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Transition exemptions
Section 35.10(t) deals with derivatives. It allows entities the choice to apply hedge accounting from the date of transition if the conditions for hedge accounting and the documentation requirements stated in Section 12.18(d) and 12.19(e) are met before the first set of FRS 102 financial statements are authorised for issue. Section 35.10(t) also allows entities who met the conditions at period ends after the date of transition to apply hedge accounting if the conditions for hedge accounting are met and the documentation requirements stated in Section 12.18(d) and 12.19(e) before the first set of FRS 102 financial statements are authorised for issue.
Therefore where an entity choses to apply hedge accounting from the date of transition, transition adjustments will be required to recognise the amount to be recognised in the cash flow hedge at that date.
Section 35 provides no exemptions with regard to fair valuing derivatives or any other items that come within the remit of Section 12. Therefore transition adjustments will be required. See examples of such adjustments below.
Principal transition adjustments
- Forward contracts, interest rate swaps (and other derivatives) not previously recognised under old GAAP instead disclosed requires recognition under Section 12 (hedging not adopted).
Under old GAAP (for non-FRS 26 adopters) derivatives such as forward contracts and interest rate swaps which were still open at the year-end reporting date were not recognised on the balance sheet instead they were disclosed. Section 12 requires such derivatives to be recognised at fair value on the balance sheet. Therefore at the date of transition where forward contracts, interest rate swaps etc. exist, an adjustment will be required to recognise these at fair value and where hedge accounting is not adopted the other side of the transaction will be to the profit and loss. It is also likely deferred tax will arise on the adjustments as they will not have been taxed in the past as they would not have been included in the profit under old GAAP.
Note in the example below we have assumed it was used to hedge debtors etc. at year end, however the same type of journal would be required where the forward contract was used to hedge future purchases or sales. The accounting would be the same.
Old GAAP allowed entities to use the average forward contract rate to retranslate the foreign currency balance at the year end. Section 30 does not allow this so if under old GAAP foreign entities applied this treatment, then they will have to make an adjustment on transition to show the foreign balances at the year-end spot rate and fair value the forward contract. An example of the adjustment required to show the balances at the spot rate is included in the transition adjustments section of Section 30 of this guide.
The examples below assume hedge accounting is not adopted.
Example 19: Forward Contracts
Company A entered into a forward contract to hedge against foreign exchange movements as the company engages in a significant volume of foreign currency sales. The year end is 31 December. It entered into a forward contract on 1 November 2013 to sell FC100,000 of FC in return for CU at a set rate of CU1:FC0.80 maturing on 31 March.
Assume the spot rate at 31 December 2013 and 31 December 2014 was CU1:FC0.70 and the date of transition is 1 January 2014. Assume deferred tax of 10%.
The forward rate quoted for sterling contract at 31 December 2013 by the bank for a contract that matures on 31 March is CU1:FC0.75.
Under old GAAP this forward contract was not accounted for; instead it was disclosed in the financial statements. However under FRS 102 this should be fair valued.
The transition adjustments as a result of entering into this forward contract at 31 December year end under FRS 102 assuming it does not meet the conditions for hedge accounting are as follows:
1 January 2014
|
|
CU |
CU |
|
Dr Profit and Loss reserves |
8,333 |
|
|
Cr Forward Contract Liability |
|
8,333* |
Being journal to reflect fair value of the forward contract at the year-end not accounted for under old GAAP.
|
|
CU |
CU |
|
Dr Deferred Tax Asset (CU8,333*10%) |
833 |
|
|
Cr Profit and Loss reserves |
|
833 |
Being journal to reflect deferred tax on the above adjustment for the fact that this will be tax deductible in future years.
*Fair value of the forward contract:
Amount of CU’s 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 spot rate.
Amount of CU’s that could theoretically be obtained on 31 March at contracted rate of CU1:FC0.75 = FC100,000/0.75= CU133,333
Fair value loss at 31 December 2013/1 January 2014 is CU133,333-CU125,000 = CU8,333
Journals required for year ended 31 December 2014 assuming the above journals are brought forward)
|
|
CU |
CU |
|
Dr Forward Contract Liability |
8,333 |
|
|
Cr Foreign Exchange Gain |
|
8,333 |
Being journal to derecognise the liability recognised on 1 January 2014 above on the contract maturing
|
|
CU |
CU |
|
Dr Deferred Tax in P&L |
833 |
|
|
Cr Deferred Tax Asset |
|
833 |
Being journal to reverse deferred tax as this was taxed in the 2014 tax computation when the forward contract was settled.
