The Hindu Business Line : AS 11: India Inc. vs ICAI

India Inc. should not look at the volatility resulting from AS 11 from a narrow perspective. If financial performance is volatile, the function of accounting is to report that volatility.

R. Narayanaswamy

Indian industry associations are demanding suspension of the provisions of AS 11 that require recognising foreign exchange losses in the profit and loss (P&L) account. The ICAI is unwilling to concede their demand. Does Indian industry have a case?

First let us set out the problem. AS 11 requires foreign currency monetary assets and liabilities to be measured at the exchange rate on each balance sheet date. Any change in a monetary asset or liability that arises because of exchange rate variation is to be taken to the P&L account.

Suppose that an Indian company borrows US$1,000 repayable after five years. Assume the following exchange rates: At the time of borrowing, $1 = Rs 45; Year 1, $1 = Rs 50; Year 2, $1 = Rs 48; Year 3, $1 = Rs 41; Year 4, Rs 52; Year 5 (settlement of liability), Rs 47.

Note that when the rupee appreciates the borrower gains because it can buy the required dollars with fewer rupees. However, when the rupee depreciates, it needs more rupees to buy the same amount of dollars and hence it loses. The table shows the effect of re-measuring the liability.

The rupee value of the liability fluctuates from one balance sheet date to the next, because the rupee is volatile. The balance sheet is a statement of financial position and it therefore shows the current value of the liability in each year. In years 2, 3 and 5, there is a gain because the rupee appreciated; in years 1 and 4, there is a loss because the rupee depreciated. The P&L account correctly reflects the volatility in the value of the rupee. So what is the issue?

Schedule VI and AS 11

In 1966, there was a major devaluation of the rupee. Indian industry was concerned that the additional rupee liability would not be tax-deductible. The Government amended the Income-Tax Act and Schedule VI to provide that the additional tax liability would be added to the cost of the fixed asset that was financed using a foreign currency borrowing. Likewise, any gain resulting from a future rupee appreciation was to be reduced from the cost of the asset.

What should have been a one-time income-tax relief measure, unfortunately became a permanent feature of financial reporting. In this context, we should distinguish between an operating decision and a financing decision. The decision to acquire an asset is an operating decision.

That decision is based on the expected cash flows from the use of the asset. The fact that the enterprise must pay more rupees because of rupee depreciation does not change those cash flows. That is a financing issue. In effect, the amendment to Schedule VI confused operating and financing decisions.

We should remember that the external value of the rupee was tightly controlled until the 1990s, and hedging foreign currency liabilities was not possible in those years.

The situation changed in the 1990s when the rupee became partly convertible. The Government and the Reserve Bank of India now allow foreign currency liabilities to be hedged.

In the changed situation, the practice of adjusting the cost of a fixed asset for change in the rupee value of the related foreign currency borrowing has become untenable. It is up to an enterprise to decide whether to hedge its liabilities. It is a financing decision that would not affect the future cash-generating ability of an asset.

The revised AS 11 reflects this thinking. Schedule VI is bad accounting. Going back to it would make no sense.

Accounting Convergence

The revised AS 11 is one of those standards that is almost fully in conformity with IAS 21, the corresponding international standard. Abandoning AS 11 would raise serious questions about the commitment of Indian companies to follow IFRS.

So India Inc. should not look at the volatility resulting from AS 11 from a narrow perspective. If financial performance is volatile, the function of accounting is to report that volatility. As Indian standards converge with IFRS, there will be a lot more volatility in the reported profit. A good accounting system should bring out the underlying volatility of a business, and not seek to hide it from investors and other users of financial statements. Volatility in the foreign exchange markets can be managed by hedging. Let us not fiddle with accounting to fix that problem.

(The author is Professor, Finance and Control Area, IIM-Bangalore.)