Accounting for changes in the foreign-exchange rate is a sore point for many corporate entities, as rate movements pose several challenges. To make it worse, Indian GAAP principles tend to be nebulous and conflicting.

Consider, for example, a company holding an investment in a US subsidiary. To hedge this investment against foreign-exchange risks the company takes a dollar forward contract, which it rolls forward each year under a documented hedging strategy. In accordance with the accounting standard AS-11 — The Effects of Changes in Foreign Exchange Rates, the forward premium is amortised over the life of the contract.

Exchange differences on the forward contract are recognised in the profit-and-loss statement. However, investment as a non-monetary item under AS-11 is not re-valued and is stated at historical cost. This would result in an accounting mismatch as the P&L recognises gains and losses on the forward contract but not on the investment.

Hedging strategy

However, it may be argued that in accordance with hedging principles established in AS-30 – Financial Instruments Recognition and Measurement, the changed value of the investment on account of exchange rate changes will be offset by changes in the value of the forward contract. This hedging strategy will ensure a neutral P&L. The question is: Can AS-30, a recommendatory accounting standard, override AS-11, which is mandatory accounting standard?

This quandary can be resolved if one sees the two standards as complementing, rather than conflicting, each other. This can be done by creating a separate asset or liability for the offsetting gain/loss on investment instead of revaluing the investment (as per AS-11). This will ensure that while AS-11 is complied with, the hedging principles under AS-30 are also applied seamlessly.

Accordingly, cash instruments such as a dollar loan could be used to hedge future dollar sales/receivables. Strict compliance with AS-11 will require exchange gains/losses on the dollar loan to be recognised in the P&L. But with the hedging principles in AS-30, the gains/losses recognised in the P&L on translation of the loan can be reversed to a hedge reserve, to hedge future receivables/sales, neutralising the P&L. In this approach, AS-11 is complied with and the hedging principles of AS-30 are also achieved. Accounting standards should clarify if the latter view is permissible.

Interest component

Separating the interest element in the foreign-exchange differences is another challenge for companies. Paragraph 4(e) of AS-16 — Borrowing Costs sees exchange differences arising from foreign currency borrowings as interest costs to the extent they are adjusted as that.

AS-11 allows amortisation/ capitalisation of exchange gains and losses on long-term monetary items. The standards have subsequently clarified that the amortisation of exchange gains/losses would exclude the implicit interest cost. In other words, the implicit interest component within the exchange difference is not amortised (when not related to the construction of an asset) but charged to P&L account.

In addition to this disadvantage, there are numerous difficulties in separating the interest component from the exchange difference. It is not clear whether this is done on a quarter-on-quarter basis or cumulative basis. In the case of dollar borrowing, at the outset it may appear that rupee would depreciate because of the interest rate difference between the two countries; hence, it would be possible to allocate some amount to the interest element.

This theoretical concept may not hold good if, subsequently, the rupee strengthens, which results in exchange gain, and no amount can be allocated to the interest component. This difficulty in implementing 4(e) calls for more judgment in this matter.

Between standards

With multiplicity of standards, there could be situations where foreign-exchange derivatives are partly covered under AS-11 and partly under AS-30 — for example, in a cross-currency interest rate swap.

AS-11 covers the cross-currency swap, which is in the nature of a forward contract and hedges the underlying loan. The interest rate swap is covered under AS-30. It is unclear whether the derivative should be split and accounted separately under AS-11 and AS-30, or whether the entire derivative should be treated as one instrument under AS-30.

Several thorny issues now plague foreign exchange accounting. AS-30, which is recommendatory, should be made mandatory after suitable modification to help remedy the situation.

(Dolphy D'souza is Partner and National Leader, IFRS Services, Ernst & Young Pvt Ltd.)

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