Description
Exchange problems encountered by certain Indian companies
KeyWords: Accounting Standard 11, Companies Act 1956, Reliance Communications, Reliance Industries, Bharti Airtel, Bhushan Steel, Jet Airways
Abstract: To analyze the Accounting Standard 11 and Schedule VI of the Indian Companies Act, 1956 with respect to a recent article in the Business Line newspaper, titled “Forex accounting by blue chip companies under lens.”
Background
Business Line, the Business Daily from The Hindu group of publications carried an article on 17th August 2008, titled “Forex accounting by blue chip companies under lens” where it reports inflation of profits by several of the listed blue chip companies, namely, Reliance Industries, Reliance Communications, Bharti Airtel, Bhushan Steel and Jet Airways. The reporting of the substantially higher profits by these companies has occurred because of the accounting treatment adopted for Forex Borrowings, had they adopted the prescribed accounting norms, as per Accounting Standards (AS) 11, issued by the Institute of Chartered Accountants of India (ICAI), they would have reported significantly lower profits, and even losses in case of certain companies. However these companies have taken refuge under Schedule VI of the Companies Act, 1956. The major issue is whether changes in the rupee valuation of foreign currency due to changes in the exchange rate ought to be directly reflected as a loss/gain in the profit and loss account or adjusted against the cost at which fixed assets are currently carried in the books of account. This has lead to significant differences in the bottomline that has been reported for the first quarter of the current fiscal of the leading listed companies depending on whether they followed the norms prescribed by the Ministry under the company act or the ICAI. Depending on the method adopted the difference could be as high as a company showing over all profits or losses. For example, suppose that rupee that was trading at 40 for a dollar, goes up to 45 for a dollar, then the value of the asset worth 10 dollars , would have increased from 400 to 450. If this change is not reflected in the asset and charged to the PnL account then we would be looking at a profit of 50. Hence the difference In this case, we shall try to understand the required accounting treatment as per AS-11, issued by the ICAI, the provisions of Schedule VI of the Indian Companies Act, 1956 in regards to the treatment of Forex Borrowings, and the divergence between the two. Subsequently, we will calculate the profits of the above companies as per AS 11, and compare the same with the reported profits, which has been calculated as per Schedule VI treatment of Forex Borrowings.
Accounting Standard (AS) 11
Accounting Standard (AS) 11, issued by the Council of the Institute of Chartered Accountants of India (ICAI), pertains to the effects of changes in Foreign Exchange Rates. The standard was originally issued in 1989, revised in 1994, and revised again in 2003, which is currently in effect. One of the objectives of the standard is to deal with the principal issues in accounting for foreign currency transactions and foreign operations which is to decide which exchange rate to use and how to recognise in the financial statements the financial effect of the changes in the exchange rates. This case pertains to the accounting treatment of fluctuations in exchange rate on Forex borrowings. Paragraph 13 of AS 11 states “Exchange differences arising on the settlement of monetary items or on reporting an enterprise’s monetary items at rates different from those at which they were initially recorded during the period, or reported in previous financial statements, should be recognised as income or as expenses in the period in which they arise.” As per the standard “Monetary items are money held and assets and liabilities to be received or paid in fixed or determinable amounts of money.” Hence what the standard implies is that the exchange rate differences that arise on the settlement or on reporting at rates different from those at which they were initially recorded during the period or previous financial statements on monetary items like loans should be recognised as income or as expense in the period in which they arise. Exchange rate differences which arise in respect of liabilities incurred or in respect of repayment of borrowings in foreign currency made specifically for acquisition of fixed assets, should be recognised as Income or expense in the period in which it arises, and should not be added to the carrying cost of the asset, in other words the difference should not be capitalized. Also it is mandatory for the company to disclose the amount of exchange differences included in the net profit or loss for the period.
Schedule VI of the Companies Act, 1956
Schedule VI of the Companies Act , 1956, relates to the presentation of the financial statements by the companies registered under the Act. It contains a clause which relates to the treatment of FOREX differences on the financial statements. As per Schedule VI of the companies Act, 1956, the original cost and additions and deductions thereto, relate to any fixed asset which has been acquired from a country outside India, and in consequence of a change in the rate of exchange at any time after the acquisition of such asset, there has been an increase or reduction in the liability of the company, as expressed in Indian currency, for making payment towards the whole or a part of the cost of the asset or for repayment of the whole or a part of moneys borrowed by the company from any person, directly or indirectly, in any foreign currency specifically for the purpose of acquiring the assets (being in either case the liability existing immediately before the date on which the change in the rate of exchange takes effect), the amount by which the liability is so increased or reduced during the year, shall be added to, or , as the case may be, deducted from the cost, and the amount arrived at after such addition or deduction shall be taken to be the cost of the fixed asset. Hence what the schedule imply is that the change in the liability incurred towards the fixed asset due to fluctuations in the forex rates, shall be added or deducted from the cost of the fixed asset, or the carrying cost of the asset, that is in other words it should be capitalized.
