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Contents
12.1 Deciding what instruments come within the scope of section 12.
12.2 Accounting policy choice.
12.2.1 Extract from FRS 102-Sections 12.2–12.2A.
12.2.2.1 What is the accounting policy choice?
12.2.2.2 What accounting policy to choose for an entity.
12.3.1 Extract from FRS 102-Section 12.3–12.5.
12.3.2.1 Items excluded from Section 12 of FRS 102:
12.3.2.2 Items coming within the scope of Section 12 of FRS 102.
12.3.2.2.1.1 Unguaranteed Capital and variation in return linked to a fund.
12.3.2.2.1.2 Collective investment funds.
12.3.2.2.1.3 Loan extension option where rate on the extension is determined at inception.
12.3.2.2.1.5 Variation in return which is dependent on future contingencies.
12.2.2.2.1.7 Investments with profit bonds.
12.3.2.2.1.8 Loans which are linked to value of net assets.
12.3.2.2.1.9 Loan repayments linked to repayments on another loan or tranche of a loan.
12.3.2.2.1.12 Leases with non-standard contractual terms.
12.3.2.2.1.13 Contingent consideration for the seller.
12.3.2.2.1.14.1 The own use exemption.
12.3.2.2.1.16 Warrants that can be settled in cash or in exchange for another financial instrument;
12.3.2.2.1.19 Repurchase agreements;
12.3.2.2.1.20 Compound financial instruments.
12.3.2.2.1.21 A firm commitment which is contractually binding.
12.3.2.2.1.22 Where the variable rate on a loan is leveraged.
12.3.2.2.1.23 Where a bond has a negative yield.
12.4 Initial recognition and subsequent measurement of financial assets and liabilities.
12.4.1 Extract from FRS 102-Section 12.6-12.9.
12.4.2.2 Subsequent recognition.
12.4.2.2.1 Subsequent recognition – General.
12.4.2.2.1.1.1 Financial instruments not permitted to be fair valued under Company Law.
12.4.2.2.1.1.1.1 The accounting treatment where this exception applies.
12.4.2.2.1.1.2.1 The accounting treatment where this exception applies.
12.4.2.2.1.1.3 Where hedge accounting is applied.
12.4.2.2.2 Financial instruments not permitted to be fair valued under Company Law.
12.4.2.2.2.1.1 Financial instruments permitted to be fair valued under Company Law.
12.4.2.2.2.1.1.2.2 Derivative financial instrument.
12.4.2.2.2.1.1.2.2.1 Derivative – defined.
12.4.2.2.2.1.1.2.2.1.1 Examples of Derivatives.
12.4.2.2.2.1.1.2.3 Eliminate an accounting mismatch.
12.4.2.2.2.1.1.2.4 Instrument contains an embedded derivative that is not closely related.
12.4.2.2.2.1.1.2.4.0 Overview.
12.4.2.2.2.1.1.2.4.2 Embedded derivative defined.
12.4.2.2.2.1.1.2.4.3 Identify whether the embedded derivative is or is not closely related.
12.4.2.2.2.1.1.2.4.3.1 Examples where the embedded derivative is not closely related.
12.4.2.2.2.1.1.2.4.3.2 Examples where the embedded derivative is closely related.
12.5.1 Extract from FRS 102 section 12.10 – 12.12.
12.5.2.1 The fair value model to utilise.
12.5.2.2 The fair value of a financial instrument due on demand.
12.5.2.3 Transaction costs and fair value.
12.5.2.4 Examples of fair valuation techniques for complex instruments.
12.5.2.5 Deferred tax and the fair value adjustments.
12.5.2.5.1 Deferred tax and fair value adjustments where they relate to trade assets/liabilities.
12.5.2.5.3 Deferred tax where hedge accounting is applied.
12.5.2.6 Examples of fair valuing financial instruments where market rates are not available.
12.5.2.7 Foreign currency forward contracts.
12.5.2.7.2 Accounting for forward foreign currency contracts – non hedging – Examples.
12.5.2.7.3 Accounting for interest rate swaps – non hedging – Examples.
12.6 Impairment of financial instruments measured at cost or amortised cost.
12.6.1 Extracts from FRS 102 – section 12.3.
12.7 Derecognition of a financial asset or financial liability.
12.7.1 Extract from FRS 102 – section 12.14.
12.7.2.1 Non-hedged instruments.
12.8.1 Extract from FRS102 section 12.15 – 12.17C.
12.8.2.2 Hedged item – defined.
12.8.2.3 Hedging instrument – defined.
12.8.2.4 Purpose of hedge accounting.
