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Accounting Treatment of Currency Derivatives

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Accounting Treatment of Currency Derivatives ECONOMICS FOCUS 22 ACCOUNTING TREATMENT OFCURRENCY DERIVATIVES ACCOUNTING TREATMENT OF CURRENCY DERIVATIVES CURRENCY FORWARDS, CURRENCY SWAPS, CROSS CURRENCY SWAPS Ing. Eleonóra Vajdová This is the first in a series of papers dealing with accounting treatment of certain generally tradable derivatives, more specifically currency and interest rate derivatives, including options, in accordance with accounting procedures for banks. Definition of Derivatives In accounting terms, treated as currency derivatives are financial instruments composed of two or more Under Decree of the Ministry of Finance of the SR underlying currency instruments, which are denomina- No. 20 359/2002-92, a derivative is defined as a finan- ted in at least two currencies, and the fair value of which cial instrument, which concurrently meets the following is not influenced by the interest rate of a risk-bearing conditions: financial instrument of another accounting entity. a) its fair value changes depending on changing In accounting terms, treated as equity derivatives are interest rates, security prices, commodity prices, prices financial instruments composed of at least one under- of foreign currencies, the price index, the credit rating or lying equity instrument, or also of one or more underly- credit index, or depending on a similar variable, ing interest rate instruments, but not an underlying b) it does not require any initial net investment or only commodity instrument, the fair value of which is not requires initial net investment lower than the one requi- influenced by the interest rate of a risk-bearing financial red for other types of financial instruments, which simi- instrument of another accounting entity. larly respond to changes in lending and market factors, In accounting terms, treated as commodity derivati- c) is agreed and settled as of a future date, with ves are financial instruments composed of at least one a period from the trade date to the settlement date lon- underlying commodity instrument, or also of one or ger than for a spot operation. more underlying interest rate instruments or underlying In terms of underlying financial instruments, a distin- equity instruments, the fair value of which is not influ- ction is made between: enced by the interest rate of a risk-bearing financial • interest rate derivatives, that is, derivatives based instrument of another accounting entity. upon interest rate instruments, In accounting terms, treated as credit derivatives are • currency derivatives, that is, derivatives based upon financial instruments composed of at least one under- currency instruments, lying interest rate instrument, or also of one or more • equity derivatives, that is, derivatives based upon underlying equity instruments or underlying commodity equity instruments, instruments, the fair value of which is influenced by the • commodity derivatives, that is, derivatives based interest rate of a risk-bearing financial instrument of upon commodity instruments, another accounting entity. • credit derivatives, that is, derivatives based upon Derivatives are kept in off-balance sheet and balance credit instruments, sheet accounts from the trade date till the date of their In accounting terms, treated as interest rate derivati- last settlement or termination, the exercise of a right, ves are financial instruments composed of two or more their sale or repurchase. underlying interest rate instruments, which are denomi- nated in just one currency, and the fair value of which is Currency Derivatives – Forwards not influenced by the interest rate of a risk-bearing financial instrument of another accounting entity. Also A forward represents an agreement (a commitment) considered as interest rate derivatives are forward time to exchange two currencies in the future, with the matu- deposits. rity extending beyond the spot value date, i.e. equal to BIATEC, Volume XII, 6/2004 ECONOMICS FOCUS ACCOUNTING TREATMENT OFCURRENCY DERIVATIVES 23 at least D + 3, and with the forward rate being set on the – an increase in the positive difference: commitment date. It is used to hedge against the expo- Dr 31 Fixed term operations with currency instru- sure of the client’s future foreign currency cash flows to ments – gains from forward revaluation the currency risk. Cr 71 Revenue from derivative operations – gains A forward may: from forward revaluation 1. involve a physical delivery – the purchase or sale – an increase in the negative difference: of an agreed volume of one currency in exchange for Dr 61 Cost of derivative operations – losses from another at an agreed-upon forward rate and on an forward revaluation agreed-upon date, with the transaction being settled