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Navigating the Complexities of Forward Exchange Contracts: A Comparative Analysis of AS 11, Ind AS 109, and ICDS VI for Income Computation

Introduction

Forward exchange contracts are essential financial instruments used to manage or hedge foreign currency risks. The accounting standards, Accounting Standard (AS) 11 - 'The Effects of Changes in Foreign Exchange Rates' and Ind AS 21 - 'The Effects of Changes in Foreign Exchange Rates', prescribe distinct accounting methods for Forward exchange contracts based on their nature and purpose.

Additionally, the computation of income under Income Computation and Disclosure Standards (ICDS) VI - 'Effects of Changes in Foreign Exchange Rates' outlines the methodology for determining the income or loss on forward exchange contracts. These computations are aligned with the provisions of the Income Tax Act, 1961 to determine the allowable income or loss on forward exchange contracts.

This article aims to explain and clarify the accounting treatment prescribed under AS and Ind AS and discusses its implications when computing the taxable income of the Assessee under the provisions of the Income Tax Act, 1961.

Brief

Forward exchange contracts are entered for various purposes, which can primarily be categorized into the following broad categories:

1. Forward Exchange Contracts for Hedging

Forward exchange contracts are frequently used to hedge foreign currency exposures, either existing or expected.

(a) Existing Exposure

This involves hedging risks related to foreign currency assets or liabilities already recorded in the books.

Example: Foreign trade receivables (from export sales) or trade payables (from imported goods or services)

(b) Expected Exposure

Hedging expected exposures relate to anticipated foreign currency transactions, which can be further divided into Firm Commitment & Highly Probable Forecast Transaction (HPFT)

• Firm Commitment: A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified future date or dates. A firm commitment arises when there is a contractual obligation to settle a foreign currency asset or liability on a future date, even if it is not yet recognized in the books. For Example, A company has signed a contract to purchase goods priced in foreign currency, with delivery scheduled in the future. There is no existing recognized asset or liability for such exposure at the time of the commitment.
• Highly Probable Forecast Transaction (HPFT): An HPFT is an uncommitted but anticipated future transaction. It is highly likely to occur, based on the company's operations, contractual obligations, or historical patterns. For Example, An entity expects to import machinery within three months and uses a forward contract to lock in the exchange rate. Although no firm commitment exists, based on current updates, the transaction is highly likely to occur.

2. Forward Exchange Contracts for Trading and/or Speculation

Forward exchange contracts not intended for hedging are typically used for trading or speculative purposes:

• Trading: These Forward exchange contracts aim to benefit from expected currency movements without directly managing business exposures.
• Speculation: Contracts entered purely to profit from anticipated fluctuations in exchange rates.

The graphical presentation of the above text for better understanding is given below

Accounting Under Different Accounting Standards

Accounting prescribed under Accounting Standard (AS) 11 The Effects of Changes in Foreign Exchange Rates

1. Forward Exchange Contracts for Hedging

(a) Premium or Discount

When the forward exchange contract is signed, there may be a premium (extra cost) or a discount (saving) depending on the difference between:

• The current exchange rate on the date the contract is made.
• The forward rate specified in the contract for the settlement date.

This premium or discount is amortized over the life of the contract.

(b) Exchange Differences

Over time, as the exchange rates change, the value of the forward contract will also change. The exchange difference is calculated as the difference between:

• current exchange rate (at the reporting date or settlement date, if the contract is closed earlier).
• exchange rate at the start date of the contract, or last reporting date, whichever is later.

It is important to note that under Accounting Standard 11, Forward exchange contracts entered to hedge future transactions i.e. firm commitment/HPFT are not covered by the provisions of this standard. As per ICAI's Guidance Note on Accounting for Derivative Contracts (Revised 2021), the Guidance note applies to cases where accounting standard 11 is not applicable and accordingly the accounting for firm commitment/HPFT is covered in this guidance note. The key accounting principles for derivatives covered under this guidance note are the recognition on the balance sheet and measurement at fair value.

Accordingly, in my view such forward exchange contracts should be accounted for on marked to-market (MTM) basis a similar approach is followed for speculation/trading purposes which is discussed below.

2. Forward Exchange Contracts for Speculative or Trading Purposes

(a) Premium or Discount

The premium or discount on the forward contract is not accounted for separately in this method.

