CFM84050 - Old rules: derivative contracts: basic rules pre FA 2004: accruals basis examples

Examples of accruals accounting

This guidance applies to periods of account beginning before 1 January 2005

Forward contract

Airgrant Ltd supplies supermarkets with cocoa. It has renewed its contract with a supermarket chain agreeing to supply cocoa for the next 24 months at an agreed price equivalent to £1,200 per tonne. In order to lock in its profit it enters into forward contracts to purchase cocoa at £1,000 per tonne for the next 12 months and £1,100 per tonne for the 12 months after that.

For accounting purposes the treatment of these contracts is to record them in the same way as any other commodity contracts. Accordingly nothing is recognised in the accounts until the commodity purchase takes place, with the purchase price then being recognised in cost of sales at the contract rate.

This accounting method is an authorised accruals method for the purposes of the legislation.

On rare occasions, forward physical contracts may move out of the money sufficiently to become onerous contracts. For instance, if in the example above the supermarket chain had agreed to buy at a price linked to the market price prevailing at the supply date, then the forward contracts could become onerous if cocoa prices dropped significantly. In such a case, a contract loss provision will be made in the accounts of the company under FRS12 to reflect expected losses.

Option

As an alternative to using futures Airgrant Ltd may hedge its position by purchasing call options on cocoa futures. If prices rise above the strike price Airgrant will exercise the option, while if they drop it will allow it to lapse. The company is thus protected against any increase in cocoa prices but will still benefit from any drop in prices. If a premium equivalent to £10 per tonne had been paid this would be spread over the life of the option. On exercise the strike price would again be reflected as the cost of the commodity. Note that no loss could arise on the option (apart from the lost premium) because if onerous it will not be exercised.