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HMRC internal manual

# Foreign exchange: tax rules on exchange gains and losses: loan relationships and derivative contracts: special rules on fair value accounting: available for sale assets

## Exchange differences on an available for sale (AFS) asset

(This example is based on FRS 26 (IAS 39) Implementation Guidance E.3.2)

### Facts

On 31 December 2005, a company acquires a bond denominated in a foreign currency (FC) for its fair value of FC 1,000. The principal amount of the bond is FC 1,250 (i.e. the company acquires the bond at a discount).

The bond has 5 years remaining to maturity, and carries fixed interest of 4.7% per annum, paid each 31 December. The interest payable annually is therefore FC 1,250 x 4.7% = FC 59.

The effective interest rate will, however, also include amortisation of the discount. The effective interest rate is 10%.

On 31 December 2006, the fair value of the bond is FC 1,060.

The company designates the bond as an available for sale (AFS) asset.

The exchange rate at 31 December 2005 is FC 1 = LC (local currency) 1.5

The exchange rate at 31 December 2006 is FC1 = LC 2

The average exchange rate for year ended 31 December 2006 is FC 1 = LC 1.75

### Accounting - year ended 31 December 2006

Since the bond is accounted for as an AFS asset, the company needs to identify three amounts:

• A fair value change that is taken to equity
• Interest income, taken to profit and loss, calculated using the effective interest rate method
• An exchange gain (or loss) taken to profit and loss.

### The amount taken to equity

In order to report the exchange gain or loss in accordance with paragraphs 23(a) and 28 of FRS 23 (IAS 21), the bond is treated as an asset measured at amortised cost in a foreign currency.

The carrying value of the bond on initial recognition is LC 1,500 (FC 1,000 x 1.5)

If the bond were accounted for on an amortised cost basis, its foreign currency value would be FC 1,041, arrived at as follows:

 Value at beginning of year = FC 1,000 Increased by effective yield of 10% = FC 1,100 Less interest paid 31/12/06 = FC 59 Value at end of year = FC 1,041

Translated into local currency, this gives a carrying value of LC 2,082 (FC 1,041 x 2) at the end of the year.

Using fair value accounting, the carrying value is LC 2,120 (FC 1,060 x 2). So the total fair value profit on the bond is LC 620 (LC 2,120 - LC 1,500).

The amount taken to equity is the difference between the fair value carrying amount and the amortised cost carrying amount, i.e.

LC 2,120 - lC 2,082 = LC 38

### Interest income

The company will report interest income of FC 100 (using the effective interest rate method - FC 1,000 x 10%)

It translates this at the average exchange rate for the year (assumed to be a good approximation of the spot rates applicable to the accrual of interest income throughout the year), giving interest income of LC 175 (FC 100 x 1.75).

This figure includes accretion of the initial discount. The amount involved is the total interest income less the cash interest receivable: (FC 100 - FC 59) x 1.75 = LC 72.

### Exchange gain

The exchange gain that is recognised in profit and loss is:

LC 2,082 - LC 1,500 - LC 72 = LC 510

This represents the increase in the bond’s value on an amortised cost basis, less the amount of LC 72 attributable to the accretion of the discount.

There is also an exchange gain on the interest receivable for the year of LC 15 (FC 59 x (2.00 - 1.75)). This is essentially a balancing figure. In arriving at the amount taken to equity, the cash interest of FC 59 has been deducted, using the closing rate of FC 1 = LC 2. In arriving at the amount of interest reported in P&L (which includes the cash interest), the average rate of FC 1 = LC 1.75 is used. So it is necessary to recognise an additional exchange gain on the interest.

### Reconciliation

The fair value of the bond at the beginning of the year is LC 1,500 (FC 1,000 translated at the FC 1 = LC 1.5). At the end of the year, it is LC 2,120 (FC 1,060 x 2). Thus there is an increase in fair value of LC 620. In addition, cash interest of LC 118 (FC 59 x 2) is received on 31 December 2006, making total profits of 738.

This is recognised in the accounts as follows:

 Taken to equity LC 38 Interest income in P&L LC 175 Exchange gain in P&L - bond LC 510 Exchange gain in P&L - interest receivable LC 15 ## Exchange differences on an available for sale (AFS) asset {#IDA1XS1G}

(This example is based on FRS 26 (IAS 39) Implementation Guidance E.3.2)

### Facts

On 31 December 2005, a company acquires a bond denominated in a foreign currency (FC) for its fair value of FC 1,000. The principal amount of the bond is FC 1,250 (i.e. the company acquires the bond at a discount).

