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Capitalisation of exchange losses of foreign currency borrowings arising from the devaluation of the Renminbi
Executive summary ................................................................. 2
Background .............................................................................. 4
Can exchange losses arising from foreign currency loans be capitalised in the entities with RMB as functional currency? ..... 5
What are the practical ways to estimate the amount of exchange losses to be capitalised for each loan? To what extent can exchange losses be capitalised? ................................................. 6
In an accounting period, what approaches are available for capitalising the exchange losses in the qualifying assets when the construction of the qualifying assets takes more than one accounting period? .................................................................10
PwC contacts ...........................................................................12
Page
Contents
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• Certain portion of the exchange losses arising from the devaluation of Renminbi (RMB) in August 2015 is considered as an adjustment to interest costs and is eligible for capitalisation in the qualifying assets of the entities.
• There are two possible methods to estimate the amount of exchange losses that can be included in borrowing costs and to be capitalised:
(a) based on interest rates on similar borrowings in the entity’s functional currency
(b) based on forward currency rates at the inception of the loan
• With method (a), it might be practically difficult or even impractical to identify RMB borrowings which are similar to foreign currency borrowings in major terms at the date of inception of the foreign currency borrowings. Method (b) is considered to be more objective, entity-specific and practical as it makes use of the market spot and forward exchange rates at the date of inception of the foreign currency borrowings of an entity and the entity’s specific interest rate.
Key highlights:
• According to our analysis of spot rates, three-year and five-year forward exchange rates of RMB/USD from January 2011 to September 2015, the extent of exchange losses which can be capitalised ranges from 0.5% to 3.0% per annum of the borrowings, depending on the date of inception, tenor and USD interest rate of the borrowings.
• Entities need to choose an accounting policy between “discrete annual period approach” and “cumulative approach” for capitalising the exchange losses in the qualifying assets when construction of the qualifying assets takes more than one accounting period.
Executive summary Since mid-August 2015, real estate industry players in Mainland China have been experiencing unprecedentedly significant exchange losses arising from their foreign currency borrowings.
This publication provides insights into the accounting treatment of such exchange losses.
3
Capitalisation of exchange losses of foreign currency borrowings arising from the devaluation of the Renminbi
In briefExchange losses of foreign currency borrowings in entities with RMB as functional currency can be capitalised in the qualifying assets to the extent that they are regarded as an adjustment to interest costs. There are two possible methods in estimating the amount of exchange losses to be capitalised.
When the construction of the qualifying assets takes more than one financial year, the exchange differences can be capitalised by one of the two approaches, namely the discrete annual period approach and the cumulative approach.
In using any method of estimating the exchange differences to be capitalised and either approach of capitalising them, an entity cannot capitalise more than the actual total costs incurred (actual interest costs and exchange differences). It is an accounting policy choice, once selected, it should be applied consistently to all the foreign currency borrowings.
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1 Can exchange losses arising from foreign currency loans be capitalised in the entities with RMB as functional currency?
BackgroundAs part of the Chinese government’s initiative to liberate the RMB, within a short period of three days in August 2015, the RMB was allowed to depreciate by approximately 4.6%. This drastic move is generally seen internationally as an adjustment to align the rate setting mechanics to arrive at a more market-driven approach.
In the past few years, many companies engaged in the real estate industry in Mainland China had issued USD loans in the offshore/overseas markets. As RMB had been appreciating in the past years, exchange gain from the USD loans has been recognised for these companies with RMB as their functional currency.
The sharp devaluation of RMB in August 2015 has given rise to exchange losses for these companies during the current period, and it is expected that exchange losses will also be resulted for the financial year ending 31 December 2015. We aim at dealing with the following questions:
What are the practical ways to estimate the amount of exchange losses to be capitalised for each loan? To what extent can exchange losses be capitalised?
2
3 In an accounting period, what approaches are available for capitalising the exchange losses in the qualifying assets when the construction of the qualifying assets takes more than one accounting period?
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Borrowing costs are defined in IAS 23 as “interest and other costs that an entity incurs in connection with the borrowing of funds”. Exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs are one of the examples of borrowing costs. They are eligible for capitalisation. The gains and losses that are an adjustment to interest costs include the interest rate differential between borrowing costs that would be incurred if the entity borrowed funds in its functional currency, and borrowing costs actually incurred for foreign currency borrowings.
