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Accounting for forward contracts under the new GAAP

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  • Publish date: 26 June 2015
  • Archived on: 26 June 2016

The Financial Reporting Faculty’s Marianne Mau highlights important changes to the way we account for forward contracts under the new UK GAAP.

As has been discussed in recent articles on FRS 102, it isn’t safe to assume that smaller businesses will be unaffected by the more complex accounting requirements for financial instruments on the basis that their financing arrangements are usually straightforward. Among small businesses, the use of forward contracts, particularly foreign currency forward contracts, is a reasonably common-place method of managing risk.

Managing risks using forward contracts

Any business buying or selling goods in a foreign currency may well want to manage the risk of foreign currency fluctuations, and to mitigate the impact of those fluctuations on the cash flows and reported earnings of the entity. This can be achieved by entering into an arrangement to buy or sell the foreign currency at an agreed future rate, matching the date that the foreign currency is expected to be paid out or received.

These arrangements would usually be made with the bank, and each contract may be linked to a specific transaction, but equally there could be a number of contracts to cover a pool of transactions.

Accounting under SSAP 20

For those companies applying UK GAAP and not previously adopting FRS 23 The Effects of Changes in Foreign Exchange Rates (ie, the vast majority of UK companies), SSAP 20 Foreign currency translation provided the option of translating a transaction at the rate ruling at the date the transaction occurred or at a matching forward contract rate. If the forward rate is used, no exchange gains or losses are recognised in the accounts when recording the sale and eventual settlement.

The majority of entities take this approach when forward contracts are used.

Illustrative example under SSAP 20

Brit Ltd has a 30 June year end. On 1 June 2015, Brit Ltd sells goods to ASU Inc for $100,000 on three months credit ie, for settlement on 1 September 2015. On 1 June 2015 Brit Ltd also enters into a forward contract to sell $100,000 on 1 September 2015 at a forward rate of £1:$1.62.

ASU Inc paid Brit Ltd on 1 September in full.

The £ to $ exchange rates are as follows:

 Date   Spot rate  Forward rate 
 1 June 2015  1.60  1.62
 30 June 2015  1.57  1.59
 1 September 2015  1.55  –

Assuming that Brit Ltd applies the forward rate to the transaction, the accounting entries would be as below.

As at 1 June 2015, the date of the transaction:

  DR   CR
   £  £


Debtors 
 61,728  
Sales

   61,728
To record the sale of $100,000 at the forward rate of £1:$1.62     

At 30 June 2015, the balance sheet date, no translation of the debtor is required as the forward rate has been used.



As at 1 September 2015, the date of settlement:

  DR CR
   £  £
Cash   61,728  
Debtors    61,728
To record the receipt of $100,000 at the forward rate of £1:$1.62    

No exchange differences arise as the sale of the goods in a foreign currency and the forward contract are effectively treated as one transaction. The rate of £1:$1.62 is used throughout.

Accounting treatment under FRS 102

FRS 102 takes a somewhat different approach, treating the sale and the forward contract as two separate transactions.

Section 30 Foreign Currency Translation requires foreign currency transactions (eg, the buying or selling of goods and services in a foreign currency) to be recorded at the spot rate at the date of the transaction, and monetary items to be translated using the closing rate at the balance sheet date. There is no option to use a forward rate. Any exchange differences arising at the balance sheet date or on settlement are recognised in profit or loss.

Forward currency contracts will fall into the ‘other financial instruments’ classification in FRS 102 and will therefore be accounted for in accordance with Section 12 Other Financial Instruments Issues. Section 12 requires that the derivative contract be recognised at fair value on initial recognition (which will usually be zero for forward currency contracts), and again at the balance sheet date. Any changes in fair value are generally recognised in profit or loss. When foreign currency contracts are part of a qualifying hedging arrangement they may be accounted for in accordance with the hedge accounting rules (see below).

Illustrative example FRS 102

Using the same information as above, the accounting entries would be as below.

As at 1 June 2015, the date of the transaction:

  DR  CR
   £  £
Debtors   62,500

 
Sales    62,500

To record the sale of $100,000 at the spot rate of £1:$1.60    


DR  CR  £ £

Debtors  61,728 Sales 

  61,728    To record the sale of $100,000 at the forward rate of £1:$1.62  

There will be no accounting entries for the forward foreign currency contract as its fair value is zero.

As at 30 June 2015, the balance sheet date:

   DR CR
   £

 £

Debtors   1,194  
Exchange gain (P&L)   1,194 
To retranslate the debtor of $100,000 at the year-end spot rate of £1:$1.57    
     
Loss on derivative (P&L) 

1,165   
Derivative liability

   1,165
To value the derivative at the year-end fair value (the difference between the agreed forward rate and the forward rate at the balance sheet date for a contract maturing on 1 September 2015)

   

The impact of the exchange rates on the value of the debtor and the derivative almost cancel each other out, recognising the effectiveness of the hedge. The difference between the gain on the debtor on the one hand and the loss on the derivative on the other is attributable to the spot rate being used for debtor and the forward rate for the derivative.

As at 1 September 2015, the date of settlement:

  DR  CR
   £  £
Debtors   822  
Exchange gain (P&L)    822
To retranslate the debtor of $100,000 at the spot rate on settlement £1:$1.55

   
     
Loss on derivative (P&L)

 1,623  
Derivative liability

   1,623
To value the derivative to fair value at settlement date (the difference between the forward rate at the previous balance sheet date and the spot rate on 1 September 2015)

   
     
Cash   61,728

 


Derivative liability

 2,788  
Debtors

  64,516 
To record the settlement of the debtor and the derivative contract

   

Although it may be difficult to see at first glance, the overall impact on the P&L account over the life of the transaction is the same. However, there may be differences year on year. This can be summarised as follows:

  SSAP

£ 
FRS 102

£


1 June 2015

Sales 
 61,728  62,500
30 June 2015

Exchange gain on debtor

Exchange loss on derivative



 –

 –
 

 1,194

 (1,165)

1 September 2015

Exchange gain on debtor

Exchange loss on derivative

 –

 –
 822

 (1,623) 
Total  61,728  61,728

Hedge accounting

When forward currency contracts are entered into to cover cash flows on foreign currency sales or purchases that have already occurred (as in the illustrative examples above), there is no need to apply the special hedge accounting rules available in FRS 102. This is because the differences arising on the hedged item (in this case the debtor) and the hedging instrument (in this case the forward currency contract) are both recognised in profit or loss. Where forward contracts are used to cover future highly probable foreign currency sales or purchases, then hedge accounting may be appropriate. 

As these contracts are less common for small businesses, these are not considered further in this article.

Marianne Mau FCA is a Technical Manager in the Financial Reporting Faculty

Find out more about the new UK GAAP by visiting icaew.com/newukgaap

Follow the faculty on Twitter @ICAEW_FRF

July 2015