The bond has 5 years remaining to maturity, and carries fixed interest of 4.7% per annum, paid each 31 December. The interest payable annually is therefore FC 1,250 x 4.7% = FC 59.

The effective interest rate will, however, also include amortisation of the discount. The effective interest rate is 10%.

On 31 December 2006, the fair value of the bond is FC 1,060.

The company designates the bond as an available for sale (AFS) asset.

The exchange rate at 31 December 2005 is FC 1 = LC (local currency) 1.5

The exchange rate at 31 December 2006 is FC1 = LC 2

The average exchange rate for year ended 31 December 2006 is FC 1 = LC 1.75

### Accounting - year ended 31 December 2006

Since the bond is accounted for as an AFS asset, the company needs to identify three amounts:

• A fair value change that is taken to equity
• Interest income, taken to profit and loss, calculated using the effective interest rate method
• An exchange gain (or loss) taken to profit and loss.

### The amount taken to equity

In order to report the exchange gain or loss in accordance with paragraphs 23(a) and 28 of FRS 23 (IAS 21), the bond is treated as an asset measured at amortised cost in a foreign currency.

The carrying value of the bond on initial recognition is LC 1,500 (FC 1,000 x 1.5)

If the bond were accounted for on an amortised cost basis, its foreign currency value would be FC 1,041, arrived at as follows:

 Value at beginning of year = FC 1,000 Increased by effective yield of 10% = FC 1,100 Less interest paid 31/12/06 = FC 59 Value at end of year = FC 1,041

Translated into local currency, this gives a carrying value of LC 2,082 (FC 1,041 x 2) at the end of the year.

Using fair value accounting, the carrying value is LC 2,120 (FC 1,060 x 2). So the total fair value profit on the bond is LC 620 (LC 2,120 - LC 1,500).

The amount taken to equity is the difference between the fair value carrying amount and the amortised cost carrying amount, i.e.

LC 2,120 - lC 2,082 = LC 38

### Interest income

The company will report interest income of FC 100 (using the effective interest rate method - FC 1,000 x 10%)

It translates this at the average exchange rate for the year (assumed to be a good approximation of the spot rates applicable to the accrual of interest income throughout the year), giving interest income of LC 175 (FC 100 x 1.75).

This figure includes accretion of the initial discount. The amount involved is the total interest income less the cash interest receivable: (FC 100 - FC 59) x 1.75 = LC 72.

### Exchange gain

The exchange gain that is recognised in profit and loss is:

LC 2,082 - LC 1,500 - LC 72 = LC 510

This represents the increase in the bond’s value on an amortised cost basis, less the amount of LC 72 attributable to the accretion of the discount.

There is also an exchange gain on the interest receivable for the year of LC 15 (FC 59 x (2.00 - 1.75)). This is essentially a balancing figure. In arriving at the amount taken to equity, the cash interest of FC 59 has been deducted, using the closing rate of FC 1 = LC 2. In arriving at the amount of interest reported in P&L (which includes the cash interest), the average rate of FC 1 = LC 1.75 is used. So it is necessary to recognise an additional exchange gain on the interest.

### Reconciliation

The fair value of the bond at the beginning of the year is LC 1,500 (FC 1,000 translated at the FC 1 = LC 1.5). At the end of the year, it is LC 2,120 (FC 1,060 x 2). Thus there is an increase in fair value of LC 620. In addition, cash interest of LC 118 (FC 59 x 2) is received on 31 December 2006, making total profits of 738.

 This is recognised in the accounts as follows: ## Exchange differences on an available for sale (AFS) asset {#IDA1XS1G}

(This example is based on FRS 26 (IAS 39) Implementation Guidance E.3.2)

### Facts

On 31 December 2005, a company acquires a bond denominated in a foreign currency (FC) for its fair value of FC 1,000. The principal amount of the bond is FC 1,250 (i.e. the company acquires the bond at a discount).

The bond has 5 years remaining to maturity, and carries fixed interest of 4.7% per annum, paid each 31 December. The interest payable annually is therefore FC 1,250 x 4.7% = FC 59.