Example 20: Forward contracts in existence after the date of transition
If we take the example above and this time assume that the forward contract was entered into on 1 November 2014 and it matured on 31 March with the same dates and fair values. The journals that would be required on transition is:
31 December 2014
|
|
CU |
CU |
|
Dr Foreign Exchange Gain in P&L |
8,333 |
|
|
Cr Forward Contract Liability |
|
8,333 |
Being journal to reflect fair value of the forward contract at the year-end not accounted for under old GAAP.
|
|
CU |
CU |
|
Dr Deferred Tax Asset (CU8,333*10%) |
833 |
|
|
Cr Deferred Tax in P&L |
|
833 |
Being journal to reflect deferred tax on the above adjustment for the fact that this will be tax deductible in future years
31 December 2015 assuming the above journals were posted to reserves
|
|
CU |
CU |
|
Dr Forward Contract Liability |
8,333 |
|
|
Cr Foreign Exchange Gain |
|
8,333 |
Being journal to derecognise the liability recognised at 31 December on the contract maturing
|
|
CU |
CU |
|
Dr Deferred Tax in P&L |
833 |
|
|
Cr Deferred Tax Asset |
|
833 |
Being journal to reverse deferred tax as this will be taxed in the 2015 tax computation when the forward contract was settled.
Note if a forward contract exists at 31 December 2015 no deferred tax will be required to be recognised on the adjustment as it will be taxed/tax deductible in the 2015 year.
Example 21: Interest rate swap – non hedge accounting
Company A gets a loan for CU100,000 on 1 January 2013 at a fixed rate of 5% 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. The notional amount hedged is CU100,000 Assume the current average variable interest rate was 6%.
Under old GAAP (for non-FRS 26 adopters) this interest rate swap was not accounted for, instead it was disclosed in the financial statements. However under FRS 102 this should have been fair valued.
Assume at the end 31 December 2013 and 2014, there was a loss of CU5,000 and profit of CU6,000 respectively on the interest rate swap.
The transition adjustments required are:
1 January 2014
|
|
CU |
CU |
|
Dr Profit and Loss Reserves |
5,000 |
|
|
Cr Interest Rate Swap Liability |
|
5,000 (CU500*10%) |
Being journal to recognise the fair value of the interest rate swap
|
|
CU |
CU |
|
Dr Profit and Reserves with Deferred Tax |
500 |
|
|
Cr Deferred Tax Liability |
|
500 |
Being journal to reflect the deferred tax on the above adjustment.
Journals required for year ended 31 December 2014 assuming the above journals are brought forward)
|
|
CU |
CU |
|
Dr Interest Rate Swap Liability |
5,000 |
|
|
Cr Interest Expense |
|
5,000 |
Being journal to reverse the fair value of the interest rate swap at the end of prior year.
|
|
CU |
CU |
|
Dr Deferred Tax Liability |
500 |
|
|
Cr Deferred Tax P&L |
|
500 |
Being journal to reflect the deferred tax on the above adjustment.
|
|
CU |
CU |
|
Dr Interest Rate Swap Liability |
6,000 |
|
|
Cr Interest Expense |
|
6,000 |
Being journal to recognise the fair value of the interest rate swap at 31 December 2014
|
|
CU |
CU |
|
Dr Deferred Tax P&L |
600 |
|
|
Cr Deferred Tax Liability |
|
600 |
Being journal to reflect the deferred tax on the above adjustment as it was not taxed in 2014 tax computation.
Journals required for year ended 31 December 2015 (assuming the above journals are brought forward)
|
|
CU |
CU |
|
Dr Interest Expense |
6,000 |
|
|
Cr Interest Rate Swap Liability |
|
6,000 |
Being journal to reverse the fair value of the interest rate swap at 31 December 2014.
Note that only 1/5th of the deferred tax is reversed in 31 December 2015 as under the tax transition rules the adjustment in 2014 will be taxable over 5 years from 2015. This journal is not illustrated below.
Note that no deferred tax journals are required on the fair value of the interest rate swap adjustment in 31 December 2015 as this will be taxed/tax deductible in the 2015.
2. Ability to apply hedge accounting under FRS 102 which was not available for non-FRS26 adopters under old GAAP
Under old GAAP non-FRS 26 adopters did not have the opportunity to apply hedge accounting. FRS 102 provides these entities with an opportunity provided the conditions in Section 12.18 are met. Note the documentation requirements of Section 12.18 (d) and (e) do not have to be met at the date of transition under Section 35.10(t) instead if these conditions are met by the date the first set of FRS 102 financial statements were authorised for issue then hedge accounting can be applied.
