7.2.1 General rule

Basic financial instruments within the scope of Section 11 will be initially measured at the transaction price, adjusted for transaction costs, unless they are subsequently measured at fair value though profit or loss (see exception in 7.2.2 below).

For basic financial instruments designated as at fair value through profit or loss and other financial instruments within the scope of Section 12, initial measurement will be at fair value, which is normally the transaction price. [FRS 102.11.13, 12.7].

In essence, the main difference in the initial measurement is in the treatment of transaction costs. Transaction costs are capitalised as part of the initial carrying value for those financial instruments subsequently measured at amortised cost or cost, and expensed to the profit or loss account for those instruments that are subsequently measured at fair value through profit or loss.

7.2.2 Exception: financing transactions

There is one exception to the general rule of initially measuring a financial instrument measured at amortised cost at its transaction price, in the case of ‘financing transactions’. In October 2015, the FRC issued Staff Education Note 16 – Financing Transactions – (‘SEN 16’), which provides guidance on the measurement requirements applicable to financing transactions.

A financing transaction is an arrangement for which payment is deferred beyond normal business terms or is financed at a rate of interest that is not a market rate. FRS 102 provides the example of a seller providing interest-free credit to a buyer for the sale of goods or an interest-free or below market interest rate loan made to an employee. [FRS 102.11.13, 12.7].

Sections 11 and 12 require financing transactions to be initially measured at the present value of the future payments, discounted at a market rate of interest for a similar debt instrument as determined at initial recognition and adjusted for transaction costs. [FRS 102.11.13, 12.7]. By requiring the instrument to be recorded initially at its net present value, the future yield will be approximately the market rate. When there is no initial payment at the time of the transaction, the difference between the net present value and the transaction price is effectively interest income or expense and is accounted for in the subsequent measurement of the receivable/payable by applying the effective interest method under the amortised cost model.

In applying this requirement to the sale of goods or services on deferred payment terms, an entity may use the current cash price of the goods or services on an arm's length basis as an estimate for the present value of the future payments. However, if there is no cash sale alternative or the cash selling price is the same as the price when buying on credit, the entity must calculate the present value of the future cash flows.

It should be noted that the present value of a financial asset or financial liability that is repayable on demand is equal to the undiscounted cash amount payable reflecting the lender's right to demand immediate payment. This would not constitute a financing transaction.

Consider the following examples:

Each subsequent year, the manufacturer recognises the interest earned based on the annual effective interest rate of 5.4%^* in the period with the following accounting entries.

For the year ended 31 December 2019, interest income is calculated applying the effective interest rate (5.4%) on the opening balance (£900):

For the year ended 31 December 2020, interest income is calculated applying the effective interest rate (5.4%) on the opening balance of the year (£949):

On 1 January 2019 the purchase of the piece of machinery is recorded by the customer at the cash selling price of £900. The customer also records a trade payable measured at the cash selling price of £900 as an estimate of the present value of the future payments. The customer records the following accounting entries when the piece of machinery is purchased:

Each subsequent year, the customer recognises the finance cost for the period with the following accounting entries based on the calculations described above for the seller.

For the year ended 31 December 2019:

For the year ended 31 December 2020:

* The effective interest rate was calculated as the annual compound rate that discounts the transaction price of £1,000 payable in 2 years to the £900 cash price.

In Example 10.3 above, after initial recognition both the manufacturer and the customer account for this basic debt instrument at amortised cost using the effective interest method; the difference of £100 between the present value of £900 and the transaction price of £1,000 is therefore recorded as interest income (for the manufacturer) or interest expense (for the customer) over the two years until payment is due from the customer, at which time the amortised cost will match the transaction price of £1,000 as illustrated in the example above.

The accounting for financing transactions raises the question of how to account for the difference between the initial measurement and the transaction price. When the transaction is a fixed term loan with no interest or with a below market rate of interest, the cash exchanged upon initial recognition will differ from present value calculated in accordance with the initial measurement rules for financing transactions discussed above (as shown in Example 10.4 above). This difference reflects that the lender has made a loan at a lower than market rate of interest and thereby has provided an additional benefit to the borrower. FRS 102 does not set out specific accounting requirements for that difference on initial recognition of the financing transaction. Where FRS 102 does not specifically address the accounting for a transaction, an entity applies judgement to select an accounting policy that results in relevant and reliable information. FRS 102 sets out the hierarchy of the sources an entity should consider for that analysis (see Chapter 9 at 3.2).

To determine the accounting treatment for the difference, an entity should assess the particular facts and circumstances of each arrangement. In that regard it is particularly important to establish the reasons a lender decided to make a loan at a non-market rate of interest.

In most cases, these types of loans take place between related parties. When that is the case, SEN 16 states that the accounting for the difference will be determined by the nature of the related party relationship:

1. Fixed term loans between a parent and a subsidiary: Loans between parents and their subsidiaries are often made on interest-free terms. It can be presumed that a loan is made on these terms because the parent owns and controls its subsidiary. The difference between the amount initially paid or received and the present value of a fixed-term loan at a market rate of interest represents in essence a capital contribution from the parent to the subsidiary (when the parent is the lender) or a distribution from the subsidiary to the parent (when the subsidiary is the lender).
2. Fixed term loans between fellow subsidiaries: In a situation where fellow subsidiaries enter into a loan which constitutes a financing transaction, it can generally be presumed that the loan was made on the direction of their parent. However, sometimes the facts and circumstances may indicate otherwise, for example when a fixed term interest-free loan is made in return for receiving goods or services at a discounted price, in which case the recognition of the financing component may have an impact on the accounting for the related goods or services acquired.

   If an interest-free loan is made on the direction of the parent, the subsidiaries account for the transaction as if it had been conducted through the parent. The lending subsidiary accounts for the measurement difference as a distribution to its parent (i.e. as if it had made a loan to its parent) and the borrowing subsidiary accounts for the loan as a contribution from its parent (i.e. as if it had received a loan from its parent). The transaction is not required to be reflected in the parent's own financial statements because the parent is not directly involved.

3. Fixed term loans between entities owned by the same person: In some instances a fixed term interest-free loan is made between entities that are not members of the same group, but the entities are related parties because they are owned and controlled by the same person. Unless the facts and circumstances indicate that the loan is made on these terms for a reason other than that the entities are controlled by the same owner, the accounting for the loan will be the same as shown above for a fixed term interest-free loan between fellow subsidiaries.
4. Fixed-term loans between entities and their directors: A fixed term interest-free loan may be made between an entity and its director(s). The accounting for the measurement difference arising on the initial recognition of the loan will depend on whether the loan was made in the director's capacity as a shareholder or for another reason. For example, in a situation where a director is the majority shareholder it can be presumed that the loan was made in the director's capacity as a shareholder. This presumption can be rebutted, if, for example, loans between the entity and other third parties without an ownership interest in the entity (e.g. employees) are made on the same or similar terms.

   If a fixed term interest-free loan is made between the entity and a director in its capacity as a shareholder, the accounting for the loan is similar to the accounting for a fixed term interest-free loan between a parent and its subsidiary shown above.

   If an interest-free loan is made between an entity and a director who has no direct ownership interest in the entity, the terms of the loan and the reasons for making it should be assessed carefully as this is relevant for determining the appropriate accounting under FRS 102. For example, an entity may offer interest-free loans to all employees, including its directors, as an additional employee benefit. Often these loans are made for a specific purpose, for example to purchase a travel season ticket. In this situation the entity accounts for the measurement difference as an employee benefit cost in accordance with Section 28 – Employee Benefits.

   When a director without ownership interest makes a loan to the entity, the director's motives have to be identified, as the director would not normally directly benefit from making a loan on these terms. The appropriate accounting for the measurement difference will be dependent on the individual circumstances of each transaction.

   If the reporting entity is a small entity, there is some relief in the accounting of these types of loans. We further discuss this situation at 7.2.3 below.

In all of the scenarios of fixed term loans between related parties described above, the debits and credits for the cash exchanged and the resulting basic debt instrument are the same. Taking the information in Example 10.4 above:

For the lender:

For the borrower:

The table below shows how the difference of £2,723 would be accounted for in each of the scenarios discussed above:

^*1 Investments in subsidiaries are subject to impairment under Section 27 – Impairment of Assets. An entity should apply the relevant accounting requirements in FRS 102 to determine whether an investment is impaired.

^*2 A distribution is recorded as a reduction of equity. A distribution recorded in the financial statements in accordance with FRS 102 may not be a distribution as a matter of law. The legal requirements on distributable profits are not addressed here. For limited companies subject to CA 2006, the ICAEW/ICAS Technical Release TECH 02/17BL – Guidance on Realised and Distributable Profits under the Companies Act 2006 (‘TECH 02/17BL’) considers issues concerning the determination of distributable profits and entities may refer to this or any successor document for more guidance.

^*3 For limited companies subject to the CA 2006, only profits realised at the reporting date are included in profit or loss. Therefore, depending on whether the distribution corresponds to realised gains and losses or not, the distribution received from the subsidiary could be reflected in the income statement or as OCI respectively. The legal requirements on realised profits are not addressed here. TECH 02/17BL considers issues concerning the determination of realised profits and entities may refer to this or any successor document for more guidance.

After initial recognition both the lender and the borrower will account for this basic debt instrument at amortised cost using the effective interest method over the term of the loan, at the end of which the amortised cost will match the transaction price. The effective interest rate used for this purpose will reflect a market rate of interest. [FRS 102.11.14(a)(iii)].

7.2.3 Financing transactions with simplified accounting

Prior to the Triennial review 2017, all financing transactions (except for public benefit entity concessionary loans – see Chapter 31 at 6.2) were required to be measured according to the exception discussed at 7.2.2 above. Feedback from stakeholders raised concerns about the implications for loans from directors to a company in which the director was also a shareholder. As this type of loans is often made by directors, especially to small companies, because funding is unavailable, it is difficult to determine an appropriate market rate for a similar debt instrument.

The FRC continues to believe that the accounting for financing transactions as discussed at 7.2.2 above is generally appropriate accounting as it reflects the fact that such transactions contain both an interest-bearing loan and the transfer of value representing the benefit compared to market rates of interest. However, it recognises that occasional specific exemptions may be granted in order to meet the principle of providing proportionate and practical solutions. For that reason the Triennial review 2017 included an amendment to provide simplified accounting for certain loans from directors for small entities (we further discuss the definition of small entity in Chapter 5 at 4.1).

The simplified accounting is intended to provide relief to small owner-managed businesses. As discussed at 7.2.2 above, transactions between entities within a group are subject to other considerations, including the nature of transactions between the entities and whether a distribution or investment has occurred. Therefore the simplified accounting was not extended to transactions between group entities.

In determining the scope of the simplified accounting, the FRC took into consideration that some small businesses are operated and financed by a group of family members who may have varying interests in the business. It also considered that similar relief should be provided when the small entity is a limited liability partnership instead of a company. [FRS 102.BC.B11.32-39].

The resulting relief allows a basic financial liability of a small entity to be carried at transaction price (with no subsequent recognition of interest expense) if it is a loan from a person who is within a director's group of close family members, when that group contains at least one shareholder (for a company) or member (for a limited liability partnership) in the entity. This covers situations where the director is a shareholder (including those where the person is the sole director-shareholder of the entity), but also situations where the director is not a shareholder but a close family member is. [FRS 102.11.13A]. On the other hand, a loan from a director who is not a shareholder and has no close family members that are shareholders will not qualify for this relief. [FRS 102.BC.B11.38].

For purposes of the relief, close family members of the family of a person is defined as those family members who may be expected to influence, or be influenced by, that person in their dealings with the entity including:

1. that person's children and spouse or domestic partner;
2. children of that person's spouse or domestic partner; and
3. dependants of that person or that person's spouse or domestic partner. [FRS 102 Appendix I].

