Forward Contract – Practical Accounting & Taxability of Revenue Account transaction (Actual Hedge)

Let me start with the example:

The Company has sales of $5,00,000/- on 1st April 2020. Spot Rate was Rs. 70/ $ To hedge the exchange rate fluctuation the Company has sold 2 Year forward contract of $4,00,000/-  @ Rs. 72/ $.

The accounting treatment usually followed is to calculate Fair Market value of forward contract and then create Financial Assets and liabilities. Usually there is one forward contract for multiple trade receivables or vis-à-vis multiple forward contract for one trade receivable, there is difficulty in calculating exchange gain or loss on each transaction over a period of time. Hence, company calculate the exchange gain/ loss in first year and reverse the same in next year. If contract are outstanding then the similar process is followed.

Accounting Treatment will be as follows in FY 2020-21:

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Tax Treatment will be as follows in FY 2020-21:

1. Premium or Discount on forward contracts:

Addition of difference between the exchange rate at the date of inception (Spot Rate- Rs 70) of the contract and forward rate (Rs. 72) over the period of contract i.e. 2 years

(Rs. 72-Rs. 70)*5,00,000*1/2 = Rs. 5,00,000

2. Foreign exchange gain

The ICDS is very much clear about exchange difference (which can also be termed as Marked to Market) on such a contract shall be recognized in the previous year only.

Hence we don’t need to make any adjustment in the computation of total income, as fair value gain or loss will take the same into account.

Extract Of Computation.

Notes:

“ICDS VI relating to the effects of changes in foreign exchange rates provides that forward contracts can be divided into following types for the purpose of determining the tax treatment:

• Forward Contracts NOT intended for trading or speculation purpose and entered into for the purpose of settlement of a particular asset/ liability on a future date;
• Forward Contracts intended for trading or speculation purpose and entered into for the purpose of gaining from such contract;
• Forward Contracts entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction. 

“Firm Commitment” shall mean a Commitment in foreign currency given by the entity without having the assets or liabilities existing in the books of account. In other words, forward contracts entered into for firm commitment are contracts that are related to future assets/ liabilities. “

The above contract is for hedging foreign exchange risk against accounts receivables. Hence the tax treatment is as per para 8 (1) of ICDS VI i.e.  :

“Any premium or discount arising at the inception of a forward exchange contract shall be amortised as expense or income over the life of the contract. Exchange differences on such a contract shall be recognised as income or as expense in the previous year in which the exchange rates change. Any profit or loss arising on cancellation or renewal shall be recognised as income or as an expense for the previous year.”

Premium/ Discount and Exchange difference on Forward contract is calculated as follows:

“The premium or discount that arises on the contract is measured by the difference between the exchange rate at the date of the inception of the contract and the forward rate specified in the contract.

Exchange difference on the contract is the difference between:

(a) the foreign currency amount of the contract translated at the exchange rate at the last day of the previous year, or the settlement date where the transaction is settled during the previous year; and

(b) the same foreign currency amount translated at the date of inception of the contract or the last day of the immediately preceding previous year, whichever is later.”

*The above treatment might be different from entity to entity but the principle will remain the same.