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Hedge accounting
Extract from FRS102 section 12.15 – 12.25A
12.15 A hedging relationship consists of a hedging instrument and a hedged item. Provided the qualifying conditions in paragraph 12.18 are met, an entity may apply hedge accounting.
Hedged items
12.16 A hedged item can be:
– a recognised asset or liability,
– an unrecognised firm commitment,
– a highly probable forecast transaction, or
– a net investment in a foreign operation, or
– a component of any such item, provided the item is reliably measurable.
What can be hedged?
12.16A For hedge accounting purposes, only:
– assets,
– liabilities,
– firm commitments; or
– a highly probable forecast transaction with a party external to the reporting entity can be a hedged item.
– Hedge accounting can be applied to transactions between entities in the same group only in the individual financial statements of those entities, except for:
(a) transactions with subsidiaries, where the subsidiaries are not consolidated in the consolidated financial statements;
(b) the foreign currency risk of intragroup monetary items that result in an exposure to foreign exchange gains or losses that are not fully eliminated on consolidation in accordance with Section 30 Foreign Currency Translation; and
(c) the foreign currency risk of highly probable forecast intragroup transactions, provided the transactions are denominated in a currency other than the functional currency of the entity entering into the transactions and the foreign currency risk affects consolidated profit or loss.
OmniPro comment
Companies face many types of business risks including financial risks, therefore companies try to reduce this risk.
Hedging is an attempt to mitigate the impact of economic risks of an entity’s performance.
The purpose of hedge accounting is to:
- Provide a match to related gains and losses and to avoid distorting financial reports;
- Avoid income statement volatility. Without hedge accounting there is a mismatch. It modifies the normal basis for recognising gains and losses or revenues and expenses on associated hedging instruments and hedged items so both are recognised in the profit and loss at the same time. In example 2 above there was a hit to the profit and loss of CU8,333 in the year for the fair value of the forward contract in year 1 but in year 2 there was an FX gain of CU15,686.
Hedge accounting prevents this as it allows the CU8,333 to be posted to other comprehensive income and it would not be debited to the profit and loss until the forward contract is closed: therefore it sets against the sale so that only the real gain is shown in the profit and loss in the year when the sale occurs; and
- Mitigate the risks.
Applying the example of hedged items and hedged instruments to example 1 and 2 above:
- The hedged item is the anticipated future sale. Other examples of hedged items would include fixed or variable rate loans, anticipated purchase in a foreign currency, options in a contract; and
- The hedged instrument is the forward contract. Another example would include interest rate swaps.
Firm commitment
Appendix I of FRS 102 defines a ‘firm commitment is a binding agreement for the exchange of a specified quantity of resources at specified price on a specified future date of dates.’
Therefore the key requirements are it must have:
- Fixed terms;
- Fixed quantity;
- Fixed price;
- Fixed timing of the transaction; and
- There cannot be no variability, the price paid must be set.
Hedges for firm commitments are usually classified as fair value hedges but they can also be classed as a cash flow hedge as per Section 12.19A below where the fixed price is in a currency different to the functional currency.
Firm commitments which relate to future purchases of goods, PPE may not be required to be recognised on the balance sheet on the signing of the contract, therefore the fair value of the commitment would only be included.
Note that not all firm commitments are to be fair valued and come within the scope of Section 12. Where a firm commitment is for products, commodities, stock which is for the entities own use (i.e. for usage in products, for sale and is a normal purchase) then it is not required in accordance with Section 12.4 and Section 12.5. It may be applicable if it is for property which is merely to be held for investment purposes.
The fair value of a commitment is the amount that an entity would have to pay, or the amount that it would receive, upon terminating the commitment. Usually in any commitment an entity will have to pay money in the future but in return will receive goods etc. for the payment. Therefore on initial signing of the commitment, both the amount to be paid and the goods etc. to be received are the same and hence there is a nil fair value.
However, where prices for example increase in the future and an entity has agreed a price which differs from this, the fair value of the amount to be received versus the amount to be paid differs. Therefore there is a fair value on the commitment.
Likewise some commitments can be in a foreign currency and if it is not hedged it will result in a hit to the profit and loss.
See example below where such a fixed commitment was hedged.
Forecast transactions
A forecast transaction is defined as ‘an uncommitted but anticipated future transaction’. It is taken to mean that it is highly probable the transaction will occur; i.e. it will be more likely than not occur. Indicators that a transaction is highly probable would include the following:
- The frequency of similar past transactions;
- The entity’s business plan;
- The extent of loss or disruption if the transaction did not occur;
- The financial and operating ability of the company to carry out the transaction;
- Substantial commitment of resources to a particular activity;
- The length of time in which the transaction will occur – the shorter the period the more likely it will occur; and
- It has been shown in the past that management has been accurate in their assessment.
Intra-group hedging
Section 12.16A makes it clear that individual entities of group companies, hedge accounting can be applied to intra group sales. It also allows the parent company to hedge where:
- Transactions with subsidiaries that are not included in the consolidation and therefore not eliminated;
- Foreign currency risk on an intra-group balance is not eliminated on consolidation; and
- Currency risk of a highly probable forecasted intra-group transaction where it is a currency different to the Sub entering into it and the currency will not eliminate on consolidation.
Example 5: Hedging in a group context
Sub A whose functional currency is sterling has been provided with a euro loan from its parent company whose functional currency is euro. Therefore in Sub A’s entity financial statements there is a foreign exchange gain/loss which when converted to euro for consolidation purposes is included in the profit and loss. This is not eliminated on consolidation as the Parent company has no exposure. Sub A enters into a forward contract to hedge the FX exposure and hedge accounts.
Given the Sub A has a forward contract in place, Parent A can hedge account in the consolidated financial statements such that there is no hit to the profit and loss for the foreign exchange difference.
In this case the parent company can also hedge this exposure themselves by entering into a foreign contract which meets the condition for hedging rather than the subsidiary entering into the forward contract.