It could occur that after initial recognition, the entity ceases to be a small entity. In such a case, it will no longer be able to take advantage of this simplified accounting and will be required to remeasure the financial liability at its present value. However the entity is only required to apply the accounting for financing transactions prospectively from the first reporting date after it ceases to be a small entity. FRS 102 allows the present value to be determined on the basis of the facts and circumstances existing at that time or at the date the financing arrangement was entered into. [FRS 102.11.13B].

On the other hand, if after initial recognition an entity qualifies as a small entity, it is allowed to take advantage of the simplified accounting, but if it chooses to do so, it must apply this accounting retrospectively. [FRS 102.11.13C].

7.2.4 Difference between fair value and transaction price

As noted at 7.2.1 above, even though financial instruments within the scope of Section 12 are required to be initially measured at fair value, Section 12 acknowledges that the initial fair value is ‘normally’ the transaction price. [FRS 102.12.7]. A difference will only arise in rare circumstances where fair value does not equate to the transaction price.

One such example is the wholesale markets for dealers in financial instruments, where such dealers are able to recognise a profit, being the margin that has been ‘locked in’ as a result of the differential between the price charged to a customer and the prices available to the dealer in wholesale markets.

In addition, in some markets, dealers charge minimal or no explicit transaction costs but instead quote differential prices for purchases and sales. Such prices are often referred to as ‘bid’ and ‘asking’ (or ‘offer’) prices. The term bid-ask spread is normally interpreted as the difference between the quoted bid and offer prices. The following example illustrates this point:

8.1.1 Comparison to IFRS

8.2.1 Debt instruments due within 1 year

Basic non-interest bearing debt instruments that are payable or receivable within one year must be measured at their undiscounted amount expected to be paid or received, unless the arrangement is a financing transaction as explained at 7.2.2. [FRS 102.11.14(a)(ii)]. FRS 102 refers to this method as amortised cost but clarifies that in calculating the amortised cost for these instruments, the amortisation using the effective interest method does not apply. [FRS 102.11.15]. The underlying objective of the one year rule was to simplify the measurement basis for trade receivables, which are by their nature, normally short-term and interest free.

On the other hand, basic interest-bearing debt instruments due within one year are not excluded from the general rules on amortised cost, hence amortisation using the effective interest method is required. Prior to the Triennial review 2017, FRS 102 did not differentiate between the treatment of basic interest bearing and non-interest bearing instruments that were due within one year. This could have been interpreted to mean that on initial recognition the instrument would be recognised at the total of principal plus interest, with immediate recognition of the interest in profit or loss. The updated language in FRS 102 has resolved this inadvertent omission.

8.3.1 Loan commitments

Basic commitments to receive a loan and to make a loan that are within the scope of Section 11 (see 6.1.3 above) must be measured at cost (which may sometimes be nil) less impairment. [FRS 102.11.14(c)]. The reference to cost is presumably in respect of any fees or premiums that have been paid by the borrower (representing a financial asset) and received by the lender (representing a financial liability).

FRS 102 is silent on how such costs should be accounted for once the loan is effectively withdrawn or if it is never utilised. Therefore, the entity will have to use judgement in developing and applying an accounting policy that results in reliable and relevant information. In our view, it would be acceptable to follow the guidance in IFRS 9, although other judgements could also be acceptable. The guidance in IFRS 9 in relation to commitment fees received by the entity to originate a loan is as follows:

1. If it is probable that the entity will enter into a specific lending arrangement, the commitment fee received is regarded as compensation for an ongoing involvement with the acquisition of a financial instrument. Together with the related transaction costs, the commitment fee is deferred and recognised as an adjustment to the effective interest rate when the loan is drawn. If the commitment expires without the entity making the loan, the fee is recognised as revenue on expiry.
2. On the other hand, if it is unlikely that a specific lending arrangement will be entered into, the commitment fee is recognised as revenue on a time-proportionate basis over the commitment period. [IFRS 9 Appendix B.5.4.2].

We expect the treatment by the issuer would be symmetrical; in the case described at (b), the resulting charge would represent compensation for the service provided by the lender, i.e. availability of cash during the commitment period.

8.3.2 Investments in equity instruments

As long as a reliable measure of fair value is available, investments in equity instruments should be measured at fair value through profit or loss. [FRS 102.11.14(d)(iv), 12.8]. But when a reliable measure of fair value is not available, investments in equity instruments are carried at cost less impairment. [FRS 102.11.14(d)(v), 12.8(a)].

As discussed at 6.4.1 above, the requirement to use cost less impairment for those equity investments that cannot be reliably measured is similar to that in IAS 39 (but not IFRS 9). The hurdle to overcome before concluding on the unreliability of the fair value measurement in a market that is not active is high, since FRS 102 assumes that normally it is possible to estimate the fair value of equity instruments that an entity has acquired from an outside party (see 8.6.5 below).

8.5.1 Introduction

The concept of impairment is relevant to financial assets that are measured at cost or amortised cost. FRS 102 uses the same principles and criteria as the incurred loss model under IAS 39, but with one major difference. Unlike IAS 39, under FRS 102 there is no requirement for assets that have been individually assessed for impairment and found not to be impaired to be subsequently included in a collective assessment of impairment. [IAS 39.64]. The FRS 102 requirements are set out at 8.5.2 below.

The FRC had originally suggested that the impairment requirements of FRS 102 would be updated to reflect the IFRS 9 ‘expected loss’ impairment model, once it was finalised. However, although IFRS 9 was completed in July 2014, the FRC has not incorporated changes to its impairment model. The IFRS 9 expected credit loss model is complex and practical experience of its application is still at an early stage, so it is no surprise that the FRC would not wish to introduce this model soon. Any amendments to FRS 102 to reflect such a major change will require consideration of the appropriate timing. The FRC agrees with respondents that, in most cases, it will be preferable to learn from IFRS implementation experience in determining whether, and if so how and when, FRS 102 should be amended. [FRS 102.BC.A.45]. However, if entities desire to use the expected credit loss model, they are able to choose to apply IFRS 9 for recognition and measurement purposes as discussed at 4 above.

The effect of moving from the current incurred loss model of FRS 102 and IAS 39 to the IFRS 9 expected loss approach is that entities recognise impairment losses earlier. Under IFRS 9 entities are required to recognise either 12-month or lifetime expected credit losses, depending on whether there has been a significant increase in credit risk since initial recognition or not. The measurement of expected credit losses must reflect a probability-weighted outcome, the time value of money and be based on reasonable and supportable information. Further information regarding impairment under IFRS 9 can be found in EY International GAAP 2019.

In the sections below, comparisons and references to IFRS are mostly made to IAS 39 as its principles and criteria are also based on incurred credit losses. We do not further discuss differences with the expected credit loss approach in IFRS 9 as it is substantially different.

8.5.2 Recognition of impairment

Under FRS 102, an assessment should be made at the end of each reporting period as to whether there is any objective evidence of impairment of financial assets that are measured at cost or amortised cost. [FRS 102.11.21, 12.13]. Financial assets carried at fair value through profit or loss are not subject to an impairment assessment, since decreases in value are reflected in the fair value and related profit or loss.

8.5.3 Measurement of impairment

8.5.4 Reversal of impairment

If, in a subsequent period, the amount of the impairment loss decreases and the decrease can be objectively related to an event occurring after the impairment was recognised (such as an improvement in the debtor's credit rating), the previously recognised impairment loss should be reversed and recognised in profit or loss, either directly or by adjusting an allowance account. However, the reversal should not result in a carrying amount of the asset that exceeds what its amortised cost would have been had the impairment not been recognised. [FRS 102.11.26].

FRS 102 does not specifically prohibit the reversal of impairment in the case of investments in equity instruments. This constitutes a difference compared to IAS 39, since the IASB could not find an acceptable way to distinguish reversals of impairment losses from other increases in fair value of available-for-sale equity instruments. Therefore, it decided to preclude such reversals for equity instruments. [IAS 39.BC129-130]. This also differs from IFRS 9, where equities, even those carried at fair value through other comprehensive income, are not subject to impairment.

8.6.1 Hierarchy used to estimate fair value

As mentioned above, the key guidance on how to calculate fair values is contained in the Appendix to Section 2. The guidance sets out a hierarchy to estimate fair value for which the best evidence of fair value is a quoted price in an active market. [FRS 102.2A.1]. Figure 10.1 below shows the fair value hierarchy to be used.

Reporting entities should measure fair value using the highest available level within the hierarchy. FRS 102 is explicit that the best evidence of fair value is a quoted price for an identical or similar instrument in an active market and only when such quoted prices are unavailable, does an entity use the price of a recent transaction for an identical instrument and failing that, a valuation technique. [FRS 102.2A.1-3]. However, the above guidance is somewhat theoretical and no examples are provided to illustrate its application.

8.6.2 Quoted price in an active market

‘Active market’ is defined as ‘a market in which all the following conditions exist:

1. the items traded in the market are homogeneous;
2. willing buyers and sellers can normally be found at any time; and
3. prices are available to the public.’ [FRS 102 Appendix I].

Based on the above definition, most equities and bonds that are listed on an exchange for which there is a liquid secondary market in terms of regular trading will be considered to be traded in an active market. In addition, instruments that are frequently traded in over-the-counter markets (i.e. instruments that are not listed on an exchange), such as interest rate swaps and options, foreign exchange derivatives and credit default swaps, and for which there are available quotes may also be captured if closing prices are published.

The requirement that the best evidence of fair value is a quoted price for an identical asset in an active market is similar to that in IFRS 13. However, FRS 102 does not reproduce the additional guidance contained in IFRS 13 that the fair value of a portfolio of financial instruments is the product of the number of units of the instrument and its quoted market price, known as ‘p times q’. [IFRS 13.80]. This guidance means that an entity which has a very large holding of an actively traded financial instrument is unable to adjust the quoted price to reflect any discount or premium that might arise if the holding were to be unloaded onto the market. Given that this guidance is not contained in FRS 102, some might read it as not to require the use of p times q in these circumstances.

8.6.3 Price of a recent transaction

The use of the price of a recent transaction for an identical instrument is a simple valuation technique. However, what requires some judgement is determining whether that price is representative of fair value or not. An adjustment is required if the last transaction is not a good estimate of fair value. This could be the situation if there has been a significant change in economic circumstances, a significant lapse in time or the price of the transaction reflects an amount that an entity was forced to pay or receive in a forced transaction, involuntary liquidation or distressed sale. [FRS 102.2A.1(b)].

8.6.4 Other valuation techniques

In addition to the use of the price of a recent transaction for an identical instrument, other valuation techniques could include reference to the current fair value of another instrument that is substantially the same as the instrument being measured, discounted cash flow analysis and option pricing models. If there is a valuation technique commonly used by market participants to price the asset and that technique has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, the entity uses that technique. [FRS 102.2A.1(c), 2A.2].

The objective of using a valuation technique is to establish what the transaction price would have been on the measurement date in an arm's length exchange, motivated by normal business considerations. Fair value is estimated on the basis of the results of a valuation technique that makes maximum use of market inputs, and relies as little as possible on entity-determined inputs. A valuation technique would be expected to arrive at a reliable estimate of the fair value if:

1. it reasonably reflects how the market could be expected to price the asset; and
2. the inputs to the valuation technique reasonably represent market expectations and measures of the risk return factors inherent in the asset. [FRS 102.2A.3].

Many entities applying FRS 102 will not enter into instruments that are required to be recorded at fair value through profit or loss and for which a quoted price in active markets is not available. However if they do invest in, or issue complex instruments that must be fair valued but do not have quoted prices in active markets, they may have to draw upon the larger body of guidance within IFRS 13 in making judgements regarding how to measure fair value, especially regarding the use of valuation techniques. Further information regarding IFRS 13 can be found in EY International GAAP 2019.

