Sunday, April 10

Accounting for Foreign Exchange Forward Contracts


An enterprise having exposure to multiple currencies by virtue receivable and payables (e.g. import and export) is likely to be worried about the exchange rate fluctuations that may result in gains and losses in the future. In order to hedge its position and to avoid the losses due to foreign exchange rate changes, the enterprise may enter into a forward exchange contract to manage the amount of the reporting currency required or available at the settlement date of transaction. Generally Accepted Accounting Principles (GAAP) and International Financial reporting Standards (IFRS) provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognised as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognised as income or as expense for the period.

Suppose MSD Ltd needs USD 500,000 on 1st May 2010 for repayment of a loan instalment and interest. As on 1st December 2009, it appears to the company that the USD may be dearer as compared to the exchange rate prevailing on that date, say USD 1 = INR 44.50. Accordingly, MSD Ltd may enter into a forward contract with a banker for USD 500,000. The forward rate may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us assume forward rate as on 1st December 2009 was USD 1 = INR 45.00 as against the spot rate of INR 44.50. As on the future date, i.e., 1st May 2010, the banker will pay MSD Ltd USD 500,000 at Rs. 45 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be USD 1 = INR 45.80

Contract Summary:
Exchange Rate on the date of the Transaction (1-Dec-2009): USD 1 = INR 44.50
6 month Forward Rate on the date of the transaction (1-Dec-2009): USD 1 = INR 45.00
Spot Rate on maturity (1-May-2010) USD 1 = INR 45.80
Company’s expectation: USD may be more expensive in future
Company’s requirement: To hedge the payable of USD 500,000
Company’s Strategy: Enter into a Forward transaction with Bank. Bank will pay USD 500,000 to the company on 1-May-2010

In the given example MSD Ltd gained INR 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract (USD 500,000 * Rs. 45) INR 22,500,000
Amount payable had the forward contract not been in place (USD 500,000 * Rs. 45.80) INR 22,900,000
Gain arising out of the forward exchange contract INR 400,000

Recognition of expense/income of forward contract at the inception

The difference between the forward rate and Exchange rate of the transaction should be recognised as income or expense over the life of the contract. In the above example, the difference between the spot rate and forward rate as on 1st December is INR 0.50 per USD. In other words the total loss was INR 250,000 as on the date of forward contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of the forward contract should be apportioned on time basis. In the given example, the time ratio would be 4:1; so a loss of INR 200,000 should be apportioned to the accounting year 2009-2010 and the balance INR 50,000 should be apportioned to 2010-2011.
The exchange difference between forward rate and spot rate on the date of forward contract should be accounted for. As a result, the benefits or losses accruing due to the forward cover are not accounted.

Profit/loss on cancellation of forward contract
Profit/loss arising on cancellation of renewal of a forward exchange should be recognised as income/expense for the period.

In our example, if the forward contract were to be cancelled on 1st March 2010 @ USD 1 = INR 45.90, MSD Ltd would have sustained a loss @ INR 0.10 per USD. The total loss on cancellation of forward contract would be INR 50,000. This loss should be recognised in the financial year 2009-2010.


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  3. are you sure that the difference between spot ex-rate and forward rate should be amortised over the peiod of forward? seems wrong to me, check what is in IFRS 39

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  4. Hi suppose the spot rate is 45 and forward rate is 48 , so we have 3 as premium which is to deferred , but before the original tenure the forward is canceled , and at tge time od cancellation 1 out of the 3 has been Amortized so what will be the accounting for the the remaining deffered premium of 2.