Chapter 3 - IFRS GAAP treatment

3.1 The basic IFRS GAAP treatment of an agreement is to record the property or services at the spot exchange rate on the dates that the transactions first qualify for recognition. These dates may coincide with the dates of payments but often do not.

3.2 The rules for the IFRS GAAP recognition of the goods or services in an agreement are generally as follows:

• Assets – when it is probable that future economic benefits associated with the item will flow to the entity and the cost of the item can be measured reliably.
• Liabilities – when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.
• Income – when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities.
• Expenses – when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets.

3.3 Where the payment dates do not coincide with the relevant items’ recognition dates there will often be FX gains/losses recognised in the profit and loss account. The FX gains/losses are calculated as the difference between the spot exchange rates on the recognition dates and the payment dates.

3.4 When prepayments, deposits or instalment payments (collectively called prepayments in this paper) are paid/received there can be two treatments. They can be recognised as monetary items at the spot values on the payment dates. They are revalued to spot rates at subsequent reporting dates until the assets/liabilities/revenue items are recognised, with the revaluation gains/losses going to the profit and loss account. The prepayments are included in the value of the relevant items at the spot rates on the dates the items are recognised.

3.5 However, in practice we understand that most of these payments are treated as non-monetary items at historic cost. They are recognised in the items’ values at the spot rates on the prepayments dates – that is, with no subsequent revaluation to spot rates after the dates of the prepayments and no revaluation gains/losses going to the profit and loss account.

Hedging FECs – IFRS GAAP treatment

Designated cashflow hedges

3.6 When agreements are hedged with FECs which are designated as cashflow hedges for accounting, FX gains/losses on the FECs up to the date of recognition of the hedged items are included in the amounts recorded for those items. These FX gains/losses on the FECs may have been included in an equity reserve (cashflow hedge reserve) prior to the relevant hedged item being recognised. FX gains/losses on the FECs from the recognition date of the items through to the settlement of the FECs are required to be included in the profit and loss account, along with the FX gains/losses for the spot rates mentioned in para 3.3 above.

3.7 When prepayments (both monetary and non-monetary items) are hedged with FECs designated as cashflow hedges, any FX gains/losses on the FECs are included in the values of the prepayments recognised on the balance sheet. The prepayment amounts (revalued to spot rates for monetary items) and the final payment amount (spot or hedged rates) are aggregated and recognised as the IFRS GAAP value of the item (and capitalised if they are a fixed asset).

3.8 The IFRS GAAP recognised values for items that are the subject of these agreements can therefore be a mixture of payments made at spot rates and associated hedging gains/losses up to the recognition dates. They will almost never be the same amounts that are used as the cost (lowest price) for tax purposes for Methods A and B of Determination G29.

Designated fair value hedges

3.9 We understand that these agreements are rarely hedged with FECs that are designated as fair value hedges. Where FECs are designated as fair value hedges of these agreements, the gain or loss on the FEC goes to the profit and loss account. The gain or loss on the hedged item attributable to the hedged risk adjusts the carrying amount of the hedged item and is recognised in profit and loss.

3.10 The overall result is that the recognised amount of the hedged item includes gains/losses on the hedged items attributable to the hedged risk – that is, it will be capitalised at the hedged rate to the extent it is hedged. The profit or loss account will include gains and losses on both the FEC and the agreement and will be neutral to the extent that the designated hedge is effective.

3.11 As with designated cashflow hedges, the IFRS GAAP recognised values for items subject to these agreements can be a mixture of spot rates and associated hedging gains/losses.

Rolled hedges

3.12 We understand that IFRS GAAP hedging rules allow for hedges to be rolled[1] when payment dates in these agreements are changed. The FX gains/losses on the FECs at the point they are rolled will be retained in the cashflow hedge reserve for designated cashflow hedges and be included in the recognised amount for the hedged item as described above, along with gains/losses on the replacement FEC. Designated fair value FEC hedges which are rolled will be treated similarly and dealt with as described above for designated fair value hedges. Undesignated hedges which are rolled are fair valued at all times through the profit and loss account (including the gain/loss at the point they are rolled) so these are effectively treated as a realisation for accounting purposes.

Criteria for IFRS GAAP hedge accounting

3.13 GAAP hedge accounting starts when an item (usually a financial arrangement) is designated as a hedge of another item under GAAP hedging criteria. The hedging criteria are quite strict about what can be designated as a hedge, and designation can only occur on a prospective basis. For FECs, any unrealised FX gains/losses prior to a FEC being designated as a hedge are taken to the profit and loss account and will not be included in amounts subsequently recognised for the hedged item. If a hedge (say FEC) is de-designated as a hedge before it matures, unrealised gains/losses on the hedge for the period it is designated as a hedge are included in the value of the hedged item. Gains/losses on the hedge subsequent to de-designation are included in the profit and loss account and do not affect the value of the hedged item.

