S. Gopalakrishnan discusses the application of AS 11 to a few situations of forward contracts
PARA 14 of Accounting Standard 11 reads thus: "When the transaction is settled within the same accounting period as that in which it occurred, all the exchange difference is recognised in that period. However, when the transaction is settled in a subsequent accounting period, the exchange difference recognised in each intervening period up to the period of settlement is determined by the change in exchange rates during that period."
The clarifications given are not clear. If the intention is that the exchange difference should be booked pro rata, it may be specifically stated. Again the forward contract can take one of the following forms.
Firm forward contract wherein delivery of the contracted currency in exchange for other currency is compulsory.
The customer may decide to purchase/sell option in which case he is not obliged to buy/sell as he has the option not to exercise his right.
The customer may enter into a forward rate agreement (FRA).
In respect of options contract, the customer has the right to exercise option or allow the option to lapse according to his choice. AS 11 has not dealt with option, FRA and other derivatives. This is applicable to para 12 also.
In para 24(a) it is stated that the assets and liabilities, both monetary and non-monetary, of the non-integral foreign operation should be translated at the closing rate.
Illustration: Bank A decides to remit $100 million by way of assigned capital to their London office on April 1, 2003. If the rate of exchange is Rs 46 per dollar, the head office will show in its books Rs 460 crore as assigned capital sent to their London office. In the books of the London branch, the assigned capital will be revalued on March 31, 2004, by applying the closing rate.
If the closing rate on March 31is Rs 50 per dollar, the assigned capital will be shown as Rs 500 crore. When the consolidated balance-sheet is prepared, the assigned capital of Rs 460 crore shown in the head office book and Rs 500 crore shown by the London office will have to be netted out. However, because of the different figures shown by both the head office and the London branch, a surplus of Rs 40 crore will be shown.
For accounting the surplus of Rs 40 crore, no guidelines have been given in AS 11. By applying the closing rate, if the exchange rate is taken as profit, the profit of the entity will be overstated. The correct method is that both the head office and London branch office should value the transactions at the same rate as they are required to net out the item and show it as `0'. In short, the branch office should continue to show the assigned capital at the same figure as was shown by the head office.
If the London branch has purchased fixed assets worth $100 million out of assignment capital on September 30, 2004, when the exchange rate is Rs 55 per dollar, the fixed assets will be shown at Rs 550 crore in the books of the London branch. In case the exchange rate moves to Rs 60 on March 31, 2005, assigned capital will have to be valued at Rs 600 crore (by applying the closing rate). However, if the assets continue to be shown at Rs 550 crore, there will be difference between assets and liabilities on account of different rates applied for translation.
In para 25, it is stated that for practical reasons, a rate that approximates the actual exchange rates, for example an average rate for the period, is often used to translate income and expense items of a foreign operation.
It is very difficult for anybody to state what is the rate that approximates the actual exchange rate. Hence, AS 11 should always spell out clearly the basis to be followed by the constituent
Paragraph 36 reads thus: "An enterprise may enter into 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.
"The premium or discount arising at the inception of such a forward exchange contract should be amortised as expense or income over the life of the contract. Exchange differences on such a contract should be recognised in the statement of profit and loss in the reporting period in which the exchange rates change. Any profit or loss arising on cancellation or renewal of such a forward exchange contract should be recognised as income or as expense for the period."
It is stated that the premium or discount arising at the inception of such a forward exchange contract should be amortised as expense or income over the life of the contract. In practice, customers book foreign exchange contract in respect of imports or exports. The bank concerned quotes a forward rate which is required to be applied on the date of delivery. Hence, the question of determining the premium or discount has no meaning. In respect of outright forward contracts, it is not correct to amortise the premium or discount, as the spot rate has no relevance and only the future rate has been determined in respect of the foreign currency to be delivered or received.
Illustration: Bank A buys $5 million on spot basis on January 1, 1996, at Rs 35 and simultaneously sells forward for six months at Rs 36.80 value July 1, 1996. In this case, on March 31, 1996, the three months premium (3 x 30 paise per month) will have to be credited to P&L Interest Earned A/c and the remaining 90 paise will have to be carried forward to the next year as income received in advance.
In case Bank A sells forward for six months at Rs 36.80 value July 1,1996. In this case, for valuation of the forward contract on March 31, 1996, reference to spot rate will be irrelevant. If we take spot rate as the basis, we will be booking an income of 90 paise per dollar, even though there is no outlay of funds.
In order to meet the obligation of the contract, if Bank A purchases on spot basis at Rs 38.80, the bank will be losing Rs 2 per dollar. Even though the transaction has resulted ultimately in loss, by taking spot rate as the basis for valuation as on March 31, 1996, Bank A has booked profit of 90 paise per dollar at the time of closing the books as on March 31, 1996. It is, therefore, essential that swap rate should not be the basis for valuation in respect of outright forward contract.
Similarly, in the case of forward-to-forward contracts also spot rate cannot be the basis for valuation at the time of closing the books, for example, bank can enter into a forward contract on January 1, 1996, to purchase $5 million (value March 1, 1996), and simultaneously sell $5 million (value July 1, 1996). Both the forward purchase and forward sale are to be valued but without reference to the spot rate.
Forward exchange contracts entered into for hedging purposes: It is very difficult for the exchange dealing operations to be segregated into hedging and trading transactions, as they are totally interlinked. For determining the net position, spot and forward transactions are taken together. In short, a spot transaction can be squared with a forward transaction and vice-versa.
Again a trading position can be squared with a merchant position, whereby the trading position gets hedged. In the integrated treasury, conversion of foreign currency into rupee duly hedged by swap could be traded by reversing the swap when an opportunity is spotted to make money. Thus, it is impracticable to segregate hedged and trading transactions. Thus there are practical problems in applying paragraphs 36, 37, 38 and 39.
Forward exchange contracts entered into to hedge the foreign currency risk of firm commitments or highly probable forecast transactions: The ICAI, in 2004, issued an announcement titled "Applicability of Accounting Standard (AS) 11 (revised 2003) by which it was clarified that AS 11 was not applicable in respect of forward contracts entered into to hedge the foreign currency risk of firm commitment or highly probable forecast transactions.
The ICAI should do well to define these transactions with illustrations to avoid confusions. The ICAI is preparing an Indian Accounting Standard corresponding to International Accounting Standard (IAS) 39. Pending finalisation, the enterprises have been allowed to follow an appropriate accounting treatment for such forward contracts.
This means that different enterprise will follow different methods, thereby adding to the confusion.