Treatment on loss of Foreign Exchange
Treatment on loss of Foreign Exchange
    The difference resulting from translating a given number of units of one currency into another currency at different exchange rates is Exchange Gain loss.

    Exchange differences arising when monetary items are settled or when monetary items are translated at rates different from those at which they were translated when initially recognised or in previous financial statements are reported in profit or loss in the period, with one exception. [IAS 21.28] The exception is that exchange differences arising on monetary items that form part of the reporting entity's net investment in a foreign operation are recognised, in the consolidated financial statements that include the foreign operation, in a separate component of equity; they will be recognised in profit or loss on disposal of the net investment. [IAS 21.32]

    Main gist of accounting standard 11 of the Indian Accounting Standards:
    The statement applies mandatory in respect of:
    a. Accounting for transaction in foreign currencies.
    b. Translating the financial statements of foreign branches for inclusion in the financial statements of the reporting enterprise. A transaction in a foreign currency is recorded in the financial records of an enterprise normally at the rate:
    i. On the date of transaction i.e. spot rate,
    ii. Approximate actual rate i.e. averaging the rates during the week/month in which transactions occur if there is no significant fluctuations.
    iii. Weighted average in the above line.
    However, for interrelated transaction (by virtue of being set off against receivables and payables) it is translated with reference to the net amount on the date of transaction. After initial recognition, the exchange difference on the reporting date of financial statement should be treated as under:
    a. Monetary items like foreign currency balance, receivables, payables, loans at closing rate (in case of restriction or remittance other than temporary or when the closing rate is unrealistic, it is reported at the rate likely to be realized).
    b. Non-monetary items like fixed assets, which are recorded at historical cost, should be made at the rate on the date of transaction.
    c. Non-monetary items other than fixed assets are carried at fair value or net realizable value on the date which they are determined i.e. Balance Sheet date (i.e. inventories, investments in equity-share, etc.)

    Exchange difference on repayment of liabilities incurred for acquiring fixed assets should be adjusted in the carrying amount of fixed assets on reporting date. The same concept applies to revaluation as well but in case such adjustment on revaluation should result into showing the actual book value of the fixed assets/class of, exceeding the recoverable amount, the remaining amount of the increase in liability should be debited to Revaluation Reserve or Profit and Loss Statement in case of inadequacy/absence of Revaluation Reserve. Except as stated above (fixed assets) other exchange difference should be recognized as income or expense in the period in which they arise or spread over to pertaining accounting period. Depreciation as per AS-6 should be provided on the unamortized carrying amount of depreciable assets (after taking into account the effect of exchange difference).

    Disclosure under AS – 11: An enterprise should disclose:
    a. The amount of exchange difference included in the net profit or loss for the period.
    b. The amount of exchange difference adjusted in the carrying amount of fixed assets during the accounting period.
    c. The amount of exchange difference in respect of forward contracts to be recognized in the profit / loss for one or more subsequent accounting period.
    d. Foreign currency risk management policy.

    Interpretation of AS – 11:
    This accounting standard applies mandatorily in respect of: a. Accounting for transaction in foreign currencies, and b. Translating the financial statements of foreign branches for inclusion in the financial statements of the reporting enterprise.
    A transaction in a foreign currency is recorded in the financial records of an enterprise normally at the rate: a. On the date of transaction i.e. spot rate, b. Approximately actual rate i.e. averaging the rates during the week / month in which transactions occur if there is no significant fluctuations, c. Weighted average in the above line.
    Exchange difference on repayment of liabilities incurred for acquiring fixed assets should be adjusted in the carrying amount of fixed assets on reporting date.
    The exchange difference should be recognized and included in the net profit or loss as income or expense in the period in which they arise or spread over to pertaining accounting period.
    The amount of exchange difference in respect of forward contracts to be recognized in the profit / loss for one or more subsequent accounting period.

    Thus there are two broad categories of foreign exchange losses:
    1. Transaction Losses: These losses arise on settlement of foreign exchange transactions. The exchange difference between the date on which the transaction is entered into and the date of settlement of foreign exchange transaction is a foreign exchange loss or gain as the case might be,
    2. Translation Losses: These losses are a provision for restatement of unpaid foreign exchange liabilities as on the Balance Sheet date. The foreign exchange liabilities are converted into Indian Rupees as on the balance sheet date and the difference in the value of the liabilities appearing in the books of accounts vis a vis the restated liabilities is booked as a foreign exchange loss or a gain as the case may be.

    Accounting Standard 11 states that all unpaid monetary liabilities should be restated at closing value as on the balance sheet date. Any exchange gain or loss arising there on, is considered as an income or an expenditure as the case might be. This is in conformance with the accrual concept of accounting, wherein even unrealized but expenditure pertaining to a particular year is allowed to be expenses out in that year itself.