3.14 GAAP hedge accounting for these agreements will probably be cashflow hedging and not fair value hedging. However, the result under both types of hedging for the value of the hedged item and amounts in the profit and loss account is likely to be the same.

3.15 Some taxpayers may not take out specific hedges for these agreements because they consider that they are economically hedged in other ways. For example, by projected sales in the relevant foreign currency over the periods of the agreements. They will account for both the sales and the assets resulting from the agreements at spot exchange rates on the dates they settle.

3.16 However, both economically and in cash terms, the taxpayer has effectively fully offset any foreign exchange exposure on the agreements with the receipt of the foreign sales.

IFRS GAAP interest amounts

3.17 IFRS GAAP will capture any actual interest in the agreement price by including it in the profit and loss account at the effective interest rate. This approach is used generally for financial arrangements in IFRS GAAP and is acceptable under the IFRS financial reporting method for tax.

3.18 IFRS GAAP may impute interest into deferred property settlements based on the fair value of the consideration received or receivable. It would not usually require the imputation of interest if the amount was immaterial or the period of deferral was less than 12 months.

Trading stock

3.19 In some situations (not mass produced/high volume inventory) the GAAP costs in the valuation of trading stock include interest and other costs (such as derivatives hedging amounts) which are considered to be part of the interest costs.

3.20 NZ IAS 39 (para 98) allows foreign exchange hedging gains/losses previously recognised in other comprehensive income to be included in the cost of the relevant non-financial asset. This has been a common accounting treatment for many taxpayers both pre- and post-IFRS GAAP. The result is recognition of trading stock at a cost using the FEC hedged exchange rate.

Summary of IFRS GAAP accounting

3.21 The following is a high level summary of present IFRS GAAP accounting:

• IFRS GAAP generally accounts for these agreements at the spot rate when the underlying item is first recognised.
• Where hedging is involved, FX fluctuations on the hedging instrument for the period of the hedge will be included in the IFRS GAAP values recognised for the underlying item. FX variations on the items included in the agreements and any hedging instruments after the recognition of the underlying item generally go through the profit and loss account.
• IFRS GAAP designated hedging criteria are reasonably strict and designated hedging can only be done on a prospective basis.
• IFRS GAAP will capture any actual and imputed interest for the agreement by including it in the profit and loss account.
• Trading stock – both IFRS and pre-IFRS GAAP allow FX gains/losses on associated hedging FECs to be included in the cost of trading stock.

Examples of the IFRS GAAP tax treatment of goods included in foreign currency agreements for the sale and purchase of property or services

Example 1: Purchase of trading stock

This example is based on the following assumptions:

The trading stock is purchased within one accounting/income year and is either on hand or not on hand at year-end.

The US$ spot rate at settlement is 0.80 and the forward rate to settlement from the contract date is 0.70.

The cost of the stock is US$100.

A FEC is taken out which is a full hedge of the cost of stock.

The IFRS GAAP results are set out for three situations: the hedges are designated as cashflow hedges, the hedges are not designated, and there are no hedges at all.

 The trading stock is valued at the forward rate in the designated hedge situation and that value will be included in the cost of goods sold in the relevant year when the goods are sold. Where the hedge is undesignated, a timing difference occurs for the $18 between the two years when the stock is on hand at the end of the first year.

Example 2: Purchase of a depreciable asset

This is a summary of the detailed example set out in the Appendix. The example is based on the following assumptions:

The purchase of a depreciable asset for US$100 in 12 months, which is the IFRS GAAP recognition date/tax rights date.

The payments are – US$50 in 6 months (payment A, a non-monetary item for IFRS GAAP), and US$50 at the recognition/rights date in 12 months (payment B).

Both payments are hedged from the beginning with FECs designated as cashflow hedges.

The forward rate for payment A is 0.72 and the forward rate for payment B is 0.65.

The spot rate for payment A is 0.65 and the spot rate for payment B is 0.80.

The IFRS GAAP results are set out for three situations: the hedges are designated as cashflow hedges, the hedges are not designated, and there are no hedges at all.

The asset is capitalised at the forward rates via the FECs (in the designated hedge case) or the spot rates (in the other two cases). Where the hedges are not designated there is a difference between the amount capitalised and the cash paid which is reflected in the profit and loss account. This impact will be spread over the term of the agreement depending on the durations of the FECs hedging the payments. The full example in the Appendix includes a balance date 3 months before payment B/the recognition date to demonstrate the effect of cashflow hedging at that point.

1The FEC is extended beyond its original maturity and any FX gain or loss on the existing FEC at the point it is extended is included in the extended FEC and will be realised at the new maturity date.