CFM12065 - Accounting for derivative contracts

Foreign exchange risk

The principal methods of hedging currency risks are:

• forward contracts
• swaps
• options.

SSAP20 touches on forward contracts, but not on the other methods. However, the standards that will result from FRED30 will cover all methods of hedging currency risk. As with many other aspects of derivatives, if you are in any doubt you should contact your local Revenue accountant.

Forward contracts

Forward contracts (forwards) may be used to hedge future commitments (or forecast transactions) relating to:

• the purchase or sale of foreign currency
• existing foreign currency assets and liabilities
• investments in foreign operations
• the results of a foreign operation.

There are two ways of accounting for the forward contract. For example, assume the purchase of an asset.

1. The asset and the liability are both recorded at the contracted rate. This method is permitted by SSAP20, but will not be allowed once FRED24 becomes a standard.
   
2. The forward is treated as a separate transaction from the purchase of the asset. This method is mandatory under US GAAP, for example, and will become so in the UK once FRED24 becomes a standard.

See CFM11070+ for more detail on forwards and how they work.

Swaps

Though SSAP20 does not refer to these, the US equivalent standard does and says that '... agreements that are, in substance, essentially the same as forward contracts, for example, currency swaps, shall be accounted for in a manner similar to accounting for forward contracts'. This means that there are again (as with forwards) two methods of accounting for swaps.

Assume a swap is used to hedge a foreign currency loan payable.

1. Under method one the liability is recorded at the contracted rate. (Most companies which use currency swaps do so to hedge their foreign currency borrowings and so translate those borrowings at the swap rate.)
   
2. In the second method (i.e. that sanctioned by US GAAP, and due to become the standard in the UK once FRED24 is implemented) the swap is considered to be a separate foreign currency transaction which gives rise to exchange gains and losses which are taken to the profit and loss account. In a perfect hedge position, these will offset exactly the losses or gains arising on the loan. The premium should be amortised evenly over the swap life.

See CFM11090+ for more detail on swaps and how they work.

Options

Again, SSAP20 makes no reference to options. As their nature is different from forwards and swaps (as it is not known whether or not an option will be exercised), it is not practical to use the exercise rate (or strike price) to translate the hedged item. This means that options have to be dealt with separately.

If the company is unlikely to exercise the option, it will simply be written off. To the extent a loss is less than the premium paid, then the premium would only be written off to the extent of that loss.

If the option is in the money, the relevant asset or liability is translated at the closing rate and the option is accounted for in one of two ways:

1. The option is revalued to the current premium for the currency option at that strike price. This is known as 'marking to market', and is the gain the company can make by closing out the option.
   
2. The currency option amount is translated at the current rate and is compared with the strike price under the option. The overall gain/loss is this amount less the cost of the option.

See CFM11080+ for more detail on options and how they work.

Examples of these three methods of hedging foreign exchange risk are provided at CFM12065a.