Derivative contracts: hedging: regulation 10(3A): example
This guidance applies to periods of account starting on or after 1 January 2015 where the company has elected for regulation 7 or 8 to apply.
Example of regulation 10(3A)
F plc is a UK company in the oil industry whose functional currency is US dollars. Its accounting date is 30 June. In April 20X5, it enters into negotiations to acquire a 20-year lease on warehouse premises in Liverpool. It regards it as highly probable that, some time in October 20X5, it will have to pay a premium of £8 million for the lease. It enters into a forward contract to buy £8 million sterling for dollars on 15 October 20X5.
It adopts FRS 102 with effect from 1 July 20X5.
Because of the uncertainty about the timing of the transaction, and the exact amount to be paid for the lease, the hedge cannot be highly effective and the company does not account for it as a cash flow hedge. Nevertheless it intends the forward contract to be a hedge of the forecast transaction and there is a hedging relationship, such that regulation 7 applies.
At 1 July 20X5, when the currency contract is fair valued for the first time, there has been a loss on the contract - its fair value is (negative) US$150,000. The company therefore has a CTA09/S613 debit of US$150,000, which is disregarded under regulation 7.
On 1 October 20X5, the company pays £7.2 million for the lease - US$13,032,000 when translated at the spot rate. In its accounts, it amortises the lease premium on a straight line basis over 20 years, so that in its accounts to 30 June 20X6 it writes off US$488,700. The company terminates the forward contract on 1 October: at that point it is in the money, and the company receives US$200,000 on cash settlement. Its fair value has therefore increased by US$350,000 between 1 July and 1 October 2005. This fair value change, which is credited to profit or loss in the accounts, is disregarded under regulation 7.
The disregarded amounts are brought into account under regulation 10(3A). For the period ended 30 June 20X6:
- DA, the depreciation or amortisation charged in the accounts, is US$488,700;
- E, the total expenditure on the asset, is US$13,032,000;
- FVP, the aggregate amount deferred under regulation 7, is US$200,000 - a CTA09/S613 debit of US$150,000, and a fair value increase of US$350,000.
- The amount to be brought back into account under for the period is therefore US$488,700/13,032,000 x 200,000 = US$7,500. (The company’s profits will be computed in its functional currency, dollars.)
The company may be able to claim plant and machinery allowances on fixtures included in the warehouse, or it may be able to claim industrial buildings allowance. The existence of the hedging derivative will not affect such claims. For example, suppose that it is agreed that £800,000 of the premium relates to fixtures on which the company is eligible to claim capital allowances. The company’s qualifying expenditure is £800,000, translated into dollars at the spot rate for the day on which the expenditure is incurred.