Accounting Treatment of Forward Cover in Different scenario

In global scenario, import and export transactions are commonly used by every industry and these transactions are increasing day by day. In last couple of years, rupee and dollar exchange prices’ movement are drastically changed and due to exchange rate movement, it is impact exchange loss / gain in financial statement which in turns impact bottom line (profitability) of industry. To vary in exchange rate, various industry used hedging activities for their outstanding receivable / payable through entering into various derivative instrument contract. Presently various derivatives instruments like forward cover , option , commodity hedging etc are being  used by industry to minimize the exchange rate movement risk.

Here we specifically discuss regarding forward cover and its accounting in different scenario.

Accounting standard (AS) 11 is applied  in accounting  for  transactions  in  foreign  currencies;  and in  translating  the  financial  statements of  foreign operations . It is also apply to foreign currency transactions in the nature of forward exchange contracts.

Basic question is that what is meaning of forward cover:

Para 7.8 of AS 11, forward exchange contracts means an agreement to exchange different currencies at a forward rate.

That means as laymen language, forward exchange contracts is 

“Contract to deliver or receive certain quantity of foreign currency “

“at a specified rate (forward rate)”

“and on a stipulated date”

Generally three types of forward exchange contract differentiated for accounting treatment:

(1) Forward Exchange Contract Entered into for Hedging Purposes (accounting treatment as per Para 36 & 37 of AS 11)

(2) Forward Exchange Contract Entered into for trading/speculation Purposes (accounting treatment as per Para 38 & 39 of AS 11)

(3) Forward Exchange Contracts entered into to Hedge the Foreign Currency Risk of Firm Commitments or Highly Probable Forecast Transactions (accounting treatment as per ICAI an Announcement on Announcement - ACCOUNTING FOR DERIVATIVES, 2008)

As per Para 8(c) of AS 11 (revised 2003), foreign currency transactions include transactions when an enterprise becomes a party to an unperformed forward exchange contract. Therefore, AS 11 (revised 2003) contemplates accounting for forward exchange contracts separate from the underlying asset. Thus, the accounting for forward exchange contract has to be done separately considering it as a transaction separate from the underlying transaction.

· Forward Exchange Contract Entered into for Hedging Purposes (this is explained in “by  the Technical Directorate of the ICAI”, reproduce here again for the benefit of readers):

If a forward exchange contract is entered into to mitigate the foreign exchange fluctuation risk on an item (called as underlying), it is a forward exchange contract entered into for hedging purposes.

AS 11 (revised 2003) is applicable to forward exchange contracts entered into to hedge the foreign exchange fluctuation risk in respect of an existing asset/liability.

Hedging is a tool that aims to reduce/eliminate its risks and ultimately reduce the variability in cash flows or earnings that arises from these risks, simple example is as one pays insurance premium to an insurance company in protection against a specific event.

To get more clarity, let’s understand through illustration:

On  1st  January,  2005,  a  company  entered  into  a  foreign  currency  transaction  by  taking a  loan  of US  $  1  Lakh.  The  amount  of  loan  is  required  to  be  paid  on  30th  June,  2005. On 1st  January 2005  itself,  the  company entered  into a  forward exchange  contract  for  the transaction  to mitigate  the  risks  associated with  changes  in  exchange  rates.

The exchange rates (Rs. per US $) are as below:

In above case,

Underlying Liabilities: Loan payable

Risk: Exchange rate as on 30.6.2005 (at the time of repayment of loan)

Hedging: to minimize the Exchange rate risk

Underlying items, Risk and hedging condition are satisfy in above example and based on that this transactions are accounted as per Para 36 & 37 of AS 11.

Assuming  that  the accounting  year of  the  company  is  financial  year,  the  journal entries for  the  above  transaction  are  as below (Amount in - Rs. Lakhs):

01.01.2005

(i) Bank A/c Dr. 45

To Foreign Currency Loan A/c Cr. 45

(Entry passed for taking the foreign currency loan)

(ii) Foreign currency receivable A/c Dr. 45

Deferred Premium A/c Dr. Dr. 3

To Amount payable to bank Cr. 48

(Entry passed for entering into forward exchange contract)

31.03.2005

(iii) Premium A/c Dr. 1.5

To Deferred Premium A/c Cr. 1.5

(Entry passed for amortisation of proportionate premium on forward exchange contract for three months)

(iv) Foreign Exchange Loss A/c Dr. 2

To Foreign Currency Loan A/c Cr. 2

(Entry passed for booking exchange loss on foreign currency loan at the balance sheet date (47-45)*1 lakh)

(v) Foreign currency receivable A/c Dr. 2

To Foreign exchange gain A/c Cr. 2

(Entry passed for booking of exchange gain on forward exchange contract)

30.06.2005

(vi) Premium A/c Dr. 1.5

To Deferred Premium A/c Cr. 1.5

(Entry passed for amortisation of proportionate premium on forward exchange contract for the next three months)

(vii) Foreign Exchange Loss A/c Dr. 5

To Foreign Currency Loan A/c Cr. 5

(Entry passed for booking exchange loss on foreign currency loan (52-47)*1 lakh)

(viii) Foreign currency receivable A/c Dr. 5

To Foreign exchange gain A/c Cr. 5

(Entry passed for booking of exchange gain on forward exchange contract)

(ix) Amount payable to bank A/c Dr. 48

To Bank A/c Cr. 48

(Entry passed for amount paid to bank for the settlement of forward exchange contract)

(x) Foreign currency received A/c Dr. 52

To Foreign currency receivable A/c Cr. 52

(Entry passed for valuing amount of foreign currency at the spot rate)

(xi) Foreign Currency Loan A/c Dr. 52

To Foreign currency received A/c Cr. 52

(Entry passed for repayment of loan in foreign currency)

· Forward Exchange Contract Entered into for trading/ speculation Purposes

Paragraphs 38 and 39 of AS 11 (revised 2003) deal with forward exchange contracts intended for trading or speculation purposes.