via Cr 31 Fixed term operations with currency instru- current accounts, ments – losses from forward revaluation 2. not involve a physical delivery (a Non Delivery For- – a decrease in the positive difference: ward – NDF) – an agreement to purchase an agreed- Dr 71 Revenue from derivative operations – gains upon volume of one currency in exchange for another from forward revaluation at an agreed-upon forward rate and on an agreed-upon Cr 31 Fixed term operations with currency instru- date, without moving current accounts. On the transac- ments – gains from forward revaluation tion maturity date, only a difference between an agre- – a decrease in the negative difference: ed-upon and actual currency amount is settled, which is Dr 31 Fixed term operations with currency instru- called netting. ments – losses from forward revaluation For accounting entries to be correctly made, it is Cr 61 Cost of derivative operations – losses from important to determine a valuation method for forwards. forward revaluation A forward rate, which corresponds with the fair value – a change from a positive to a negative difference: entered in accounting records, is determined as the cancellation Fixed term operations with currency sum of a spot rate and forward points, i.e., an interest Dr 31 instruments – gains from forward rate differential for the two currencies over an agreed- revaluation upon period. cancellation Revenue from derivative operations Cr 71 – gains from forward revaluation Accounting procedures for banks Dr 61 Cost of derivative operations – losses from 1. On the day of concluding a forward, a bank: forward revaluation a) makes an off-balance sheet entry on Cr 31 Fixed term operations with currency instru- – an off-balance sheet receivable: ments – losses from forward revaluation Dr 95 Receivables from fixed term operations with – a change from a negative to a positive difference: currency instruments – forward – buy cancellation Cost of derivative operations – losses Cr 99 Redistribution account of operations with Dr 61 from forward revaluation currency instruments cancellation Fixed term operations with currency – an off-balance sheet payable: Cr 31 instruments – losses from forward Dr 99 Redistribution account of operations with revaluation currency instruments Dr 31 Fixed term operations with currency instru- Cr 95 Payables from fixed term operations with cur- ments – gains from forward revaluation rency instruments – forward – sell Cr 71 Revenue from derivative operations – gains b) enters the first revaluation to account for the fair from forward revaluation value 3. On the forward maturity date, the bank: – if the difference is positive: a) removes an off-balance sheet entry on Dr 31 Fixed term operations with currency instru- – an off-balance sheet receivable: ments – gains from forward revaluation Dr 99 Redistribution account of operations with Cr 71 Revenue from derivative operations – gains currency instruments from forward revaluation Cr 95 Receivables from fixed term operations with – if the difference is negative: currency instruments – forward – buy Dr 61 Cost of derivative operations – losses from – an off-balance sheet payable: forward revaluation Dr 95 Payables from fixed term operations with cur- Cr 31 Fixed term operations with currency instru- rency instruments – forward – sell ments – losses from forward revaluation Cr 99 Redistribution account of operations with 2. During the following period, up until the maturity date currency instruments of a forward, the bank recalculates the fair value on b) enters in current accounts the conversion as purcha- a daily basis se of one FC and sale of another FC BIATEC, Volume XII, 6/2004 ECONOMICS FOCUS 24 ACCOUNTING TREATMENT OFCURRENCY DERIVATIVES – buy: Dr 95 Receivables from fixed term operations with Dr 13 Current accounts with banks currency instruments – spot leg of the swap – Cr 35 Redistribution account of exchange rate dif- buy ferences Cr 99 Redistribution account of operations with – sell: currency instruments Dr 35 Redistribution account of exchange rate dif- – an off-balance sheet spot payable: ferences Dr 99 Redistribution account of operations with Cr 13 Current accounts with banks currency instruments c) charges netted balances on revaluation accounts to Cr 95 Payables from fixed term operations with cur- the fair value rency instruments – spot leg of the swap – sell – a negative difference: – an off-balance sheet forward payable: Dr 31 Fixed term operations with currency instru- Dr 99 Redistribution account of operations with ments – losses from forward revaluation currency instruments Cr 35 Redistribution account of exchange rate dif- Cr 95 Payables from fixed term operations with cur- ferences rency instruments – forward leg of the swap – a positive difference: – sell Dr 35 Redistribution account of exchange rate
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