investors need to understand its implications on reported financial numbers

The Number Game

While some companies benefit from the modification in AS11, investors need to understand its implications on reported financial numbers of companies

THE year 2008 would not only be remembered for the slump in equity and commodity market, but also for the sharp volatility in the foreign exchange market. For instance, Indian rupee depreciated by around 25% against dollar in 2008, the largest swing of the currency in any direction in the last 10 years. The currency experts, traders and finance head of companies went terribly wrong in predicting the movement.
    Indian companies, with huge expansion plans, went overseas to borrow cheap foreign currency loan two-three years back. That was at a time when the rupee was appreciating strongly against other currencies, such as US dollar and pound sterling. But the trend reversed suddenly and the rupee began to depreciate following a meltdown in the equity market. What followed afterwards is the economic slowdown and lower earnings for the corporate. Besides, companies, which had borrowed from overseas, had to take significant hit on their profits because of mark-to-market (MTM) losses arising out of such foreign currency loans, thanks to accounting standard 11 (AS11).
    This double whammy — lower operating profit and higher exchange loss — pulled down net profits for many companies, such as Tata Steel, JSW Steel, Tata Motors, Mahindra & Mahindra, Suzlon Energy and Jubilant Organosys among others. For instance, JSW Steel reported a net forex loss of Rs 176 crore that wiped out most of its operating profit during the December 2008 quarter.
    Such a situation was considered extraordinary and national advisory committee on accounting standard (NACAS) stepped in to make some modification in AS11.
    As per the modification, companies will have the option to bring in the effect of long-term foreign currency loan (with tenure of more than 12 months) onto the balance sheets till March 2011. This would provide significant relief to Indian companies, while preparing their annual profit and loss statement for the fiscal year 2008-09.
    There are many things, related to the technicality of application of this modified version of AS11 that are still not very clear. There are also a lot of disagreements among industry leaders, accounting experts and analysts on the modification of this standard. Since this issue is fairly complex and confusing, we at ET Intelligence Group decided to give some guidance to our readers on this topic so that they can be at ease while reading the upcoming quarterly and annual financial statements of companies and comparing these figures with previous periods.
    If a company has been following AS11, it would have booked foreign exchange losses due to the depreciation of rupee in the past few quarters. So, if a company had $1,000 of long-term foreign currency loan and the rupee depreciated from Rs 45 at the beginning of the quarter to Rs 50 at the end of quarter, then the company would book foreign exchange loss of Rs 5,000 during that quarter. So for comparison, investors should add this loss to the reported net profit to arrive at actual operational net profit figures for the past quarters/years.
    The new modification is applicable retrospectively from December 2006 and
hence, would be applicable from the financial year 2007-08 onwards till 2010-11. For simplicity lets assume that, the company had Rs 500 crore of foreign exchange gain in 2007-08 when rupee was appreciating and Rs 2,000 crore of foreign exchange loss in 2008-09. After the application of the modification, the company would have a cumulative loss of Rs 1,500 crore (1,700 minus 500), and this would be brought back to its balance sheet. This Rs 1,500 crore would be distributed within the balance sheet in two ways — capitalisation through fixed asset and creating a special account on liability side — depending on how much of foreign currency loan has been spent for capital assets.
    Further, assume that the company has around $1,500 million of total loan, out of which $1,000 million has been spent for acquiring capital asset. Now, to offset the impact of this Rs 1,500 crore of cumulative loss on balance sheet, fixed asset would have to be increased by Rs 1,000 crore and a negative entry of Rs 500 crore would be made on the liability side of the balance sheet under the heading “foreign currency monetary item translation difference account”.
    What these transactions effectively mean is that the fixed asset at the end of the fiscal year 2008-09 would increase and hence, the depreciation amount would also increase in the coming years. Further, Rs 500 crore (as shown in above example) should be amortised over the tenure of loan or March 2011, whichever is earlier. If the loan expires before March 2011, companies have to write-off the entire amount from its balance sheet and it has to be reflected in the profit and loss statement in that financial year. If the current depreciation of rupee continues or at least remain at the current level, there would be significant impact on the profit and loss statements of these companies during the year in which the foreign currency loan expires.
    The tax implication of this modification is still not very clear. What we understand is that the companies and tax authorities would continue to treat such unrealised gain/loss as they have done in the past.
    As far as the applicability of this new version is concerned, like any other issue, there are different pros and cons. The benefit is that companies’ profitability would be immune to unrealised foreign exchange gain/loss, which unnecessarily distorts the actual profitability figures. On the other hand, it might be viewed by some as tinkering with the accounting standard and inflating the profit figures. Also, this might create a lot of confusion among investors.
    

 

 

 

 

 

Subscribe for FREE SMS  Calls on Indian Stock Market