8.6.5 Fair value not reliably measurable

For instruments that do not have a quoted market price in an active market, fair value is considered reliably measurable when the range of reasonable fair value estimates is not significant or the probabilities of the various estimates within the range can be reasonably assessed and used in estimating fair value. There are many situations in which the variability in the range of reasonable fair value estimates of assets that do not have a quoted market price is likely not to be significant. Normally it is possible to estimate the fair value of an asset that an entity has acquired from an outside party. However, if the range of reasonable fair value estimates is significant, and the probabilities of the various estimates cannot be reasonably assessed, an entity is precluded from measuring the asset at fair value. [FRS 102.2A.4-5].

No further guidance is provided to assess significance or probabilities in this context, hence, entities will need to exercise judgement. However, we believe that the bar for determining that a fair value measurement is not reliably measurable is relatively high and is limited to investments such as equity holdings in private companies, for which the investee has no comparable peers.

If, initially, fair value can be reliably measured, but such measurement ceases to be reliable at a subsequent date, a financial instrument's carrying amount at the last date it was reliably measurable becomes its new cost. Going forward, the instrument should be measured at its new cost less impairment until a reliable measure of fair value becomes available again. [FRS 102.2A.6, 12.9].

8.6.6 Financial liabilities due on demand

The fair value of a financial liability that is due on demand is deemed to be not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid. [FRS 102.12.11]. The logic is that a rational lender would demand repayment if the fair value were ever less than the net present value of the amount repayable, even though in practice many people do not withdraw their demand deposits in such circumstances. No guidance is provided in this context as to the appropriate discount rate, although the guidance on financing transactions set out at 7.2.2 above would be appropriate. This requirement is identical to that in IFRS 13.47, hence, further information can be found in EY International GAAP 2019.

9.2.1 Transfer of risks and rewards of ownership of the asset

FRS 102 does not provide any guidance as to what constitutes the transfer to another party of substantially all the risks and rewards of ownership. [FRS 102.11.33(b)]. The analysis needs to take into account all facts and circumstances and the most common risks to be evaluated will usually include credit risk, foreign exchange risk, late payment risk and price risk.

In the case of trade receivables, which are usually short-term in nature, the main risks are normally late payment risk (e.g. the debtor does not settle within the stipulated credit period such as 30 days or 90 days, but does eventually make payment in full for the amount due) or credit risk (i.e. the debtor is unable to make full payment for the amount owing and it results in a bad debt for the creditor). In most cases, we would expect the issue of whether substantially all risks and rewards have been transferred to be uncontroversial.

9.2.2 Transfer of control of the financial asset

In between the two extremes of transferring or retaining substantially all the risks and rewards, the transferor may have retained some risks and rewards. The derecognition assessment is then dependent on whether the transferor has retained control of the asset or not. This will depend on whether the transferee has the practical ability to sell the asset in its entirety to an unrelated third party and whether the transferee is able to exercise that ability unilaterally and without needing to impose additional restrictions on the transfer. [FRS 102.11.33(c)].

This is where the second challenge arises, as no further guidance is given in FRS 102 on what is meant by ‘practical ability’. IFRS 9 and IAS 39 contain the following guidance:

‘An entity has not retained control of a transferred asset if the transferee has the practical ability to sell the transferred asset. An entity has retained control of a transferred asset if the transferee does not have the practical ability to sell the transferred asset. A transferee has the practical ability to sell the transferred asset if it is traded in an active market because the transferee could repurchase the transferred asset in the market if it needs to return the asset to the entity. For example, a transferee may have the practical ability to sell a transferred asset if the transferred asset is subject to an option that allows the entity to repurchase it, but the transferee can readily obtain the transferred asset in the market if the option is exercised. A transferee does not have the practical ability to sell the transferred asset if the entity retains such an option and the transferee cannot readily obtain the transferred asset in the market if the entity exercises its option’. [IFRS 9 Appendix B.3.2.7, IAS 39.AG42].

In our view, most FRS 102 reporters will use this guidance when assessing the practical ability test. Consider the following example, which helps illustrate these requirements:

The call option is a derivative, which falls within the scope of Section 12 and thus would need to be measured at fair value through profit or loss until it expires (see 8.1 above). In this example, the practical ability test has been satisfied as the bonds are listed on an exchange and they are regularly traded; however, being exchange-listed is not necessarily itself a requirement, it is sufficient for there to be an active market.

In the example above, if the corporate bonds were not traded in an active market, with all other things being equal, the transaction would have failed the practical ability test and the corporate bonds would not have been derecognised. See further discussion on the accounting in this situation at 9.2.3.B and 9.2.4.B below.

9.2.3 Accounting for derecognition of financial assets

9.2.4 Comparison with IFRS

9.4.1 General rule: extinguishment

The derecognition requirements for financial liabilities are identical to those in IFRS 9 and IAS 39; i.e. an entity should derecognise a financial liability or part of a financial liability only when it is extinguished. In essence, a financial liability or a part of it is only extinguished when the obligations specified in the contract are discharged, are cancelled or expire. [FRS 102.11.36].

9.4.2 Exchange and modification

If an existing borrower and lender exchange financial instruments with substantially different terms or substantially modify the terms of an existing financial liability, the transaction should be accounted for as an extinguishment of the original financial liability and the recognition of a new one. [FRS 102.11.37].

FRS 102 does not contain the additional guidance in IFRS 9 and IAS 39 on what constitutes ‘substantially different’. While that guidance may be used by an entity reporting under FRS 102, it is, itself, not without issues of interpretation and we do not believe that it must be applied under FRS 102; hence we do not discuss it further here. Further details can be found in EY International GAAP 2019.

The subsequent accounting for exchanges or modifications that fail derecognition is discussed at 9.5 below.

9.4.3 Gains and losses on derecognition

Any difference that may arise between the carrying amount of the financial liability that has been extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, is recognised in profit or loss. [FRS 102.11.38].

10.1.1 What is hedge accounting?

Every entity is exposed to business risks from its daily operations. Many of those risks have an impact on the cash flows or the value of assets and liabilities, and therefore, ultimately affect profit or loss. In order to manage these risk exposures, companies often enter into derivative contracts (or, less commonly, other financial instruments) to hedge them. ‘Hedging’ can therefore be seen as a risk management activity in order to change an entity's risk profile.

Applying FRS 102 to those risk management activities can result in accounting mismatches when the gains or losses on a hedging instrument are not recognised in the same period(s) and/or in the same place in the financial statements as gains or losses on the hedged exposure. The idea of hedge accounting is to reduce this mismatch by changing either the measurement or (in the case of certain firm commitments) recognition of the hedged exposure, or alternatively, the accounting for the hedging instrument.

Under FRS 102, all derivatives are recorded on the balance sheet at fair value with subsequent fair value changes recorded in the profit and loss account. [FRS 102.11.6(b), 12.8]. The impact on profit or loss from derivatives may be reduced if the hedge accounting criteria are met. FRS 102 describes three types of hedging relationships:

1. fair value hedges (see 10.7 below);
2. cash flow hedges (see 10.8 below); and
3. hedges of net investments in foreign operations (see 10.9 below). [FRS 102.12.19].

The resultant hedge accounting entries depend on the type of hedge accounting relationship.

For example, an entity with sterling functional currency may expect highly probable future revenue of US$200 in 3 months' time. As £/US$ foreign currency exchange rates change, the revenue recognised by the entity in profit or loss will also change, as the entity's cash flows are exposed to foreign exchange risk. In order to reduce this potential profit or loss volatility, the entity may enter into a forward currency contract to pay US$200 and receive a fixed sterling equivalent. Under FRS 102, the forward currency contract will be recorded at fair value through profit or loss, and the forecast revenue will not be recognised until it occurs, resulting in a measurement and timing mismatch in profit or loss. If FRS 102 hedge accounting is applied, the forward currency contract would be accounted for differently, in order to reduce the mismatch. This is an example of a cash flow hedge, as the hedging instrument is reducing variability in the cash flows of the hedged item. The associated hedge accounting is to remove the effective portion of the change in fair value of the hedging derivative from profit or loss, and recognise it initially in other comprehensive income (OCI), thereby reducing volatility in profit or loss. The amounts recorded in OCI are then recycled to be reflected in profit or loss at the same time as the forecast revenue is recognised, so that the revenue is recorded as the hedged rate (see 10.8.3 below).

The special treatment for hedge accounting of a net investment in a foreign operation is consistent with that described above for a cash flow hedge (see 10.9 below).

An entity may also transact a derivative that converts a fixed exposure into a variable one. This is described as a fair value hedge. An example of a fair value hedge would be an entity that has issued fixed rate debt and enters into an interest rate swap in which it receives a fixed rate and pays a variable rate of interest on an underlying notional value. The entity might view this as converting the fixed interest flow into a variable interest flow, but this activity is described in the standard as eliminating variability in fair value with respect to interest rate risk. On application of FRS 102 (without hedge accounting) the interest rate swap would be accounted for at fair value through profit or loss whilst the debt would be held at amortised cost, resulting in an accounting mismatch. If FRS 102 hedge accounting is applied to this fact pattern, an adjustment would be made to the carrying amount of the debt and to profit or loss, to reflect the revaluation of the debt with respect to interest rate risk. This hedge accounting adjustment would mitigate some of the volatility in profit or loss from fair value changes in the derivative (see 10.7.3 below).

10.1.2 Hedge accounting overview

An entity may choose to designate a hedging relationship between a hedging instrument and a hedged item in order to achieve hedge accounting. [FRS 102.12.18]. Prior to hedge accounting being applied, all of the following steps must have been completed:

• identification of eligible hedged item(s) and hedging instrument(s) (see 10.2 and 10.3 below);
• ensuring that the hedge relationship meets the definition of one of the permitted types (a fair value, cash flow or net investment hedge) (see 10.7, 10.8 and 10.9 below);
• ensuring that the hedge relationship is consistent with the entity's risk management objective for undertaking the hedges (see 10.4.2 below);
• assessing that there is an economic relationship between the hedged item(s) and hedging instrument(s) (see 10.4.3 below);
• formal designation of the hedge relationship, including identification of the hedged risk (see 10.4.4 below); and
• the sources of hedge ineffectiveness are determined and documented (see 10.5 below).

Once these requirements are met, hedge accounting can be applied prospectively, but the ongoing qualifying criteria and assessments must continue to be met, otherwise hedge accounting will cease (see 10.10 below).

The table below summarises the application of hedge accounting for the three types of hedge relationships:

As it can be seen from the above, for a fair value hedge, an adjustment is made to the carrying value of the hedged item to reflect the change in value of the hedged risk, with an offset to profit or loss for the change in value of the hedging instrument. Where the offset is not complete, this will result in ineffectiveness to be recorded in profit or loss (see 10.5 below).

However, for both a cash flow and net investment hedge, the carrying amount of the hedged item, which for a cash flow hedge may not even yet be recognised, is unchanged. The effect of cash flow and net investment hedge accounting is to defer the effective portion of the change in value of the hedging instrument in OCI. Any ineffective portion will remain in profit or loss as ineffectiveness.

10.2.1 Introduction

A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a highly probable forecast transaction, a net investment in a foreign operation, or a component of any such item, provided the item is reliably measurable. [FRS 102.12.16].

Recognised assets and liabilities can include financial items and non-financial items such as inventory.