Grouping of items as hedged items
Extract from FRS102-Section 12.16B
12.16B A group of items, including components of items, can be an eligible hedged item provided that all of the following conditions are met:
(a) it consists of items that are individually eligible hedged items;
(b) the items in the group share the same risk;
(c) the items in the group are managed together on a group basis for risk management purposes; and
(d) it does not include items with offsetting risk positions.
OmniPro comment
When assessing group entities, it should be considered whether the below factors are similar:
(a) the currency in which the assets/liabilities are held;
(b) the scheduled maturity date; and
(c) the types of assets/liabilities.
The groupings do not have to share the same risk but share a common risk characteristic that is subject to the hedge (e.g. foreign currency risk). The hedged item should move in the same direction in order for them to be grouped.
Hedging a component of an item
Extract from FRS102-Section 12.16C
12.16C A component of an item comprises less than the entire fair value change or cash flow variability of an item. The following components of an item (including combinations thereof) may be a hedged item:
(a) changes in the cash flows or fair value attributable to a separately identifiable and reliably measureable specific risk or risks, including cash flow and fair value changes above or below a specified price or other variable;
(b) one or more selected contractual cash flows; or
(c) a specified part of the nominal amount of an item.
OmniPro comment
See illustration of the above points in the examples below:
Example 6: Hedging with a forward contract where contract is less than the probable sale amount
Company A who has a euro functional currency has entered into a probable forecasted transaction for FC100,000. Company A has taken out a forward contract to cover FC70,000 of this sale.
In this instance under Section 12.16C, the company can designate the FC70,000 as the hedged item.
Example 7: Hedging part payments
Company A entered into a purchase contract in which it will pay 10 payments over the next year. In this example Company A can designate 5 of these payments to be considered for hedge accounting and treated as the hedged item and the other 5 where it takes out a forward contract to cover the five payments.
These payments are separately identifiable.
Example 8
Company A gets a loan for CU100,000 at a fixed rate of 5% which is repayable in 5 years.
At the same time Company A enters into an interest rate swap with a third party e.g. another bank for a 5 year period (notional amount is CU50,000) whereby Company A will pay the floating rate to the third party and the third party will pay the fixed rate to Company A.
In this case this specified notional amount of CU50,000 can be held as the hedged item.
Example 8B: Partial term hedging
Company A gets a loan for CU100,000 at a fixed rate of 5% which is repayable in 5 years.
At the same time Company A enters into an interest rate swap with a third party e.g. another bank for a 2 year period whereby Company A will pay the floating rate to the third party and the third party will pay the fixed rate to Company A.
In this case the specified notional amount of CU50,000 can be held as the hedged item.
Hedging instruments
Extract from FRS102-Section 12.17-12.17C
12.17 An instrument may be a hedging instrument provided all of the following conditions are met:
(a) it is a financial instrument measured at fair value through profit or loss;
(b) it is a contract with a party external to the reporting entity (i.e. external to the group or individual entity that is being reported on); and
(c) it is not a written option, except as described in paragraph 12.17C.
12.17A An instrument (or a combination of such instruments) meeting the conditions of paragraph 12.17, may only be a hedging instrument:
(a) in its entirety; or
(b) a proportion of such an instrument or a proportion of a combination of such instruments, e.g. 50 per cent of the nominal amount of the instrument.
12.17B For a hedge of foreign currency risk, the foreign currency risk component of a financial instrument, provided that it is not a financial instrument as described in paragraph 11.6(b), may be a hedging instrument.
12.17C A written option is not a hedging instrument unless the written option is an offset to or is combined with a purchased option and the effect of the offset or combination is not a net written option. An example of a combination of a written and a purchased option that is not a net written option is a zero cost interest rate collar.
OmniPro comment
See illustration of Section 12.17A(b) below:
Example 9: Portion of a hedging instruments
Company A has a highly probable sale forecasted for FC100,000. It enters into a forward contract to cover this.
On inception Company A believes there is 75% chance of making the sale. Therefore Company A can designate FC75,000 of the sale as the hedged item.
Depending on whether the remaining 25% can be used as a hedge for something else, fair value may be posted to other comprehensive income or the profit and loss where it cannot be utilised as a hedge.
Example 10: Portion of a hedging instrument not allowed
Company A gets a variable loan for CU100,000 which is repayable in 5 years.
At the same time Company A enters into an interest rate swap with a third party e.g. another bank for an 8 year period (notional amount of swap is CU100,000) whereby Company A will pay the fixed rate to the third party and the third party will pay the floating rate to Company A.
In this case this is not an allowable hedge accounting treatment as the term of the swap is more than the hedged item itself.
If the Variable loan was for 8 years and swap for 5 years, it would then be an allowable hedge.
Instrument used to hedge a foreign currency risk
In relation to Section 12.17A, this means that foreign currency debt instruments and debt investment including cash deposits which are carried at amortised cost can be designated as a hedging instrument in a hedge for a foreign currency risk. The amortised cost should be remeasured to incorporate the hedged risk (foreign currency).
Options
Options by their nature do not impose an obligation to exercise an instrument, it just gives them a right to but they do not have to, they have the choice not to take up the option. Therefore it reduces risk so it could then qualify as a cash flow. Where an option reduces the risk to nil then it would not qualify for hedging.
A written option as opposed to a purchased option does not reduce profit or loss exposure of hedged items and therefore does not qualify as a hedging instrument in its own right.
Where an option exists, then only cash flows above the option amount would be hedged. Changes in the time value of money will also have to be incorporated where deemed material which would be charged to the profit and loss and not other comprehensive income i.e. the intrinsic value is only treated as forming part of the hedge.
Example 11: Forward contract option
Company A whose functional currency is CU operates a toy production and sales business. Each year it sets its prices in FC and gives it to customers. The prices do not change in the year. The company maintains a FC bank account.
