Accounting for corporate finance: derivative contracts: speculative instruments
Under UK GAAP prior to the introduction of FRS 25 and FRS 26, one would generally mark-to-market instruments such as futures. However, under the traditional realisation principle profit should not be recognised in the profit and loss account until the contract matures or is closed out. Thus, any gain - unless forming part of a financial business as discussed in CFM24100 - should be deferred. Losses, conversely, should be recognised in the profit and loss account immediately.
This deferral methodology is the application of the historic cost accounting model. In practice, the financial instrument is recorded at cost and written down to zero if necessary (or a liability recognised if a loss, on a future, for example, has been incurred). The same principle applies equally for swaps.
The position with forward currency contracts is slightly more complicated. To illustrate this with an example, assume a company enters into a 3-month forward contract on 30 November 2001 to buy €100,000 on 28 February 2002 in the hope of making a profit; it has no monetary liability in euros, nor is it contemplating entering into any transactions denominated in euros. Assume the spot rate at that date was £1 = €1.55 and the contracted rate is £1 = €1.54. The company makes its accounts up to 31 December when the spot rate has moved to £1 = €1.60. Also assume, for the purpose of this example, the contract rate for a 2 month forward is £1 = €1.58.
The company could record an exchange loss of £2,016, being £62,500 (€100,000 at year end spot rate €1.60, being the rate at which the contract could theoretically be closed out) less £64,516 (€100,000 at opening spot rate €1.55), together with the £419 premium, a total of £2,435. (Unlike in the hedging situation considered above, it would be inappropriate to carry forward £279 of this premium for expensing in the following accounting period.) Thus, the loss is calculated by reference to ‘realisable value’.
In reality, the contract cannot be closed out because the currency would have to be held until the forward matures 2 months later. The method, therefore, recommended to overcome this situation is to use the forward rate at the balance sheet date, i.e. effectively to take out an equal and opposite forward to sell €100,000 on 28 February 2002. Thus, the loss becomes £1,644, being £63,291 (€100,000 at year-end forward rate €1.58 to sell) less £64,935 (€100,000 at contract forward rate €1.54 to buy).
Had the spot rate moved to £1 = €1.50 at 31 December 2001 and, assuming the forward rate at that date were £1 = €1.49, the position would become: a profit of £2,179, being £67,114 (€100,000 at €1.49) less £64,935 (€100,000 at €1.54). However, following the realisation principle set out above, this should be deferred. In practice, no entries would be recognised in the financial statements. Instead, a suitable note to the accounts would be made explaining the financial commitment the company had entered into (in accordance with a Companies Act 1985 disclosure requirement).