    Accounting Standard I notified u/s 145(1) of the Income Tax Act, 1961 also permits accrual method of accounting. An extract of Accounting Standard I as has been notified is as follows:
    A. Accounting Standard I relating to disclosure of accounting policies :

    1. All significant accounting policies adopted in the preparation and presentation of financial statements shall be disclosed.

    2. The disclosure of the significant accounting policies shall form part of the financial statements and the significant accounting policies shall normally be disclosed in one place.

    3. Any change in an accounting policy which has a material effect in the previous year or in the years subsequent to the previous year shall be disclosed. The impact of, and the adjustments resulting, from, such change, if material, shall be shown in the financial statements of the period in which such change is made to reflect the effect of such change. Where the effect of such change is not ascertainable, wholly or in part, the fact shall be indicated. If a change is made in the accounting policies which has no material effect on the financial statements for the previous year but which is reasonably expected to have a material effect in any year subsequent to previous year, the fact of such change shall be appropriately disclosed in the previous year in which the change is adopted.

    4. Accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business, profession or vocation in the financial statements prepared and presented on the basis of such accounting policies. For this purpose, the major considerations governing the selection and application of accounting policies are following, namely:

    i. Prudence : Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information;
    ii. Substance over form : The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form;
    iii. Materiality : Financial statements should disclose all material items, the knowledge of which might influence the decisions of the user of the financial statements.

    5. If the fundamental accounting assumptions relating to Going Concern, Consistency and Accrual are followed in financial statements, specific disclosure in respect of such assumptions is not required. If a fundamental accounting assumption is not followed, such fact shall be disclosed.
    6. For the purposes of the paragraphs (1) to (5), the expressions,
    a. "Accounting policies" means the specific accounting principles and the methods of applying those principles adopted by the assessee in the preparation and presentation of financial statements;
    b. "Accrual" refers to the assumption that revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate ;
    c. "Consistency" refers to the assumption that accounting policies are consistent from one period to another;
    d. "Financial Statements" means any statement to provide information about the financial position, performance and changes in the financial position of an assessee and includes balance sheet, profit and loss account and other statements and explanatory notes forming part thereof;
    e. "Going concern" refers to the assumption that the assessee has neither the intention nor the necessity of liquidation or of curtailing materially the scale of the business, profession or vocation and intends to continue his business, profession or vocation for the foreseeable future.

    Accounting Standard I unequivocally state that the accounting policies adopted by an assessee should be such that they should represent true and fair view of the state of affairs of the business. It also clearly permits accrual concept of accounting. Keeping in view the true and fair view and accrual concept of accounting, foreign exchange gain/ loss on translation of unpaid liabilities as on the balance sheet date should be allowed as expenditure or income as the case might be so that a true and fair profitability can be derived.

    The captioned issue was discussed in great detail in the recent landmark ruling of Supreme Court in the case of CIT vs Woodward Governor India P. Ltd (312 ITR 254) where in the SC relied on the earlier judgment in the case of Sutlej Cotton Mills Ltd vs. CIT (116 ITR 1) which observed as follows :- "The law may, therefore, now be taken to be well settled that where profit or loss arises to an assessee on account of appreciation or depreciation in the value of foreign currency held by it, on conversion into another currency, such profit or loss would ordinarily be a trading profit or loss if the foreign currency is held by the assessee on revenue account or as a trading asset or as part of circulating capital embarked in the business. But, if on the other hand, the foreign currency is held as a capital asset or as fixed capital, such profit or loss would be of capital nature."

    Further in the aforesaid ruling the Apex Court also affirmed the principles laid down in the ruling of CIT vs. V.S.Dempo & Co Pvt. Ltd (206 ITR 291) which are as below:
    A loss arising in the process of conversion of foreign currency which is part of trading asset of the assessee is a trading loss as any other loss. In determining the true nature and character of the loss, the cause which occasions the loss is immaterial; what is material is whether the loss has occurred in the course of carrying on the business or is incidental to it.

