Derivative contracts: hedging: regulation 7: second example
This guidance applies to periods of account starting on or after 1 January 2015 where the company has elected for regulation 7 to apply.
Hedge of fixed asset purchase
On 30 June 20X0, a manufacturer places an order with a US supplier for machinery that will be used as a fixed asset in its trade. Completion of the machine is expected to take 18 months and it is highly probable that the company will pay US$1,000,000 to take delivery on 31 December 20X1. The company hedges the foreign exchange risk by entering into a forward currency contract to buy US$1,000,000 for £600,000 on 31 December 20X1.
On 31 December 20X1, the transaction happens as forecast. The £/US$ spot rate at 31 December is such that US$1,000,000 is worth £700,000. The company therefore pays £700,000 for the machinery (equivalent to US$1,000,000 at spot rate) and receives £100,000 cash under the forward contract.
The company draws up balance sheets at 31 December 20X0 and 20X1. Following acquisition, the machine will be depreciated at £140,000 per annum over its expected lifespan of 5 years.
The company designates a cash flow hedge of exchange rate risk, with the forecast transaction (the anticipated purchase of machinery) as the hedged item and the currency contract as the hedging instrument.
The forward currency contract is at-the-money when entered into, and so has a fair value of zero.
Suppose that on 31 December 20X0 the contract represents a fair value liability of £20,000.
The forecast transaction is not recognised in the balance sheet. Instead fair value changes in the hedging contract are taken to a cash flow hedging reserve (CFHR) with the amounts recognised as items of other comprehensive income (OCI)). Thus, at 31 December 20X0 a loss of £20,000 is debited to reserves.
Between 1 January 20X1 and 31 December 20X1 the value of the contract increases by £120,000. At 31 December 20X1 a profit of £120,000 is credited to reserves so that the cumulative amount in reserves is a profit of £100,000. This represents the fact that the company will pay £100,000 less for the currency than its spot value.
The journal entries on 1 December 20X1 are:
Representing the receipt of £100,000 cash under the forward contract.
To reflect the payment of the purchase price, translated at spot rates.
The £100,000 credit in reserves remains there at acquisition. It will be released to income statement using the same profile as the depreciation. That is, 1/5 of the credit will be released to income statement each year for 5 years. The position for year ended 31 December 20X2 is shown below:
An alternative accounting treatment would be to apply the £100,000 in reserves to reduce the acquisition cost of the asset to £600,000. This would have the same effect as reducing the depreciation charge by £20,000 each year.
Some companies applying New UK GAAP (FRS 102) will not have this choice in accounting policy. They are required to apply the latter treatment to adjust the cost of the asset.
Where a company has elected for regulation 7 to apply, this regulation will have effect because:
- there is a hedging relationship between the derivative contract and the forecast transaction; and
- the hedged item is not one to which fair value accounting applies.
The debit to reserves of £20,000 in 20X0 and credit of £120,000 in 20X1 are both disregarded for tax.
The termination of the contract on 31 December 20X1 is a termination event within regulation 10. The profit on the contract will be brought back into account in accordance with regulation 10(3A). This provides that 14/70, or 20%, of the £100,000 profit is brought into account in each accounting period. If the machinery were disposed of within the 5 year period, the balance remaining in reserves at that point would be brought into account at once. The actual debits to reserves, and credits to the income statement, are disregarded under regulation 10(10)(b).
For capital allowances purposes, the company’s qualifying expenditure will be £700,000 - the foreign currency price is translated into sterling at the spot rate for the day on which the capital expenditure is treated as incurred (see CA11750).