CFM57100 - Derivative contracts: hedging: Regulation 7: first example
Currency contract hedging a forecast transaction
On 4 January 20X0 a manufacturer receives an order for widgets from a US customer. As a result of the order, it is highly probable that the company will receive US$100,000 on 1 December 20X0. The company hedges the foreign exchange risk by entering into a forward currency contract to sell US$100,000 for £60,000 on 1 December.
On 1 December 20X0, the transaction happens as forecast. The £/US$ spot rate at 1 December is such that US$100,000 is worth £70,000. The company therefore receives the equivalent of £70,000 (US$100,000 at spot rate) but has to pay £10,000 cash to settle the forward contract.
Accounting
The company accounts for a cash flow hedge of exchange rate risk, with the forecast transaction (the anticipated sale) as the hedged item and the currency contract as the hedging instrument.
The forward currency contract is at-the-money when entered into, and so has a fair value of nil.
The company draws up a balance sheet at 30 June 20X0. At 30 June 20X0, the contract represents an asset with fair value of £2,000.
The forecast transaction is not recognised on the balance sheet. As the contract is designated as a cash flow hedge, fair value changes in the contract are taken to reserves (for example, the Statement of Total Recognised Gains and Losses if the company uses FRS 26, Statement of Changes in Equity or Statement of Recognised Income and Expense if it uses IAS). Thus at 30 June 20X0, a profit of £2,000 is credited to reserves.
Between 1 July and 1 December 20X0, the fair value of the contract decreases by £12,000. At 1 December, a loss of £12,000 is debited to reserves, so that the cumulative amount standing there is a loss of £10,000. This reflects the fact that as a result of the hedge the company will receive £10,000 less for the currency than its spot value.
The journal entries on 1 December 20X0 are:
|
1) |
Dr |
Forward contract |
£10,000 |
|
|
Cr |
Cash |
£10,000 |
Representing the payment of £10,000 cash to settle the forward contract.
|
2) |
Dr |
Cash |
£70,000 |
|
|
Cr |
Sales |
£70,000 |
To reflect the receipt of the sales proceeds, translated at spot rates.
|
3) |
Dr |
Sales |
£10,000 |
|
|
Cr |
Reserves |
£10,000 |
Representing the ‘recycling’ of accumulated fair value changes to profit and loss.
Tax consequences under Disregard Regulations
Regulation 7 applies because:
- there is a hedging relationship between the derivative contract and the forecast transaction;
- the hedged item is not one to which fair value accounting applies, so fair value changes cannot be taken into account for CT purposes.
The result is that the credit of £2,000 in the y/e 30 June 20X0 and the debit of £12,000 at 31 December 20X0 are both excluded from tax.
The amounts would not be disregarded if the company had elected out of Regulations 7 and 8, under Regulation 6(3). In that case all fair value profits and losses would be taxable. If, however, the company had elected under Regulation 6(3A) for Regulation 9A to apply, the credits and debits to equity would be disregarded.
Recycling
The termination of the contract on 1 December 20X0 is a termination event within Regulation 10(2), with the result that the loss of £10,000 on the derivative contract initially disregarded is then brought back into account. The company will bring in £70,000 (the sale price of the widgets, translated at the spot rate) as a trading receipt.
Since the £10,000 debit brought into account under Regulation 10 is a trading debit, treated as a trading expense under CTA09/S573(3), the overall result will be as if the widgets had been sold for £60,000. Thus in practice the tax treatment of the overall transaction is the same as it was under ‘old UK GAAP’.
