Jun

8

Accounting for a derivative financial instrument

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accountancy-150x150[1]FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland is mandatory for accounting periods commencing on or after 1 January 2015 and therefore some companies will have already begun their transition to this new regime. Small companies will also be moved under the scope of FRS 102 for accounting periods commencing on or after 1 January 2016 due to the transposition of the EU Accounting Directive into company law which came into effect on 6 April 2015 and the new standards for small and micro-entities will shortly be issued by the Financial Reporting Council (FRC).

Small companies are expected to present and disclose financial information in accordance with Section 1A Small Entities of FRS 102 – but the full recognition and measurement principles contained in FRS 102 will be applicable to small companies.

New standards for the small and micro-entities regime are expected to be published by the FRC in July 2015 with a mandatorily effective date of accounting periods commencing on or after 1 January 2016.

A new regime brings with it changes in accounting methodologies and whilst most of the accounting treatments found in the FRSSE (and outgoing mainstream GAAP) are carried over into FRS 102, there are certain transactions which are accounted for differently; one of these being the issue of financial instruments – specifically derivative financial instruments.

Financial instruments

Financial instruments are very broad and are dealt with in two sections of FRS 102; Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues. Section 12 deals with the more complex financial instruments such as options, swaps and investments in convertible debt. Section 11 deals with the more common instruments applicable to small companies such as trade debtors, trade creditors, cash and basic loans (among other things).

A notable feature of FRS 102 is the requirement to bring derivative financial instruments onto the balance sheet. This was not previously done under outgoing UK GAAP (other than for listed entities) because such instruments were accounted for on settlement and this new requirement will undoubtedly cause an issue for many smaller entities who are about to transition across to FRS 102.

So what is a derivative financial instrument? A derivative is basically a piece of paper that will generally have no value attached to it when it is received (i.e. when the entity enters into the contract). This is because the piece of paper (the contract) will derive its value from an underlying asset (hence the term ‘derivative’). One of the most common forms of derivative which a small company might enter into is a forward foreign currency contract and this article will look at a fairly simple example of how to account for a derivative instrument within such a contract to illustrate the theory.

If a company enters into a forward foreign currency contract, say, one month before its year-end to sell foreign currency one month after its year-end, then on the date the contract is entered into, the contract will usually have a fair value of zero. Over the next two months foreign exchange rates are likely to fluctuate and these fluctuations will generate a value for the forward foreign currency contract and it is this value that gets brought onto the balance sheet with changes in that value from one accounting period to the next going through profit or loss.

Example

North Ltd (North) has an accounting reference date of 31 March each year and reports under FRS 102. On 1 February 2017 North sells goods to a customer based in America for $120,000 and payment is to be received in three months’ time (i.e. payment to be received on 30 April 2017).

North enters into a forward foreign currency contract to sell $120,000 on 30 April 2017 at a contracted rate of £1.65:$1. Details of the foreign exchange rates are as follows:

Forward rate

Spot rate

to 30 April 2017

Date

£1:$

£1:$

01.02.2017

1.63

1.65

31.03.2017

1.60

1.62

30.04.2017

1.58

 

Under previous UK GAAP, North Ltd would have normally accounted for this transaction using the contracted rate (i.e. 1.65).

Note – although in this example the client would normally have accounted for this transaction using the contracted rate under outgoing UK GAAP, it could also have chosen not to and used the spot rate at the transaction date.

Step 1 – Recognise the debtor at the date of sale – 1 February 2017

North would have accounted for this transaction using the rate in the contract (1.65) under previous UK GAAP as paragraph 4 of SSAP 20 Foreign currency translation allowed this and hence under old UK GAAP, North would have recognised a debtor of £72,727 (being $120,000 ÷ 1.65).

FRS 102 at paragraph 30.7 requires foreign currency transactions to be recorded at the spot rate at the date of the transaction and hence under FRS 102, North will translate the $120,000 at 1.63 and will therefore:

DR debtors       £73,620

CR sales           £73,620

Being translation of sale at spot rate at date of sale ($120,000 ÷ 1.63)

The difference of £893 (£73,620 recognised less £72,727 what would have been recognised under old UK GAAP) is equal to the difference arising on $120,000 translated at spot rate of 1.63 (£73,620) and $120,000 translated at contracted rate of 1.65 (£72,727).

Step 2 – Calculate the derivative instrument at the year-end 31 March 2017

As the contracted rate cannot be used under FRS 102, a derivative financial instrument has to be recognised at fair value at North’s year-end. This can be calculated as follows:

   £

$120,000 @ contracted rate of £1:$1.65        72,727
$120,000 @ year-end forward rate of £1:$1.62

74,074

Loss on derivative

1,347

The loss on the derivative has occurred because of what has happened with the exchange rates. If North Ltd were to sell at the year-end forward rate of 1.62 they would receive $74,074 but as they are selling at a contract rate of 1.65 they would only receive £72,727 and hence a loss has been generated on the contract at the year-end which has to be recognised in the financial statements to comply with Section 12 of FRS 102.