The effective interest rate will, however, also include amortisation of the discount. The effective interest rate is 10%.

On 31 December 2006, the fair value of the bond is FC 1,060.

The company designates the bond as an available for sale (AFS) asset.

The exchange rate at 31 December 2005 is FC 1 = LC (local currency) 1.5

The exchange rate at 31 December 2006 is FC1 = LC 2

The average exchange rate for year ended 31 December 2006 is FC 1 = LC 1.75

### Accounting - year ended 31 December 2006

Since the bond is accounted for as an AFS asset, the company needs to identify three amounts:

• A fair value change that is taken to equity
• Interest income, taken to profit and loss, calculated using the effective interest rate method
• An exchange gain (or loss) taken to profit and loss.

### The amount taken to equity

In order to report the exchange gain or loss in accordance with paragraphs 23(a) and 28 of FRS 23 (IAS 21), the bond is treated as an asset measured at amortised cost in a foreign currency.

The carrying value of the bond on initial recognition is LC 1,500 (FC 1,000 x 1.5)

If the bond were accounted for on an amortised cost basis, its foreign currency value would be FC 1,041, arrived at as follows:

 Value at beginning of year = FC 1,000 Increased by effective yield of 10% = FC 1,100 Less interest paid 31/12/06 = FC 59 Value at end of year = FC 1,041

Translated into local currency, this gives a carrying value of LC 2,082 (FC 1,041 x 2) at the end of the year.

Using fair value accounting, the carrying value is LC 2,120 (FC 1,060 x 2). So the total fair value profit on the bond is LC 620 (LC 2,120 - LC 1,500).

The amount taken to equity is the difference between the fair value carrying amount and the amortised cost carrying amount, i.e.

LC 2,120 - lC 2,082 = LC 38

### Interest income

The company will report interest income of FC 100 (using the effective interest rate method - FC 1,000 x 10%)

It translates this at the average exchange rate for the year (assumed to be a good approximation of the spot rates applicable to the accrual of interest income throughout the year), giving interest income of LC 175 (FC 100 x 1.75).

This figure includes accretion of the initial discount. The amount involved is the total interest income less the cash interest receivable: (FC 100 - FC 59) x 1.75 = LC 72.

### Exchange gain

The exchange gain that is recognised in profit and loss is:

LC 2,082 - LC 1,500 - LC 72 = LC 510

This represents the increase in the bond’s value on an amortised cost basis, less the amount of LC 72 attributable to the accretion of the discount.

There is also an exchange gain on the interest receivable for the year of LC 15 (FC 59 x (2.00 - 1.75)). This is essentially a balancing figure. In arriving at the amount taken to equity, the cash interest of FC 59 has been deducted, using the closing rate of FC 1 = LC 2. In arriving at the amount of interest reported in P&L (which includes the cash interest), the average rate of FC 1 = LC 1.75 is used. So it is necessary to recognise an additional exchange gain on the interest.

### Reconciliation

The fair value of the bond at the beginning of the year is LC 1,500 (FC 1,000 translated at the FC 1 = LC 1.5). At the end of the year, it is LC 2,120 (FC 1,060 x 2). Thus there is an increase in fair value of LC 620. In addition, cash interest of LC 118 (FC 59 x 2) is received on 31 December 2006, making total profits of 738.

 This is recognised in the accounts as follows:

### Tax treatment

The company will be taxable on its total profit on the bond, whether in P&L or equity - thus its total loan relationship credits will be LC 738.

Where it is necessary to separately identify an exchange gain component, the exchange gain will be LC 525 - the amount shown in P&L as an exchange gain. The exchange gain on the principal of the bond, and on interest receivable, both come within the statutory definition.

### What if the bond were accounted for at FVTPL?

Suppose that the facts remain the same, except that the bond is accounted for at fair value through profit and loss (FVTPL). The accounts would therefore show a fair value increase of LC 620 in P&L, plus interest receivable of LC 118.

In order to isolate the exchange gain, under regulation 5, a company may follow the computational procedure outlined above, in other words identifying the exchange gain that would be taken to P&L if the bond were accounted for as an AFS asset - and giving, again, an answer of LC 525.

However, it is possible that some companies may use other methods. If there is any doubt as to whether a method gives a reasonable result that accords with regulation 5, HMRC staff should consult their local compliance accountant.