Only assets, liabilities, firm commitments and forecast transactions with a party external to the reporting entity can qualify as hedged items. This means that hedge accounting can only be applied to transactions between entities in the same group in the individual financial statements of those entities, and not in the consolidated financial statements. Three exceptions to this rule are given: [FRS 102.12.16A]

1. transactions with subsidiaries, where the subsidiaries are not consolidated in the consolidated financial statements;
2. a hedge of the foreign currency risk of an intragroup monetary item if that foreign currency risk affects consolidated profit or loss; and
3. foreign currency risk of a highly probable forecast intragroup transaction denominated in a currency other than the functional currency of the entity entering into the transactions, if the foreign currency risk affects consolidated profit or loss.

By way of example, foreign currency risk from intra group monetary items will usually affect consolidated profit or loss when the intra group monetary item is transacted between two group entities that have different functional currencies, as it will not be eliminated on consolidation.

10.2.2 Components

FRS 102 permits components of an item to be hedged (including combinations of components). For example, an item may be hedged with respect to the risks associated with only a portion of its cash flow variability or fair value change, as long as the risk component is separately identifiable and reliably measurable. [FRS 102.12.16C]. For example, if an entity issued debt paying a coupon of LIBOR + 2%, it would be possible to only include the LIBOR component of the total interest rate exposure within the hedge accounting relationship. Similarly, for fixed rate debt, it would also be possible to identify, say, a 5% coupon component of debt paying a 6% fixed rate coupon.

If a risk component is contractually specified, as in the above LIBOR debt issued example, it would usually be considered separately identifiable. In this circumstance, the contractually specified risk component would usually be referenced to observable data, such as a published price index. Therefore, the risk component would usually also be considered reliably measurable.

Ordinary purchase or sales agreements sometimes contain clauses that determine the contract price via a specified formula linked into a benchmark commodity price. Accordingly these contracts may also contain components that are separately identifiable and reliably measurable. Examples of contractually specified risk components in purchase and sale contracts are as follows:

1. the price of wires contractually linked in part to a copper benchmark price and in part to a variable tolling charge reflecting energy costs; and
2. the price of coffee contractually linked in part to a benchmark price of Arabica coffee and in part to transportation charges that include a diesel price indexation.

While it is certainly easier to determine that a risk component is separately identifiable and reliably measurable if it is specified in the contract, it is not a requirement that a component must be contractually specified in order for it to be eligible as a hedged item. We believe that in order to determine that the risk component is separately identifiable and reliably measurable and qualify for hedging, it must have a distinguishable effect on changes in the value or the cash flows that an entity is exposed to.

The fact that a commodity is a major physical input in a production process does not automatically translate into a separately identifiable effect on the price of the item as a whole, but it might. For example, although crude oil price changes might influence the long term price of plastic toys to some degree, they are unlikely to have a distinguishable effect on the retail price in the short term. Similarly, the price for pasta at food retailers in the medium to long term also responds to changes in the price for wheat, but there is no distinguishable direct effect of wheat price changes on the retail price for pasta, which remains unchanged for longer periods even though the wheat price changes. If retail prices are periodically adjusted in a way that also directionally reflects the effect of wheat price changes, that is not sufficient to constitute a separately identifiable risk component. The evaluation would always have to be based on relevant facts and circumstances.

An example of a risk component that has a distinguishable effect on changes in the cash flows an entity is exposed to is provided in the application guidance to IFRS 9.

Other components that can be hedged include selected contractual cash flows and a specified part of the nominal amount of an item and combinations of these items. [FRS 102.12.16]. FRS 102 does not provide detail on what is meant by a ‘specified part of the nominal amount of an item’. The hedge accounting rules in FRS 102 are based on IFRS 9 which states that such a component of a nominal amount could be a proportion of an entire item (such as, 60% of a fixed rate loan of £10 million) or a layer component (for example, the first £6 million of sales). [IFRS 9 Appendix B.6.3.16].

IFRS 9 contains some restrictions when hedging a layer component that includes a prepayment option. In particular, a layer component that includes a prepayment option does not qualify as a hedged item in a fair value hedge if the fair value of the prepayment option is affected by changes in the hedged risk (unless the changes in fair value of the prepayment option as a result of changes in the hedged risk are included when measuring the change in fair value of the hedged item). However, this restriction is not included in FRS 102 and there is no requirement to analogise to the requirements of IFRS 9 or to assume that IFRS 9 applies where FRS 102 is silent. Hence, an entity applying FRS 102 does not encounter this issue and can designate a layer component in a fair value hedge, although the effect of the related prepayment option on the layer's fair value with respect to the hedged risk will still need to be included.

In FRS 102, risk components may also include a designation of changes in the cash flows or the fair value of a hedged item above or below a specified price or other variable (i.e. a one-sided risk). [FRS 102.12.16C]. For example, an entity could hedge the cash flow losses resulting from an increase in the price of a forecast commodity purchase above a specified level. This would be useful when economically hedging with options, which only provide protection above or below a specified price level.

An issue that entities have faced under IAS 39 and IFRS 9 is the prohibition on hedge accounting for changes in LIBOR when the hedged item attracts a ‘sub-LIBOR’ interest rate, e.g. LIBOR–0.25%. Application of hedge accounting to the LIBOR component is not permitted under IFRS because the hedged component cannot be more than the total cash flows of the hedged item. Part of the rationale for this prohibition is that if LIBOR fell to 0.25% in this example, any changes in LIBOR below 0.25% would not ordinarily cause any further variability in cash flows on the hedged item, as there is usually an inherent floor. Whilst this restriction is not explicit in FRS 102, the logic would appear to be equally valid. However, an entity could still achieve hedge accounting by designating the cash flows of the hedged item in their entirety (e.g. LIBOR–0.25%) with, for example, a LIBOR swap as the hedging instrument, although some ineffectiveness may arise and need to be recorded in profit or loss.

10.2.3 Groups of items as hedged items

Hedging relationships typically include a single hedging instrument (e.g. an interest rate swap) hedging a single item (e.g. a loan). However, for operational reasons entities often economically hedge several items together on a group basis (e.g. a number of purchases in a foreign currency could be hedged with a single forward contract).

FRS 102 explains that a hedged item can either be a single item or a group of items, including components of items, provided that all of the following conditions for groups of items are met:

1. the group consists of items that are individually eligible hedged items;
2. the items in the group share the same risk;
3. the items in the group are managed together on a group basis for risk management purposes; and
4. the group does not include items with offsetting risk positions. [FRS 102.12.16B].

Whether the items in the group are managed together on a group basis is a matter of fact, i.e. it depends on an entity's behaviour and cannot be achieved by mere documentation. Examples of groups of items that could be eligible for hedging if all of the conditions are met are a portfolio of customer loans that pay interest based on LIBOR, or a portfolio of shares of Swiss companies that replicates the Swiss Market Index (SMI).

Hedge accounting for a net position (e.g. a group of assets and liabilities or income and expenses) is not permitted, as this would include offsetting risk positions. However, where an entity undertakes economic hedge accounting of a net position, the entity could still achieve hedge accounting under FRS 102 by designating a specified component of the gross hedged items. For example, consider an entity with sterling functional currency that has forecast foreign currency sales of €100 and purchases of €80, both in 6 months. It hedges the net exposure using a single forward contract to sell €20 in 6 months. Hedge accounting could be achieved by designating the forward contract as hedging €20 of the €100 forecast sales.

10.3.1 Introduction

FRS 102 defines a hedging instrument as a financial instrument measured at fair value through profit or loss that is a contract with a party external to the reporting entity and is not a written option unless:

1. the written option is an offset to a purchased option in the hedged item and the combination is not a net written option; or
2. the written option is combined with a purchased option and the combination is not a net written option. [FRS 102.12.17, 17C].

Entities are therefore permitted to designate derivatives as hedging instruments, but also non-derivative financial assets or non-derivative financial liabilities that are accounted for at fair value through profit or loss are eligible hedging instruments. This can be helpful if an entity does not have access to derivatives markets or does not want to be subject to margining requirements and could also be operationally simpler than transacting derivatives.

If a derivative is not measured at fair value (for example, if the fair value cannot be reliably measured), then the derivative cannot be designated as a hedging instrument. [FRS 102.11.32]. With the exception of certain written options, the circumstances in which a derivative recorded at fair value through profit or loss may be designated as a hedging instrument are not restricted, provided the relevant conditions for hedge accounting are met. The reason written options cannot be designated as hedging instruments is because net options written by an entity do not reduce risk exposure or the potential effect on profit or loss. In practice many so-called ‘zero cost collars’ (i.e. a combination of a put and call option, one of which is purchased and the other sold, priced so that the premiums offset to zero) are transacted as legally separate written and purchased options. However, the standard includes an example of a zero cost interest rate collar to illustrate circumstances under which a written option is combined with a purchased option such that the combination is not a net written option, and hence is eligible as a hedging instrument (as per exception (ii) above). [FRS 102.12.17C].

FRS 102 also permits the foreign currency risk component of a non-derivative financial instrument (for example, a basic foreign currency loan carried at amortised cost) to be designated as a hedging instrument in the hedge of foreign currency risk. [FRS 102.12.17B]. This is illustrated in the following example.

Similarly as for hedged items, a hedging instrument must be a contract with a party external to the reporting entity and there are no exceptions to this. [FRS 102.12.17(b)].

10.3.2 Combinations of hedging instruments

A combination of instruments that individually meet the criteria to be treated as hedging instruments to be designated in a hedge relationship are permitted to be jointly designated in the hedging relationship. Hence a purchased bond measured at fair value through profit or loss and an interest rate swap could be jointly designated as ‘the hedging instrument’. [FRS 102.12.17A].

10.3.3 Proportions and components of instruments

FRS 102 specifies that a hedging instrument can only be designated:

• in its entirety;
• a proportion (e.g. 50% of the nominal amount of the instrument): or
• by separating the spot risk element of a foreign currency contract and excluding the forward element, or by separating the intrinsic value of an option and excluding the time value. [FRS 102.12.17A].

The requirement to designate an instrument in its entirety is consistent with IFRS 9 and IAS 39. The reason given for that original guidance in IAS 39 is because there is normally a single fair value measure for a hedging instrument in its entirety and the factors that cause changes in its fair value are co-dependent. [IAS 39.74].

Similar to IFRS 9 and IAS 39, this means that the entity cannot designate a ‘partial-term’ component of a financial instrument as the hedging instrument. For example, in the case of a five year interest rate swap hedging a four year exposure, the swap payments and receipts over the next four years (i.e. ignoring those in year five) could not be designated as the hedging instrument. Instead, the whole derivative (i.e. including payments and receipts in year five) must be designated as the hedging instrument, although the hedging relationship may itself last for only four years. Likewise, components of particular cash flows in the hedging instrument cannot be designated in hedge relationships.

It is possible to designate a proportion of the entire hedging instrument, such as 50% of the notional amount, in a hedging relationship. The proportion that is not designated is available for designation within other hedge relationships, such that a maximum of 100% of the notional is designated as a hedging instrument. Any proportions of an instrument not designated within hedge relationships are accounted under the usual FRS 102 classification and measurement guidance.

The ability to separate the spot risk in a forward foreign currency contract or the intrinsic value in an option contract, and exclude the forward element and time value respectively from the hedge relationship was introduced as part of the Triennial review 2017. The option to apply this treatment is consistent with IAS 39. [IAS 39.74]. The excluded elements of the hedging instrument (i.e. the forward element of a foreign exchange contract, or the time value of an option contract) are accounted under the usual FRS 102 classification and measurement guidance, which will be at fair value through profit or loss for derivatives. Hence the application of this amendment has minimal effect on the accounting for hedging instruments in a fair value hedge (see 10.7.3 below); fair value changes in the forward element of forward contracts and time value of option contracts would previously form part of hedge ineffectiveness, whereas on application of the amendment, such fair value changes are deemed to be outside the hedge relationship but will still be recognised in the profit or loss, albeit possibly in a different line. Application of the amendment could have more of an impact on accounting for cash flow and net investment hedges, as not all ineffectiveness is always recognised in profit and loss due to the ‘lower of’ accounting (see 10.8.3 and 10.9.2 below).

