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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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12.15 Cash flow hedges
12.15.1 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.
12.15.2 OmniPro comment
12.15.2.1 Cash flow hedge defined
Section 12.22(b) of FRS 102 defines a cash flow hedge as:
- 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;
12.15.2.2 Accounting for cash flow hedges – hedge accounting
Section 12.23 of FRS 102 provides the rules for accounting for cash flow hedges. See below a summary of the accounting requirements as stated in Section 12.23 of FRS 102
| Instrument | Accounting treatment |
| The hedged item (e.g. anticipated purchase or sale in foreign currency) | Not yet recognised in the accounts |
| Hedging item (e.g. Variable rate loan) | Fair value on balance sheet
Fair balue movements recgonised in profit and loss Ineffectiveness remains in profit and loss |
| Hedging instrument (e.g. Forward foreign exchange contract, interest rate swap receive variable pay fixed, fair value of fixed commitment that is in a foreign currency) | Fair value on balance sheet
Fair value movements recognised in other comprehensive income/equity-cash flow hedge reserve, subsequently recycled to profit and loss Ineffectiveness portion to profit and losss immediately Recycle to P&L when hedged transaction affects income (forecasted sales/purchases) Recycle to the initial measurement of an asset where the hedged item is a non-financial asset/liability or becomes a firm commitment |
Section 12.23 of FRS 102 requires the following treatment where the conditions for hedge accounting apply:
- recognise the effective element of the fair value movement on the hedging instrument in Other comprehensive income and the cash flow hedge reserve (see 12.15.2.3);
- recognise the ineffective portion of the fair value movement on the hedging instrument in the P&L (see 12.15.2.3);
- any amounts accumulated in the cash flow hedge reserve should:
- if a hedged forecast transaction subsequently results in the recognition of a non-financial asset/liability then you must remove the amount included in the cash flow hedge reserve and include it directly in the carrying amount of the non-financial asset/liability.
- For cash flow hedge reserves created for all other items other than the above then the amount is the cash flow hedge reserve is transferred to the P&L in the period end the expected future cash flows affect the P&L e.g. on the date the sale/purchase arises AND
- If the amount included in the cash flow hedge reserve 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 classified to profit and loss immediately.
See applications of the requirements of Section 12.23 of FRS 102 at 12.15.2.3
12.15.2.3 Examples of cash flow hedge accounting
See below the common examples of cash flow hedges:
12.15.2.3.1 Forward contract for a probable forecasted sale
- Forward contract for a probable forecasted sale/purchase.
Where a foreign exchange contract is entered into for probable forecasted purchases/sale then hedge accounting can be applied assuming the conditions in Section 12.18 of FRS 102 apply (See 12.12.2). For a discussion on what is classified as a highly probable sale/purchase see 12.8.2.7.2.
In accordance with Section 12.23 of FRS 102, the fair value of the forward foreign currency contract must be recognized on the balance sheet as a derivative and the effective portion must be recognized in the cash flow hedge reserve/other comprehensive income (with the ineffective portion recognized directly in the profit and loss account) which is transferred to the P&L once the probable date of the transaction has passed or when it no longer become probable.
Where a forward contract is entered into for a sale/purchase expected to occur 2 months from the date of entering into the forward contract which will not be paid until a month later (i.e. in 3 months time) and a forward FX contract is taken out which has a maturity date in 3 months’ time, any fair value movement on the FX contract is recognized in other comprehensive income/cash flow hedge reserve (as per Section 12.23(b) & (c) of FRS 102) up to the end of the 2 months/when the sale occurs, at the end of the 2 months, the fair value movement recognized in other comprehensive income/cash flow hedge reserve is transferred to the P&L as required by Section 12.23(d)(i) of FRS 102. The fair value movement on the FX contract between the date between the recognition of the transaction and the receipt of payment must be recognized in the P&L.
12.15.2.3.1.1 Forward contract for a probable forecasted sale
Example 23: 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.
12.15.2.3.1.2 Forward contract for a probable forecasted purchase
Example 24: 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:
12.15.2.3.1.3 Probable future purchase/sale where probable date of sale differs from maturity of the contract
Example 25: Probable future purchase/sale where probable date of sale differs from maturity of the contract
Where a forward contract is entered into for a sale/purchase expected to occur 2 months from the date of entering into the forward contract which will not be paid until a month later (i.e. in 3 months time) and a forward FX contract is taken out which has a maturity date in 3 months’ time, any fair value movement on the FX contract is recognized in other comprehensive income/cash flow hedge reserve (as per Section 12.23(b) & (c) of FRS 102) up to the end of the 2 months/when the sale occurs, at the end of the 2 months, the fair value movement recognized in other comprehensive income/cash flow hedge reserve is transferred to the P&L as required by Section 12.23(d)(i) of FRS 102. The fair value movement on the FX contract between the date between the recognition of the transaction and the receipt of payment must be recognized in the P&L.
