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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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12.9 Grouping of items as hedged items
12.9.1 Extract from FRS102-Section 12.16B
12.16B A group of items, including components of items, can be an eligible hedged item provided that all of the following conditions are met:
(a) it consists of items that are individually eligible hedged items;
(b) the items in the group share the same risk;
(c) the items in the group are managed together on a group basis for risk management purposes; and
(d) it does not include items with offsetting risk positions.
12.9.2 OmniPro comment
12.9.2.1 Overview
As per Section 12.16B of FRS 102 a group of items, including components of items, can be an eligible hedged item provided that all of the following conditions are met:
(a) it consists of items that are individually eligible hedged items;
(b) the items in the group share the same risk;
(c) the items in the group are managed together on a group basis for risk management purposes; and
(d) it does not include items with offsetting risk positions. In relation to this point, an entity cannot net future foreign currency sales with future purchases in that same foreign currency and then only entre into a forward foreign exchange currency for the net amount. If it does then hedge account cannot be applied. One way to overcome this would be to set the hedging strategy to state that the entity hedges the first X amount of purchases or sales. E.g. Company A enters into CU100,000 of FC purchases and CU 150,000 of FC sales. In this case the hedging strategy should be that the entity hedges the first CU50,000 of sales as the hedging instrument.
When assessing group entities, it should be considered whether the below factors are similar:
(a) the currency in which the assets/liabilities are held;
(b) the scheduled maturity date; and
(c) the types of assets/liabilities.
The groupings do not have to share an identical risk but share a common risk characteristic that is subject to the hedge (e.g. foreign currency risk). The hedged item should move in the same direction in order for them to be grouped.
12.9.2.2 Hedging a group of highly probable future foreign sales with numerous forward contracts & assessing whether it meets the requirements as highly probable
Example 12: Hedging a group of highly probable future foreign sales with numerous forward contracts & assessing whether it meets the requirements as highly probable
Company A enters into a significant volume (40% of its total sales) of foreign currency sales (i.e. FC sales). As a result the entity enters into forward foreign exchange contracts to cover the risk of the foreign exchange fluctuations on expected cash flows from highly probable forecasted sales (sales to be invoiced in foreign currencies), with those fluctuations (change in exchange rates will effect both its net income and financial position, as expressed in the functional currency of the Company) impacting the profit and loss account. The company’s functional currency is CU. By entering into the contracts the company is able to manage its cash flow whereby the company knows the amount in CU the company will obtain on that sale from the outset. It eliminates the risk of foreign currency movements altering the amount received in CU on that sale (which would ultimately impact the profit and loss account). The Company’s policy is to hedge all material foreign exchange risk associated with highly probable forecast transactions, firm commitments. The policy is to hedge the risk of changes in the relevant spot exchange rate. The Company has made these FC sales consistently year on year and has been proven to be very good at forecasting. The policy is to hedge highly probable sales 12 months from the expected date of sale. The Company hedges the first amount of foreign sales each month. See below the analysis carried out when assessing whether hedge accounting can be applied and whether group hedging can be done.
Assessment as to whether the transactions meet the definition of a forecasted/highly probable transaction:
In assessing the likelihood that a transaction will occur in order to meet the definition of a highly probable forecasted transaction the following factors are considered by the company:
– The frequency of similar past transactions
As stated the company make circa 40% of its sales in foreign currencies/sterling and this is somewhat consistent year to year. it has regular customers in the foreign country that it sells to which are recurring in nature. As a result it is evident that there is frequent sakes to the regular Foreign country customers. During 20X4 & 20X5 a new FC customer was obtained ‘Customer XYZ’ and significant probable sales were expected so as a result forward contracts were entered into to hedge against those sales
– The financial and operational ability of the entity to carry out the transaction
The company has significant operations in its home country which will allow the company to meet the sales demand. The company’s strong net asset position allow the company to produce the goods required to meet the sales demand
– Substantial commitments and resources to a particular activity
The sales relate to the sale of goods which is the company principal activities. As the foreign country is one of the company’s key customer base, it expends a large volume of costs in maintaining these customers. The goods being sold are not of a one off type, they are products which the company has manufactured for the past number of years and they are the source of income for the company
– The extent of loss or disruption of operations that could result if the transaction did not occur
As almost 40% of the company’s sales are invoice in foreign currencies, if these sales were not to arise it would have a detrimental impact on the company. Given the significance of these sales, it is in the best interest of the company to ensure that the forecasted sales materialise.
– The entities business plan
The company’s budgets for the next 12 months have been prepared and the forecasted probable sales are in line with these budgets. The forecasted sales are not only based on the budgets for the next 12 months but also confirmed orders (in certain circumstances). The company generally enters into contracts for 6-12 months in advance (a shorter period is used for new FC countries (6-7 months) for US sales as some of these sales are newer and 11 months for established foreign currency sales as there is consistent sales year on year in that country. During the year one new customer was won which resulted in an increase in forecasted sales and therefore an increase in forward contracts entered into). The company has a history of always selling at least the budgeted amount and there has been no material changes in the budgeting process in preparing the budget for the current period than the processes that were used in the past.
– The length of time until a forecast transaction is projected to occur
As detailed below the strategy as dictated by group is to only hedge transactions for 12 months from the month end date. Given that the company prepares budgets which are usually accurate for those 12 months, this 12 month period is considered appropriate in that reasonable estimates of probable sale in that period can be determined with reasonable accuracy and is supported by similar sales in those months in previous years. This is supported by the fact that customers are recurring customers and transactions in foreign currency make up approx 40% of all sales. As stated generally the company enters into contracts 11 months in advance for FC and 6 months for US sales and US sales are less established
– Hedge accounting analysis
(a) The hedging relationship consists only of a hedging instrument item as described in paragraphs 12.16 to 12.17c of FRS 102;
– The quantity/value of transactions compared to prior periods
The probable transaction are in line with the actual quantity of sales that arose in the prior periods on a monthly basis. This then supports the fact that these are highly profitable. FC sales are increasing year on year and the company budgets based on market demands and contracts are entered into based on these market demands
On the basis of the above responses, it is evident that the forecasted sales are highly probable and therefore meet the definition of a hedged item for hedge accounting purposes.
When looking at a highly probable sales/purchase under Section 12.16b of FRS 102, it is permitted to use a group of items as an eligible hedged item provided that all of the following conditions are met:
(a) it consists of items that are individually eligible hedged items; – For this company each of the probable transactions are eligible as a hedged item individually
(b) the items in the group share the same risk; – For this company the sales to customers in the for foreign country in FC share the same foreign exchange risk therefore this requirement has been met
(c) The items in the group share the same risk; – For this company, the company reviews its foreign exchange exposure on foreign currencies of the same type as a whole
(d) it does not include items with offsetting risk positions; – This company does not net foreign currency purchases with sales, instead these are separated out. The risk hedged is the same for all of the probable transactions
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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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