There could be some hedge relationships for which it will be easier to determine that an economic relationship exists between the hedged item and the hedging instrument if the forward element of forward contracts or time value of option contracts are excluded from the hedge relationship. For example, if based on the current market situation, the majority of fair value movements of a purchased option (designated as a hedging instrument) are expected to arise from changes in the time value, no offset will arise for changes in the time value unless the time value also exists in the hedged item (see 10.4.3 below).

Although the amendment brings FRS 102 into line with IAS 39 on this particular issue, IFRS 9 has additional guidance that has not been included in FRS 102. IFRS 9 includes guidance on the ability to exclude cross currency basis from a hedging instrument, and to achieve a ‘cost of hedging’ treatment for the excluded portions of a hedging derivative. Given FRS 102 is silent on these issues, even after the Triennial review 2017, we do not believe it is possible to apply the IFRS 9 guidance on excluding cross currency basis from a hedging instrument, or costs of hedging.

The exclusion of the forward element of a foreign currency contract or the time value of an option from an existing hedge relationship would be a change to the documented hedged item and risk management objective. Such a change can only be accommodated by discontinuing an existing hedge relationship and starting a new one (see 10.4.2 below). Although the Triennial review 2017 amendments are generally applied retrospectively, we believe that the need to start a new hedge relationship in order to separate the spot risk element of a foreign currency contract and exclude the forward element, or to separate the intrinsic value of an option and exclude the time value, means the amendment can only be applied prospectively, once all the criteria for hedge accounting are met for such a strategy (see 10.4.1 below).

As noted at 10.3.1 above, for a hedge of foreign currency risk, the foreign currency risk component of a non-derivative financial instrument can be designated as a hedging instrument.

10.4.1 Introduction

In order to qualify for hedge accounting a hedging relationship has to consist of eligible hedging instruments and eligible hedged items as described at 10.2 and 10.3 above. In addition:

1. the hedging relationship must be consistent with the entity's risk management objectives for undertaking hedges;
2. there must be an economic relationship between the hedged item and hedging instrument;
3. the entity must document the hedging relationship; and
4. the entity must determine and document causes of hedge ineffectiveness. [FRS 102.12.18].

Each of these criteria is discussed below.

An entity is required to discontinue hedge accounting if the conditions for hedge accounting are no longer met. [FRS 102.12.25(b)]. This means that there is an ongoing requirement to assess whether the criteria are met. We would expect entities to undertake the assessment, at a minimum, at each reporting date. If it is determined that the criteria are no longer met, then the standard says that hedge accounting should be discontinued prospectively. No further guidance is provided in FRS 102 as to what is meant by ‘discontinued prospectively’. IAS 39 states that hedge accounting ceases from the date the hedge relationship last met the effectiveness requirements. [IAS 39.AG113], whereas IFRS 9 states that discontinuation applies prospectively from the date on which the qualifying criteria are no longer met. [IFRS 9 Appendix B.6.5.22]. Given the lack of guidance, in FRS 102 and the fact that IAS 39 and IFRS 9 have different requirements, we believe an accounting policy choice can be made as to the date as of which hedge accounting is discontinued.

10.4.2 Risk management objectives

Hedge accounting must reflect the entity's risk management objectives for undertaking a hedge. The risk management objective is set at the level of an individual hedging relationship and defines how a particular hedging instrument is designated to hedge a particular hedged item. For example, a risk management objective for an entity with sterling functional currency might be to designate a foreign exchange forward contract in a hedge of the foreign exchange risk of the first €1m of sales in March 2019 or to designate a particular interest rate swap in a fair value hedge of £10m fixed rate debt. If this objective for the hedge relationship changed, then hedge accounting should cease (see 10.10 below). Accordingly, the risk management objective should be written in such a way that it can be determined if it has changed, and therefore whether discontinuation is required or not. [FRS102.12.25(b)].

10.4.3 Economic relationship

FRS 102 states that ‘an economic relationship between a hedged item and hedging instrument exists when the entity expects that the values of the hedged item and hedging instrument will typically move in opposite directions in response to movements in the same risk, which is the hedged risk’. [FRS102.12.18A].

This relationship should be based on an economic rationale rather than just by chance, as could be the case if the relationship is based only on a statistical correlation. However, although a statistical correlation on its own is not sufficient to determine the existence of an economic relationship, it may provide corroboration of an economic rationale.

Where statistical correlation or other quantitative methods are applied to demonstrate the existence of an economic relationship, the standard does not provide any bright lines or other success criteria, hence judgement will be required.

This requirement will quite obviously be fulfilled for many hedging relationships, for example if the underlying of the hedging instrument matches, or is closely aligned with the hedged risk in the hedged item. For example, an economic relationship clearly exists when hedging the 3 month LIBOR variable interest rate payable on a £100,000 loan with a 3 month LIBOR (pay fixed, receive floating) interest rate swap with a notional of £100,000. This is because the present value of the changes in the cash flows of the loan and the swap would move systematically in opposite directions in response to changes in the underlying interest rate. However, an economic relationship is unlikely to exist when an entity hedges a currency exposure using a different currency where the two currencies are not pegged or otherwise formally linked.

Even when there are differences between the hedged item and the hedging instrument, the economic relationship will often be capable of being demonstrated using a qualitative assessment. However, when the critical terms of the hedging instrument and hedged item are not closely aligned, it may be necessary to undertake a quantitative assessment.

IFRS 9 includes additional effectiveness criteria such as that credit risk must not dominate the hedge relationship and an appropriate hedge ratio must be used. [IFRS 9.6.4.1(c)]. There is no expectation that these criteria must be applied for hedge accounting under FRS 102.

10.4.4 Documentation

The FRS 102 documentation requirements are intended to be relatively informal and undemanding (compared to those of IAS 39 or IFRS 9) and should not pose a significant administrative burden on entities. However, appropriate documentation remains an important element of hedge accounting under FRS 102, and hedge accounting cannot be applied until the documentation criteria are met. [FRS102.12.18(d)-(e)]. The documentation supporting the hedge relationship should include the identification of:

1. the hedging instrument;
2. the hedged item;
3. the economic relationship between the hedging instrument and hedged item;
4. the nature of the risk being hedged;
5. how the hedge fits in with the entity's risk management objectives for undertaking hedges; and
6. the possible causes of hedge ineffectiveness within the hedge relationship.

Designation of a hedge relationship takes effect prospectively from the date all of the criteria for hedging are met. In particular, hedge accounting can be applied only from the date all of the necessary documentation is completed (although there are different rules for transition to FRS 102 – see Chapter 32 at 5.16). Hedge relationships cannot be designated retrospectively. [FRS102.12.18].

Hedge designation need not take place at the time a hedging instrument is entered into. For example, a derivative contract may be designated and formally documented as a hedging instrument any time after entering into the derivative contract. However, hedge accounting will only apply prospectively from the date of documentation of the hedge designation, provided all the other conditions are met.

10.7.1 Introduction

Typically a fair value hedge is undertaken where an entity wishes to convert a fixed rate exposure into a variable one. The fair value of an exposure that contractually pays a fixed or ‘locked in’ market index, such as an interest rate or a commodity price, is sensitive to changes in that market index. By converting the fixed index into a variable one, that fair value sensitivity is reduced. In many circumstances an entity may actually be more focused on creating variable rate cash flows, rather than eliminating fair value sensitivity. However the two economic perspectives are not dissimilar and both would fall within the FRS 102 description of a fair value hedge for accounting purposes.

An example of a fair value hedge is a hedge of the exposure to changes in the fair value of a fixed rate debt instrument (not measured at fair value through profit or loss) as a result of changes in interest rates – if interest rates increase, the fair value of the debt decreases and vice versa. If the debt instrument were to be sold before maturity, the fair value changes would affect profit or loss. Such a hedge could be entered into either by the issuer or by the holder.

Another example of a fair value hedge is where an entity wishes to eliminate the ongoing price risk from inventory. If an entity holds 100 tonnes of commodity A as inventory, for which they paid a price of 1 per tonne, the entity may wish to protect the value of that inventory against future changes in the market price that would affect profit or loss when the inventory is sold. In this case the entity would transact a derivative to sell that inventory forward at a locked in price.

10.7.2 Hedges of firm commitments

A hedge of a fixed price firm commitment (for instance, a hedge of the change in fuel price relating to an unrecognised contractual commitment by an electricity utility to purchase fuel at a fixed price) is considered a hedge of an exposure to a change in fair value. Accordingly, such a hedge is a fair value hedge.

However, a hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge. [FRS 102.12.19A]. This is because foreign currency risk affects both fair values and cash flows. This would mean that a foreign currency cash flow hedge of a forecast transaction need not be re-designated as a fair value hedge when the forecast transaction becomes a firm commitment.

10.7.3 Accounting for fair value hedges

From the date the conditions for hedge accounting are met, a fair value hedge should be accounted for as follows:

1. the gain or loss on the hedging instrument shall be recognised in profit or loss; and
2. the hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item (if applicable). [FRS 102.12.20].

The gain or loss on the hedging instrument will be the change in its fair value (subject to any excluded elements, see 10.3.3 above). Accordingly, the application of FRS 102 hedge accounting does not change the usual measurement requirements for the hedging instrument. The hedging gain or loss on the hedged item is the change in its value attributable to the hedged risk, and this must be added to, or subtracted from, the carrying value of the hedged item. This has the effect that the carrying amount of the hedged item is a hybrid value. For example, in the case of hedged debt, the carrying amount is a combination of amortised cost plus the change in the valuation due to changes in interest rates since hedge designation.

To the extent these amounts differ, a net amount will be recognised in profit or loss, commonly referred to as hedge ‘ineffectiveness’ (see 10.5 above). For fair value hedges all ineffectiveness is recognised in profit or loss.

The following example illustrates the basic mechanics of fair value hedge accounting.

In this example, it can be seen that ineffectiveness of £1 has been recognised as a credit to profit or loss, reflecting some mismatches between the hedged debt security and the hedging derivative.

Where the hedged item is a financial instrument for which the effective interest method of accounting is used, the adjustment to the hedged item referred to above, should be amortised to profit or loss. Amortisation may begin as soon as the adjustment exists and should begin no later than when the hedged item ceases to be adjusted for hedging gains and losses. The amortisation should be based on a recalculated effective interest rate at the date amortisation begins. [FRS 102.12.22]. For the fair value hedge of an exposure that is issued at par and redeems at par, any fair value adjustments to the hedged exposure during its life will automatically reverse through the natural unwind or pull to par of the revaluation adjustment, and hence amortisation is not necessary.

When the hedged item is an unrecognised firm commitment (see 10.7.2 above), the cumulative hedging gain or loss on the hedged item attributable to the hedged risk is recognised as an asset or liability with a corresponding gain or loss recognised in profit or loss. The initial carrying amount of the asset or liability that results from the entity meeting the firm commitment is adjusted to include the cumulative hedging gain or loss on the hedged item that was recognised in the statement of financial position. [FRS 102.12.20-21].

The following example, based on Example 1 in the Appendix to Section 12, provides a more detailed illustration of the mechanics of a simple fair value hedge and in particular, a fair value hedge of a firm commitment.

1 This is the fair value of the contract prior to settlement.

2 The commitment is fair valued only for the hedged risk, which in this example is the forward exchange rate risk.

9 June 2019

Note that there are no hedge accounting entries on 9 June 2019.

31 December 2019

Accounting entries:

30 March 2020

Accounting entries:

10.8.1 Introduction

Typically a cash flow hedge is undertaken where an entity wishes to convert a variable rate exposure into a fixed one. An example of a cash flow hedge is the use of an interest rate swap to change floating rate debt to fixed rate debt. The cash flows being hedged are the future interest payments.