12.15.2.3.2 Hedge of variability in cash flows in a floating rate loan due to interest rate risk
- Hedge of variability in cash flows in a floating rate loan due to interest rate risk (interest rate swap
12.15.2.3.2.1 Overview
For an interest rate swap the effective portion of the interest rate swap is recognized in other comprehensive income/cash flow hedge reserve and the ineffective portion is recognized in the profit and loss account. The amount included in the cash flow hedge reserve is transferred to the profit and loss account once the cash flows actually hit the P&L. Where there is an ineffective portion on the hedge, Section 12.23(a) of FRS 102 states that the cash flow hedge is adjusted to the lower of (in absolute terms) the cumulative gain or loss on the hedging instrument (i.e. the interest rate swap) and the cumulative change in fair value of the hedged item. Where there is no ineffectiveness given the (e.g. because the main terms match i.e. the notional amounts and interest reset dates) Section 12.23(a) of FRS 102 will have no impact.
Full details of the rules have been illustrated in the example at 12.15.3.2.3.
12.15.2.3.2.1.1 Fair valuing an interest rate swap
The fair value of an interest rate swap is based on the difference between the future interest payments on the loan at the contracted rate and the expected interest rate had no hedge been taken out and related amount over the remaining periods discounted at a rate of interest expected over the remaining period.
Example 26: Fair valuing an interest rate swap
Company A took out a variable loan which is repayable over 10 years. At the same time, in order to prevent variability on the repayment/interest amounts payable the company entered into an interest rate swap to pay the fixed and receive the variable rate 3 month euribor for the first 5 years. The interest rate swap was less than the expected loan amount each time. The fixed rate payable is 5% and the variable rate is the 3 month Euribor.
At the end of year 1 the way in which this will be fair valued is that you will look at the future interest payments at the fixed rate and then use something like bloomburg to get the 3 month Euribor rates forecasted from the start of year 2 to the end of year 5. The difference between the fixed rate payments and the expected variable rate receipts over the remaining 4 years is the fair value of the interest rate swap after applying a discount rate.
12.15.2.3.2.2 Testing for the ineffective portion on an interest rate swap and determining fair value – hypothetical swap
In order to assess the ineffective portion of an interest rate swap where qualitatively it is evident that there is ineffectiveness a possible method to do this would be as follows:
Identify the hypothetical interest rate swap which is a swap that mirrors the exact terms of the variable element on the loan. In essence you are assuming that an interest rate swap has been taken out where you will receive the fixed interest rate and pay the variable interest rate (i.e. the opposite of the actual interest rate swap which the entity holds) and that variable interest rate follows the exact benchmark on the loan itself and assumes a perfect match i.e. the notional amounts agree at each reset date to the actual amount of the loan on that date and the reset date is the same date as the repayments on the loan are made, the interest reset dates agree exactly, the interest rate linked to the benchmark on the swap agrees exactly to the benchmark (e.g. Euribor 6 months) on the loan itself (excluding any margin where the margin is not hedged) etc. etc. The fair value of the hypothetical swap moves in the opposite direction of the actual interest rate swap that the entity has entered into. If the amounts agree exactly to the fair value of the actual interest rate swap held by the entity, then the interest rate swap is 100% effective (for example if the interest rate on the loan to which the interest rate swap relates was the 3 month Euribor and the interest rate swap taken out by the entity used the 6 months euribor then when determining the hypothetical swap the entity would use the 3 month euribor regardless of the fact that the actual interest rate swap used the 6 month euribor as when determining the hypothetical swap you must assume that a perfect hedge is taken out such that the hypothetical swap agrees exactly to the notional amount, interest reset dates etc. on the loan itself).
12.15.2.3.2.3 Hedge of variability in cash flows in a floating rate loan due to interest rate risk
Example 27: 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) of FRS 102, 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) of FRS 102, 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) of FRS 102 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) of FRS 102, 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 hedge reserve moves from CU78,000 to (CU59,000), a change of (CU137,000). In accordance with paragraph 12.23(b) of FRS 102, 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) of FRS 102.
(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) of FRS 102 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) of FRS 102, 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) of FRS 102, 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) of FRS 102 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.
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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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