In order to hedge the risk of the CU/FC exchanges affecting future sales prices and the CU amount taken in after conversion, company A enters into a call option from the bank where they can convert FC100,000 in four months time (which is the expected sales in the first four months) at a rate of CU1:FC0.80.
The spot rate at the time of obtaining the option was CU1:FC0.85.
In this case Company A can designate the intrinsic value of the forward option as a hedge against movement in the CU/FC FX rates. The exposure hedged is the variability in cash flows where the FX rate exceeds CU1:FC0.80. A call option has intrinsic value if the strike price (CU1:FC0.80) is below the spot exchange rate (opposite for put option). Therefore a hedge will not exist until the spot rate goes below the CU1:FC0.80 rate.
Conditions for hedge accounting
Extract from FRS102-Section 12.18-12.18A
12.18 An entity may apply hedge accounting to a hedging relationship from the date all of the following conditions are met:
(a) the hedging relationship consists only of a hedging instrument and a hedged item as described in paragraphs 12.16 to 12.17C;
(b) the hedging relationship is consistent with the entity’s risk management objectives for undertaking hedges;
(c) there is an economic relationship between the hedged item and the hedging instrument;
(d) the entity has documented the hedging relationship so that the risk being hedged, the hedged item and the hedging instrument are clearly identified; and
(e) the entity has determined and documented causes of hedge ineffectiveness.
12.18A An economic relationship between a hedged item and hedging instrument exists when the entity expects that the values of the hedged item and hedging instrument will typically move in opposite directions in response to movements in the same risk, which is the hedged risk.
OmniPro comment
An example of an economic relationship would include an interest rate swap whereby a third party will receive the fixed rate and receive the variable rate.
The terms of the hedging instrument and the hedged item should be the same to determine that there is hedge effectiveness. For example, for an interest rate swap, the most important aspect with regard to hedging would be that the amounts, terms, re-pricing dates, dates of interest and principal, receipts and payments and basis of measuring interest are the same for the hedging instrument as it is for the hedged item.
If the terms do not match exactly then a qualitative assessment would be required.
One of the key requirements for hedge accounting is that management prepare a detailed assessment of the hedge relationship and detail how the hedge meets the requirements in Section 12.17 at inception of the hedge. The document prepared should:
- Specify the nature of the risk being hedged e.g. foreign exchange, interest rate, commodity price; and risk.
- Can clearly identify the hedged item (i.e. the asset, liability, probably forecast, firm commitment) and the hedged instrument.
Accounting for qualifying hedging relationships
Extract from FRS102-Section 12.19-12.19A
12.19 There are three types of hedging relationships:
(a) Fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that are attributable to a particular risk and could affect profit or loss;
(b) cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction, and could affect profit or loss; and
c) hedge of a net investment in a foreign operation.
12.19A A hedge of the foreign currency risk of an unrecognised firm commitment may be accounted for as a fair value hedge or as a cash flow hedge.
OmniPro comment
Section 12.19 identified three types of hedges, namely;
(a) a fair value hedge;
(b) a cash flow hedge; and
(c) a hedge of a net investment in a foreign operation.
Each of these have been reviewed below.
Fair value hedges
Extract from FRS102 – Section 12.19B-12.22
12.19B Fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that are attributable to a particular risk and could affect profit or loss;
12.20 A fair value hedge shall be accounted for as follows from the date the conditions in paragraph 12.18 are met:
(a) the gain or loss on the hedging instrument shall be recognised in profit or loss; and
(b) the hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item (if applicable) and be recognised in profit or loss.
When a hedged item is an unrecognised firm commitment, the cumulative hedging gain or loss on the hedged item is recognised as an asset or liability with a corresponding gain or loss recognised in profit or loss.
12.21 When an unrecognised firm commitment to acquire an asset or assume a liability is the hedged item:
– the initial carrying amount of the asset or liability that results from the entity meeting the firm commitment is adjusted to include the cumulative hedging gain or loss of the hedged item that was recognised in the statement of financial position.
12.22 Any adjustment arising from paragraph 12.20(b) shall be amortised to profit or loss if the hedged item is a financial instrument measured at amortised cost. Amortisation may begin as soon as an adjustment exists and shall begin no later than when the hedged item ceases to be adjusted for hedging gains and losses. The amortisation is based on a recalculated effective interest rate at the date amortisation begins.
OmniPro comment
Fair value hedge: hedges for risk of changes in fair value of assets/liabilities affecting P&L.
If a fair value hedge was fully effective the amount recognised in the profit and loss on the hedged item would be directly offset by the amount recognised on the financial instrument. This is unlikely to occur in reality as there is always some degree of ineffectiveness.
To summarise:
An interest rate swap on a loan liability where the company receives the fixed and pays the floating would be an example of a fair value hedge. Note if the opposite interest rate swap was entered into this would not be a fair value hedge but a cash flow hedge.
Examples of fair value hedges include:
- Fixed interest rate on a debt instrument
Example 12: Fair value hedge – Interest rate swap – fixed interest rate on a debt instrument (carried at amortised cost)
Company A gets a loan for CU100,000 at a fixed rate of 7% which is repayable in 5 years.
At the same time Company A enters into an interest rate swap with a third party (e.g. another bank) for a 5 year period whereby Company A will pay the floating rate to the third party and the third party will pay the fixed rate to Company A (i.e. receive fixed, pay variable). The notional amount hedged is CU100,000. Assume the current average variable interest rate for the year was 6%.
At the end of year 1 the interest rate swap has a positive fair value of CU6,100 and the negative fair value of the loan attributable to the hedged interest rate risk is CU5,600.
The accounting entries required at the end of year 1 assuming all other conditions for hedge accounting have been met and the interest has already been charged and paid/received
| CU | CU | |
| Dr Swap fair value on balance sheet | 6,100 | |
| Cr Swap FV loss in P&L | 6,100 | |
| Dr Loan fair value gain in P&L | 5,600 | |
| Cr Loan Liability | 5,600 |
Being journal to reflect fair value of loan and swap.