Cash flow hedge
On transition, the amount to be shown in the cash flow hedge reserve should reflect the extent the transaction has not yet affected the profit or loss. Under a cash flow hedge the fair value of the derivative (e.g. forward currency contract, interest rate swap – pay variable receive fixed and the hedged item) should be recognised in other comprehensive income. See example below:
Example 22: Cash flow hedge example
On 1 December 2013 Company A whose functional currency is CU secured a highly probable contract with a foreign currency customer worth FC100,000. The sale is expected to happen on 31 March 2015 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 2013 was CU1:FC0.70 and the date of transition is 1 January 2014. Assume deferred tax of 10%.
The forward rate quoted for the foreign currency contract at 31 December 2013 by the bank for a contract that matures on 31 March is CU1:FC0.75.
Under old GAAP this forward contract was not accounted for instead it was disclosed in the financial statements. However under FRS 102 this should have been fair valued. The contract also meets the hedge accounting requirement in 12.18 and the client wants to hedge account.
The transition adjustments as a result of entering into this forward contract and chosing to adopt hedge accounting is as follows:
1 January 2014
|
|
CU |
CU |
|
Dr – Cash Flow Hedge Reserve |
8,333 |
|
|
Cr Forward Contract Liability |
|
8,333* |
Being journal to reflect fair value of the forward contract at the year-end not accounted for under old GAAP and applying hedge accounting (i.e. posted to OCI as it meets the condition for hedging).
|
|
CU |
CU |
|
Dr Deferred Tax Asset (CU8,333*10%) |
833 |
|
|
Cr Deferred Tax in Cash Flow Hedge Reserve |
|
833 |
Being journal to reflect deferred tax on the above adjustment
*Fair value of the forward contract:
Amount of CU that will be obtained on 31 March at contracted rate of CU1:FC0.80 is FC100,000/FC0.80= CU125,000.
Note any FC balances in the balance sheet at 31 December should be retranslated to the year-end spot rate.
Amount of euros that could theoretically be obtained on 31 March at contracted rate of CU1:FC0.75 is FC100,000/FC0.75 = CU133,333.
Fair value loss at 31 December 2013/1 January 2014 is CU133,333-CU125,000 = CU8,333.
Journals required for year ended 31 December 2014 assuming the above journals are brought forward)
|
|
CU |
CU |
|
Dr Forward Contract Liability |
8,333 |
|
|
Cr Other Comprehensive Income – Cash Flow Hedge Reserve |
|
8,333 |
Being journal to reverse the journals posted at 1 January as the contract has now matured and the FX gain on the contract has already been posted to the P&L under old GAAP (i.e. contract settled for CU125,000 (FC100,000/FC0.80) less the FC100,000 at the spot rate at 31 March of CU1:FC0.84p i.e. (CU119,048)= CU5,952.
|
|
CU |
CU |
|
Dr Deferred Tax in OCI/Cash Flow Hedge Reserve |
833 |
|
|
Cr Deferred Tax Asset (CU8,333*10%) |
|
833 |
Being journal to reflect reversal of deferred tax recognised on transition as the contract has now matured.
If another forward contract was entered into in 2014 and 2015, the same type of journals would be required
Example 23: Interest rate swap – cash flow hedge accounting
Company A gets a loan for CU100,000 on 1 January 2012 at a variable rate 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 fixed rate of 6% to the third party and the third party will pay the floating rate to Company A. The notional amount hedged is CU100,000 and the variable rate at inception such that the swap has a nil fair value is 6%. The expected average variable interest rate set in advance at the start of the year was 6%, 5% and 8% for 2012, 2013 and 2014 respectively. Interest is paid the following year.
Under old GAAP (for non-FRS 26 adopters) the fair value of the interest rate swap was not accounted for, instead it was disclosed in the financial statements. However under FRS 102 this should have been fair valued. The entity has also chosen to hedge account as it meets the hedge accounting requirements in Section 12.18.
Assume at the 31 December 2013, the fair value of the interest rate swap was a loss of CU5,000 up to that date. Under cash flow hedge rules assume CU1,000 of this would have been recognised in the profit and loss account if the due to this element being ineffective and the remaining CU4,000 would be recognised in the cash flow hedge reserve.
The transition adjustments required are:
1 January 2014
|
|
CU |
CU |
|
Dr Cash Flow Hedge Reserve |
4,000 |
|
|
Dr Profit and Loss Reserve |
1,000 |
|
|
Cr Interest Rate Swap Liability |
|
5,000 |
Being journal to recognise the fair value of the interest rate swap.
|
Dr Deferred Tax Asset |
CU 500 |
CU
|
|
Cr Deferred Tax in Cash Flow Hedge Reserve (CU4,000*10%) Cr Profit and loss reserves Deferred Tax |
|
400
100 |
Being journal required to reflect the deferred tax on the above adjustment.