(b) Exchange Differences

The gain or loss is calculated by multiplying the foreign currency amount in the contract by the difference between:

• The forward rate available on the reporting date for the remaining contract period.
• The contracted forward rate.

Please refer to the graphical presentation for a clearer understanding of the above accounting

Accounting prescribed under Indian Accounting Standard (Ind AS) 109 Financial Instruments

1. Under Ind AS, the accounting treatment for forward exchange contracts is uniform across hedging (existing or expected), trading, and speculative purposes.
2. There is no requirement for accounting for any premium or discount on the forward exchange contracts under Ind As.
3. The Exchange Differences on the Contract is accounted on MTM basis i.e. the gain or loss is calculated by multiplying the foreign currency amount in the contract by the difference between:

• The forward rate available on the reporting date for the remaining contract period.
• The contracted forward rate

Please refer to the graphical presentation for a clearer understanding of the above explanation

ICDS VI: Effects of Changes in Foreign Exchange Rates

1. Forward Exchange Contracts for Hedging

Para 8(1) of ICDS VI, prescribes similar treatment for an existing hedge, Trading, and speculation purposes as given in Accounting Standard 11 while commuting the gain/loss on a forward exchange contract. To reiterate, the prescribed treatment is given hereunder: -

(a) Premium or Discount

When the forward exchange contract is signed, there may be a premium (extra cost) or a discount (saving) depending on the difference between:

• The current exchange rate on the date the contract is made.
• The forward rate specified in the contract for the settlement date.

This premium or discount is amortized over the life of the contract.

(b) Exchange Differences

Exchange differences on such a contract shall be recognised as income or as expense in the previous year in which the exchange rates changed. The exchange difference is calculated as the difference between:

• current exchange rate (at the reporting date or settlement date, if the contract is closed earlier).
• exchange rate at the start date of the contract, or last reporting date, whichever is later.

2. Forward Exchange Contracts for Speculative or Trading Purposes or hedge a firm commitment or a highly probable forecast transaction

Premium, discount, or exchange difference on contracts that are intended for trading or speculation purposes, or that are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction shall be recognised at the time of settlement.

Please refer to the graphical presentation for a clearer understanding of the above explanation.

Notes:

(1) Para 8(1) of ICDS VI allows MTM for Existing Exposures

(2) Para 8(2) of ICDS VI excludes Trading / Speculations contracts from applying para 8(1) and hence MTM to be revered (if accounted in books) and to be claimed on settlement basis only.

(3) Para 8(3) of ICDS VI excludes Firm Commitment and HPFT from applying para 8(1) and hence MTM to be revered (if accounted in books) and to be claimed on settlement basis only

Comparison of AS 11, IND AS 109 and ICDS VI

After understanding the accounting treatment prescribed for forward exchange contract in AS 11, Ind AS 109 and its treatment under ICDS VI, it is now important to compare the impact of accounting vis a vis treatment under ICDS in determining the income or loss on forward exchange contracts.

AS 11 vs ICDS VI

Based on the accounting treatment prescribed by Accounting Standard 11, as explained above, which is similar to the method prescribed under ICDS VI, no adjustment would be required under ICDS VI while computing the gain or loss on a forward exchange contract.

Ind AS 109 vs ICDS VI

However, in comparison with accounting treatment prescribed under Ind AS 109, there is a departure in comparison with ICDS VI. Ind AS109 prescribes MTM accounting for forward exchange contracts where under ICDS MTM is allowed only in case of existing exposure (Para 8(1) of ICDS VI) and settlement basis for any other types (Para 8(2) and 8(3) of ICDS VI).

Conclusion

The accounting treatment for forward exchange contracts under Accounting Standard (AS) 11, Ind AS 109, and ICDS VI varies significantly.

• AS 11 emphasizes a distinct treatment for premiums, discounts, and exchange differences, requiring separate recognition and amortization.
• Ind AS 109, however, adopts a more integrated approach, consolidating these elements for simplicity, particularly under derivative accounting or hedge accounting frameworks.
• ICDS VI aligns its treatment with the purpose of the contract, distinguishing between contracts tied to recognized assets or liabilities (existing exposure) and those related to anticipated commitments or speculative ventures (expected exposure).

Understanding these differences is crucial for accurate financial reporting, effective risk management, and compliance with accounting and tax regulations.

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