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 derivatives, including options, in accordance with accounting procedures for .

Definition of Derivatives In accounting terms, treated as currency derivatives are financial instruments composed of two or more Under Decree of the Ministry of of the SR underlying currency instruments, which are denomina- No. 20 359/2002-92, a 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 : 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 dif- – an off-balance sheet forward receivable: ferences Dr 95 Receivables from fixed term operations with Cr 31 Fixed term operations with currency instru- currency instruments – forward leg of the ments – gains from forward revaluation swap – buy On the maturity date, after all accounting entries on Cr 99 Redistribution account of operations with a transaction have been made in revaluation accounts currency instruments of the account group 31 and a currency conversion b) enters the first valuation to account for the fair value account in the account group 35, the account balan- – if the difference is positive: ces for that particular transaction must be equal zero. Dr 31 Fixed term operations with currency instru- It is possible to post any halier differences, which may ments – gains from swap revaluation arise upon the foreign currency conversion, to expen- Cr 71 Revenue from derivative operations – gains se accounts (the account group 61), or revenue from swap revaluation accounts (the account group 71) for entering losses or – if the difference is negative: gains from derivative operations due to forward reva- Dr 61 Cost of derivative operations – losses from luation. swap revaluation Cr 31 Fixed term operations with currency instru- Currency Derivatives – Swaps ments – losses from swap revaluation 2. During the following period, the bank recalculates the A currency swap is an agreement to buy and sell one swap fair value on a daily basis. On the spot value date, currency in exchange for another, at a concurrent resa- the revaluation covers both the spot and forward leg of le and repurchase on an agreed-upon future date and the swap. After the spot leg of the swap transaction at an agreed-upon rate. It is a combination of a spot and matures, only the forward leg is revaluated. The forward transaction. accounting treatment is the same, the only differences The following swaps are distinguished: appear in subledger accounts in the respective account 1. Buy and Sell – spot purchase of the base currency group: at its concurrent forward sale, – an increase in the positive difference: 2. Buy and Sell – spot sale of the base currency at its Dr 31 Fixed term operations with currency instru- concurrent forward purchase, ments – gains from swap revaluation Swaps are valued in the same way as forwards. A swap Cr 71 Revenue from derivative operations – gains rate, which corresponds with the fair value entered in from swap revaluation accounting records, is determined as the sum of a spot – an increase in the negative difference: rate and swap points, i.e., an interest rate differential for Dr 61 Cost of derivative operations – losses from the two currencies over an agreed-upon period. swap revaluation Cr 31 Fixed term operations with currency instru- Accounting procedures for banks ments – losses from swap revaluation 1. On the day of concluding a swap, a bank: – a decrease in the positive difference: a) makes an off-balance sheet entry on Dr 71 Revenue from derivative operations – gains – an off-balance sheet spot receivable: from swap revaluation

