The recent suspension of the application of AS11, which deals with accounting for exchange difference, has brought relief to companies. AS 11 requires that liabilities and monetary assets (e.g. receivables) denominated in foreign currency should be presented in the balance sheet in INR by translating the same using the exchange rate at the balance sheet date.
For example, liability of $100,000 should be reported in the balance sheet as at March 31, 2009 using the exchange rate ($1 = Rs 50.64022) of that date. Thus the liability is to be reported at Rs 50,64,022. On March 31, 2008 the exchange rate was $1 = Rs 40.02000. Therefore, if we assume that the liability on March 31, 2008 was at the same level ($100,000), which was reported at Rs 40,02,000.
AS 11 requires that the exchange difference of (Rs 50,64,022 — Rs 40,02,000) or Rs 10,62,022 should be recognised as a loss in the profit and loss account for year-ended March 31. Therefore, application of AS 11 requires companies that borrowed when exchange rate ws low, to recognise loss arising from translation of foreign currency borrowings/liabilities in INR. Companies are uncomfortable in recognising this loss. The requirement of AS 11 is no different from stipulations in IFRS.
Notional loss
The loss of Rs 10,62,022 in our example above is a notional loss. The loss would have been real had the company repaid the amount to the lender on March 31, 2009. In an environment in which exchange rate fluctuates, it is difficult to estimate the future movement of exchange rate. Therefore, it is difficult to estimate the amount of actual gain or loss that will arise when the company will repay the liability. It is also difficult to predict whether this notional loss will be reversed in future. In this situation AS 11 provides the best accounting solution.
Earlier position
Ministry of Corporate Affairs through a notification dated December 7, 2006 made AS 11 (along with other Accounting Standards) applicable to companies. Prior to this date companies were allowed to adjust carrying amount of the fixed asset for exchange difference arising from translating foreign currency liabilities assumed by a company in connection with acquisition of that asset. This method resulted in allocation of exchange difference over the remaining useful life of the asset.
Companies used to recognise other exchange differences as gains or losses for the period. It may not be wrong to assume that at the time of issuance of notification in December 2006, National Advisory Committee on Accounting Standards (NACAS) and the Ministry of Corporate Affairs thought that the accounting principles in As 11 are superior than the then prevailing accounting practice.
Suspension of AS 11
As reported in media, as per the new Rule notified by the Ministry of corporate affairs in the first week of April 2009, companies have been given an option either to apply AS 11 or to adopt an alternative method stipulated in the notification.
The alternative method requires a company to adjust carrying amount of fixed assets for exchange difference arising from foreign currency liabilities assumed on acquisition of the asset; and for other exchange differences, a company will create a special reserve or transitory account to park the exchange differ-ence and amortise (that is allocate) the amount over the balance maturity period of the loan or the period ending on March 31, 2011(which is is the last day before adoption of IFRS), whichever is shorter. If a company adopts the alternative method, it has to apply it retrospectively from December 7, 2006.
Accounting and Valuation
Empirical researches show that valuation of a company does not depend on the accounting policy of the company, provided disclosures are adequate. Intrinsic value of a company depends on the estimate of the amount, timing and uncertainties of cash flows that the company will generate in future. Valuation does not depend on the amount of profit reported by the company.
If valuation depends on reported profit, the valuation of the companies will go up immediately on declaration of result for the year 2008-09 using the alternative method provided in the notification and will go down immediately on release of first IFRS financial statements for the year 2011-12, of course other things remaining the same.
But if that happens then we have to conclude that players in the capital market (e.g. analysts) cannot read stories behind numbers and are naive. However, empirical researches show that market players can read stories behind numbers and therefore, accounting engineering does not enhance firm value. Therefore, the change in accounting policy will neither materially affect valuation of companies nor it will improve the productivity of capital. However, it will help companies to report profit and declare dividend from the same.
Reporting in functional currency
Functional currency is the currency of the primary economic environment in which the entity operates. For example, functional currency is US dollar of a company which determines the sale price of goods and services, pays for inputs (e.g. labour, material and expenses), issues debt and retains receipts in US $, a company whose functional currency is US $ will never pay US $ borrowings in INR, even if it is domiciled in India.
Therefore, it will not be affected by fluctuations in exchange rate between US $ and INR. If companies domiciled in India and having functional currency other than INR are allowed to present financial statements in functional currency, it will not be required to recognise notional gain or loss arising from fluctuations in exchange rate between the functional currency and INR.
However, it will not give comfort to companies in which equity holders are predominantly Indian. They will issue financial statements in INR for the comfort of equity holders, even if the same is not required by statute. Financial statements presented in INR will recognise notional gain or loss arising from fluctuations in exchange rate.
Moreover, allowing some companies to present financial statements in a currency other than INR will impair comparability. It is the time that we debate whether the companies should be allowed to present financial statements in functional currency.
Conclusion
Suspension of AS 11 will not hurt investors if companies do not use the increased profit to pay dividend. But, in the context of India’s’ commitment to adopt IFRS, suspension of AS 11 is a step in retrograde. It will provide a wrong signal to foreign investors. It will signal that India can change accounting standards if companies are uncomfortable in applying the same in a given business environment. However, one can argue that it is a global trend to search accounting solutions to non-accounting problems.