The journals for 31 December 2014 assuming the above journals were brought forward are:
|
|
CU |
CU |
|
Dr Deferred Tax in OCI/Cash Flow Hedge reserve |
400 |
|
|
Dr Deferred Tax in P&L |
100 |
|
|
Cr Deferred Tax in Asset |
|
500 |
Fair value hedge
On transition, an adjustment will be required to recognise the fair value of the interest rate swap and the adjustment to reflect the carrying amount of the loan through profit and loss reserves. Under a fair value hedge, the fair value adjustments are recognised in the profit and loss. See example below
Example 24: 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 on 1 January 2013.
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 31 December 2013 the interest rate swap has a positive fair value of CU6,100 and the negative fair value of the loan attributable to the hedged interest rate risk is CU5,600. Assume for the simplicity these values are the same for 31 December 2014 and 2015 year end.
Assume the transition date is 1 January 2014 and that all conditions for hedge accounting in 12.18 have been met. Assume the deferred tax rate is 10%.
The transition adjustments required are:
1 January 2014
The accounting entries required 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 |
|
|
Dr Profit and Loss Reserves on Loan Fair Value Gain |
5,600 |
|
|
Cr Loan Liability |
|
5,600 |
|
Cr Profit and Loss Reserves on Swap FV loss |
|
6,100 |
Being journal to reflect fair value of loan and swap at date of transition
|
|
CU |
CU |
|
Dr Profit and Loss Reserves (CU6,100-CU5,600*10%) |
50 |
|
|
Cr Deferred Tax Liability |
|
50 |
Being journal to reflect deferred tax on the above adjustment
Journals required at 31 December 2014 assuming the above journals are brought forward
|
|
CU |
CU |
|
Dr Swap FV Loss in P&L |
6,100 |
|
|
Dr Loan Liability |
5,600 |
|
|
Cr Loan Fair Value Gain in P&L |
|
5,600 |
|
Cr Swap Fair Value on Balance Sheet |
|
6,100 |
Being journal to reverse prior year fair value of loan and swap
|
|
CU |
CU |
|
Dr Deferred Tax Liability |
50 |
|
|
Cr Deferred Tax in P&L (CU6,100-CU5,600*10%) |
|
50 |
Being journal to reverse prior year deferred tax
|
|
CU |
CU |
|
Dr Swap Fair Value on Balance Sheet |
6,100 |
|
|
Dr Loan Fair Value Gain in P&L |
5,600 |
|
|
Cr Swap FV Loss in P&L |
|
6,100 |
|
Cr Loan Liability |
|
5,600 |
Being journal to reflect fair value of loan and swap at 31 December 2014
|
|
CU |
CU |
|
Dr Deferred Tax in P&L (CU6,100-CU5,600*10%) |
50 |
|
|
Cr Deferred Tax Liability |
|
50 |
Being journal to reflect deferred tax on year end journal
The final balance sheet will look like the below at 31 December 2014:
Note in accordance with 12.22 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 just lies there any moves in line with the fair value adjustments year on year.
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.
Journals required at 31 December 2015 assuming the above journals are brought forward
|
|
CU |
CU |
|
Dr Swap FV loss in P&L |
6,100 |
|
|
Dr Loan Liability |
5,600 |
|
|
Cr Swap Fair Value on Balance Sheet |
|
6,100 |
|
Cr Loan Fair Value Gain in P&L |
|
5,600 |
Note the deferred tax journal above is not reversed here as this will be taxable in the tax computation over the 5 year period as part of the tax transition exemptions.
|
|
CU |
CU |
|
Dr Deferred Tax Liability |
10 |
|
|
Cr Deferred Tax in P&L (CU50/5 years) |
|
10 |
Being journal to release 1/5 of the deferred tax liability on transition
|
|
CU |
CU |
|
Dr Swap Fair Value on Balance Sheet |
6,100 |
|
|
Dr Loan Fair Value Gain in P&L |
5,600 |
|
|
Cr Swap FV loss in P&L |
|
6,100 |
|
Cr Loan Liability |
|
5,600 |
Being journal to reflect fair value of loan and swap at 31 December 2015
It is evident that there are no deferred tax journal at 31 December 2015 for the 2015 contract entered into for the 2015 contract entered into. The reason for same is that this adjustment will be included in the tax computation in 2015.
3. Options in contracts
Where entities have options to purchase or sell/firm commitments and these options relate to commodities, products which are not for own use i.e. (that are not used as stock in trade, used in production or sold) then these contracts will have to be fair valued on the balance sheet under FRS 102. This was not the case under old GAAP. Therefore if any such options exist then these will need to be fair valued. The fair value of these options would be the value they would get if they were disposed of then reacquired straight away or the penalty that would be payable if a party wanted to cancel the option. The way in which this would be accounted would be similar to the forward exchange example above where no hedging existed.
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