Where an entity is in the practice of entering into a derivative contract to either buy or sell a non-financial item in foreign currency, such contracts will also not be regarded as financial instruments. The entity should not be in the practice of dealing with such non-financial item merely with the intention to buy or sell in the short term with a view to making profits.
At the time of entering into contract to either buy or sell a non-financial item in foreign currency, there is also a foreign exchange component that is involved in such contracts. The question arises as to whether the FX component should be segregated and treated as an embedded derivative to be valued on a fair value basis.
The answer is provided in the accounting standard whereby it clearly mentions that the embedded portions in such contracts need not be segregated.
An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument (such as a contract for the purchase or sale of a non-financial item where the price is denominated in a foreign currency) is closely related to the host contract provided it is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies:
- the functional currency of any substantial party to that contract;
- the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as the US dollar for crude oil transactions); or
- a currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade).
Hence, the forward contract dealing with a non-financial item in a foreign currency need not be fair valued.