    If there is loss in a trading asset, it would be a trading loss, whatever be its cause because it would be a loss in the course of carrying on the business. Loss in respect of circulating capital is revenue loss whereas loss in respect of fixed capital is not. Loss resulting from depreciation of the foreign currency which is utilised or intended to be utilised in business and is part of the circulating capital, would be a trading loss, but depreciation of fixed capital on account of alteration in exchange rate would be capital loss. For determining whether devaluation loss is revenue loss or capital loss what is relevant is the utilisation of the amount at the time of devaluation and not the object for which the loan had been obtained. Even if the foreign currency was intended or had originally been utilised for acquisition of fixed asset, if at the time of devaluation it had changed its character and had assumed the new character of stock-in-trade or circulating capital, the loss that occurred on account of devaluation shall be a revenue loss and not a capital loss. The way in which the entries are made by an assessee in the books of account is not determinative of the question whether the assessee has earned any profit or suffered any loss. What is necessary to be considered is the true nature of the transaction and whether in fact it has resulted in profit or loss to the assessee. The argument generally raised by the revenue authorities to deny deduction of exchange fluctuation loss was that if the loss is recognized on MTM basis w.r.t year end rates, it is notional or contingent in nature. Losses are allowable only on actual crystallization on payment/receipt. The aforesaid issue has now been settled by the SC which has held that the MTM loss recognized on the basis of recognized accounting standards is a real loss. As a corollary, gain on revenue account recognized in books on MTM basis will also be taxable. The propositions laid down by the SC in CIT vs Woodward Governor India P. Ltd (supra) can be summarized as follows :-

    MTM loss is allowable in the year of recognition by debit to P&L A/c in terms of the mercantile method of accounting followed as per the mandatory Accounting Standards Though provisions of Section 37 refer to 'expenditure', the 'expenditure' may, in some cases, cover an amount which is really a 'loss', even though the said amount has not gone out from the taxpayer's pocket. Accounts regularly maintained by a taxpayer in the course of business are to be taken as correct unless there are strong and sufficient reasons to indicate that they are unreliable. Emphasis placed on requirement of adopting ordinary principles of commercial accounting, unless such principles stand superseded or modified by legislative enactments.

    Unless legislatively intervened or found by the Tax Authority to be not reflective of true and correct profits for valid reasons, the method of accounting consistently followed by a taxpayer is 'supreme'. Disallowance is not permissible unless accounting system followed by taxpayer found to be incorrect.

    The SC keeping in view the above principles laid out by their predecessors made the following conclusion, which may now be regarded as tests for determining the tax allowance of such items :-
    "In conclusion, we may state that in order to find out if an expenditure is deductible the following have to be taken into account
    1. whether the system of accounting followed by the assessee is mercantile system, which brings into debit the expenditure amount for which a legal liability has been incurred before it is actually disbursed and brings into credit what is due, immediately it becomes due and before it is actually received;
    2. whether the same system is followed by the assessee from the very beginning and if there was a change in the system, whether the change was bona fide; 3. whether the assessee has given the same treatment to losses claimed to have accrued and to the gains that may accrue to it;
    4. whether the assessee has been consistent and definite in making entries in the account books in respect of losses and gains;
    5. whether the method adopted by the assessee for making entries in the books both in respect of losses and gains is as per nationally accepted accounting standards;
    6. whether the system adopted by the assessee is fair and reasonable or is adopted only with a view to reducing the incidence of taxation." The appellant is consistently following mercantile system of accounting and restating its foreign exchange liabilities at the closing exchange rate on the date of the Balance Sheet. Foreign Exchange Loss or Gain if any arising due to the above exercise is shown as an expenditure or revenue respectively as the case might be. The appellant follows Accounting Standard 11 which has been notified by Sec 211 (3C) of the Companies Act, 1956. Thus all the above conditions laid down by the aforementioned Supreme Court have been followed.

    Also please refer the following cases:
    DCIT V Bank of Baharain & Kuwait
    Woodword Governor 249 DTR 451
    Diamond R US V DCIT 9 Taxmann.com 67.
    LG Electronics India P. Ltd. 309 ITR 265
    ONGC Ltd. V CIT. Civil Appeal No. 7223 of 2008 dated March 15 2010

    In all these cases it has been held that loss claimed by the assessee on foreign exchange fluctuation as on the date of balance sheet is allowable on an accrual basis.

    To sum up, the following conclusions can be drawn from the aforementioned legal precedents
    1. Translation Losses as well as transaction losses on conversion of foreign currency of trading assets can be expensed out by the assessee.
    2. Losses on conversion of foreign currency of capital assets have to be necessarily capitalized even though AS 11 and IAS specifically allow those losses to be expensed out.
    3. Mark to Market (MTM) losses as a concept for recognition of losses is well recognised by the Apex Court.
    4. Expenditure may cover a loss, even though the amount may not have gone out of the assessee's pocket. Such a loss should be allowed as expenditure U/S 37 of the Income Tac Act, 1961.

    Thus the Income Tax Department stand of not allowing translation losses as expenditure cannot stand the test of the Honourable Supreme Court judgements on the said issue.