Accounting Standard (AS) 11 V/S Schedule VI of the Companies Act, 1956
The differences arising from the change in liability incurred towards a fixed asset due to fluctuations in the exchange rate from those which they were initially recorded during the period or previous financial statements is treated differently as far as the accounting treatment is concerned as per the Accounting Standard 11 and Schedule VI of the Companies Act 1956. As we have observed above, AS 11 treats the difference as revenue or expenses while Schedule VI of the Companies Act, 1956 adds or deducts from the carrying cost of the asset. Let’s consider an example, if an Indian company buys an asset at $100 and incurs a liability towards it. The prevailing exchange rate is Rs.42 / $1. Hence both the fixed asset and the liability would be recorded at Rs.4,200 in the financial statements of the company. Now in the next period the rupee depreciates to Rs.44/ $1, now the liability for the company is Rs.4,400, which would be reflected in the LT borrowings on the balance sheet, however the treatment of the second entry of the Rs.200 difference is the matter of contention between AS 11 which would consider the difference as Expenses, and deduct it from the net profit and Schedule VI of the Companies Act, 1956 which would add it to the Carrying cost of the related fixed asset, not affecting the net profit. This has been the matter of contention for the listed blue chip companies. They have recorded this difference as per Schedule VI of the Companies Act, 1956 based on legal advice received by them, giving themselves an opportunity to adjust their foreign exchange losses against the carrying cost of the fixed asset, giving an opportunity to inflate or in other words over state the profits. Let’s compare the scenarios as reported by the companies and, adjusted outcomes if reported as per AS 11, issued by ICAI.
Reliance Industries (Based on FY 09 Q1 Results)
As reported by the company NPAT Total Sales Total Capital Employed NPAT/Sales NPAT / Capital Employed If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.940 crore after tax, which will be adjusted with the net profit and the capital employed will be deducted by the same amount, after adjustment to the fixed asset and the current tax liability. Rs. In crores Adjusted NPAT Total Sales Adjusted Total Capital Employed 3,170 41,579 129,729 9.88% 3.15% Rs. In crores 4,110 41,579 130,669
Adjusted NPAT/Sales Adjusted NPAT / Capital Employed Difference
7.62% 2.44%
The Net Profit after Tax is overstated by the company in effect of Rs.940 crore, also causing an overstatement of NPAT/sales and NPAT/Capital employed in tune of 2.26% and 0.70% respectively
Reliance Communications (Based on FY 09 Q1 Results)
As reported by the company
NPAT Total Sales Total Capital Employed NPAT/Sales NPAT / Capital Employed
Rs. In crores 1,512 5,322 41,279
28.41% 3.66%
If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.1,088 crore after tax, which will be adjusted with the net profit and the capital employed will be deducted by the same amount, after adjustment to the fixed asset and the current tax liability. Rs. In crores Adjusted NPAT Total Sales Adjusted Total Capital Employed 424 5,322 40,191
Adjusted NPAT/Sales Adjusted NPAT / Capital Employed Difference
7.97% 1.05%
The Net Profit after Tax is overstated by the company in effect of Rs.1,088 crore, also causing an overstatement of NPAT/sales and NPAT/Capital employed in tune of 20.44% and 2.61% respectively.
Bharti Airtel (Based on FY 09 Q1 Results)
As reported by the company NPAT Total Sales Rs. In crores 2,167 8,506
Total Capital Employed NPAT/Sales NPAT / Capital Employed
34,279
25.48% 6.32%
If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.250 crore after tax, which will be adjusted with the net profit and the capital employed will be deducted by the same amount, after adjustment to the fixed asset and the current tax liability. Rs. In crores Adjusted NPAT Total Sales Adjusted Total Capital Employed 1,917 8,506 34,029
Adjusted NPAT/Sales Adjusted NPAT / Capital Employed Difference
22.54% 5.63%
The Net Profit after Tax is overstated by the company in effect of Rs.250 crore, also causing an overstatement of NPAT/sales and NPAT/Capital employed in tune of 2.94% and 0.69% respectively.