An entity with GBP functional currency may have highly probable monthly forecast sales in a foreign currency over the next year. In order to eliminate variability from changes in foreign currency risk in the highly probable forecast revenue, the entity may transact a series of foreign currency forward contracts to lock in the GBP equivalent for that revenue. This scenario is an example of a cash flow hedge of foreign exchange risk.

10.8.2 Highly probable forecast transactions

FRS 102 permits a cash flow hedge of a forecast transaction only where it is considered highly probable. [FRS102.12.16A]. The glossary to FRS 102 defines ‘highly probable’ and ‘forecast transaction’ (see 3.1 above). To meet the ‘highly probable’ criteria, entities are not required to predict and document the exact date a forecast transaction is expected to occur but should be able to identify and document the forecast transaction within a reasonably specific and generally narrow range of time from a most probable date, as a basis for determining fair values and assessing hedge effectiveness.

The high probability of a transaction should be supported by observable facts and attendant circumstances and should not be based solely on management intent, because intentions are not verifiable. In making this assessment, entities may find it helpful to consider the following (although this is not an exhaustive list):

1. the frequency of similar past transactions;
2. the financial and operational ability to carry out the transaction;
3. whether there has already been a substantial commitments of resources to a particular activity, e.g. a manufacturing facility that can be used in the short run only to process a particular type of commodity;
4. the extent of loss or disruption of operations that could result if the transaction does not occur;
5. the likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose, e.g. there may be several ways of raising cash ranging from a short-term bank loan to a public share offering; and
6. the entity's business plan.

The length of time until a forecast transaction is projected to occur is also a consideration in determining probability. Other factors being equal, the more distant a forecast transaction is, the less likely it is to be considered highly probable and the stronger the evidence that would be needed to support an assertion that it is highly probable. For example, a transaction forecast to occur in five years may be less likely to occur than a transaction forecast to occur in only one year. However, forecast interest payments for the next 20 years on variable-rate debt would typically be highly probable if supported by an existing contractual obligation.

In addition, the greater the physical quantity or future value of a forecast transaction in proportion to transactions of the same nature, the less likely it is that the transaction would be considered highly probable and the stronger the evidence that would be required to support such an assertion. For example, less evidence would generally be needed to support forecast sales of 500,000 units in the next month than 950,000 units when recent sales have averaged 950,000 units for each of the past three months.

A history of having designated hedges of forecast transactions and then determining that the forecast transactions are no longer expected to occur, would call into question both the ability to accurately predict forecast transactions and the propriety of using hedge accounting in the future for similar forecast transactions. However there are no prescriptive ‘tainting’ provisions in this area and entities are not automatically prohibited from using cash flow hedge accounting if a forecast transaction fails to occur. Instead, whenever such a situation arises, the particular facts, circumstances and evidence would normally need to be assessed to determine whether doubt has, in fact, been cast on an entity's ongoing hedging strategies.

If a hedged forecast transaction is no longer considered to be highly probable, the hedge must be discontinued prospectively (see 10.4.1 above and 10.10 below).

10.8.3 Accounting for cash flow hedges

From the date the conditions for hedge accounting are met, a cash flow hedge should be accounted for as follows:

1. 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):
   1. the cumulative gain or loss on the hedging instrument from the date the conditions for hedging are met; and
   2. 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 for hedging are met;
2. the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (i.e. the portion that is offset by the change in the cash flow hedge reserve calculated in accordance with (a)) is recognised in OCI;
3. 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 is recognised in profit or loss. The reference to ‘balance’ here refers to the difference between the effective part of a hedge recorded in OCI and the fair value change on the derivative;
4. the amount that has been accumulated in the cash flow hedge reserve in accordance with (a) above is accounted for as follows:
   1. 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 (commonly referred to as a ‘basis adjustment’);
   2. 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);
   3. if the amount accumulated 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 reclassified to profit or loss immediately. [FRS102.12.23].

The cash flow hedge mechanics described in (a) to (b) above are often referred to as the ‘lower of’ calculation. This can be explained more easily by way of an example.

It can be seen from the above example that, for cash flow hedges, ineffectiveness is only recognised in profit or loss to the extent that the absolute change in fair value of the hedging instrument exceeds the absolute change in fair value of the hedged item. This comparison of value changes should be undertaken on a cumulative basis, i.e. the change in value over the life of the designated hedge relationship since inception.

If the hedging instrument's cumulative fair value changes are less than the cumulative fair value changes of the hedged item, no ineffectiveness is recorded in profit or loss (i.e. the full fair value change of the derivative would be recorded in OCI). If the hedging instrument's cumulative fair value changes are more than the cumulative fair value changes of the hedged item, the excess is recorded as ineffectiveness in profit or loss.

In practice entities often use what is called the ‘hypothetical derivative’ method to measure ineffectiveness in a cash flow hedge. As its name suggests, the hypothetical derivative method involves establishing a notional derivative that would be the ideal hedging instrument for the hedged exposure (normally an interest rate swap or forward contract with no unusual terms and a zero fair value at inception of the hedge relationship). The fair value of the hypothetical derivative is then used as a proxy for the net present value of the change in hedged future cash flows (requirement (a)(ii) above) against which changes in value of the actual hedging instrument are compared to measure ineffectiveness. The Appendix to Section 12 illustrates the use of the hypothetical derivative method to measure ineffectiveness (see Example 10.17 below).

In order to meet the requirements of (d) above, consideration must be given to the nature of the hedged item. The following are some examples of how amounts recorded in OCI are subsequently recycled.

The purpose of the recycling is so that the impact of the cash flow hedge is reflected in profit or loss to match the timing of recognition of the hedged item. We believe the reclassification from accumulated other comprehensive income to profit or loss should be recognised in the same line item in profit or loss as the hedged transaction to reflect the offsetting effect of hedge accounting (see 10.11 below).

The following example, based on Example 2 in the Appendix to Section 12, illustrates in more detail how to account for a cash flow hedge.

Key to table:

1: This valuation is determined before the receipt of the cash settlement of £40,000 due on 31 December 2020.

2: This valuation is determined before the payment of the cash settlement of £130,000 due on 31 December 2021.

3: £40,000 is the settlement of the interest rate swap as at 31 December 2020 which affects the fair value of the swap, but is not included in the fair value of the swap at 31 December 2020 of £89,000.

4: The fair values of the interest rate swap and the hedged item shown in the table are those given in Example 2 in the standard, but may not reflect the market data given.

31 December 2019

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, e.g. an entry to recognise the loan liability.

31 December 2020

Accounting entries:

31 December 2021

Accounting entries:

The table below summarises the effects of the accounting entries shown above on the interest rate swap, profit or loss and other comprehensive income.

¹ This is the balance of the cash flow hedge reserve.

10.9.1 Introduction

Many reporting entities have investments in foreign operations which may be subsidiaries, associates, joint ventures or branches. Section 30 requires an entity to determine the functional currency of each of its foreign operations as the currency of the primary economic environment of that operation. When translating the results and financial position of its foreign operation into a presentation currency, on consolidation foreign exchange differences should be recognised in other comprehensive income (with no reclassification to profit or loss in future periods).

From the perspective of an investor (e.g. a parent) it is clear that an investment in a foreign operation is likely to give rise to a degree of foreign currency exchange rate risk and an entity with many foreign operations may be exposed to a number of foreign currency risks.

FRS 102 defines a net investment in a foreign operation as ‘the amount of the reporting entity's interest in the net assets of that operation’. [FRS 102 Appendix I]. A hedge of a net investment in a foreign operation is a hedge of the foreign currency exposure, not a hedge of the change in the value of the investment. The net investment hedge accounting rules can also be applied to a monetary item that is accounted for as part of the net investment (see Chapter 27 at 3.7.4). For example, if a parent grants a foreign currency loan to an overseas subsidiary and settlement is neither planned nor likely in the foreseeable future, the loan can be hedged as part of the net investment in the foreign subsidiary.

Net investment hedge accounting can be applied only when the net assets of the foreign operation (and not fair value or cost less impairment) are included in the financial statements. This will be the case for consolidated financial statements, financial statements in which investments such as associates or joint ventures are accounted for using the equity method or those that include a branch or a joint operation. Investments in foreign operations may be held directly by a parent entity or indirectly by its subsidiary or subsidiaries. Accordingly it is also possible to achieve net investment hedge accounting of a foreign branch in an entity's standalone financial statements under FRS 102, if the other requirements for hedge accounting are met, as confirmed in April 2015 when the FRC issued FRS 102 – Editorial amendments and clarification statements.

10.9.2 Accounting for net investment hedges

Hedges of a net investment in a foreign operation, including a hedge of a monetary item that is accounted for as part of the net investment, are accounted for similarly to cash flow hedges from the date the conditions for hedging are met:

1. the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognised in other comprehensive income; and
2. the ineffective portion is recognised in profit or loss.

The effective portion is determined by applying the same cash flow hedge ‘lower of’ accounting, as explained at 10.8.3 above. However, the cumulative gain or loss on the hedging instrument relating to the effective portion of the hedge that has been accumulated in equity is not reclassified from equity to profit or loss in subsequent periods. [FRS102.12.24]. This ensures consistency with Section 30 which requires that foreign exchange gains and losses relating to the consolidation of a subsidiary are not recycled on disposal of the subsidiary. [FRS 102.30.13].

The following example, based on the Appendix to Section 12, illustrates how to account for a simple net investment hedge.

1 The calculation is based on the translation of the NZ$200,000 loss at the average rate of 0.325 £:NZ$. [FRS 102.30.13(a)].

2 The calculation is based on the translation of the NZ$100,000 profit at the average rate of 0.375 £:NZ$. [FRS 102.30.13(a)].

3 The calculation is based on the opening net assets of NZ$1,000,000, after the losses of NZ$200,000 during 2019. [FRS 102.30.13(b)].

31 December 2019

A component of equity is adjusted to the lower of (in absolute amounts) the cumulative exchange gain on the loan of £60,000 and the cumulative retranslation difference on the net investment of (£55,000).

A gain of £55,000 is recognised in OCI, with the remainder of the gain on the loan of £5,000 is recognised in profit or loss.

Accounting entries:

Note that only the accounting entry in relation to net investment hedge accounting are shown. Other accounting entries in relation to the loan and the investment in the foreign operation would be required in practice.

31 December 2020

A component of equity is adjusted to the lower of (in absolute amounts) the cumulative exchange loss on the loan of £120,000 and the cumulative exchange difference on the net investment of £102,500.

The amount recorded in equity changes from £55,000 to (£102,500), a change of (£157,500). A loss of £157,500 is recognised in OCI, and the remainder of the loss on the loan of £22,500 is recorded in profit or loss.

Accounting entries:

10.10.1 Rollover strategies

IAS 39 and IFRS 9 sometimes permit a hedging relationship to continue where a hedging instrument is ‘rolled-over’, replacing an expired or terminated hedging instrument. For example, both standards state that an entity shall discontinue hedge accounting if the hedging instrument ‘expires or is sold, terminated or exercised…the replacement or rollover of a hedging instrument is not an expiration or termination if such replacement or rollover is part of the entity's documented hedging strategy’. [IFRS 9.6.5.6, IAS 39.101(a)].

Similarly, FRS 102 states that an entity shall discontinue hedge accounting if the hedging instrument has ‘expired, is sold, terminated or exercised’. However, FRS 102 is silent on the issue of rollover strategies. The absence of guidance in FRS 102 does not mean that the guidance in IFRS automatically applies and in this situation, it would appear the difference in the two standards is deliberate. FRS 102 is a simplification of IFRS and it was not intended that every rule in IFRS would apply to entities applying FRS 102. Hence, under FRS 102, a hedge relationship is discontinued when the hedging instrument expires regardless of whether the instrument is rolled over.

