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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Derivative contracts: hedging: regulation 7: no designated hedge

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

Contract not accounted for as a hedge

Assume that the facts are as at CFM57100, in particular that the currency contract was intended to act as a cash flow hedge of the highly probable forecast transaction; but that the company does not treat the currency contract as a hedge for accounting purposes. The fair value movements in the derivative contract are therefore taken directly to the company’s income statement or profit and loss account rather than reserves. They nonetheless fall within regulation 7, where a company has elected for regulation 7 to apply, because:

  • there is a hedging relationship between the hedging contract and the hedged item; and
  • the hedged item is not fair valued.

In consequence, if a company has elected for regulation 7 to apply, the fair movements are disregarded and brought back into account as in CFM76100.

Hedge ineffectiveness

Suppose that the hedge was not 100% effective as a cash flow hedge of the forecast transaction. For instance, assume in the example at CFM57100 that the sale is delayed until 20 December, but the currency contract still matures on 1 December (and the company does not re-hedge for the remaining 19 days). The difference in timing means that the hedge will not be 100% effective.

The ineffective portion of the gain or loss on the hedging instrument is recognised in the income statement. Nevertheless

  • despite hedge ineffectiveness, there is still a hedging relationship between the currency contract and the forecast transaction, and
  • credits and debits to the income statement, as well as credits or debits to reserves, are included within ‘all credits and debits representing the whole or part of the fair value profit or loss’, specified in regulation 7(1)(a).

This means that debits and credits arising from hedge ineffectiveness can be disregarded under regulation 7 where an election has been made.

This contrasts with the situation where a currency contract is split, and only part of the derivative contract is designated as a hedge. This includes not only the case where only part of the notional principal amount of the contract is designated as the hedging instrument, but also the cases where

  • the spot rate element of a currency forward, but not the interest rate element, is designated as a hedging instrument, or
  • the intrinsic value, but not the time value, of a purchased currency option is designated.

There will not be a hedging relationship between the interest rate element of the forward, or the time value of the option, and the hedged item. So fair value changes on these elements - which will be reflected in the income statement - will fall outside of regulation 7.