The entries as at 31 March 2017 are therefore

£

DR loss on derivative – profit and loss 1,347
CR derivative liability – balance sheet 1,347
Being loss on derivative at fair value 

Under outgoing UK GAAP no entries are needed at the year-end as North would have accounted for the transaction at the contracted rate which can be used to measure the monetary asset.

Step 3 – Work out the foreign exchange gain/loss at the year-end 31 March 2017

North will have to work out the foreign exchange gain or loss for the year-end as follows:

 

£

$120,000 at year-end spot rate (1.60)        75,000
Less original debtor recognised on 01.02.17

73,620

Foreign exchange gain at year-end

1,380

This gain is taken to the profit and loss account. Under previous UK GAAP, as North would have used the contracted rate, there would be no gain to take to profit and loss. However, if North were to use the spot rate, a foreign exchange gain would also arise.

Step 4 – Settlement takes place on 30 April 2017

Once North’s customer has settled the invoice, we first need to deal with the derivative instrument at the date of settlement and then clear the invoice from debtors.

Derivative

Work out the fair value of the derivative instrument at the date of settlement as follows:

£

$120,000 at settlement date spot rate £1:$1.58      75,949
$120,000 at year-end forward rate of £1:$1.62

74,074

Loss on derivative at settlement date

1,875

The entries at 30 April 2017 in respect of the derivative instrument are:

£

DR loss on derivative – profit and loss 1,875
CR derivative liability – balance sheet 1,875
Being loss on derivative at fair value

Clear the derivative and debtor

North’s customer will pay them £72,727, being $120,000 at the contracted forward rate of 1.65. The derivative instrument is recognised as a liability of £3,222 (£1,347 + £1,875) and hence the journals will be:

£

DR bank                                            72,727
DR derivative liability

3,222

CR trade debtors

75,949

Being removal of derivative instrument and debtor on settlement

The derivative liability as at the date of settlement (30 April 2017) can be reconciled as follows:

£

$120,000 @ settlement date spot rate 1.58      75,949
$120,000 @ contract rate of 1.65

72,727

Loss on foreign exchange contract at 30.04.17

3,222

The £3,222 loss on the derivative represents the loss that North has made by taking out the forward foreign currency contract – in other words the company would have received £3,222 more had they undertook the transaction using spot rates.

A balance of £949 will be left on the customer’s account made up of £75,000 year-end debtor (see step 3) less £75,949 ($120,000 ÷ spot rate at settlement of 1.58 – see step 4). This represents the foreign exchange gain.

Comparison old GAAP versus FRS 102

We can compare the effect on the accounts under SSAP 20 (using contracted rate) versus FRS 102 as follows:

Old

GAAP FRS 102

£

£

Profit and loss account – 31 March 2017
Turnover

72,727

73,620

Foreign exchange gain

1,380

Loss on derivative

(1,347)

72,727

73,653

Balance sheet – 31 March 2017
Asset – trade debtors

72,727

75,000

Liability – derivative instrument

(1,347)

72,727

73,653

Profit and loss account – 30 April 2017
Turnover

Foreign exchange gain

949

Loss on derivative

(1,875)

(926)

Balance sheet – 30 April 2017
P&L reserves b/fwd 72,727 73,653
P&L reserves c/fwd 72,727 72,727

Conclusion

This article has considered a simple scenario involving foreign exchange contracts. However, under FRS 102 other, more complex, financial instruments will have to be recognised on the balance sheet (such as interest rate swaps). There will be differences encountered between outgoing UK GAAP and FRS 102 because under SSAP 20 and the FRSSE gains and losses were accounted for in profit and loss on settlement. Under FRS 102 requirements, gains and losses are recognised in the period they occur hence derivatives are brought forward onto the balance sheet.

Category: Accounting and standards

About the Author ()

Steve Collings is the audit and technical director at Leavitt Walmsley Associates Ltd and the author of 'Interpretation and Application of International Standards on Auditing'. He is also the author of 'IFRS For Dummies' and 'The AccountingWEB Guide to IFRS'. More about Steve's publications can be found by clicking on the 'Published Work' tab on the homepage. Steve is also a regular contributor of articles to www.accountingweb.co.uk, the UK's largest resource for professional accountants on a free subscription basis and is a member of the Society of Authors. Steve is an Editorial Board member for Wiley Insight IFRS and sits on the AAT's Financial Reporting Technical Panel. In 2011 Steve was named 'Accounting Technician of the Year' at the British Accountancy Awards and won 'Outstanding Contribution to the Accountancy Profession' by the Association of International Accountants in 2013. Follow Steve on Twitter - @stecollings

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