CFM12065a - Accounting for derivative contracts

Foreign exchange risk - example

This guidance describes the post-FA 2002 taxation of loan relationships, derivative contracts and FOREX.

Forward contract

On 30 November 2001 a UK company contracts with a German manufacturer to purchase an item of plant and machinery for €100,000 for delivery on 31 January 2002, with the invoice due for payment on 28 February 2002. The company’s accounting date is 31 December.

To hedge against exchange-rate movements, the company takes out a 3-month forward contract on 30 November 2001 to buy €100,000. The spot rate at 30 November 2001 is £1 = €1.55 and the premium is €0.01, giving a contracted rate of £1 = €1.54. Other spot rates are:

There are two ways of accounting for the forward contract.

1. The asset and the liability are both recorded at the contracted rate.
2. The forward is treated as a separate transaction from the purchase of the asset.

Method 1

The contracted rate of €1.54 applies, which means that both the asset and the liability will be recorded at £64,935. No exchange differences arising from the forward will be reported in either 2001’s or 2002’s profit and loss account, nor any exchange difference in 2002 in relation to the liability.

Method 2

In the second method, which is mandatory under US GAAP and will become so in the UK when FRED24 becomes a standard, the forward is treated as a separate transaction from the purchase of the asset.

• The asset and the liability are initially recorded at the spot rate ruling on 31 January 2002, the date of delivery (€100,000 at €1.52 = £65,789).
• The 2002 profit and loss account will report an exchange loss due to the supplier of £436, being the amount paid on the settlement of the forward on 28 February 2002 (€100,000 at €1.51 = £66,225) less £65,789 (the sum at which the liability was originally recorded).

Under hedge accounting, the exchange difference on the forward up to the transaction date (i.e. 31 January 2002) is not recognised in the financial statements, but rather is deferred and then matched with the asset. Thereafter, the difference (again) is recognised in profit and loss to match the related loss of £436 (see bullet 2 above).

The exchange gain on the forward consist of two elements:

• up to 31 December 2001: £843 (€100,000 at €1.53 = £65,359) less (€100,000 at €1.55 = £64,516)
• 31 December 2001 to 31 January 2002: £430 (€100,000 at €1.52 = £65,789 less £65,359).

This total of £1,273 is deducted from the figure at which the asset is initially listed in the balance sheet (£65,789). The resulting £64,516 is the €100,000 at €1.55 (the spot rate on 30 November 2001, when the forward was entered into).

Finally, the premium on the forward (i.e. the difference between the contract rate and the spot rate ruling on the date the contract was taken out) must be dealt with.

This is equivalent to interest expense and should be amortised evenly over the contract period:

• £140 (one-third) should be expensed in 2001
• £279 (two-thirds) should be expensed in 2002.

The detailed profit and loss accounts and the balance sheets under the second method are set out below.

The net effect is to record the asset at the spot rate ruling at the date the forward was taken out and to charge the premium to profit and loss.

The principles embodied in this example generally apply, whether the forward contract is entered into for hedging purchases or sales of currency, or for other reasons listed at CFM12565.

Swaps

Method 1

Referring to the example at CFM11232a, the $100m loan receivable would be translated at the contracted rate of £1 = $1.60 ie at £62.50m. (The resulting profit of £0.06m, being $100m at $1.6015 (spot) = £62.44m less £62.50m, is taken either directly to profit and loss account, or, as it represents the premium, may be amortised evenly over the contract period of 5 years).

Method 2

The swap is treated as a separate transaction from the hedged item. Thus, in the example at CFM11232a, the loan receivable of £100m would continue to be translated at the closing rate and exchange differences taken to profit and loss account. 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, as in the example, these will offset exactly the losses or gains arising on the loan. The premium should be amortised evenly over the swap life.

Options

Referring to the example at CFM11231a, the maximum amount the company can lose is the cost of the premium – £63,000. So, initially this is recorded as an asset. Under scenario 2, where sterling depreciates, the option is unlikely to be exercised (as the company receives more income in sterling from the sale of its business) and the option is simply written off. However, under scenario 1, where the option is in the money the two ways of accounting for the option are:

• revalue it to the current premium for the currency option at that strike price (‘marking to market’). Assuming this were to be, say, £200,000, a gain of £137,000 would arise
• the currency option amount is translated at the current rate and is compared with the strike price under the option, i.e. in the example, at A$2.8191, £4,256,677 and at A$2.6985, £4,446,915, respectively; a gain of £190,238, against which the cost of the option of £63,000 is set. Thus, a net gain of £127,237.

Both gains, and the loss on the related A$ receivables are reported in the profit and loss account and are set against each other.

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