The final balance sheet will look like the below:
Note in accordance with 12.22 if the hedge is discontinued before the loan is repaid in 5 years time the CU5,600 would have to be credited as interest to the profit and loss at the effective interest rate from that date to bring the liability to CU100,000 by the end of year 5. The amortisation does not take place until the hedge is ceased, it remains present and moves in line with the fair value adjustments year on year.
If the swap is in place for all 5 years then the movement in fair values year on year will bring it back to CU100,000.
2. Firm commitment not recognised on balance sheet
Note that not all firm commitments are to be fair valued or come within Section 12. Where a firm commitment is for products, commodities, stock which is for the entities own use (i.e. for usage in products, for sale and is a normal purchase) then it is not required in accordance with Section 12.4 and Section 12.5.
Example 13: Firm Commitment
Company A has committed with company B to purchase 10,000 products (which are nuts and are used regularly) from them at a fixed price of CU10 per product and they will be delivered in two months’ time (it is now 1 December and year end is 31 December). As the ownership does not pass until they are delivered under the agreement the products are not recognised on the balance sheet of Company A until delivery.
At 31 December the price of the product increased to CU12 per product.
Assume there are no further changes in the fair value up to the date the products are delivered.
As the price changed from CU10 to CU12 from the date of entering the commitment to the year end, this means that there is a fair value in the commitment at the year-end; that being the fact that the commitment is now worth CU2*10,000 = CU20,000. In essence if Company B were to pull out of this on that day it would have to pay CU20,000 to Company A.
Per Section 12.21 this CU20,000 would be shown as an asset on the balance sheet and the gain shown as a credit to the profit and loss. The journals required are:
| CU | CU | |
| Dr Fair Value of firm commitment | 20,000 | |
| Cr Gain on firm commitment in P&L | 20,000 |
On the goods being delivered and the commitment honored on 31 January, the goods would be recognised on the balance sheet:
| CU | CU | |
| Dr Inventory | 100,000 | |
| Cr Creditors | 100,000 |
Being journal to reflect liability.
| CU | CU | |
| Dr Inventory | 20,000 | |
| Cr Fair Value of firm commitment | 20,000 |
Being journal to reclassify the fair value adjustment to be included in the cost of inventory in accordance with Section 12.21.
3. Hedge of a foreign currency risk of an unrecognised firm commitment.
Where a firm commitment is a commitment to be honored in a foreign currency then entities have a choice to either treat it as a fair value hedge or a cash flow hedge under Section 12.19A. In the example below it has been treated as a fair value hedge.
See the example below (extracted from the Appendix to Section 12 of FRS 102):
Example 14: Hedge of a foreign currency risk of an unrecognised firm commitment
On 9 June 20X5 an entity enters into a purchase agreement with a third party over a non-financial asset in a foreign currency (FC) for FC515,000. On the same day, the entity enters into a forward currency contract to buy FC500,000 for CU1,000,000. Under the purchase agreement, the non-financial asset will be delivered and paid for on 30 March 20X6, the same day the forward currency contract is required to be settled.
In this example the hedged item is the total of the commitment of FC515,000 and the hedging instrument is the forward contract to buy FC500,000. Since the nominal amounts of the two contracts do not match, hedge ineffectiveness arises. It should be noted that in practice an entity could avoid ineffectiveness arising for this reason by identifying an amount of FC500,000 of the total commitment as the hedged item in accordance with paragraph 12.16C.
For simplification, this example disregards other sources of ineffectiveness, e.g. counter party credit risk associated with the forward currency contract.
The entity’s financial year ends on 31 December.
This example assumes that the qualifying conditions for hedge accounting in paragraph 12.18 are met from 9 June 20X5.
The table below sets out the applicable forward exchange rates, the fair value of the forward currency contract (the hedging instrument) and the hedging gains/losses on the purchase commitment (the hedged item) on the relevant dates. This example ignores the effects of discounting.
| 9 June 20X5 | 31 Dec 20X5 | 30 March 20X6 | |
| Forward exchange rate (CU:FC) | 2:1 | 2.2:1 | 2.16.1 |
| Forward currency contract (hedging instrument) | |||
| Fair Value | Nil | FC500,000xFC0.2: = CU100,000 | FC500,000 x FC0. 16: = CU80,000{ |
| Fair value change | Nil | CU100,000 – 0 = CU100,000 | CU80,000-CU100,000= (CU20,000) |
| Purchase commitment (hedged item) | |||
| Cumulative hedging (loss){ | Nil | (FC515,000) x FC0.2:=(CU103,000) | (FC515,000) x FC0. 16: = (CU82,400) |
| Hedging (loss)/Hedging (loss)/ gain | Nil | (CU103,000) – 0 = (CU103,000) | (CU82,400)- (CU103,000)= CU20,600 |
Key to table:
This is the fair value of the contract prior to settlement in accordance with paragraph 12.20(b), the commitment is fair valued only for the hedged risk, which in this example is the forward exchange rate risk.
12A.2 Hedge accounting:
Note that there are no hedge accounting entries on 9 June 20X5.
31 December 20X5
(1) In accordance with paragraph 12.20(a) the fair value gain of CU100,000 on the forward currency contract is recognised in profit or loss.
(2) In accordance with paragraph 12.20(b) the cumulative hedging loss of CU103,000 on the commitment is recorded as a liability with a corresponding loss recognized in profit or loss.
Accounting entries:
| Ref | Debit | Credit | |
| (1) | Forward currency contract | CU100,000 | |
| Profit or Loss | CU100,000 | ||
| (2) | Profit or Loss | CU103,000 | |
| Hedged item (commitment) | CU103,000 |
30 March 20X6
(1) In accordance with paragraph 12.20(a) the fair value loss of CU20,000 on the forward currency contract is recognised in profit or loss.