12.8.2.5 What can be hedged under hedge accounting?
12.8.2.6.1 Firm commitment – Defined.
12.8.2.6.2 Classification of Firm commitments as a hedge – fair value or cash flow hedge?
12.8.2.6.3 The exception for fair valuing firm commitments – Own use exception to fair value.
12.8.2.6.4 Determining the fair value of a commitment.
12.8.2.7 Forecast transaction.
12.8.2.7.1 Forecast transaction – Defined.
12.8.2.7.2 Forecast transaction – Indicators that such a transaction exists.
12.8.2.8 Intra-group hedging & when hedge accounting can be applied.
12.8.2.8.1 Intra-group hedging – Example.
12.9 Grouping of items as hedged items.
12.9.1 Extract from FRS102-Section 12.16B.
12.10 Hedging a component of an item.
12.10.1 Extract from FRS102-Section 12.16C.
12.10.2.2 Examples illustrating hedging a component of an item.
12.10.2.2.1 Hedging with a forward contract where contract is less than the probable sale amount.
12.10.2.2.2 Hedging part payments.
12.10.2.2.3 Hedging part payments.
12.11.1 Extract from FRS102-Section 12.17-12.17C.
12.11.2.1 What instruments can be classified as a hedging instrument?
12.11.2.2 Portion of a hedging instruments.
12.11.2.3 Instrument used to hedge a foreign currency risk.
12.11.2.4.1 What is an option and what is a written option?
12.11.2.4.2 Determining the fair value of an option and using it as a hedging instrument.
12.12 Conditions for hedge accounting.
12.12.1 Extract from FRS102-Section 12.18-12.18A.
12.12.2.1 When can hedge accounting be applied from and conditions must be met?
12.12.2.2 What is an economic relationship?
12.12.2.3 Designation and documentation.
12.12.2.4 Causes of hedge ineffectiveness.
12.12.2.4.2 Example of hedge ineffectiveness documented for an interest rate swap.
12.13 Accounting for qualifying hedging relationships.
12.13.1 Extract from FRS102-Section 12.19-12.19A.
12.13.2.1 The three types of hedge relationships for hedge accounting.
12.14.1 Extract from FRS102 – Section 12.19B-12.22.
12.14.2.1 What is a fair value hedge and what does it do?
12.14.2.2 The accounting for a fair value hedge.
12.14.2.2.1 Examples of fair value hedges and the accounting for same.
12.14.2.2.1.1 Fixed interest rate on a debt instrument (financial instrument).
12.14.2.2.1.1.1 Amortised cost on cessation of hedging where financial instrument exists.
12.14.2.2.1.2 Firm commitment not recognised on balance sheet.
12.14.2.2.1.3 Hedge of a foreign currency risk of an unrecognised firm commitment.
12.15.1 Extract From FRS 102 – Section 12.22(b) and 12.23.
12.15.2.1 Cash flow hedge defined.
12.15.2.2 Accounting for cash flow hedges – hedge accounting.
12.15.2.3 Examples of cash flow hedge accounting.
12.15.2.3.1 Forward contract for a probable forecasted sale.
12.15.2.3.1.1 Forward contract for a probable forecasted sale.
12.15.2.3.1.2 Forward contract for a probable forecasted purchase.
12.15.2.3.2 Hedge of variability in cash flows in a floating rate loan due to interest rate risk.
12.15.2.3.2.1.1 Fair valuing an interest rate swap.
12.15.2.3.2.3 Hedge of variability in cash flows in a floating rate loan due to interest rate risk.
12.16 Hedges of a net investment in a foreign operation.
12.16.1 Extract from FRS 102 Section 12.24.
12.16.2.1 Net investment in a foreign operation defined.
12.16.2.2 When can a net investment in a foreign operation be hedged?
12.16.2.3 What is the hedged item and instrument in a net investment in a foreign operation?
12.17 Discontinuing hedge accounting.
12.17.1 Extract from FRS102 Section 12.25 to 12.25A.
12.17.2.2 When can/must hedge accounting be discontinued and is it applied retrospectively.
12.17.2.2.1 Fair value hedge and discontinuance rules.
12.17.2.2.2 Cash flow hedge and discontinuance rules.
12.17.2.2.3 Net investment in a foreign operation hedge and discontinuance rules.
12.17.2.2.4 Examples of discontinuance.
12.18 Taxation of fair valuing derivatives – current and deferred tax.
