Would the gain or loss be considered an allowable cost? Is not, would any of the associated costs (e.g., labor, hedging agreement cost, etc.) also be considered unallowable?
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Neither ‘hedging”, nor “currency fluctuation” is specifically identified in the descriptions of unallowable costs in Federal Acquisition Regulation subpart 31.2 (the cost principles), so it can’t be said that all hedging related costs are in non-compliance with specific limitations set forth in the FAR (and therefore unallowable). But it should be recognized that FAR 31.2 identifies five (5) requirements for a cost to be an allowable cost and all five must be met before a cost is allowable. The cost must be: (1) reasonable, (2) allocable to the contract, (3) compliant with Cost Accounting Standards (as applicable, otherwise generally accepted accounting principles (GAAP)), (4) compliant with the terms of the contract, and (5) compliant with any specific limitations set forth in FAR subpart 31.2. All five requirements must be met for a cost to be allowable.
A hedging strategy is a risk management strategy designed to reduce the risk in an investment, an asset, or a liability. In this context, the item for which the risk is to be managed is sometimes referred to as a hedged item. A hedging strategy is generally implemented by entering into a hedging instrument, of which there are numerous types. The risk is said to be hedged or offset because the value of the hedging instrument is expected to change in the opposite direction from the hedged item.
More specifically, here the concern expressed in this question appears to be material purchases and the associated risks of currency exchange rates. Simply put, hedging against currency fluctuations often involves entering into a financial contract, a hedging instrument, that is expected to offset currency related value changes in an asset or liability (the hedged item). The question posed here identifies only that the contractor “has entered into hedging agreements” and does not provide any further description of the nature or type of this hedging instrument. These undisclosed additional facts about the type of hedge may be relevant in determining allowability of related costs and should be considered further in order to arrive at a more conclusive answer. Compliance with applicable GAAP for foreign currency and hedging transactions is required. For example, foreign currency transactions, derivatives, and hedging are addressed by GAAP in ASC 815 and 830.
Notwithstanding the small number of details provided and assuming some facts, a suggested approach to arriving at an answer to the question posed is provided.
The hedged item in a materials purchase may be the accounts payable (liability) created by the purchase transaction. Generally Accepted Accounting Principles (GAAP) generally require a transaction denominated in a foreign currency (currency payment will be made in) be recorded in the functional or reporting currency of the buyer. That is, it is recorded initially in the functional currency of the buyer utilizing the spot rate of currency exchange at the date of the transaction. The risk, due to timing, then appears because the accounts payable liability and related inventory are recorded/expressed in the functional currency as of the transaction date, but will be paid in cash, using the foreign currency, at a later date. Currency exchange rates, of course, are subject to change over time.
This is to say, due to exchange rate fluctuations, if more dollars (U.S. currency) are needed to settle the liability/accounts payable as denominated in a foreign currency than were expected (spot exchange rate) at the time the purchase was made, a currency transaction loss would have occurred. Alternatively, if less dollars are needed to settle the liability/accounts payable than were expected at the time of the purchase was made, then a currency transaction gain would have occurred. It is this risk of change in the cash required that may need to be hedged.
A hedging instrument may take numerous forms (e.g., forward contracts, options contracts, among others). As a somewhat simple example, the hedging instrument might be a money-market hedge. In this approach, the hedging company might buy a money market security, to be paid in the foreign currency amount needed to settle the liability/accounts payable and maturing at or near the date cash payment will be made. The foreign currency transaction risk is this hedged.
Whether the gain or loss from a hedging agreement for currency fluctuations related to future buys of materials are allowable costs requires first a determination of whether or not the “gain or loss” at issue is a cost, or an adjustment to a cost (e.g., gain or loss on the sale of depreciable assets is not a cost, but rather is an adjustment to depreciation expense), at all. In accordance with accepted accounting principles, gains and losses do not always flow through the income statement to arrive at net operating income.
If it is a cost, or an adjustment to a cost, the analysis then moves to the general cost allowability requirements used to determine whether or not a cost is allowable under a cost reimbursement type Government contract where the Federal Acquisition Regulations (FAR) are applicable. Specifically, the five requirements at FAR 31.201-2(a) are summarized as follows, the cost must be: (1) reasonable, (2) allocable to the contract, (3) compliant with Cost Accounting Standards (as applicable, otherwise generally accepted accounting principles), (4) compliant with the terms of the contract, and (5) compliant with any specific limitations set forth in FAR subpart 31.2.
As might be obvious from the list of the five requirements, detailed facts and understanding of the nature and circumstances of the cost transaction are likely necessary in order to properly determine whether a given claimed cost is allowable. Such detailed facts and understanding is not present in the posed question and question background.
Many contracting community members encountered, have looked at the fifth of the above cited requirements ((5) compliant with any specific limitations set forth in FAR subpart 31.2) early in the allowability decision process. This may be efficient because the cost principals for contracts with commercial organizations are included in FAR 31.2 and this same section, among other things, delineates some types or labels of costs that are explicitly unallowable (e.g., interest, bad debts, etc.). However, neither ‘hedging” nor “currency fluctuation” is specifically identified in the descriptions of unallowable costs in Federal Acquisition Regulation subpart 31.2 (the cost principles), so it can’t be said that all hedging related costs are in non-compliance with specific limitations set forth in the FAR (and therefore unallowable). But to say that subpart 31.2 doesn’t explicitly make the costs of a hedging agreement explicitly unallowable is not the whole story with FAR 31.2. As previously stated all five of the above allowability requirements must be met.