10.10.2 Novation of derivatives

IAS 39 and IFRS 9 both contain guidance on dealing with novation of derivatives that are part of a hedging relationship – the guidance was added following an Interpretations Committee discussion on the topic of mandated novation of derivatives to a central clearing party. A novation in this context is the act of replacing an existing counterparty to a derivative with a new party, such that all the obligations to the derivative contract must now be performed by the new party. The Interpretations Committee confirmed that a change in the counterparty of a derivative results in derecognition of the derivative. As noted at 10.10.1 above, it follows therefore that a hedge relationship would be discontinued if the derivative is novated, unless the change in counterparty is part of a documented replacement strategy or roll over strategy. IAS 39 was amended to include an additional exception such that a novation of a derivative in a hedge relationship would not result in discontinuation of the hedge relationship if the novation was as a consequence of laws or regulation requiring a change to a central clearing counterparty. The same guidance also appears in IFRS 9.

The basis for conclusions for IAS 39 explain the principle why a derivative is derecognised when it is novated to another counterparty: financial assets are derecognised when the contractual rights to the cash flows expire; whilst financial liabilities are extinguished when the debtor is legally released from primary responsibility for the liability. In a novation, both of these conditions are met. These conditions are also set out in FRS 102 implying that a derivative that is novated under FRS 102 would also need to be derecognised and the existing hedge would need to be terminated. [FRS 102.11.33, 36]. However, unlike IAS 39, FRS 102 does not contain the ‘exception’ for novations that are part of a documented hedging strategy or with a central clearing counterparty. Therefore, in our view, novations result in termination of the hedging relationship under FRS 102.

Due to various regulatory changes and political events such as the probable end of IBOR benchmark interest rates, the departure of the UK from the European Union (‘Brexit’) and the ‘ring fencing’ of certain activities of banks, how these might all affect cash flow hedge accounting has been the subject of discussion. Entities could find that the counterparty to some of their existing hedging derivatives may change to a different legal entity within an existing banking group, as banks make their preparations for Brexit or compliance with ring fencing regulations. In these circumstances, the entity will need to conclude whether such a change in counterparty would require discontinuation of the existing hedge relationship and its replacement with a new one.

10.10.3 The replacement of IBOR benchmark interest rates

As a result of the reforms mandated by the Financial Stability Board following the Financial Crisis, regulators are pushing for IBOR to be replaced by new ‘official’ benchmark rates, known as Risk Free Rates (RFRs). For instance, in the UK, the new official benchmark will be the reformed Sterling Overnight Interest Average (SONIA) and banks will no longer be required to quote LIBOR beyond the end of 2021. Such a change will necessarily affect future cash flows in both contractual floating rate financial instruments currently referenced to IBOR, and highly probably forecast transactions for which IBOR is designated as the hedged risk. This raises a number of accounting questions, many of which relate to hedge accounting.

This raises a number of accounting questions, many of which relate to hedge accounting. Two key questions are whether:

1. there continues to be an IBOR component of future variable cash flows if it is known that IBOR will not exist in its current form beyond the end of 2021 (or the equivalent date for other jurisdictions) (see 10.8.2 above); and
2. a change of designated hedged risk from IBOR to the new RFR should result in a de-designation and re-designation of existing hedge relationships for interest rate risk.

Issue (i) above is the most urgent, as it is possible that IBOR will cease to be a component of future variable cash flows well in advance of 2021. We believe that, as at the date of writing, it is possible to consider that IBOR is still a component of variable interest rates in the context of the market structure and that IBOR and RFR interest rates are equivalent for the purposes of cash flow hedge accounting. Hence, at present, it is still possible to designate IBOR as a risk component in a cash flow hedge. However, this conclusion may become invalid once RFRs take over from IBOR as the main interest rate market benchmarks.

11.1.1 Requirements

The rules regarding the offsetting, sometimes called ‘netting’, of a financial asset and a financial liability are contained in both Sections 11 and 12. However, the guidance is identical, that is, a financial asset and a financial liability should be offset and the net amount presented in the statement of financial position when and only when, an entity:

1. currently has a legally enforceable right to set off the recognised amounts; and
2. intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. [FRS 102.11.38A, 12.25B].

The offsetting principle set out above is identical to that in IAS 32 but without the additional guidance contained in IAS 32. The IASB decided to incorporate additional guidance into IAS 32 to deal with historical ambiguities as well as emerging practical application issues arising from the growth in the clearing of financial instruments. The additional guidance has helped to clarify aspects such as current legal enforceability and simultaneous settlement. We would expect FRS 102 reporters to default to the guidance within IAS 32 where helpful, but this would not itself be a requirement. Further information on offsetting under IAS 32 can be found in EY International GAAP 2019.

The effect of the offsetting rules described above is that, when the requirements are met, in effect the entity presents a single financial asset or liability which represents the net cash flow intended to be received or paid. When the requirements are not met, the financial asset and the financial liability need to be presented separately.

11.1.2 Interaction with derecognition rules

It is worth clarifying that offsetting and derecognition are different. Offsetting does not result in derecognition of the financial asset or liability from the statement of financial position, but in their net presentation in the statement of financial position as either a net financial asset or a net financial liability. Offsetting does not have an impact on the income statement as there is no gain or loss arising from the net presentation.

When a transfer of financial assets does not qualify for derecognition, the entity has to recognise an associated liability as discussed at 9.2.3.B above. In such cases, the financial asset retained in the statement of financial position and the resulting financial liability cannot be offset. [FRS 102.11.34].

11.2.1 Introduction

The disclosures contained in Section 11 are also applicable to financial instruments within the scope of Section 12, where relevant. [FRS 102.12.26]. The disclosure requirements of Sections 11 and 12 apply to all entities regardless of their accounting policy choice for recognition and measurement of financial instruments (see 4 above).

However, a qualifying entity which is not a financial institution (i.e. most subsidiaries and parents in their separate financial statements) is not required to make all of the disclosures required by Sections 11 and 12, providing the equivalent disclosures are included in the consolidated financial statements of the group in which the entity is consolidated. [FRS 102.1.8, 9, 12(c)]. The August 2014 version of FRS 102 exempted qualifying entities that were not financial institutions from all disclosures required by Sections 11 and 12. Nevertheless, all entities (including qualifying entities) preparing Companies Act accounts were required to make certain disclosures in respect of financial instruments. To remove this inconsistency, the July 2015 amendments to FRS 102 removed some of the disclosure exemptions for qualifying entities that are not financial institutions. These disclosures apply to all entities, even those that do not prepare financial statements in accordance with UK company law. Therefore, for a qualifying entity that is not a financial institution that is not required to prepare Companies Act accounts, certain disclosures are now required that were not previously. [FRS 102.1.12(c)].

When IFRS 9 was finalised, amendments were also made to IFRS 7 to reflect the new requirements of IFRS 9. In particular, many changes were made to IFRS 7 in relation to the new expected credit loss approach to impairment of financial assets. As a result, some of the disclosure requirements of FRS 102 would have been inconsistent with the application of the recognition and measurement requirements of IFRS 9. Consequently the Triennial review 2017 introduced a number of changes to the disclosure requirements to ensure that entities applying the recognition and measurement requirements of IFRS 9 through the accounting policy choice discussed at 4 above are providing relevant information about the impairment of financial assets. [FRS 102.BC.B11.50-51].

In addition, the Triennial review 2017 updated the disclosure requirements in relation to the statement of financial position to: (a) remove the requirement to disclose the carrying amounts of categories of financial assets and financial liabilities other than those carried at fair value though profit or loss; and (b) clarify that when the risks arising from financial instruments are particularly significant to the business of the entity, additional disclosure may be required. See 11.2.3 below.

As a result of the interaction of requirements described above, 11.2.2 to 11.2.5 below summarise the disclosure requirements on a cumulative basis, starting with the minimum FRS 102 disclosure requirements applicable to all reporting entities, followed by:

• the additional disclosures applicable to entities that do not take the qualifying entity exemptions;
• the additional disclosures applicable to financial institutions according to Section 34; and
• the additional disclosures applicable to entities reporting under UK company law.

11.2.2 Disclosures applicable to all entities, including qualifying entities

The disclosure requirements for all entities, including qualifying entities, are listed below:

Accounting policies

1. In its significant accounting policies, the measurement basis (or bases) used for financial instruments and the other accounting policies used for financial instruments that are relevant to an understanding of the financial statements. [FRS 102.11.40]. Even though FRS 102 does not explicitly stipulate it, we expect the accounting policy to include disclosure of which standard was chosen and applied by the entity for recognition and measurement of financial instruments, as this constitutes an accounting policy choice.

Statement of financial position – categories

2. Separate disclosure of the carrying amounts at the reporting date of:
   1. financial assets measured at fair value through profit or loss;
   2. financial liabilities measured at fair value through profit or loss. Those that are not held as part of a trading portfolio and are not derivatives should be shown separately; [FRS 102.11.41]

   This disclosure may be made separately by category of financial instrument.

3. For all financial assets and financial liabilities measured at fair value, the basis for determining fair value, (e.g. quoted market price in an active market or a valuation technique). When a valuation technique is used, the assumptions applied in determining fair value for each class of financial assets or financial liabilities. For example, if applicable, information about the assumptions relating to prepayment rates, rates of estimated credit losses, and interest rates or discount rates. [FRS 102.11.43].

Collateral

4. When an entity has pledged financial assets as collateral for liabilities or contingent liabilities, the carrying amount of the financial assets pledged as collateral and the terms and conditions relating to its pledge. [FRS 102.11.46].

Items of income, expense, gains or losses

5. An entity should disclose income, expense, net gains or net losses, including changes in fair value, recognised on financial assets measured at fair value through profit or loss, financial liabilities measured at fair value through profit or loss (with separate disclosure of movements on those which are not held as part of a trading portfolio and are not derivatives). [FRS 102.11.48(a)(i)-(ii)].

Financial instruments at fair value through profit or loss

6. An entity should provide the disclosures below only for financial instruments that are measured at fair value in accordance with paragraph 36(4) of Schedule 1 to the Regulations (see 6.4.1 above):
   1. financial liabilities, unless they are held as part of a trading portfolio or are derivatives;
   2. financial instruments to be held to maturity, other than derivatives;
   3. loans and receivables originated by the company unless they are held for trading;
   4. interests in subsidiary undertakings, associated undertakings and joint ventures;
   5. equity instruments issued by the company;
   6. contracts for contingent consideration in a business combination; and
   7. other financial instruments with such special characteristics that the instruments, according to generally accounting principles or practice should be accounted for differently from other financial instruments.

   The disclosure requirements are as follows: [FRS 102.11.48A]

   • For a financial liability designated at fair value through profit or loss, the amount of change, during the period and cumulatively, in the fair value of the financial instrument that is attributable to changes in the credit risk of that instrument, determined either:
     • as the amount of change in its fair value that is not attributable to changes in market conditions that give rise to market risk; or
     • using an alternative method the entity believes more faithfully represents the amount of change in its fair value that is attributable to changes in the credit risk of the instrument.
   • The method used to establish the amount of change attributable to changes in own credit risk, or, if the change cannot be measured reliably or is not material, that fact.
   • The difference between the financial liability's carrying amount and the amount the entity would be contractually required to pay at maturity to the holder of the obligation.
   • If an instrument contains both a liability and an equity feature, and the instrument has multiple features that substantially modify the cash flows and the values of those features are interdependent (such as a callable convertible debt instrument), the existence of those features.
   • If there is a difference between the fair value of a financial instrument at initial recognition and the amount determined at that date using a valuation technique, the aggregate difference yet to be recognised in profit or loss at the beginning and end of the period and a reconciliation of the changes in the balance of this difference.
   • Information that enables users of the entity's financial statements to evaluate the nature and extent of relevant risks arising from financial instruments to which the entity is exposed at the end of the reporting period. These risks typically include, but are not limited to, credit risk, liquidity risk and market risk. The disclosure should include both the entity's exposure to each type of risk and how it manages those risks.