(2) In accordance with paragraph 12.20(b) the hedging gain on the commitment of CU20,600 is recognised in profit or loss with a corresponding adjustment to the recognised liability from CU103,000 to CU82,400.
(3) In accordance with paragraph 12.21 the non-financial asset’s carrying amount is adjusted to include the cumulative hedging loss on the hedged item of CU82,400.
Note A: For illustrative purposes the accounting entry in respect of the settlement of the forward currency contract in cash for CU80,000 is shown below.
Note B: For illustrative purposes the accounting entry for the purchase of the non-financial asset at the applicable spot rate of FC2.16: for CU1,112,400 (settled in cash) is shown below.
Accounting entries:
| Ref | Debit | Credit | |
| (1) | Profit or Loss | CU20,000 | |
| Forward currency contract | CU20,000 | ||
| (2) | Hedged item (commitment) | CU20,600 | |
| Profit or Loss | CU20,600 | ||
| (3) | Hedged item (commitment | CU82,400 | |
| Property, plant and equipment (PP&E) | CU82,400 | ||
| (A) | Cash | CU80,000 | |
| Forward currency contract | CU80,000 | ||
| (B) | Property, plant and equipment (PP&E) | CU1,112,400 | |
| Cash | CU1,112,400 |
Cash flow hedges
Extract From FRS 102 – Section 12.22(b) and 12.23
12.22(b) cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction, and could affect profit or loss; and
12.23 A cash flow hedge shall be accounted for as follows from the date the conditions in paragraph 12.18 are met:
(a) the separate component of equity associated with the hedged item (cash flow hedge reserve) is adjusted to the lower of the following (in absolute amounts):
(i) the cumulative gain or loss on the hedging instrument from the date the conditions of paragraph 12.18 are met; and
(ii) the cumulative change in fair value on the hedged item (i.e. the present value of the cumulative change of expected future cash flows) from the date the conditions of paragraph 12.18 are met;
(b) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (ie the portion that is offset by the change in the cash flow hedge reserve calculated in accordance with (a)) shall be recognised in other comprehensive income;
(c) any remaining gain or loss on the hedging instrument (or any gain or loss required to balance the change in the cash flow hedge reserve calculated in accordance with (a)), is hedge ineffectiveness that shall be recognised in profit or loss; and
(d) the amount that has been accumulated in the cash flow hedge reserve in accordance with (a) shall be accounted for as follows:
(i) if a hedged forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, or a hedged forecast transaction for a non-financial asset or non-financial liability becomes a firm commitment for which fair value hedge accounting is applied, the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset or liability;
(ii) for cash flow hedges other than those covered by (i), that amount shall be reclassified from the cash flow hedge reserve to profit or loss in the same period or periods during which the hedged expected future cash flows affect profit or loss (for example, in the periods that interest income or interest expense is recognised or when a forecast sale occurs); and
(iii) if the amount is a loss, and all or part of that loss is not expected to be recovered, the amount of the loss not expected to be recovered shall be reclassified to profit or loss immediately.
OmniPro comment
See below summary of the requirements:
See below the common examples of cash flow hedges:
- Forward contract for a probable forecasted sale.
Example 15a: Forward contract for a probable forecasted sale
On 1 December Company A whose functional currency is euro secured a highly probable contract with a FC customer worth FC100,000. The sale is expected to happen on 31 March of the following year.
In contemplation of the sale Company A enters into a forward FX contract to sell FC100,000 at a rate of CU1:FC0.80.
Assume the spot rate at 31 December was CU1:FC0.70.
Assume the spot rate at 31 March was CU1:FC0.84.
Assume the spot rate at 31 May was CU1:FC0.85.
The forward rate quoted for sterling contract at 31 December by the bank for a contract that matures on 31 March is CU1:FC0.75.
The accounting requirement as a result of entering into this forward contract at 31 December year end and 31 March assuming it meets the conditions for hedge accounting are:
*Fair value of the forward contract at 31 December:
Amount of CU that will be obtained on 31 March at contracted rate of CU1:FC0.80 is FC100,000/0.80= CU125,000.
Note any FC balances in the balance sheet at 31 December should be retranslated to the year-end rate.
Amount of CU that could theoretically be obtained on 31 March at contracted rate of CU1:FC0.75 is FC100,000/0.75= CU133,333
Fair value loss at 31 December is CU133,333-CU125,000 – CU8,333
** Fair value of the forward contract at 31 March:
Amount of CU that will be obtained on 31 March at contracted rate of CU1:FC0.80 is FC100,000/0.80= CU125,000
The fair value at the date of expiration is therefore the CU125,000 less FC100,000 at the spot rate at 31 March of CU1:FC0.84 i.e. (CU119,048)= CU5,952
Movement to be posted to reflect the CU5,952 is CU5,952 plus the debit previously posted of CU8,333 is CU14,285.
If the above was related to a probable purchase for inventory, the journals would be of similar type but obviously the foreign exchange loss/gain will be the opposite way around.
2. Probable forecasted purchase of equipment
Example 15b: Probable forecasted purchase of equipment
On 1 December Company A whose functional currency is euro secured a highly probable purchase of a piece of equipment with a sterling (FC) supplier worth FC100,000. The delivery of the equipment is expected to happen on 31 March of the following year and be paid for on 31 May.
In contemplation of the purchase Company A enters into a forward FX contract to sell FC100,000 at a rate of CU1:FC0.80.
Assume the spot rate at 31 December was CU1:FC0.70.
Assume the spot rate at 31 March was CU1:FC0.84.
Assume the spot rate at 31 May was CU1:FC0.85.
Assume for this example the purchase goes ahead and was paid on 31 May.
The forward rate quoted for the foreign currency contract at 31 December by the bank for a contract that matures on 31 March is CU1:FC0.75.
The forward rate quoted for the foreign currency contract at 31 March by the bank for a contract that matures on 31 March is CU1:FC0.83.