Other differences that are not adjustments to interest cost may include, for example, changes in foreign currency rates as a result of changes in other economic indicators, such as unemployment rate, productivity or government currency regulation.
Can exchange losses arising from foreign currency loans be capitalised in the entities with RMB as functional currency?
It is difficult to determine the role of various factors on exchange rates. In the simplest terms, foreign exchange differences can be considered as an adjustment to interest costs if they narrow the cost differences between borrowings in functional and foreign currencies.
In the past, the exchange gain from foreign currency borrowings together with their lower interest rates would move the borrowing costs of RMB and foreign currency borrowings further apart. Accordingly, such exchange gain cannot be considered as an adjustment to interest costs.
With the devaluation of the RMB, exchange losses arising from foreign currency borrowings compensate for the lower interest rates of the foreign currency borrowings and are likely to represent an adjustment to interest costs (or at least some portion of it). Such exchange losses bring the borrowing costs for borrowings in foreign currencies and functional currency closer. They are therefore eligible for capitalisation in the qualifying assets.
6
What are the practical ways to estimate the amount of exchange losses to be capitalised for each loan? To what extent can exchange losses be capitalised?IAS 23 does not prescribe which method should be used to estimate the amount of foreign exchange differences that can be included in borrowing costs.
The following two methods were considered by the IFRS Interpretations Committee (IFRIC):
(i) based on interest rates on similar borrowings in the entity’s functional currency
(ii) based on forward currency rates at the inception of the loan
Below are the application of these methods with our observation.
(a) Interest rates on similar borrowings in the entity’s functional currency
To apply this method, the borrowings in the entity’s functional currency (in our case, RMB) should be similar to the foreign currency borrowings (e.g. USD bonds) in terms of the size of borrowings, tenor and credit risk of the entity. These similar borrowings in the functional currency are normally considered at the inception of the foreign currency borrowings, i.e. principal of the RMB borrowing is estimated at spot exchange rate at the inception and the related interest is calculated based on interest rates existing at the inception of the USD borrowings. The amount of exchange losses which can be taken as borrowing costs for capitalisation is limited by the difference between the estimated interest amount for RMB borrowings and the actual interest amount incurred for the USD bonds. The amount of exchange losses exceeding the difference should be charged to profit or loss.
7
Example:
Exchange loss which should be charged to profit or loss = RMB10.5 million (i.e. RMB21.9 million – RMB11.4 million)
1 October 2014 - inception of USD bond of USD100 millionSpot exchange rate of RMB/USD = 6.1394USD bond interest rate = 7%
Assume similar RMB borrowing with interest rate at 9%Estimated interest amount for RMB borrowing= USD100 million x 6.1394 x 9% = RMB55.0 million (A)
Assume year end to be 30 September 2015Actual interest incurred for USD bonds in the current reporting period of 2015 = USD100 million x 7% x average exchange rate (6.223) = RMB43.6 million (B)
Estimated amount of exchange loss eligible for capitalisation =Difference (A) – (B) = RMB11.4 million
Exchange loss in the reporting period of 2015 = RMB21.9 million [i.e. USD100 million x 6.3582 (30 September 2015 exchange rate) – USD100 million x 6.1395 (30 September 2014 exchange rate)]
Entities need to collect information of interest conditions they can obtain if they borrow in the functional currency, at the inception of the foreign currency borrowings. Care must be taken to derive the interest rate of comparable RMB borrowings, entities should compare like with like. However, it might be practically difficult or even impractical to identify RMB borrowings which are similar to foreign currency borrowings in major terms at the date of inception of the foreign currency borrowings.
PwC’s observation
8
This method makes use of the market spot and forward exchange rate at the date of inception of the foreign currency borrowings of an entity and the entity’s specific interest rate. It is considered to be more objective and entity specific.
PwC’s observation
(b) Forward currency rates at the inception of the loan
While this is one of the two methods suggested by the IFRIC staff, there is no further elaboration from IFRIC on how to apply it.