Bhushan Steel (Based on FY 09 Q1 Results)
As reported by the company NPAT Total Sales NPAT/Sales Rs. In crores 173 1,320 13.11%
If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.26 crore after tax, which will be adjusted with the net profit Rs. In crores Adjusted NPAT Total Sales Adjusted NPAT/Sales Difference The Net Profit after Tax is overstated by the company in effect of Rs.26 crore, also causing an overstatement of NPAT/sales 1.97%. 147 1,320 11.14%
Note: The Company has no mention of the Total Assets or Capital Employed in its Q1 2009 financial statements.
Jet Airways (Based on FY 09 Q1 Results)
As reported by the company NPAT Total Sales Total Capital Employed NPAT/Sales NPAT / Capital 4.95% 0.85% Rs. In crores 143 2,899 16,890
Employed If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.622 crore after tax, which will be adjusted with the net profit and the capital employed will be deducted by the same amount, after adjustment to the fixed asset and the current tax liability. Rs. In crores Adjusted NPAT Total Sales Adjusted Total Capital Employed (479) 2,899 16,268
Adjusted NPAT/Sales Adjusted NPAT / Capital Employed Difference
-
The Net Profit after Tax is overstated by the company in effect of Rs.622 crore, which if adjusted results in the company reporting a net loss.
Conclusions
We can observe that the companies overstate the profits by reporting their financial statements as per the Indian Companies Act, 1956, instead of AS 11, issued by the ICAI. The government notification of the Companies (Accounting Standards) Rules 2006, says in a footnote to AS 11: “It may be noted that the accounting treatment of exchange differences contained in this Standard is required to be followed irrespective of the relevant provisions of Schedule VI to the Companies Act 1956.” What these companies are doing is very clear from this notification. They mention in their statements that what they do is following the legal advice, which is to follow the Companies Act, 1956, which remains the law of the land, and is not yet invalid. Conceptually AS 11, presents a truer picture of the affairs of the company , as if one has to pay more on the borrowings because of Forex fluctuations does not mean that the value of the asset changes.
The companies should take an onus on themselves to present profits in a manner which gives the most true and fair view. Also the Indian Companies Act, 1956, appears to be a bit outdated, so it should be reviewed, and the accounting standards and Indian Companies Act, should be standardized or brought on the same platform to avoid such issues of contention.
doc_904615697.doc
Exchange problems encountered by certain Indian companies
KeyWords: Accounting Standard 11, Companies Act 1956, Reliance Communications, Reliance Industries, Bharti Airtel, Bhushan Steel, Jet Airways
Abstract: To analyze the Accounting Standard 11 and Schedule VI of the Indian Companies Act, 1956 with respect to a recent article in the Business Line newspaper, titled “Forex accounting by blue chip companies under lens.”
Background
Business Line, the Business Daily from The Hindu group of publications carried an article on 17th August 2008, titled “Forex accounting by blue chip companies under lens” where it reports inflation of profits by several of the listed blue chip companies, namely, Reliance Industries, Reliance Communications, Bharti Airtel, Bhushan Steel and Jet Airways. The reporting of the substantially higher profits by these companies has occurred because of the accounting treatment adopted for Forex Borrowings, had they adopted the prescribed accounting norms, as per Accounting Standards (AS) 11, issued by the Institute of Chartered Accountants of India (ICAI), they would have reported significantly lower profits, and even losses in case of certain companies. However these companies have taken refuge under Schedule VI of the Companies Act, 1956. The major issue is whether changes in the rupee valuation of foreign currency due to changes in the exchange rate ought to be directly reflected as a loss/gain in the profit and loss account or adjusted against the cost at which fixed assets are currently carried in the books of account. This has lead to significant differences in the bottomline that has been reported for the first quarter of the current fiscal of the leading listed companies depending on whether they followed the norms prescribed by the Ministry under the company act or the ICAI. Depending on the method adopted the difference could be as high as a company showing over all profits or losses. For example, suppose that rupee that was trading at 40 for a dollar, goes up to 45 for a dollar, then the value of the asset worth 10 dollars , would have increased from 400 to 450. If this change is not reflected in the asset and charged to the PnL account then we would be looking at a profit of 50. Hence the difference In this case, we shall try to understand the required accounting treatment as per AS-11, issued by the ICAI, the provisions of Schedule VI of the Indian Companies Act, 1956 in regards to the treatment of Forex Borrowings, and the divergence between the two. Subsequently, we will calculate the profits of the above companies as per AS 11, and compare the same with the reported profits, which has been calculated as per Schedule VI treatment of Forex Borrowings.