The accounting requirement as a result of entering into this forward contract at 31 December year end, 31 March and 31 May assuming it meets the conditions for hedge accounting are:
| Date | Details | Balance Card | Profit and Loss | Other Comprehensive income/cash flow reserve | ||||
| DR | CR | DR | CR | DR | CR | |||
| 31-Dec | Dr Forward Contract Asset | 8,333 | ||||||
| Cr Foreign exchange gain in other comprehensive income * | 8,333 | |||||||
| Being journal to reflect fair value of the forward contact at year end | ||||||||
| 31-Mar | Dr Property, Plant and Equipment (FC100,000/0.84 i.e. Spot rate | 119,084 | ||||||
| Cr Creditors | 119,084 | |||||||
| Being journal to recognise the purchase at the spot rate | ||||||||
| Cr Forward Contract Asset | 12,851 | |||||||
| Dr Cash Flow Hedge Reserve/OCI | 12,851 | |||||||
| Being journal to reflect fair value of the forward contract at 31 March | ||||||||
| Dr Property, Plant and Equipment | 4,518 | |||||||
| Cr, Cash Flow Hedge Reserve/OCI | 4,518 | |||||||
| Being gain deferred in asset | ||||||||
| 31-May | Cr Bank (FC100,000/0.85) | 117,647 | ||||||
| Cr Foreign exchange gain | 1,401 | |||||||
| Dr Creditors | 119,084 | |||||||
| Being journal to reflect fair value at the date of the contract | ||||||||
| Cr Bank | 7,353 | |||||||
| Dr Forward Contract Asset** | 4,518 | |||||||
| Dr Foreign exchange gain | 2,835 | |||||||
3. Hedge of variability in cash flows in a floating rate loan due to interest rate risk
Example 16: Hedge of variability in cash flows in a floating rate loan due to interest rate risk (Example extracted from Appendix to Section 12 of FRS 102)
Cash flow hedge accounting – Hedge of variability in cash flows in a floating rate loan due to interest rate risk.
This example illustrates the accounting for a cash flow hedge of interest rate risk associated with a floating rate loan. The entity borrows money at a floating rate and enters into an interest rate swap with the effect of paying a fixed rate overall.
12A.3 On 1 January 20X5, an entity borrows CU10,000,000 from a bank at a floating rate of 3-month LIBOR plus 2.5 per cent. The interest is payable annually in arrears on 31 December. The loan is repayable on 31 December 20X7.
On 1 January 20X5 the entity also enters into an interest rate swap with a third party, under which it receives 6-month LIBOR and pays a fixed rate of interest of 4.5 per cent. The notional amount of the swap is CU10,000,000. The swap is settled annually in arrears on 31 December and expires on 31 December 20X7.
The LIBOR rates on the loan and the interest rate swap are reset and fixed annually in advance on 31 December based on the expected LIBOR rates applicable at that time. Note that in practice the loan and swap interest rates would be reset more frequently than assumed for the purpose of simplification in this example.
The entity hedges the variability of the interest rate payments on the bank loan based on 3-month LIBOR. It should be noted that because the entity receives interest based on 6-month LIBOR under the interest rate swap, ineffectiveness will arise because the expected cash flows of the hedged item and the hedging instrument differ. The fair value of the interest rate swap may be affected by other factors that cause ineffectiveness, for example counter party credit risk, but these have been disregarded in this example.
There are no transaction costs.
The entity’s financial year ends on 31 December. This example assumes that the qualifying conditions for hedge accounting in paragraph 12.18 are met from 1 January 20X5. The table in paragraph 12A.5 summarises the impact of hedge accounting on the interest rate swap, profit or loss and other comprehensive income. The table below sets out the applicable LIBOR rates, interest payments and swap settlements. The fair values of the interest rate swap and the hedged item shown in the table are shown for illustrative purposes only.
Note that in practice, when forecasted variable interest rate payments are the hedged item, the fair value of a hypothetical swap, that would be expected to perfectly offset the hedged cash flows, is used as a proxy of the fair value of the hedged item. The hypothetical derivative in this scenario is a fixed to floating interest rate swap with terms that match those of the loan and a fixed rate of 4.3 per cent, which for the purpose of this example, is the interest rate where the fair value of the hypothetical swap is nil at the inception of the hedging relationship.
| 1 Jan 20X5 | 31 Dec 20X5 | 31 Dec 20X6 | 31 Dec 20X7 | |
| Actual 3-month LIBOR | 4.3% | 5% | 3% | n/a |
| Actual 6-month LIBOR | 4.5% | 4.9% | 3.2% | n/a |
| Interest payments based on 3-month LIBOR | n/a | CU10m x (4.3% + 2.5%)= CU680,000 | CU10m x (5% + 2.5%)= CU750,000 | CU10m x (3% + 2.5%)= CU550,000 |
| Interest rate swap (hedging instrument) | ||||
| Fair value | nil | CU78,000 | (CU89,000){ | (CU130,000){ |
| Fair value change | nil | CU78,000 – 0= CU78,000 | (CU89,000) – CU78,000= (CU167,000) | (CU130,000) – (CU40,000)§ – (CU89,000)= (CU1,000) |
| Swap settlement receipts/ (payments) based on 6-month LIBOR | n/a | CU10m x (4.5% – 4.5%)= nil | CU10m x (4.9% – 4.5%)= CU40,000 | CU10m * (3.2% – 4.5%)= (CU130,000) |
| Hedged item | ||||
| Fair value | nil | (CU137,000) | CU59,000 | CU130,000 |
Key to table:
{: This valuation is determined before the receipt of the cash settlement of CU40,000 due on 31 December 20X6.
{: This valuation is determined before the payment of the cash settlement of CU130,000 due on 31 December 20X7.
: CU40,000 is the settlement of the interest rate swap as at 31 December 20X6 which affects the fair value of the swap, but is not included in the fair value of the swap at 31 December 20X6 of CU89,000.