12.19.1 Extract from FRS102-Section 12.25B.
12.20.1 Extracts from FRS 102 section 12.26 – 12.29.
12.20.2.2 Sample Disclosure requirements.
12.20.2.2.1 Extract from accounting policy notes.
12.20.2.2.2 Extract of notes to the financial statements – Financial instruments note disclosures.
12.20.2.2.3 Extract of notes to the financial statements – interest disclosures.
12.20.2.2.3.1 Note: Interest receivable and similar income.
12.20.2.2.3.2 Note: Interest payable and similar expenses.
12.20.2.2.4 – Debtors Disclosures.
12.20.2.2.5 – Creditors disclosures.
12.20.2.2.7 Statement of Comprehensive Income.
12.20.2.2.8 – Statement of Change in Equity.
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12.12 Conditions for hedge accounting
12.12.1 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.
12.12.2 OmniPro comment
12.12.2.1 When can hedge accounting be applied from and conditions must be met?
Section 12.18 of FRS 102 states that hedge accounting can only be applied from the date when all of following are met:
(a) the hedging relationship consists only of a hedging instrument (see 12.11.2) and a hedged item (see 12.8.2.2);
(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 (See 12.12.2.2);
(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 (see 12.12.2.4).
12.12.2.2 What is an economic relationship?
As per Section 12.18A of FRS 102 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.
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 100% hedge effectiveness. If there is a 100% match then a qualitative assessment is not required. 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 as to whether there is ineffectiveness.
If the critical terms do not match and a qualitative assessment is not conclusive, management needs to do a quantitative analysis at each reporting date. In particular, this is likely to be the case for entities that commonly use proxy hedges (for example, they hedge a commodity risk with a hedging instrument in a different commodity because there is no liquid market in the commodity being hedged)
12.12.2.3 Designation and documentation
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 of FRS 102 at inception of the hedge. Unlike IFRS 9, the guidance does not state that this documentation should be ‘formal’ or that it must be prepared at inception of the hedge. However, management should prepare the documentation at the inception of the hedge, because hedge accounting will only apply from the date when all the conditions are met.
The documentation 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. For forecasted transactions this would identify when the transaction is expected to take place so that when it does occur it is clear that the transaction is or is not the hedged transaction.
- Detail the company’s/group’s risk management policy;
- Document the hedging relationship so that the risk being hedged, the hedged item and the hedging instrument are clearly identified;
- Documentation of the causes of hedge ineffectiveness (see 12.12.2.4). There is no specific requirement to state in the documentation how the entity plans to measure effectiveness.
12.12.2.4 Causes of hedge ineffectiveness
Examples of the causes of hedge ineffectiveness include:
- Timing differences – the hedged item and the hedged instrument are settled at different dates.
- Basis differences – bench mark rates differ on the hedged instrument and hedged item.
- Location differences – the fair value or cash flows of the hedged item and hedging instrument both depend on the price of the same commodity, but are based on the price at different locations.
- Quantity or notional amount differences between the hedged item and the hedged instrument
- Credit risk – the risk that the holder or the entity’s credit risk changes will impact hedge ineffectiveness.
- Changes in future cash flows – If a probable sale/firm commitment does not transpire then this will cause hedge ineffectiveness.