Accounting Standard (AS) 11
Accounting Standard (AS) 11, issued by the Council of the Institute of Chartered Accountants of India (ICAI), pertains to the effects of changes in Foreign Exchange Rates. The standard was originally issued in 1989, revised in 1994, and revised again in 2003, which is currently in effect. One of the objectives of the standard is to deal with the principal issues in accounting for foreign currency transactions and foreign operations which is to decide which exchange rate to use and how to recognise in the financial statements the financial effect of the changes in the exchange rates. This case pertains to the accounting treatment of fluctuations in exchange rate on Forex borrowings. Paragraph 13 of AS 11 states “Exchange differences arising on the settlement of monetary items or on reporting an enterprise’s monetary items at rates different from those at which they were initially recorded during the period, or reported in previous financial statements, should be recognised as income or as expenses in the period in which they arise.” As per the standard “Monetary items are money held and assets and liabilities to be received or paid in fixed or determinable amounts of money.” Hence what the standard implies is that the exchange rate differences that arise on the settlement or on reporting at rates different from those at which they were initially recorded during the period or previous financial statements on monetary items like loans should be recognised as income or as expense in the period in which they arise. Exchange rate differences which arise in respect of liabilities incurred or in respect of repayment of borrowings in foreign currency made specifically for acquisition of fixed assets, should be recognised as Income or expense in the period in which it arises, and should not be added to the carrying cost of the asset, in other words the difference should not be capitalized. Also it is mandatory for the company to disclose the amount of exchange differences included in the net profit or loss for the period.
Schedule VI of the Companies Act, 1956
Schedule VI of the Companies Act , 1956, relates to the presentation of the financial statements by the companies registered under the Act. It contains a clause which relates to the treatment of FOREX differences on the financial statements. As per Schedule VI of the companies Act, 1956, the original cost and additions and deductions thereto, relate to any fixed asset which has been acquired from a country outside India, and in consequence of a change in the rate of exchange at any time after the acquisition of such asset, there has been an increase or reduction in the liability of the company, as expressed in Indian currency, for making payment towards the whole or a part of the cost of the asset or for repayment of the whole or a part of moneys borrowed by the company from any person, directly or indirectly, in any foreign currency specifically for the purpose of acquiring the assets (being in either case the liability existing immediately before the date on which the change in the rate of exchange takes effect), the amount by which the liability is so increased or reduced during the year, shall be added to, or , as the case may be, deducted from the cost, and the amount arrived at after such addition or deduction shall be taken to be the cost of the fixed asset. Hence what the schedule imply is that the change in the liability incurred towards the fixed asset due to fluctuations in the forex rates, shall be added or deducted from the cost of the fixed asset, or the carrying cost of the asset, that is in other words it should be capitalized.
Accounting Standard (AS) 11 V/S Schedule VI of the Companies Act, 1956
The differences arising from the change in liability incurred towards a fixed asset due to fluctuations in the exchange rate from those which they were initially recorded during the period or previous financial statements is treated differently as far as the accounting treatment is concerned as per the Accounting Standard 11 and Schedule VI of the Companies Act 1956. As we have observed above, AS 11 treats the difference as revenue or expenses while Schedule VI of the Companies Act, 1956 adds or deducts from the carrying cost of the asset. Let’s consider an example, if an Indian company buys an asset at $100 and incurs a liability towards it. The prevailing exchange rate is Rs.42 / $1. Hence both the fixed asset and the liability would be recorded at Rs.4,200 in the financial statements of the company. Now in the next period the rupee depreciates to Rs.44/ $1, now the liability for the company is Rs.4,400, which would be reflected in the LT borrowings on the balance sheet, however the treatment of the second entry of the Rs.200 difference is the matter of contention between AS 11 which would consider the difference as Expenses, and deduct it from the net profit and Schedule VI of the Companies Act, 1956 which would add it to the Carrying cost of the related fixed asset, not affecting the net profit. This has been the matter of contention for the listed blue chip companies. They have recorded this difference as per Schedule VI of the Companies Act, 1956 based on legal advice received by them, giving themselves an opportunity to adjust their foreign exchange losses against the carrying cost of the fixed asset, giving an opportunity to inflate or in other words over state the profits. Let’s compare the scenarios as reported by the companies and, adjusted outcomes if reported as per AS 11, issued by ICAI.
