FX embedded derivatives in executory contracts

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DJP
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Joined: 26 Jun 2020, 15:57

FX embedded derivatives in executory contracts

Post by DJP »

Hello everyone,

Was wondering if you have experience with executory contracts that include FX clauses.

Take for example a master sales agreement where the price of an equipment normally priced in a foreign currency is agreed to be sold at a certain FX rate (according to market rates at the time the master agreement is signed). But the contract also states that if the spot rate at the time the contract is settled is below the agreed spot rate, then the pricing will be according to the spot rate at settlement. When the contract is exectuted, the forward rate will likely be different from the rate agreed in the master agreement.

Question is: if the rate is below the agreed rate, will you recognise revenue according to the forward rate prevailing at the date the contract is executed (and subsequently account for fair value changes on the embedded FX derivative till settlement) or according to the master agreement's rate and book a day-1 loss for an off-market derivative?

Note: the question is not about whether or not the derivative needs to be bifurcated. Given the existence of optionalities, it must be bifurcated.

Thanks a lot in advance!
pub_acco
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Re: FX embedded derivatives in executory contracts

Post by pub_acco »

If you separate the embedded derivative, I would expect the seller to record a liability when the equipment is delivered at the initial fair value of the written option. The amount of revenue is adjusted accordingly, but it won't be equal to the forward FX-based price. The subsequent change in fair value of the separated derivative is not within the scope of IFRS 15, so I think it's not appropriate to report it as part of revenue, unless writing an option is the entity's ordinary activity. Hedge accounting cannot be applied here.

In practice, though, I've seen this kind of arrangements accounted for in an easy way, e.g. recording revenue at the agreed rate and subsequently adjusting revenue or posting FX loss when the seller loses. Such a shortcut may be acceptable if the arrangement is immaterial.
DJP
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Re: FX embedded derivatives in executory contracts

Post by DJP »

mmm... in my opinion the value of the options should not be recorded as part of revenue. The options basically represent protection purchased or sold against movements in the FX rates. To me what makes sense is to record revenue according to the forward rate as at the purchase order date (when the value of the forward is nil). If the options are in the money at that time then they should be recorded against P&L.
pub_acco
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Re: FX embedded derivatives in executory contracts

Post by pub_acco »

To me it sounds like the seller is selling the protection as well as the equipment to the buyer, so it sounds natural to break down the consideration into the revenue portion and the option premium portion....
DJP
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Re: FX embedded derivatives in executory contracts

Post by DJP »

Ok, I think you have a point there. Thanks!
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