BIATEC, Volume XII, 6/2004 ECONOMICS FOCUS ACCOUNTING TREATMENT OFCURRENCY DERIVATIVES 25

Cr 31 Fixed term operations with currency instru- 5. When both swap legs mature, the bank makes ments – gains from swap revaluation accounting entries on – a decrease in the negative difference: a) the conversion FC sell/buy in current accounts Dr 31 Fixed term operations with currency instru- Dr 13 Current accounts with banks ments – losses from swap revaluation Cr 35 Redistribution account of exchange rate dif- Cr 61 Cost of derivative operations – losses from ferences – a change from a positive to a negative difference: Dr 35 Redistribution account of exchange rate dif- cancellation Fixed term operations with currency ferences Dr 31 instruments – gains from swap reva- Cr 13 Current accounts with banks luation b) charges netted balances on revaluation accounts to cancellation Revenue from derivative operations – the fair value Cr 71 gains from swap revaluation – a negative difference: Dr 61 Cost of derivative operations – losses from Dr 31 Fixed term operations with currency instru- swap revaluation ments – losses from swap revaluation Cr 31 Fixed term operations with currency instru- Cr 35 Redistribution account of exchange rate dif- ments – losses from swap revaluation ferences – a change from a negative to a positive difference: – a positive difference: cancellation Cost of derivative operations Dr 35 Redistribution account of exchange rate dif- Dr 61 – losses from swap revaluation ferences cancellation Fixed term operations with currency Cr 31 Fixed term operations with currency instru- Cr 31 instruments – losses from swap reva- ments – gains from swap revaluation luation On the swap maturity date, after all accounting entri- Dr 31 Fixed term operations with currency instru- es on a transaction have been made in revaluation ments – gains from swap revaluation accounts of the account group 31 and a currency con- Cr 71 Revenue from derivative operations – gains version account in the account group 35, the account from swap revaluation balances for that particular transaction must be equal 3. When the spot leg of a swap matures, the bank remo- to zero. It is possible to post any halier differences, ves an off-balance sheet entry on: which may arise upon the foreign currency conversion, – an off-balance sheet spot receivable: to expense accounts (the account group 61), or reve- Dr 99 Redistribution account of operations with nue accounts (the account group 71) for entering los- currency instruments ses or gains from derivative operations due to swap Cr 95 Receivables from fixed term operations with revaluation. currency instruments – spot leg of the swap – buy Cross Currency Swaps – an off-balance sheet spot payable: Dr 95 Payables from fixed term operations with cur- A cross currency swap is a special type of the cur- rency instruments – spot leg of the swap – rency swap. It is used in the event that an original trans- sell action (e.g. a credit), which needs to be hedged, is Cr 99 Redistribution account of operations with denominated in a currency other than the local curren- currency instruments cy. As a matter of fact, it is an agreement between two 4. When the forward leg of a swap matures, the bank contracting parties to exchange future interest pay- removes an off-balance sheet entry on: ments, but unlike a classical , the – an off-balance sheet forward receivable: nominal amounts, including the interest payments, are Dr 99 Redistribution account of operations with effected in two different currencies. A cross currency currency instruments swap consists of two parts: Cr 95 Receivables from fixed term operations with 1. an interest rate swap, whereby interest rates are currency instruments – forward leg of the exchanged, swap – buy 2. a currency swap, whereby amounts, as agreed for – an off-balance sheet forward payable: the beginning and the end of a transaction, are exchan- Dr 95 Payables from fixed term operations with cur- ged at an agreed-upon rate. rency instruments – forward leg of the swap Interest payments to be made in the same currency – sell are calculated from the nominal amounts (underlying Cr 99 Redistribution account of operations with assets). This nominal value may change during the currency instruments swap life.

BIATEC, Volume XII, 6/2004 ECONOMICS FOCUS 26 ACCOUNTING TREATMENT OFCURRENCY DERIVATIVES

The value of a cross currency swap is represented by Cr 35 Redistribution account of exchange rate dif- the present value of a cash flow generated by one swap ferences leg, which is equal to the present value of a cash flow – an incoming netting payment: generated by the second swap leg, using an agreed- Dr 35 Redistribution account of exchange rate dif- upon exchange rate. That is why the price depends on ferences agreed-upon forward currency rates and implicitly set Cr 31 Fixed term operations with currency instru- forward interest rates. ments – gains from cross currency swap A cross currency swap is a derivative used to hedge revaluation against long-term exchange rate risks and against 2. If a cross currency swap revaluation is posted to exchange rate risks due to foreign currencies. The revaluation loss accounts, essence of this derivative is widely discussed by practi- – an outgoing netting payment: tioners. Its is frequently referred to as an interest rate Dr 31 Fixed term operations with currency instru- swap. According to the definition given in Decree of the ments – losses from cross currency swap MoF SR, which we cited in introduction to this paper, it revaluation is deemed to be a currency derivative. We therefore Cr 35 Redistribution account of exchange rate dif- recommend that a cross currency swap be accounted ferences for as a standard swap, with the addition of accounting – an incoming netting payment: entries on mutual payments between counter-parties. Dr 35 Redistribution account of exchange rate dif- The accounting treatment in banks is the same as for ferences swaps, except that banks open separate subledger Cr 31 Fixed term operations with currency instru- accounts for these types of derivative transactions. ments – losses from cross currency swap What is treated differently are incoming and outgoing revaluation netting payments on interest legs of the derivative in Such an accounting treatment ensures that an out- relation to contra entries in revaluation accounts in the going/incoming netting payment (on the interest leg of account group 31. a cross currency swap) is charged to the cost or reve- 1. If a cross currency swap revaluation is posted to nue, i.e. posted to losses or gains from the cross cur- revaluation gain accounts, rency swap revaluation in the account groups 61 Cost – an outgoing netting payment: of Derivative Operations and 71 Revenue from Deriva- Dr 31 Fixed term operations with currency instru- te Operations. ments – gains from cross currency swap revaluation

BIATEC, Volume XII, 6/2004