The reform of UK GAAP will impact on how firms account for forward currency contracts. Find out more, including a worked example.
UK GAAP (Generally Accepted Accounting Principles) is undergoing a substantial overhaul with the introduction of FRS 102,The Financial Reporting Standard applicable in the UK and the Republic of Ireland, a single financial reporting standard that will replace all the existing accounting standards and abstracts apart from the FRSSE, the standard for smaller entities, and FRS 27, which deals with life assurance business.
FRS 102 will need to be adopted by companies that do not qualify as small companies under Companies Act 2006 and that are not required or do not choose adopt IFRS. It is mandatory to apply the new standard to accounting periods beginning on or after 1 January 2015. Early application is permitted for periods ending on or after 31 December 2012.
FRS 102 introduces a number of significant changes to the financial reporting requirements applicable under current UK GAAP. Details of the changes brought about by FRS 102 can be found in this section of ACCA’s Technical Advisory webpages and this article examines the transition to FSR 102 from 1 January 2014.
A relevant difference between FRS 102 and current UK GAAP, namely SSAP 20 Foreign currency translation (applicable to the vast majority of entities currently not required or opting to apply FRS 23), is in respect of the accounting treatment of foreign exchange forward contracts. For entities using such contracts to mitigate the foreign exchange exposure of their commercial transactions, the changes in FRS 102 result in a more exacting financial reporting treatment.
In particular under SSAP 20 where a foreign currency trading transaction is covered by a related or matching currency forward contract, the contracted rate of exchange may be used for the translation of the items recognised as part of the trading transaction, such as sales/purchases and receivables/payables.
In practice such accounting treatment allows an entity to use a single exchange rate for the origination and settlement of a foreign currency transaction, therefore avoiding the recognition of exchange differences that may arise between the date of the transaction and that of its settlement, as a result of movements in the exchange rates in the period, and reducing their exposure to volatility in the profit and loss account.
Conversely FRS 102 does not include provisions about using a contracted exchange rate to match a trading transaction. Therefore balances covered by a forward contract will be translated using the general rules for foreign currency translations, i.e. initially at the spot exchange rate at the date of the transaction and then retranslated at the year-end exchange rate and/or at the rate of the date of settlement. The use of different exchange rates will result in exchange differences recognised in profit or loss.
Additionally, under FRS 102, a foreign exchange forward contract will be classified as a complex financial instrument and will need to be recognised in the statement of financial position/balance sheet at its fair value with changes going through profit or loss.
Forward foreign exchange contracts will be recognised at their fair value when taken out and fair value gains and losses will be recognised in profit or loss on an on-going basis at each reporting date rather than just at the time of settlement.
Effectively the accounting treatment prescribed by FRS 102 will produce two sets of entries in profit or loss, one for the transaction balances and one for the forward contract, while under SSAP 20 there would have been none.
Under FRS 102, in order to achieve an element of matching foreign exchange gains and losses on their commercial transactions, entities may choose to apply hedge accounting to such arrangements in accordance with section 12 of the standard. In fact FRS 102 allows designating a foreign exchange forward contract as a hedging instrument in a designated relationship to hedge the foreign exchange risk of a trading transaction.
In such a case the change in the fair value of the forward contract will be recognised in other comprehensive income to the extent that it effectively offsets the retranslation gain or loss on the expected cash flows from the trading transaction. However, it is likely that most entities will decide not to adopt hedge accounting because the administrative burden of maintaining the relevant documentation and the complexity of the rules and disclosures may outweigh the benefits of the permitted accounting treatment.
An example may better illustrate the implications of the accounting treatment of forward contracts under FRS 102 for an entity not applying hedge accounting:
On 31 January 2016 a UK company sells cocoa to a Belgian company for €200,000 payable in three months; on the same day the UK company enters into a currency forward contract to sell €200,000 at the exchange rate of €1.15: settled on 30 April.
The forward contract effectively locks in the value of the Euros to be received at the rate of €1.15:£. On 31 January, the fair value of the forward contract is zero, as the contract was concluded at market price (for simplicity purposes it is also assumed that no fees were incurred and no margin had to be posted).
At the company’s year-end on 31 March 2016, the Euro had strengthened against Sterling and the fair value of the forward contract had become negative as a consequence. FRS 102 requires the change in fair value to be recognised in profit or loss.
On 30 April 2016 the Euro had continued to strengthen against Sterling and the fair value of the forward contract had fallen further. On the same date the UK company receives payment for the sale from the Belgian company and settles the currency forward contract.
The accounting entries are:
31 January 2016
£ £
Dr Receivables 173,913
Cr Sales 173,913
To recognise the sale of €200,000 at the spot rate of 1.15. The spot rate is assumed to be identical to the 90 days forward rate for illustration purposes only and the fair value of the forward contract is assumed to be zero at inception.
31 March 2016
£ £
Dr Receivables 1,525
Cr Foreign exchange (statement of income) 1,525
To record the exchange gain on the receivable of €200,000 translated at the year-end rate of 1.14. Carrying amount of the receivable 173,913+1,525= 175,438.
£ £
Dr Change in Fair Value (statement of income) 1,525
Cr Forward 1,525
To recognise the forward contract at fair value following appreciation of the Euro to 1.14.
30 April 2016
£ £
Dr Cash 176,991
Cr Receivables (173,913+1,525) 175,438
Cr Foreign exchange (statement of income) 1,553
To record the receipt of €200,000 at the spot rate of 1.13, the settlement of the receivable and the connected foreign exchange gain.
£ £
Dr Change in Fair Value (statement of income) 1,553
Cr Forward 1,553
To recognise the change in the fair value of the forward contract following appreciation of the Euro to 1.13. Negative carrying value of the forward contract is 1,525+1,553= 3,078
£ £
Dr Forward 3,078
Cr Cash 3,078
To record the cash paid to settle the forward contract at the rate of 1.15. Cash amount after settlement 176,991-3,078=173,913.
The net effect of the forward contract is that of locking in the cash receivable on the sale at £173,913 (€200,000/1.15) notwithstanding the changes in exchange rates reflected in the translation of receivables and in the fair value of the contract.
Article contributed by ACCA