed assets to be adjusted).
(iv) If regulators and standard setters intend to allow the deferment and amortization of exchange differences going forward, the amendment in AS 11 needs to be done urgently because this treatment is applicable from the first quarter of the financial year 2011-12.
Conclusion:- The immediate recognition of exchange differences in P&L is technically superior accounting. If a company does not defer exchange differences for amortization to later periods, the investor community will have greater confidence in the company, resulting in better valuations and lower cost of fund raising for the company. Hence, we believe that there should be no option to defer and amortize exchange differences under both the Ind-AS and Indian GAAP.