CFM57100 - Derivative contracts: hedging: regulation 7: first example

This guidance applies to periods of account starting on or after 1 January 2015 where the company has elected for regulation 7 to apply.

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 forward is designated as a cash flow hedge, fair value changes in the forward are taken to reserves (for example, as an item of Other Comprehensive Income (OCI) if it uses IAS or New UK GAAP). 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 forward 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 (OCI) - £10,000

Representing the ‘recycling’ of accumulated fair value changes to profit and loss.

Tax consequences under Disregard Regulations

Where a company has elected for regulation 7 to apply, this election will have effect as:

• 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.

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 (where FRS 26 had not been adopted).