12A.4 Hedge accounting:
31 December 20X5
(1) In accordance with paragraph 12.23(a), the cash flow hedge reserve is adjusted to the lower of (in absolute amounts) the cumulative gain on the hedging instrument (ie the interest rate swap), which equals its fair value, of CU78,000 and the cumulative change in fair value of the hedged item, which equals its fair value of (CU137,000). In accordance with paragraph 12.23(b), the gain of CU78,000 on the interest rate swap is recognised in other comprehensive income.
(2) The fixed interest element on the hypothetical swap is CU430,000, the same amount as the variable rate component. The variability of the 3-month LIBOR did therefore not affect profit or loss during the period. The reclassification adjustment in accordance with paragraph 12.23(d)(ii) is nil. (Note that no accounting entry is shown below.)
Note A: For illustrative purposes the accounting entry for interest payments is shown below. Note that in practice the accrual and payment of interest may be recorded in separate accounting entries.
Accounting entries:
Note that the accounting entries shown are only those relevant to demonstrate the effects of hedge accounting. In practice other accounting entries would be required, eg an entry to recognise the loan liability.
| Ref | Debit | Credit | |
| (1) | Interest rate swap | CU78,000 | |
| Other comprehensive income | CU78,000 | ||
| (A) | Profit or Loss | CU680,000 | |
| Cash | CU680,000 |
31 December 20X6
(1) In accordance with paragraph 12.23(a), the cash flow hedge reserve is adjusted to the lower of (in absolute amounts) the cumulative loss on the hedging instrument (ie the interest rate swap) which equals its fair value of (CU89,000) and the cumulative change in fair value of the hedged item, which equals its fair value of CU59,000. The cash flow h medge reserve moves from CU78,000 to (CU59,000), a change of (CU137,000). In accordance with paragraph 12.23(b), a loss of CU137,000 on the interest rate swap is recognised in other comprehensive income, as this part of the loss is fully off-set by the change in the cash flow hedge reserve. The remainder of the loss on the interest rate swap of CU30,000 is recognised in profit or loss, as required by paragraph 12.23(c).
(2) The fixed interest element on the hypothetical swap is CU430,000, whilst the variable rate component is CU500,000. The variability of the 3-month LIBOR affects profit or loss during the period by CU70,000. Accordingly, the reclassification adjustment in accordance with paragraph 12.23(d)(ii) is CU70,000.
Note A: For illustrative purposes the accounting entry for interest payments is shown below. Note that in practice the accrual and payment of interest may be recorded in separate accounting entries.
Note B: For illustrative purposes the accounting entry for the settlement of the swap is shown below.
Accounting entries:
| Ref | Debit | Credit | |
| (1) | Other comprehensive income | CU137,000 | |
| Profit or loss | |||
| Interest rate swap | CU167,000 | ||
| (2) | Other comprehensive income | CU70,000 | |
| Profit or loss | CU70,000 | ||
| (A) | Profit or loss | CU750,000 | |
| Cash | CU750,000 | ||
| (B) | Cash | CU40,000 | |
| Interest rate swap | CU40,000 |
31 December 20X7
(1) In accordance with paragraph 12.23(a), the cash flow hedge reserve is adjusted to the lower of (in absolute amounts) the cumulative loss on the hedging instrument (ie the interest rate swap) which equals the fair value of (CU130,000) and the cumulative change in fair value of the hedged item, which equals its fair value of CU130,000. The cash flow hedge reserve moves from (CU129,000) to (CU130,000), a change of (CU1,000). In accordance with paragraph 12.23(b), the loss of CU1,000 on the interest rate swap is recognised in other comprehensive income.
(2) The fixed interest element on the hypothetical swap is CU430,000, whilst the variable rate component is CU300,000. The variability of the 3-month LIBOR affects profit or loss during the period by (CU130,000). Accordingly, the reclassification adjustment in accordance with paragraph 12.23(d)(ii) is (CU130,000).
Note A: For illustrative purposes the accounting entry for interest payments is shown below. Note that in practice the accrual and payment of interest may be recorded in separate accounting entries.
Note B: For illustrative purposes the accounting entry for the settlement of the swap is shown below.
Accounting entries:
| Ref | Debit | Credit | |
| (1) | Other comprehensive income | CU1,000 | |
| Interest rate swap | CU1,000 | ||
| (2) | Profit or loss | CU130,000 | |
| Other comprehensive income | CU130,000 | ||
| (A) | Profit or loss | CU550,000 | |
| Cash | CU550,000 | ||
| (B) | Interest rate swap | CU130,000 | |
| Cash | CU130,000 |
12A.5: The table below summarises the effects of the accounting entries shown in paragraph 12A.4 on the interest rate swap, profit or loss and other comprehensive income.
| Description | Interest rate swap | Other comprehensive income | Profit or loss | |
| 31 December 20X5 | ||||
| Opening balance | nil | nil | – | |
| Interest on the loan | – | – | CU680,000 | |
| Interest rate swap fair value movement | CU78,000 | (CU78,000) | – | |
| Closing balance | CU78,000 | (CU78,000) | – | |
| 31 December 20X6 | ||||
| Opening balance | CU78,000 | (CU78,000) | – | |
| Interest on the loan | – | – | CU750,000 | |
| Interest rate swap fair value movement | (CU167,000) | CU137,000 | CU30,000 | |
| Settlement receipt interest rate swap | (40,000) | – | – | |
| Reclassification from cash flow hedge reserve | – | CU70,000 | (CU70,000) | |
| Closing balance | (CU129,000) | CU129,000 | – | |
| 31 December 20X7 | ||||
| Opening balance | (CU129,000) | CU129,000 | – | |
| Interest on the loan | – | – | CU550,000 | |
| Interest rate swap Movement | (1,000) | 1,000 | – | |
| Settlement payment interest rate swap | CU130,000 | – | – | |
| Reclassification from cash flow hedge reserve | – | (CU130,000) | CU130,000 | |
| Closing balance | nil | nil | – | |
Key to table:
This is the balance of the cash flow hedge reserve.