Our view is that forward currency rates at the inception of the loan are used to derive the hypothetical interest rates for functional currency borrowings by applying the interest rate parity formula.
where
Fn= forward exchange rates of n years
S = spot exchange rate at the inception of the foreign currency borrowing
Idomestic= hypothetical interest rate of the functional currency borrowing
Iforeign= interest rate of the foreign currency borrowing at inception
n = number of years up to maturity or tenor of borrowing
After deriving the hypothetical interest rate for functional currency borrowing, it can be applied to estimate the amount of exchange loss eligible for capitalisation, like the example on Page 7.
In practice, in most cases, we can readily generate the hypothetical interest rate for RMB borrowings (called the implied CNY yield) from Bloomberg by inputting the USD borrowing interest rate and the tenor of the borrowing.
Fn= S ×(1+Idomestic )
n
(1+Iforeign)n
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Once an entity chooses a method for estimating the amount of adjustment to interest costs, it establishes an accounting policy and should apply the method consistently for all foreign currency borrowings and over different
The above chart shows the differences between spot rates and three-year
the estimated interest rate differentials at the time when there was the highest (September 2012 and March 2015) and lowest differences (April 2014) between spot rates and forward exchange rates, by assuming that USD borrowings at interest rates of 4%, 7% and 11% were incepted in these months. The extent of exchange losses which can be capitalised ranges from 0.5% to 3.0% per annum of the USD borrowings.
However, before November 2011, there was an expectation that RMB would appreciate, as shown by the forward rate curves. For USD borrowings incepted before November 2011, the forward exchange rate would give rise to lower hypothetical interest rate for RMB borrowing than that of USD borrowing. As a result, no adjustment to interest cost should be made and no exchange loss can be capitalised.
01/0
3/20
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/04/
2011
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/06/
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1203
/08/
2012
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5.85.96.06.16.26.36.46.56.66.76.86.97.07.17.27.37.4
Time
RMB/USD RMB/USD Exchange Rates
5 Year Forward RateSource: Bloomberg
3 Year Forward RateDaily Spot
10
In an accounting period, what approaches are available for capitalising the exchange losses in the qualifying assets when the construction of the qualifying assets takes more than one accounting period?After estimating the amount of exchange losses eligible for capitalisation, how should these exchange losses be capitalised in qualifying assets when the construction of the qualifying assets takes more than one accounting period?
In our view, with the lack of guidance in IFRS, management should make an accounting policy choice between “discrete annual period basis” and “cumulative basis over the construction period”, and apply it consistently.
Discrete annual period approach The amount of foreign exchange differences eligible for capitalisation is determined for each annual period and are limited to the difference between the hypothetical interest amount for the functional currency borrowings and the actual interest incurred for foreign currency borrowings. Foreign exchange losses that did not meet the criteria for capitalisation in previous years should not be capitalised in subsequent years.
Cumulative approach The amount of foreign exchange differences eligible for capitalisation is determined on a cumulative basis based on the cumulative amounts of interest expenses that would have been incurred had the entity borrowed in its functional currency. The total amount of foreign exchange differences capitalised cannot exceed the amount of total net foreign exchange losses incurred on a cumulative basis at the end of the reporting period. It views the whole construction project as the unit of account, disregarding the existence of reporting dates. The amount of foreign exchange differences eligible for capitalisation as an adjustment to interest costs in a period is an estimate. This estimate can be changed as the exchange rates vary over the construction period.
