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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Accounting for corporate finance: foreign exchange: consolidated accounts: developments in accounting standards

Background to the changes

Since accounting periods beginning on or after 1 January 2005, the consolidated accounts of listed companies have been prepared in accordance with International Financial Reporting Standards (IFRS). This follows a European Union regulation approved in June 2002.

The International Accounting Standard (IAS) dealing with ‘The effects of changes in foreign exchange rates’ is IAS 21. (IASs and IFRSs are the same thing - the designation has now been changed to IFRS).

IAS 21 was revised by the International Accounting Standards Board (IASB) in December 2003. One of the changes made by the was to move the provisions that dealt with hedging net investments in foreign operations into a revised IAS 39, also released in December 2003. Further details on IAS 39 ‘Financial Instruments: recognition and measurement’ and its UK equivalent may be found in CFM21000 onwards.

IAS 21 has been incorporated into UK GAAP by FRS 23, issued in December 2004 by the Accounting Standards Board (ASB). IAS 39 has been incorporated into UK GAAP by FRS 26 issued on the same date. FRS 23 is only to be adopted if FRS 26 is also adopted otherwise SSAP 20 remains in force. There is no IAS equivalent of SSAP 20; IAS 21 is the only IAS on foreign exchange.

Adoption of FRS 26, and therefore FRS 23, is mandatory for large (non-FRSSE) UK companies which use fair value accounting in their individual finance statements. Adoption for other UK companies is optional. If you have queries in respect of foreign exchange issues, you should clarify which accounting standard has been adopted.

Although the requirements of SSAP 20 and FRS 23/ IAS 21 are substantially the same, there are a number of differences in the detail. These are summarised at CFM26320, and also noted where appropriate in the more detailed guidance earlier in this chapter.

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Cash flow hedging under FRS 26/ IAS 39

Forward exchange contracts might be taken out to hedge the foreign exchange risk in respect of a committed future transaction, for example a purchase of stock expected to take place at some time in the future. Under SSAP 20, the effect of these contracts was only recognised when they crystallised, for example by recognising the purchase of the stock at the contracted rate.

However, FRS 26/ IAS 39 requires all derivative contracts to be accounted for at fair value, including forward exchange contracts. To recognise the gains and losses on a forward contract such as that described above in profit and loss in the period before the future transaction takes place, would result in an accounting mis-match, as no matching gains or losses can be recognised in respect of the purchased item until the purchase itself occurs.

To address this mis-match, FRS 26/ IAS 39 allows the effective portion of the gain or loss on the hedging derivative to be taken to reserves until such time as the forecast transaction takes place. This is known as cash-flow hedging. When the transaction does take place, the gains or losses are transferred from reserves and into profit and loss in the period in which the asset acquired or liability assumed affects profit or loss. If a non-financial asset or liability is acquired, the company may transfer the gains or losses from reserves and allocate them to the carrying value of the acquired asset or liability.

To illustrate this latter point, imagine that a company hedges the foreign exchange risk relating to an expected dollar purchase of stock from a US supplier in six months time. It takes out a forward contract to fix the amount it will pay in sterling terms on completion. The forward is considered to be a fully effective hedge of the underlying risk. In the six month period prior to payment, gains and losses on the forward contract are taken to reserves. On purchase of the stock, the gains and losses are transferred from reserves and incorporated into the book value of the stock. This is effectively the same as recognising the stock at the rate inherent in the forward contract. When the stock is sold, its cost, incorporating the gains and losses on the forward contract, is expensed to the profit and loss account, meeting the matching requirements of FRS 26/ IAS 39.

If a forecast transaction is no longer expected to occur, cumulative gains or losses on any hedging item are immediately transferred from reserves to profit and loss account.

Cash-flow hedging is a highly complex area, and if you have concerns, you should consult your local compliance accountant for guidance.