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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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12.14 Fair value hedges
12.14.1 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.
12.14.2 OmniPro comment
12.14.2.1 What is a fair value hedge and what does it do?
As per Section 12.19AB of FRS 102 a fair value hedge hedges for risk of changes in fair value of assets/liabilities affecting the profit and loss account.
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. Hedge ineffectiveness was discussed at 12.12.2.4
12.14.2.2 The accounting for a fair value hedge
Once the conditions for fair value hedge accounting as discussed at 12.12.2 are met then the following accounting rules apply (the below is a summary of Section 12.20A to 12.22 of FRS 102):
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.
12.14.2.2.1 Examples of fair value hedges and the accounting for same
Examples of fair value hedges include:
12.14.2.2.1.1 Fixed interest rate on a debt instrument (financial instrument)
- Fixed interest rate on a debt instrument
Example 20: 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. Note the fair value of an interest rate swap is the difference between what Company A has to pay under the variable rate estimated based on market data (after discounting) for the 5 year period less what they will receive in fixed interest (after discounting). The difference between the two represents the fair value of the interest rate swap.
At the end of year 1 the negative fair value of the loan attributable to the hedged interest rate risk is CU5,600. This is fair valued by looking at the rates that would be obtained on this loan if it was to be got out at the year end based on the credit risk, change in interest rate etc.
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:
12.14.2.2.1.1.1 Amortised cost on cessation of hedging where financial instrument exists
Note in accordance with Section 12.22 of FRS 102 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. See at 11.6.2.4 in Section 11 for further details of how the effective interest rate is calculated.
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.
12.14.2.2.1.2 Firm commitment not recognised on balance sheet
- 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 of FRS 102. See further details at 12.3.2.2.1.14.1.
Example 21: 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. Assume that the own use exception as discussed in Section 12.4 and Section 12.5 of FRS 102 does not apply as discussed at 12.3.2.2.1.14.1
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 12.20 of FRS 102 this CU20,000 would be shown as an asset on the balance sheet as a derivative financial instrument 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 (assuming the price stayed at CU12):
| 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 of FRS 102.
12.14.2.2.1.3 Hedge of a foreign currency risk of an unrecognised firm commitment
- 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 of FRS 102. 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 22: 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 |
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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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