Paragraph 38 provides that gain or loss on such contracts should be computed by multiplying the foreign currency amount of the forward exchange contract by the difference between the forward rate available at the reporting date for the remaining maturity of the contract and the contracted forward rate (or the forward rate last used to measure a gain or loss on that contract for an earlier period).

The gain or loss so computed should be recognised in the statement of profit and loss for the period. The premium or discount on the forward exchange contract is not recognized separately.

Example:

On 1st January 2005, company entered into a forward exchange contract

As in above example, there is no underlying item so that we can say that company has entered into a forward exchange contract for Trading / speculation purpose.

Following are accounting entries for Speculative / Trading Forward cover scenario:  (Amount in Rs. Lakhs)

01.01.2005

(i) Foreign Currency Receivable A/c Dr. 48

To Amount payable to bank A/c Cr. 48

(Entry passed for entering into forward exchange contract)

31.03.2005

(ii) Foreign Currency Receivable A/c Dr. 3

To Exchange Gain A/c Cr. 3

(Entry passed for marking to market of forward exchange contract (51-48)*1 Lakh)

30.06.2005

(iii) Foreign Currency Receivable A/c Dr. 1

To Exchange Gain A/c Cr. 1

(Entry passed for marking to market of forward exchange contract (52-51)*1 Lakh)

(iv) Bank A/c Dr. 4

Amount payable to bank A/c Dr. 48

To Foreign currency receivable A/c Cr. 52

(Entry passed for settling the forward exchange contract)

Note: Premium/discount under the above situation is not separately accounted.

· AS 11 (revised 2003) is not applicable to forward exchange contracts entered into in respect of firm commitments or highly probable forecast transactions.

A ‘firm commitment’ is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

‘Forecast transaction’ is an uncommitted but anticipated future transaction.

This type of transaction’s accounting treatment covered under announcement

ICAI - Announcement -Announcement - Accounting for Derivatives

1. Certain  issues  have  been  raised with  regard  to  the  foreign  currency  derivative exposures  of  various  corporates  that  are  not  being  fully  accounted  for.  These exposures may translate into heavy losses due to fluctuations in the foreign exchange rates.  The matter was  considered by  the Council  of  the  ICAI  at  its meeting  held  on March  27-29,  2008.  The Council decided  to  clarify  the best practice  treatment  to be followed  for  all derivatives, which  is  contained  in  the  following paragraphs.

2.  It may  be  noted  that  although  the  ICAI  has  issued  AS  30,  Financial  Instruments: Recognition  and Measurement, which  contains  accounting  for derivatives,  it becomes recommendatory  from 1.04.2009  and mandatory  from 1.04.2011.  In  this  scenario,  the Council  expressed  the  view  that  since  the  aforesaid Standard  contains  appropriate accounting  for  derivatives,  the  same  can  be  followed  by  the  entities,  as  the  earlier adoption of  a  standard  is  always  encouraged.

3. In  case an entity does not  follow AS 30,  keeping  in  view  the principle of prudence as enunciated  in AS 1, Disclosure of Accounting Policies,  the entity  is  required  to provide for  losses  in  respect of  all outstanding derivative  contracts  at  the balance  sheet date by marking  them  to market.

4. The  entity  needs  to  disclose  the  policy  followed with  regard  to  accounting  for derivatives  in  its  financial  statements. In case AS 30 is followed by the entity, a disclosure of the amounts  recognised  in  the financial  statements  should be made.  In  case AS  30  is  not  followed,  the  losses provided  for  as  suggested  in paragraph  3 above  should be  separately disclosed by  the  entity.

5. The  auditors  should  consider making  appropriate  disclosures  in  their  reports  if  the aforesaid  accounting  treatment  and disclosures  are not made.

6. In  case  of  forward  contracts  to which  AS  11,  ‘The  Effects  of Changes  in  Foreign Exchange Rates’,  applies,  the  entity  needs  to  fully  comply with  the  requirements  of AS  11. Accordingly, this Announcement does not apply to such contracts.

7. This  clarificatory Announcement  applies  to  financial  statements  for  the period  ending March  31, 2008, or  thereafter.

Example:

On 1st January 2005, company entered into a forward exchange contract for a contract of purchase of material US $ 1 Lakh as on 1.6.2005 and settlement on 30.6.2005

As on 1.6.2005, spot rate is Rs. 50

1.1.2005

No entry

31.3.2005

The below entry is not required because as on 31.3.2005 , there is gain on Mark to Market, but if there is loss then that loss should be recongnised as prudence concept

(i) Foreign Currency Receivable A/c Dr. 3

To Exchange Gain A/c Cr. 3

(Entry passed for marking to market of forward exchange contract (51-48)*30.06.2005

1.6.2005

As on 1.6.2012, liabilities are created and now forward cover contract is for underlying liabilities. So scheme of entries are as per scenario 1 i.e Forward Exchange Contract Entered into for Hedging Purposes.

Nirmal Shah 

Email: nirmal.shah@essar.com