The current economic climate, impending maturity of existing debt and the persistent volatility in capital markets have prompted several companies to consider refinancing their existing borrowings.

The Reserve Bank of India’s recent liberalisation measures for capital account transactions permit manufacturing or infrastructure companies to borrow in foreign currency (through external commercial borrowings or ECBs) to repay outstanding rupee loans taken to fund capital expenditure. This may further prompt companies to refinance their rupee borrowings and benefit from lower interest rates on foreign currency borrowings.

While companies may perceive obvious benefits such as lower interest costs, the other accounting implications merit consideration too. Refinancing is usually in the form of repayment of an existing loan and recognition of a new borrowing in the company’s financial statements. When a company has previously deferred the recognition of transaction costs (such as legal fees, underwriting costs and so on) over the life of the existing loan, refinancing will result in immediate recognition of such deferred costs in the profit or loss account. Further, any penalties arising from refinancing the existing loan before its maturity will also result in additional cost for the company.

Refinancing rupee loans by borrowing in a foreign currency may be more attractive in terms of lower interest rates. However, borrowers are also exposed to volatility arising from changes in foreign exchange rates; this is especially relevant in the context of the falling rupee in recent times. If the foreign currency loan is repaid from the company’s foreign exchange earnings, this volatility may be offset in an economic sense. However, the company will still have to account for foreign exchange gains or losses on the outstanding loan, while it cannot recognise the notional gain or loss from the expected sales in foreign currency. This can result in a one-sided impact on the company’s profits.

Recently, the Ministry of Corporate Affairs allowed companies to capitalise and defer the recognition of foreign exchange gains or losses on long-term loans (maturity above 12 months), even if such a loan relates to a capital asset acquired in the past. This will benefit companies that refinance rupee loans by borrowing in foreign currency. Previously, the company would have recognised a higher interest cost on its rupee borrowing and would not have been permitted to capitalise this to the cost of its asset once the asset was ready for use. Hence, the entire interest cost would have been taken to the profit or loss account. On refinancing, the company will recognise a lower interest cost on the foreign currency loan and will also be able to capitalise all foreign exchange fluctuations by including them in the cost of the asset acquired. This may result in a significant improvement in the company’s reported profits.

Equally worth considering is the cost associated with hedging the foreign currency and interest rate risks (generally, ECBs carry a floating rate of interest linked to an international benchmark such as LIBOR) on a foreign currency loan. In addition to the economic cost of entering into hedging derivatives, companies should also consider the impact on accounting profits.

While the company may be able to defer the foreign currency gains or losses on its loan by including them in the cost of its asset, the mark to market gains or losses on the hedging derivatives may not be eligible for the same exemption.

Capitalisation of exchange differences on vanilla derivatives such as long-term forward exchange contracts is permitted under the same MCA amendment. However, more complex derivatives such as cross-currency swaps may not be eligible for the same accounting treatment. Hence, these may have a significant impact on the company’s accounting profits.

(V.Venkatraman is Partner Advisory Services, KPMG)

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