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Difference between Discrete annual period and Cumulative approaches in one example:Year end date is 30 September USD loan of USD 10,000,000 of three-year maturity was incepted on 1 October 2012 USD loan interest rate: 5% p.a. RMB hypothetical interest rate based on forward rate method: 7.01% p.a. Exchange rates for various periods are as follows:
USD loan in USD 10,000 10,000 10,000 USD loan translated in RMB using the spot rate at the beginning of each year
62,858 61,230 61,395
USD loan translated in RMB using the spot rate at the end of each year
61,230 61,395 63,582
Exchange loss/(gain) for the year in RMB (X) (1,628) 165 2,187 Cumulative exchange loss/(gain) in RMB (Y) (1,628) (1,463) 724 Effective interest of USD loan in USD 500 500 500 Effective interest of USD loan translated in RMB using the average rate for each year
(A) 3,094 3,074 3,112
Hypothetical interest amount on RMB loan (RMB 62,858,000 x7.01%) in RMB
(B) 4,406 4,406 4,406
Difference between actual and hypothetical interests for each year in RMB
(C) = (B)-(A)
1,312 1,332 1,294
Cumulative difference between actual and hypothetical interests in RMB
(Z) 1,312 2,644 3,938
Discrete annual period approach Exchange loss eligible for capitalisation (RMB) Lower of
(X) and (C)Nil
(due to gain) 165 1,294
Exchange loss/(gain) recognised in profit or loss (RMB) (1,628) Nil 893 Cumulative approach Exchange loss eligible for capitalisation (RMB) Lower of
(Y) and (Z)Nil
(due to gain) Nil (due to cumulative
net gain)
724 Note (*)
Exchange loss/(gain) recognised in profit or loss (RMB) (1,628) 165 1,463
Application challenges
Year ended 30 September 2013 2014 2015‘000 ‘000 ‘000
1 October 2012: 1 USD: RMB 6.2858; three-year forward rate: 6.653
30 September 2013: 1 USD: RMB 6.123; average rate in 2013: 6.188
30 September 2014: 1 USD: RMB 6.139; average rate in 2014: 6.147
30 September 2015: 1 USD: RMB 6.358; average rate in 2015: 6.223
Notwithstanding the above mentioned consideration, the capitalisation of exchange losses should be consistent with the concept of capitalisation of interest costs, in terms of the commencement and cessation of capitalisation.
Entities need to choose the accounting policy to estimate the adjustments to interest costs and the approach of capitalisation. Once selected, the accounting policy is to be applied to all the foreign currency borrowings.
References: The basic concept of foreign exchange differences is discussed in our other publication “In depth – IAS 23 Capitalisation of borrowing costs” INT2015-09 IAS 23 - Capitalisation of borrowing costs
Note (*) - limited to cumulative net exchange loss and not exceeding cumulative difference between actual and hypothetical interests in RMB (Z)
PwC contactsOur real estate specialists
China – North & CentralJim Chen, Industry Leader+86 (10) 6533 2067 [email protected]
Jacky Wong, Partner+852 2289 [email protected]
Kenny Yeung, Partner+852 2289 [email protected]
Ming Tse, Partner +852 2289 [email protected]
Rachel Tsang, Partner +852 2289 [email protected]
Raphael Chu, Partner+852 2289 [email protected]
Richard Sun, Partner+852 2289 [email protected]
Hong KongCathy Ng, Partner+852 2289 [email protected]
Cherry Chan, Partner+852 2289 [email protected]
Clarry Chan, Partner+852 2289 [email protected]
Damien Chow, Partner+852 2289 [email protected]
Davis Cho, Partner+852 2289 [email protected]
Dilys Cheng, Partner+852 2289 [email protected]
Hong Kong & China – SouthAlan Ho, Industry Leader+852 2289 [email protected]
China – South Albert Cheung, Partner +86 (755) 8261 [email protected]
Ivan Ho, Partner +86 (20) 3819 [email protected]
Jeremy Chen, Partner +86 (755) 8261 [email protected]
Kevin Lin, Partner +86 (20) 3819 [email protected]
Michael Lam, Partner +86 (755) 8261 [email protected]
Shirley Yeung, Partner +86 (20) 3819 [email protected]
Tommy Cheung, Partner +86 (755) 8261 [email protected]
Wintan Tang, Partner +86 (20) 3819 [email protected]
Y T Chen, Partner +86 (20) 3819 [email protected]
China – CentralArthur Kwok, Partner +86 (21) 2323 [email protected]
Kathleen Chen, Partner +86 (21) 2323 [email protected]
Sally Sun, Partner +86 (21) 2323 [email protected]
China – NorthNick Xu, Partner +86 (10) 6533 [email protected]
Rock Liu, Partner +86 (10) 6533 [email protected]
Wilson Liu, Partner +86 (10) 6533 [email protected]
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