Reliance Industries (Based on FY 09 Q1 Results)
As reported by the company NPAT Total Sales Total Capital Employed NPAT/Sales NPAT / Capital Employed If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.940 crore after tax, which will be adjusted with the net profit and the capital employed will be deducted by the same amount, after adjustment to the fixed asset and the current tax liability. Rs. In crores Adjusted NPAT Total Sales Adjusted Total Capital Employed 3,170 41,579 129,729 9.88% 3.15% Rs. In crores 4,110 41,579 130,669
Adjusted NPAT/Sales Adjusted NPAT / Capital Employed Difference
7.62% 2.44%
The Net Profit after Tax is overstated by the company in effect of Rs.940 crore, also causing an overstatement of NPAT/sales and NPAT/Capital employed in tune of 2.26% and 0.70% respectively
Reliance Communications (Based on FY 09 Q1 Results)
As reported by the company
NPAT Total Sales Total Capital Employed NPAT/Sales NPAT / Capital Employed
Rs. In crores 1,512 5,322 41,279
28.41% 3.66%
If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.1,088 crore after tax, which will be adjusted with the net profit and the capital employed will be deducted by the same amount, after adjustment to the fixed asset and the current tax liability. Rs. In crores Adjusted NPAT Total Sales Adjusted Total Capital Employed 424 5,322 40,191
Adjusted NPAT/Sales Adjusted NPAT / Capital Employed Difference
7.97% 1.05%
The Net Profit after Tax is overstated by the company in effect of Rs.1,088 crore, also causing an overstatement of NPAT/sales and NPAT/Capital employed in tune of 20.44% and 2.61% respectively.
Bharti Airtel (Based on FY 09 Q1 Results)
As reported by the company NPAT Total Sales Rs. In crores 2,167 8,506
Total Capital Employed NPAT/Sales NPAT / Capital Employed
34,279
25.48% 6.32%
If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.250 crore after tax, which will be adjusted with the net profit and the capital employed will be deducted by the same amount, after adjustment to the fixed asset and the current tax liability. Rs. In crores Adjusted NPAT Total Sales Adjusted Total Capital Employed 1,917 8,506 34,029
Adjusted NPAT/Sales Adjusted NPAT / Capital Employed Difference
22.54% 5.63%
The Net Profit after Tax is overstated by the company in effect of Rs.250 crore, also causing an overstatement of NPAT/sales and NPAT/Capital employed in tune of 2.94% and 0.69% respectively.
Bhushan Steel (Based on FY 09 Q1 Results)
As reported by the company NPAT Total Sales NPAT/Sales Rs. In crores 173 1,320 13.11%
If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.26 crore after tax, which will be adjusted with the net profit Rs. In crores Adjusted NPAT Total Sales Adjusted NPAT/Sales Difference The Net Profit after Tax is overstated by the company in effect of Rs.26 crore, also causing an overstatement of NPAT/sales 1.97%. 147 1,320 11.14%
Note: The Company has no mention of the Total Assets or Capital Employed in its Q1 2009 financial statements.
Jet Airways (Based on FY 09 Q1 Results)
As reported by the company NPAT Total Sales Total Capital Employed NPAT/Sales NPAT / Capital 4.95% 0.85% Rs. In crores 143 2,899 16,890
Employed If the accounting treatment as per AS 11 been continued to be followed by the Company, the difference that exists on account of foreign exchange fluctuations is Rs.622 crore after tax, which will be adjusted with the net profit and the capital employed will be deducted by the same amount, after adjustment to the fixed asset and the current tax liability. Rs. In crores Adjusted NPAT Total Sales Adjusted Total Capital Employed (479) 2,899 16,268
Adjusted NPAT/Sales Adjusted NPAT / Capital Employed Difference
-
The Net Profit after Tax is overstated by the company in effect of Rs.622 crore, which if adjusted results in the company reporting a net loss.
Conclusions
We can observe that the companies overstate the profits by reporting their financial statements as per the Indian Companies Act, 1956, instead of AS 11, issued by the ICAI. The government notification of the Companies (Accounting Standards) Rules 2006, says in a footnote to AS 11: “It may be noted that the accounting treatment of exchange differences contained in this Standard is required to be followed irrespective of the relevant provisions of Schedule VI to the Companies Act 1956.” What these companies are doing is very clear from this notification. They mention in their statements that what they do is following the legal advice, which is to follow the Companies Act, 1956, which remains the law of the land, and is not yet invalid. Conceptually AS 11, presents a truer picture of the affairs of the company , as if one has to pay more on the borrowings because of Forex fluctuations does not mean that the value of the asset changes.
The companies should take an onus on themselves to present profits in a manner which gives the most true and fair view. Also the Indian Companies Act, 1956, appears to be a bit outdated, so it should be reviewed, and the accounting standards and Indian Companies Act, should be standardized or brought on the same platform to avoid such issues of contention.
doc_904615697.doc