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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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The below extracts and guidance is applicable for periods beginning before 1 January 2019 and are based on the September 2015 version of FRS 102. For periods beginning on or after 1 January 2019, the March 2018 version of FRS 102 applies which incorporates the changes made by the Triennial review of FRS 102. Note the March 2018 version of FRS 102 can be voluntarily applies for periods beginning before 1 January 2019. For the extracts from the March 2018 version of FRS 102 and the related guidance please click on the following link. For details of a summary of the main changes as a result of the triennial review please see the following link.
12.8 Hedge accounting
12.8.1 Extract from FRS102 section 12.15 – 12.17C
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.
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.
12.8.2 OmniPro comment
12.8.2.1 Hedging defined
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.
In order to apply hedging, there must first be a hedged item and a hedging instrument.
12.8.2.2 Hedged item – defined
As per Section 12.16 of FRS 102 a hedged item can be:
– a recognised asset or liability (i.e. a debtor/creditor balance),
– an unrecognised firm commitment (See 12.8.2.6),
– a highly probable forecast transaction (See 12.8.2.7), or
– a net investment in a foreign operation (See 12.16.2), or
– a component of any such item, provided the item is reliably measurable.
Applying the example of hedged items and hedged instruments to example 8 at 12.5.2.7.2 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;
See further details at 12.9.2 and 12.10.2.
12.8.2.3 Hedging instrument – defined
As per Section 12.17 of FRS 102 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, 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. See further details in relation to options at 12.11.2.4.
An instrument (or a combination of such instruments) meeting the conditions above, 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.
Applying the example of hedged items and hedged instruments to example 7 and 8 at 12.5.2.7.2 above:
- The hedged instrument is the forward contract. Another example would include interest rate swaps.
See further discussions on hedging instruments at 12.11.2.
12.8.2.4 Purpose of hedge accounting
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 8 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 7 and 8 at 12.5.2.7.2 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.
12.8.2.5 What can be hedged under hedge accounting?
As per Section 12.16A of FRS 102 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 between entities of the same group as long as the hedging:
- occurs in the entity financial statements and not in the consolidated financial statements. Or
if in the consolidated financial statements then it relates to:
(a) 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
(b) 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.
12.8.2.6 Firm commitment
12.8.2.6.1 Firm commitment – Defined
Appendix I of FRS 102 defines a ‘firm commitment as a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.’
Therefore the key requirements are it must have:
- Fixed terms;
- Fixed quantity;
- Fixed price;
- Fixed timing of the transaction; and
- There cannot be variability i.e. the price paid must be set.
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.
12.8.2.6.2 Classification of Firm commitments as a hedge – fair value or cash flow hedge?
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 of FRS 102 where the fixed price is in a currency different to the functional currency.
12.8.2.6.3 The exception for fair valuing firm commitments – Own use exception to fair value
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 to be fair valued in accordance with Section 12.4 and Section 12.5 of FRS 102. It may be applicable if it is for property which is merely to be held for investment purposes.
12.8.2.6.4 Determining the fair value of a commitment
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 at 12.14.2.2.1.2 where such a fixed commitment was hedged.
12.8.2.7 Forecast transaction
12.8.2.7.1 Forecast transaction – Defined
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 to occur.
12.8.2.7.2 Forecast transaction – Indicators that such a transaction exists
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.
When documenting the hedging strategy and requirements each of the above points should be considered. See application of these guidelines at 12.9.2.2.
12.8.2.8 Intra-group hedging & when hedge accounting can be applied
Section 12.16A of FRS 102 makes it clear that for individual entities of group companies, hedge accounting can be applied to intra group sales/purchases. 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 Subsidiary (group company) entering into it and the currency will not eliminate on consolidation.
12.8.2.8.1 Intra-group hedging – Example
Example 11: 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.
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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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