12.12.2.4.1 Examples of hedge ineffectiveness documented for future forward foreign exchange contracts
The causes of hedge ineffectiveness in relation to the hedged item and the hedging instrument in this case are:
– The timing of the occurrence of the highly probable future sale and the maturity of forward foreign currency contract. The sale may not occur on the exact date as the maturity of the foreign currency forward contract (e.g. The maturity of the contract may be on a certain day in the month, however the sale may not occur until sometime within that month) or the date of the sale may not occur within the stated month.
– The actual value of the forecasted sales do not match exactly to the forecasted sale
– The unlikely circumstance where a highly probable forecasted sale does not materialise
– the default of the financial instrument issuer
12.12.2.4.2 Example of hedge ineffectiveness documented for an interest rate swap
Where an interest rate swap (where the pay fixed, receive variable Euribor) is entered into to achieve a cash flow hedge the usual causes of hedge ineffectiveness in relation to the hedged item and the hedging instrument in this case are and its applicability to this case are:
– Timing differences = a floating rate debt whose variability is hedged with an interest rate swap where the interest rate reset dates on the two instruments are different – As discussed above, this is applicable for this company and this interest rate swap contract. in this case the interest rate reset dates differ from the variable interest rate reset dates on the loan itself by 5 days. This could result in hedge ineffectiveness. although there is ineffectiveness given the small difference it is unlikely to result in material ineffectiveness. See X for an estimate of this ineffectiveness.
– Basis difference = The benchmark interest rate on the interest rate swap does not agree to the benchmark interest rate on the variable element on the loan (i.e. on the hedged item) – This is not applicable in this case as both the hedged item and the hedged instruments benchmark is the same; that being the 6 month Euribor
– the default of the financial instrument issuer – In this case the issuer of the swap is ABC Bank; a strong bank with very little likelihood of default.
– the default of scheduled repayments = where the repayments are not made by the company, then the interest rate swap may still reduce on the notional reset date regardless of whether the repayment was made on the load – In this case since the load was taken out there has never been an instance where the repayment was missed and it is unlikely to occur in the future.
– Quantity or notional amount differences = the hedged item and hedging instrument are based on different quantities or notional amounts – This is applicable to this situation as the notional amount reset dates differ by 5 days when compared to the actual repayment date on the loads themselves as discussed above. This will result in hedge ineffectiveness however it is unlikely to be material given the small number of days by which they differ.
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Examples
Example 1: Unguaranteed Capital and variation in return linked to a fund.
Example 2: Collective investment funds.
Example 3: Loan extension option (Section 11.9 (AB) of FRS 102).
Example 5: Variation in return (Section 11.9 (aB) of FRS 102).
Example 6: Prepayment options (Section 11.9 (c) of FRS 102.
Example 6a: Investments held at fair values – market rates available.
Example 6b: Fair valuing complex financial instruments where no active market available.
Example 6c: Fair valuing complex financial instruments where no active market available.
Example 6d: Fair valuing complex financial instruments where no active market available.
Example 8: Foreign currency forward contract to hedge a sale.
Example 9: Foreign currency forward contract to hedge a future purchase.
Example 10: Interest rate swap – non hedge accounting.
Example 11: Hedging in a group context.
Example 13: Hedging with a forward contract where contract is less than the probable sale amount.
Example 14: Hedging part payments.
Example 15: Hedging part payments.
Example 16: Partial term hedging.
Example 17: Portion of a hedging instruments.
Example 19: Forward contract option.
Example 22: Hedge of a foreign currency risk of an unrecognised firm commitment.
Example 23: Forward contract for a probable forecasted sale.
Example 24: Probable forecasted purchase of equipment.
Example 26: Fair valuing an interest rate swap.
Example 27: Hedge of variability in cash flows in a floating rate loan due to interest rate risk.
Example 28: Net investment in a foreign operation (Extracted from Appendix to Section 12 of FRS 102.
Example 29: Discontinuance of a cash flow hedge – forecasted sale/purchase.
Example 30: Cash flow hedge example.
Example 31: Interest rate swap – cash flow hedge accounting.
Example 32: Sample Disclosure Requirements.
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