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This guidance applies to periods of account starting on or after 1 January 2015 where the company has elected for regulation 7 to apply.

Hedge of fixed asset purchase

On 30 June 20X0, a manufacturer places an order with a US supplier for machinery that will be used as a fixed asset in its trade. Completion of the machine is expected to take 18 months and it is highly probable that the company will pay US$1,000,000 to take delivery on 31 December 20X1. »Ê¹ÚÌåÓýapp company hedges the foreign exchange risk by entering into a forward currency contract to buy US$1,000,000 for £600,000 on 31 December 20X1.

On 31 December 20X1, the transaction happens as forecast. »Ê¹ÚÌåÓýapp £/US$ spot rate at 31 December is such that US$1,000,000 is worth £700,000. »Ê¹ÚÌåÓýapp company therefore pays £700,000 for the machinery (equivalent to US$1,000,000 at spot rate) and receives £100,000 cash under the forward contract.

Accounting

»Ê¹ÚÌåÓýapp company draws up balance sheets at 31 December 20X0 and 20X1. Following acquisition, the machine will be depreciated at £140,000 per annum over its expected lifespan of 5 years.

»Ê¹ÚÌåÓýapp company designates a cash flow hedge of exchange rate risk, with the forecast transaction (the anticipated purchase of machinery) as the hedged item and the currency contract as the hedging instrument.

»Ê¹ÚÌåÓýapp forward currency contract is at-the-money when entered into, and so has a fair value of zero.

Suppose that on 31 December 20X0 the contract represents a fair value liability of £20,000.

»Ê¹ÚÌåÓýapp forecast transaction is not recognised in the balance sheet. Instead fair value changes in the hedging contract are taken to a cash flow hedging reserve (CFHR) with the amounts recognised as items of other comprehensive income (OCI)). Thus, at 31 December 20X0 a loss of £20,000 is debited to reserves.

Between 1 January 20X1 and 31 December 20X1 the value of the contract increases by £120,000. At 31 December 20X1 a profit of £120,000 is credited to reserves so that the cumulative amount in reserves is a profit of £100,000. This represents the fact that the company will pay £100,000 less for the currency than its spot value.

»Ê¹ÚÌåÓýapp journal entries on 1 December 20X1 are:

1.

• Dr - Cash - £100,000
• Cr - Forward contract - £100,000

Representing the receipt of £100,000 cash under the forward contract.

2.

• Dr - Fixed Assets - £700,000
• Cr - Cash- £700,000

To reflect the payment of the purchase price, translated at spot rates.

»Ê¹ÚÌåÓýapp £100,000 credit in reserves remains there at acquisition. It will be released to income statement using the same profile as the depreciation. That is, 1/5 of the credit will be released to income statement each year for 5 years. »Ê¹ÚÌåÓýapp position for year ended 31 December 20X2 is shown below:

• Dr - CFHR (OCI) - £20,000
• Cr - Income statement - £20,000

An alternative accounting treatment would be to apply the £100,000 in reserves to reduce the acquisition cost of the asset to £600,000. This would have the same effect as reducing the depreciation charge by £20,000 each year.

Some companies applying New UK GAAP (FRS 102) will not have this choice in accounting policy. »Ê¹ÚÌåÓýappy are required to apply the latter treatment to adjust the cost of the asset.

Disregard Regulations

Where a company has elected for regulation 7 to apply, this regulation will have effect because:

• there is a hedging relationship between the derivative contract and the forecast transaction; and
• the hedged item is not one to which fair value accounting applies.

»Ê¹ÚÌåÓýapp debit to reserves of £20,000 in 20X0 and credit of £120,000 in 20X1 are both disregarded for tax.

Recycling

»Ê¹ÚÌåÓýapp termination of the contract on 31 December 20X1 is a termination event within regulation 10. »Ê¹ÚÌåÓýapp profit on the contract will be brought back into account in accordance with regulation 10(3A). This provides that 14/70, or 20%, of the £100,000 profit is brought into account in each accounting period. If the machinery were disposed of within the 5 year period, the balance remaining in reserves at that point would be brought into account at once. »Ê¹ÚÌåÓýapp actual debits to reserves, and credits to the income statement, are disregarded under regulation 10(10)(b).

For capital allowances purposes, the company’s qualifying expenditure will be £700,000 - the foreign currency price is translated into sterling at the spot rate for the day on which the capital expenditure is treated as incurred (see CA11750).