Hedges of a net investment in a foreign operation
Extract from FRS 102 Section 12.24
12.24 Hedges of a net investment in a foreign operation, including a hedge of a monetary item that is accounted for as part of the net investment (see Section 30), shall be accounted for similarly to cash flow hedges from the date the conditions of paragraph 12.18 are met:
(a) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge shall be recognised in other comprehensive income (see paragraphs 12.23(a) and (b)); and
(b) the ineffective portion shall be recognised in profit or loss. The cumulative gain or loss on the hedging instrument relating to the effective portion of the hedge that has been accumulated in equity shall not be reclassified from equity to profit or loss on disposal or partial disposal of the foreign operation.
OmniPro comment
This hedge can only be used for the retranslation of foreign operations in the consolidated financial statements. It cannot be used for individual financial statements. That said it may be possible to hedge foreign currency borrowings as a fair value hedge of the foreign currency exposure of the foreign equity investment, provided that all the conditions for hedging are met.
The hedged item is the net assets of the foreign operation including goodwill and the hedging instrument can either be foreign currency borrowings or foreign currency forward contracts.
The movement is recognised in other comprehensive income to the extent the hedge is effective. Any ineffectiveness is recognised in the profit and loss. The amount recognised in OCI is not recycled following the disposal of the subsidiary.
Example 17: Net investment in a foreign operation (Extracted from Appendix to Section 12 of FRS 102
Hedge accounting: Net investment in a foreign operation
This example illustrates the accounting for a net investment hedge in the consolidated financial statements. The entity has a foreign operation and hedges its exposure to foreign currency risk in the foreign operation by the use of a foreign currency loan.
12A.6 On 1 April 20×5 an entity with functional currency CU acquires an investment in an overseas subsidiary (with functional currency FC) at a cost of FC1,200,000. On the same day the entity takes out a loan with a third party of FC1,200,000 to finance the investment. This example disregards the effects of interest or other transaction costs associated with the loan.
This example assumes that the carrying amount of the investment denominated in FC is impaired below FC1,200,000 as presented in the table below, which causes ineffectiveness.
The entity’s financial year ends on 31 December.
This example assumes that the qualifying conditions for hedge accounting in paragraph 12.18 are met from 1 April 20X5.
The table below sets out the applicable exchange rates, the carrying amount of the loan and the foreign exchange gains and losses on the loan as determined in accordance with Section 30, as well as the retranslation differences on the foreign investment recognised in other comprehensive income in accordance with Section 30.
| 1 Apr 20X5 | 31 Dec 20X5 | 31 Dec 20X6 | |
| Spot exchange rate CU:FC | 0.35:1 | 0.3:1 | 0.45:1 |
| Loan (hedging instrument) | |||
| Carrying amount under Section 30 | (FC1,200,000) x CU0.35:FC= (CU420,000) | (FC1,200,000) x CU0.3:FC= (CU360,000) | (FC1,200,000) x CU0.45:FC= (CU540,000) |
| Cumulative gain/(loss) | nil | (CU360,000) – (CU420,000)= CU60,000 | (CU540,000) – (CU420,000)= (CU120,000) |
| Gain/(loss) | nil | (CU360,000) – (CU420,000)= CU60,000 | (CU540,000) – (CU360,000)= (CU180,000) |
| 1 April 20X5 | 31 December 20X5 | 31 December 20X6 | |
| Investment in foreign operation (hedged item) | |||
| Retranslation difference in accordance with Section 30 | nil | (CU55,000) | CU157,500 |
| Cumulative retranslation differences | nil | (CU55,000) – 0= (CU55,000) | CU157,500 + (CU55,000)= CU102,500 |
Key to table:
This is the exchange difference referred to in paragraph 30.20 which is recognised in other comprehensive income. The amount under paragraph 30.20(a) is CU5,000 and under paragraph 30.20(b) (CU60,000). The calculation is based on the translation of the FC200,000 loss at the average rate of 0.325CU:FC.
This is the exchange difference referred to in paragraph 30.20 which is recognised in other comprehensive income. The amount under paragraph 30.20(a) is CU7,500 and under paragraph 30.20(b) CU150,000. The calculation is based on the translation of the FC100,000 profit at the average rate of 0.375CU:FC.
12A.7 Hedge accounting:
31 December 20X5
A component of equity is adjusted to the lower of (in absolute amounts) the cumulative exchange gain on the loan of CU60,000 and the cumulative retranslation difference on the net investment of (CU55,000).
In accordance with paragraph 12.24(a), a gain of CU55,000 on the loan is recognised in other comprehensive income. The remainder of the gain of CU5,000 is recognised in profit or loss, as required by paragraph 12.24(b).
Accounting entry:
Note that only the accounting entry in relation to hedge accounting as described in paragraph 12.24 is shown. Other accounting entries in relation to the loan and the investment in the foreign operation would be required in practice.
| Debit | Credit | |
| Loan | CU60,000 | |
| Other comprehensive income | CU55,000 | |
| Profit or loss | CU5,000 |
31 December 20X6
A component of equity is adjusted to the lower of (in absolute amounts) the cumulative exchange loss on the loan of CU120,000 and the cumulative exchange difference on the net investment of CU102,500.
The amount recorded in equity changes from CU55,000 to (CU102,500), a change of (CU157,500). In accordance with paragraph 12.24(a) a loss of CU157,500 on the loan is recognised in other comprehensive income. The remainder of the loss of CU22,500 is recorded in profit or loss, as required by paragraph 12.24(b).
Accounting entry:
| Debit | Credit | |
| Other comprehensive income | CU157,500 | |
| Profit or loss | CU22,500 | |
| Loan |
CU180,000 |
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