New extracts from the ESMA database of IFRS decisions
In May 2022, the European Securities and Markets Authority (ESMA) published further extracts from its confidential database of enforcement decisions taken by European national enforcers.
In mid-February, just when most companies are in the process of preparing their financial statements, the Supreme Administrative Court came to a conclusion in an accounting and tax dispute regarding the translation of foreign currency prepayments.
In its verdict of 14 February 2022, ref. no. 4 Afs 170/2021 – 35, the Supreme Administrative Court quotes not only the main principles of financial reporting pursuant to the Accounting Act, but also the Interpretation of the National Accounting Board I-43 Prepayments made in foreign currency, adopted in October 2020, and accepts, not for the first time, the interpretations of the National Accounting Board as a valuable source completing the accounting legislation.
What was the issue?
The gist of the dispute was the obligation of the taxpayer to translate foreign currency prepayments with the foreign exchange rate promulgated by the Czech National Bank at the balance sheet date. These particularly included the prepayments for the acquisition of fixed assets, which the taxpayer decided not to translate, since the taxpayer did not suppose they could be returned at any point in the future. During the tax audit, the tax administrator assessed such procedure as incorrect and made an additional assessment of foreign exchange rate gains and the related tax to the taxpayer. Pursuant to the tax administrator, the prepayments must be considered as receivables and the arising foreign exchange rate gains/losses need to be recorded as revenue/cost. The appeal made at the Appellate Finance Directorate was rejected and the taxpayer thus decided to defend themselves at the District Court in Ústí nad Labem.
The District Court made a decision regarding the dispute in favour of the taxpayer and returned the issue to the tax administrator for further assessment. It came to a conclusion that the prepayments made for the acquisition of fixed assets do not represent receivables, since they do not directly comprise the right to require financial performance. Pursuant to the Court, such prepayments are rather of the nature of a partial settlement of debt arising from a purchase contract and thus do not represent assets and liabilities that are subject to revaluation obligation at the balance sheet date. Moreover, pursuant to the District Court, the revaluation of these prepayments is in conflict with the true and fair presentation of the subject matter of accounting, since it represents amounts already paid, which are not going to be returned by the taxpayer without the existence of other matters, and the taxpayer thus does not carry any foreign exchange rate risks.
The tax administrator filed a cassation appeal against this verdict and the case thus came to the Supreme Administrative Court. The Supreme Administrative Court was predominantly concerned with the question of whether the prepayments for the acquisition of assets in a foreign currency represent receivables and are thus subject to obligatory revaluation, or whether they represent a part of fixed assets and should not be revalued for accounting purposes. Since the question of foreign currency prepayments is not dealt with in the current legislation, the Court decided to build its argumentation around the accounting maintenance principle, i.e. the true and fair view.
In this context, the Supreme Administrative Court considers the revaluation of certain assets and liabilities using the current exchange rate as capturing the foreign exchange risk arising from future cash flows and supports its view with a quote of Interpretation I-43 Prepayments made in foreign currency. Pursuant to it, the assets and liabilities, which do not express the cash flow anticipated in the future (e.g. land and buildings, supplies, future costs and revenues, or current prepayments made, which will not be returned in the future) do not represent any foreign exchange rate risk for the company, and should therefore not be revalued using the exchange rate as of the balance sheet date.
Based on these arguments, the Supreme Administrative Court identified with the decision of the District Court, stating that prepayments made for the purpose of acquisition of fixed assets in a foreign currency do not require revaluation. On the contrary, in order to give a true and fair view, it is necessary that these prepayments are not revalued. An exception would be a situation where it is probable with regard to particular circumstances that the prepayment will be returned. In order to assess such probability, the Supreme Administrative Court quotes Interpretation I-43, which includes e.g. delays in supply, dispute with the supplier or information provided by the supplier stating that no performance will be made, as examples to indicate the return of the prepayment. In such case, the prepayment represents a foreign currency receivable and should be revalued using the exchange rate promulgated as of the balance sheet date.
What are the impacts of the decision on future financial statements?
The positive news is that a certain degree of light has finally been cast on the foreign exchange prepayments that have previously not been regulated by the legislation. Moreover, Interpretation I-43 representing the current best practice is no longer based only on the professional opinion of the National Accounting Board, but also on the relatively decisive judicature of the Supreme Administrative Court. The solution using the interpretation is also compatible with the solution using IFRS, which concerns many reporting entities, having e.g. a foreign owner, which prepare the reporting package for consolidation pursuant to IFRS.
Interpretation I-43 thus imposes on reporting entities the obligation to assess whether their reported foreign exchange prepayments represent cash flows expected in the future, i.e. whether there is a probability of their return. If the return of the prepayment is probable and represents a foreign exchange rate risk, it has to be translated using the foreign exchange rate promulgated by the Czech National Bank as of the balance sheet date. Otherwise, the prepayment does not represent any foreign exchange rate risk and its revaluation would breach the principle of the true and fair view of the accounting. The example of returnable prepayments, which may result in the necessity of revaluation, are security deposits in a foreign currency – e.g. for rental, if these are returnable at the end of the rental relationship – not in situations where they can be included e.g. in the last rental payment.
In any case, detailed documentation has to be maintained regarding such consideration, since the reporting entities will have to prove the correctness of (not) accounting for foreign exchange rate differences to the tax administrator as part of the tax audit.
At the same time, we would like to inform you that in February 2022, the National Accounting Board adopted Interpretation I-47 Accepted prepayments in foreign currency. The solution under this interpretation is analogical to the solution under Interpretation I-43.