1. Capitalization of exchange differences on recent acquisition of inventories
Enquiry:
Can foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency be capitalized in cost of inventory?
Opinion:
The Board notes that guidance should be obtained from IAS 2 ‘Inventories’ and IAS 21 ‘The Effects of Changes in Foreign Exchange Rates’.
The cost of inventories should be determined in accordance with IAS 2 and the accounting of inventory whose costs of purchase is denominated or requires settlement in a foreign currency should be done in accordance with IAS 21.
IAS 2 requires that inventories should be measured at lower of cost or net realizable value. The cost comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of purchase include purchase price, import duties, handling and transportation costs. However, as explained previously in introduction paragraph IN 10 of IAS 2, the exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency are not permitted to be included in the cost of purchase of inventories.
In addition to IAS 2, the principles outlined in IAS 21 for the recognition and measurement of foreign currency transactions can also be considered in respect of the inventory (whose purchase price is denominated or requires settlement in a foreign currency).
In accordance with paragraphs 21 and 22 of IAS 21, a foreign currency transaction is initially recorded at the spot exchange rate between the functional currency and the foreign currency, prevalent at the date of the transaction. The date of a transaction is the date on which the transaction first qualifies for recognition in accordance with IFRS. The date of transaction for the inventories is generally the date on which risks and rewards of ownership are transferred to the buyer.
Further, in accordance with the paragraph 23 of IAS 21, re-translation is not required at the subsequent reporting date/s for the foreign currency based non-monetary assets that are measured at historical cost. Accordingly, inventory is not required to be re-translated as it is a non-monetary asset measured at historical cost.
In context of the enquiry, it is relevant to mention that the term “recent acquisition” was used in SIC 11 ‘Foreign Exchange-Capitalisation of Losses from Severe Currency Devaluations’ (which has been superseded by IAS 21). Further, in SIC 11 the term “recent acquisition” referred to the acquisitions within twelve months prior to the severe devaluation or depreciation of the reporting currency.
Based on the above discussion, the Board is of the view that inventory whose cost is denominated or requires settlement in a foreign currency should be:
• Initially recognised using the foreign currency exchange rate at the date of transaction i.e. the date of transfer of risks and rewards of ownership of inventory;
• The exchange differences arising directly on the ‘recent acquisition’ of inventories invoiced in a foreign currency should not to be included in the cost of purchase of inventories; and
• The inventory measured at cost should not be subsequently re-measured for changes in exchange rate. Resultantly the subsequent changes in the exchange rate would not be capitalised in the cost of inventory.
(April 20, 2018)
2. Temporary Exchange Fluctuation
Enquiry:
Various financial reporting standards, dealing with valuation of assets and liabilities, including financial assets and liabilities, suggest that temporary fluctuation in value should not be considered while valuing an asset or liability. However, as far as IAS 21 is concerned, it requires each financial asset and liability to be recognized on closing date exchange rate prevailing at each reporting date.
Now we request Institute’s guidance on the matter that if the fluctuation in the exchange rates movement is temporary, i.e. exchange rate is artificially high or artificially low as on reporting and represent a “kink” or a “dip” in the curve of exchange rate movements over a close period, does accounting standards still require any reporting entity to value its financial assets and liabilities at such abnormal closing date’s rate or allow to use another rate for a meaningful presentation and reporting of a foreign exchange financial asset or liability?
Such question arises with more strength when impairment in the form of “exchange loss” is recognized in a period which requires to be reversed in the next month just due to correction in exchange rate movement.
Opinion:
The Committees would like to draw your attention towards the following paragraphs of IAS 21 (revised):
BC24 The previous version of IAS 21 allowed a limited choice of accounting for exchange differences that arise ‘from a severe devaluation or depreciation of a currency against which there is no practical means of hedging and that affects liabilities which cannot be settled and which arise directly on the recent acquisition of an asset’.* The benchmark treatment was to recognise such exchange differences in profit or loss. The allowed alternative was to recognize them as an asset.
BC25 The Board noted that the allowed alternative (of recognition as an asset) was not in accordance with the Framework for the Preparation and Presentation of Financial Statements because exchange losses do not meet the definition of an asset. Moreover, recognition of exchange losses as an asset is neither allowed nor required by any liaison standard-setter, so its deletion would improve convergence. Finally, in many cases when the conditions for recognition as an asset are met, the asset would be restated in accordance with IAS 29 Financial Reporting in Hyperinflationary Economies. Thus, to the extent that an exchange loss reflects hyperinflation, this effect is taken into account by IAS 29. For all of these reasons, the Board removed the allowed alternative treatment and the related SIC Interpretation is superseded.
Keeping in view the above, the Committee is of the view that IAS 21 does not require any reporting entity to value its financial assets and liabilities at any rate other than the closing rate.
(December 28, 2011)
3. Capitalization of Exchange Losses
Enquiry:
Prior to revision to the Fourth Schedule to the Companies Ordinance, 1984 there existed two parallel provisions regarding capitalization of exchange losses.
- IAS 21 allowed capitalization of only such exchange losses, which arose on recent acquisition of fixed assets (due to ‘severe’ fluctuation, which cannot be hedged).
ii. Fourth Schedule allowed capitalization of exchange losses on foreign currency (FCY) liabilities incurred for acquisition of fixed assets for entire life of such liabilities, even if they were long-term.
Subsequently the Fourth Schedule was revised and the above provision was removed from the revised the Fourth Schedule so that accounting treatment prescribed in IAS 21 may prevail and capitalization of exchange losses can be restricted.
The matter so far is clear. But the confusion arises from the Circular No. 01 of 2005 issued by SECP. The last paragraph of which reads as follows:
Regarding capitalization of exchange gain or loss, the listed companies and their subsidiaries which had a policy of capitalizing such exchange fluctuations and which had outstanding liabilities for foreign currency loans as on July 5, 2004 are allowed to capitalize such fluctuations for further three years i.e. up to 30th September, 2007, notwithstanding the fact that any such foreign exchange loan remains outstanding after the later date. However, in the case of any foreign currency loan contracted on or after July 5, 2004, the aforesaid accounting treatment would not be permissible.
The issue arises, whether the last line of this circular precludes capitalization of all exchange losses even if incurred on the recent acquisition of fixed assets (and other conditions as envisaged in IAS 21) or losses on long-term (FCY) liabilities only or in other words is the intention to override provisions of IAS 21.
An earlier response in this issue shall be highly appreciated.
P.S.: IAS 21 has itself withdrawn the allowed alternative of capitalization of exchange losses in 2003 revision. However, the revision is effective post January 1, 2005 (Applicable on new financial year of banks and insurance companies with year ended 31.12.05, so far).
Opinion:
Your attention is drawn towards the following Statement of Compliance which was revised by the Institute of Chartered Accountants of Pakistan vide its Circular 01/2003 dated February 24, 2003:
These financial statements have been prepared in accordance with approved accounting standards as applicable in Pakistan and the requirements of Companies Ordinance, 1984. Approved accounting standards comprise of such International Accounting Standards as notified under the provisions of the Companies Ordinance, 1984. Wherever, the requirements of the Companies Ordinance, 1984 or directives issued by the Securities and Exchange Commission of Pakistan differ with the requirements of these standards, the requirements of Companies Ordinance, 1984 or the requirements of the said directives take precedence.
In view of the above the Committee is of the opinion that capitalization of exchange losses on foreign currency loans contracted on or after July 5, 2004 would not be allowable even though paragraph 21 of IAS 21 (before revision) allowed capitalization of such losses in case of a severe devaluation or depreciation of currency, as the SECP Directive appears to override IAS provision.
(July 2, 2005)