   The purpose of these disclosures above is compliance with the disclosures in EU-adopted IFRS when using fair valuea ccounting according to paragraph 36(4) of Schedule 1 to the Regulations. These disclosure requirements will predominantly apply to certain financial liabilities. However, there may be instances where the Regulations requires that the disclosures must also be provided in relation to financial assets, for example investments in subsidiaries, associates or jointly controlled entities measured at fair value. [FRS 102. 9.27B, Appendix III.13,].

Hedging

7. For fair value hedges, the following disclosures must be provided:
   1. the amount of the change in fair value of the hedging instrument recognised in profit or loss for the period; and
   2. the amount of the change in fair value of the hedged item recognised in profit or loss for the period. [FRS 102.12.28].
8. For cash flow hedges, entities are required to disclose:
   1. the amount of the change in fair value of the hedging instrument that was recognised in other comprehensive income during the period; [FRS 102.12.29(c)]
   2. the amount, if any, that was reclassified from equity to profit or loss for the period; [FRS 102.12.29(d)] and
   3. the amount, if any, of any hedge ineffectiveness recognised in profit or loss for the period (i.e. any ineffectiveness). [FRS 102.12.29(e)].

11.2.3 Additional disclosures for entities not taking the qualifying entity exemptions

Entities that are not qualifying entities (or do not avail themselves of the disclosure exemptions available to qualifying entities) and qualifying entities that are financial institutions, should include the following disclosures in their financial statements in addition to those discussed at 11.2.2 above:

Statement of financial position – categories

1. Information that enables users of an entity's financial statements to evaluate the significance of financial instruments for its financial position and performance. For example, for long-term debt, such information would normally include the terms and conditions of the debt instrument (such as interest rate, maturity, repayment schedule, and restrictions that the debt instrument imposes on the entity). When the risks arising from financial instruments are particularly significant to the business (for example because they are principal risks for the entity), additional disclosure may be required. The disclosure requirements for financial institutions at 11.2.4 below, include examples of disclosure requirements for risks arising from financial instruments that may be relevant in such cases. [FRS 102.11.42, 34.19].

   In order to comply with the above, an entity that has taken the accounting policy choice to apply the recognition and measurement provisions of IAS 39 or IFRS 9 may need to consider additional disclosure based on IFRS 7, as it relates to the recognition and measurement policies applied. [FRS 102.BC.B11.50].

2. The fact that a reliable measure of fair value is no longer available for any financial instrument that would otherwise be required to be measured at fair value through profit or loss, if that is the case, and the carrying amount of those financial instruments. [FRS 102.11.44].

Derecognition

3. If an entity has transferred financial assets to another party in a transaction that does not qualify for derecognition, for each class of such financial assets:
   1. the nature of the assets;
   2. the nature of the risks and rewards of ownership to which the entity remains exposed; and
   3. the carrying amounts of the assets and of any associated liabilities that the entity continues to recognise. [FRS 102.11.45].

Defaults and breaches on loans payable

4. For loans payable recognised at the reporting date for which there is a breach of terms or default of principal, interest, sinking fund, or redemption terms that has not been remedied by the reporting date:
   1. details of that breach or default;
   2. the carrying amount of the related loans payable at the reporting date; and
   3. whether the breach or default was remedied, or the terms of the loans payable were renegotiated, before the financial statements were authorised for issue. [FRS 102.11.47].

Items of income, expense, gains or losses

5. An entity should disclose the following items of income, expense, gains or losses:
   1. income, expense, net gains or net losses, including changes in fair value, recognised on:
      1. financial assets measured at amortised cost;
      2. financial liabilities measured at amortised cost; and
      3. when an entity has made the accounting policy choice to apply the recognition and measurement provisions of IFRS 9 (see 4 above), financial instruments measured at fair value through other comprehensive income;
   2. total interest income and total interest expense (calculated using the effective interest method) for financial assets or financial liabilities that are not measured at fair value through profit or loss; and
   3. the amount of any impairment loss for each class of financial asset. A class of financial asset is a grouping that is appropriate to the nature of the information disclosed and that takes into account the characteristics of the financial assets. When an entity has made the accounting policy choice to apply the recognition and measurement provisions of IFRS 9 (see 4 above), the groupings shall be based on whether the amount is equal to 12-month expected credit risk losses, equal to the lifetime expected credit losses or financial assets that are purchased or originated credit-impaired. [FRS 102.11.48].

Hedging

6. When hedge accounting is applied, entities are required to disclose the following, separately for each type of hedging relationships:
   1. a description of the hedge relationship;
   2. a description of the financial instruments designated as hedging instruments and their fair values at the reporting date;
   3. a description of the hedged item; and
   4. the nature of the risks being hedged. [FRS 102.12.27].
7. For cash flow hedges, entities are required to disclose:
   1. the periods when the cash flows are expected to occur and when they are expected to affect profit or loss;
   2. a description of any forecast transaction for which hedge accounting had previously been used, but which is no longer expected to occur. [FRS 102.12.29].
8. For a hedge of net investment in a foreign operation entities must disclose separately:
   1. the amounts recognised in other comprehensive income (i.e. fair value changes in the hedging instrument that were effective hedges); and
   2. the amounts recognised in profit or loss (as ineffectiveness). [FRS 102.12.29A].

11.2.4 Additional disclosures required for financial institutions

For financial institutions (as defined in Chapter 3 at 2.5.1.A) additional disclosures are required to be provided in:

1. the individual financial statements of the financial institution; and
2. the consolidated financial statements of a group containing a financial institution when the financial instruments held by the financial institution are material to the group. Where this is the case, the disclosures apply regardless of whether the principal activity of the group is being a financial institution or not. However, the disclosures only need to be given in respect of financial instruments held by entities within the group that are financial institutions. [FRS 102.11.48B, 34.17].

The required disclosures are as follows:

Significance of financial instruments for financial position and performance

1. A disaggregation of the statement of financial position line item by class of financial instrument. A class is a grouping of financial instruments that is appropriate to the nature of the information disclosed and that takes into account the characteristics of those financial instruments. [FRS 102.34.20].

Impairment

2. Unless a financial institution has made the accounting policy choice at 4 above to apply recognition and measurement provision of IFRS 9, where a separate allowance account is used to record impairments, a reconciliation of changes in that account during the period for each class of financial asset. [FRS 102.34.21].
3. When a financial institution has made the accounting policy choice at 4 above to apply the recognition and measurement provisions of IFRS 9, it must disclose information that enables users of its financial statements to understand the effect of credit risk on the amount, timing and uncertainty of future cash flows. This shall include:
   1. an explanation of the financial institution's credit risk management practices and how they relate to the recognition and measurement of expected credit losses;
   2. a reconciliation from the opening balance to the closing balance of the loss allowance, in a table, showing separately the changes during the period for:
      1. the loss allowance measured at an amount equal to 12-month expected credit losses;
      2. the loss allowance measured at an amount equal to lifetime expected credit losses (showing separately the amount relating to financial instruments for which credit risk has increased significantly since initial recognition); and
      3. financial assets that are purchased or originated credit-impaired.
   3. by credit risk rating grade, the gross carrying amount of financial assets and the exposure to credit risk on loan commitments and financial guarantee contracts (showing separately information for financial instruments for which the loss allowance is measured at an amount equal to 12-month expected credit losses, for which the loss allowance is measured at an amount equal to lifetime expected credit losses, and that are purchased or originated credit-impaired financial assets).

Fair value

4. For financial instruments held at fair value in the statement of financial position, for each class of financial instrument, an analysis of the level in the fair value hierarchy into which the fair value measurements are categorised. [FRS 102.34.22].

   In order to simplify the preparation of disclosures about financial instruments for the entities affected, whilst increasing the consistency with disclosures required by EU-adopted IFRS, the three levels in the fair value hierarchy required for disclosures are aligned with those in IFRS 13:

   1. Level 1: The unadjusted quoted price in an active market for identical assets or liabilities that the entity can access at the measurement date.
   2. Level 2: Inputs other than quoted prices included within Level 1 that are observable (i.e. developed using market data) for the asset or liability, either directly or indirectly.
   3. Level 3: Inputs are unobservable (i.e. for which market data is unavailable) for the asset or liability.

   Even though they are based on similar considerations, the hierarchy to estimate fair value discussed at 8.6.1 is not aligned with the disclosure requirements.

Nature and extent of risks arising from financial instruments

5. Information that enables users of the financial institution's financial statements to evaluate the nature and extent of credit risk, liquidity risk and market risk arising from financial instruments to which the institution is exposed at the end of the reporting period. [FRS 102.34.23].
6. For each type of risk arising from financial instruments:
   1. the exposures to risk and how they arise;
   2. the institution's objectives, policies and processes for managing the risk and the methods used to measure the risk; and
   3. any changes from the previous period. [FRS 102.34.24].

Credit risk

7. By class of financial instrument that is not subject to the impairment requirements of IFRS 9 as a consequence of the accounting policy choice at 4 above:
   1. the amount that best represents the institution's maximum exposure to credit risk at the end of the reporting period. This disclosure is not required for financial instruments whose carrying amount best represents the maximum exposure to credit risk;
   2. a description of collateral held as security and of other credit enhancements, and the extent to which these mitigate credit risk;
   3. the amount by which any related credit derivatives or similar instruments mitigate that maximum exposure to credit risk. [FRS 102.34.25(a)-(c)].
8. Unless a financial institution has made the accounting policy choice at 4 above to apply the recognition and measurement requirements of IFRS 9, an analysis by class of financial asset of:
   1. information about the credit quality of financial assets that are neither past due nor impaired. [FRS 102.34.25(d)].
   2. the age of financial assets that are past due as at the end of the reporting period but not impaired; and
   3. the financial assets that are individually determined to be impaired as at the end of the reporting period, including the factors the financial institution considered in determining that they are impaired. [FRS 102.34.26].
9. When financial or non-financial assets are obtained by taking possession of collateral held as security or calling on other credit enhancements (e.g. guarantees), and such assets meet the recognition criteria in other sections of FRS 102, a financial institution should disclose:
   1. the nature and carrying amount of the assets obtained; and
   2. when the assets are not readily convertible into cash, its policies for disposing of such assets or for using them in its operations. [FRS 102.34.27].

Liquidity risk

10. A maturity analysis for financial liabilities that shows the remaining contractual maturities at undiscounted amounts separated between derivative and non-derivative financial liabilities. [FRS 102.34.28].

Market risk

11. A sensitivity analysis for each type of market risk (e.g. interest rate risk, currency risk, other price risk) the financial institution is exposed to, showing the impact on profit or loss and equity. Details of the methods and assumptions used should be provided. If a sensitivity analysis, such as value-at-risk is prepared, that reflects interdependencies between risk variables (e.g. interest rates and exchange rates) and the financial institution uses such analysis to manage financial risks, it may use that sensitivity analysis instead. [FRS 102.34.29-30].

Capital

12. Information that enables users of the financial institution's financial statements to evaluate its objectives, policies and processes for managing capital.
    1. qualitative information about its objectives, policies and processes for managing capital, including:
       1. a description of what it manages as capital;
       2. when the institution is subject to externally imposed capital requirements, the nature of those requirements and how those requirements are incorporated into the management of capital; and
       3. how it is meeting its objectives for managing capital.
    2. summary quantitative data about what the financial institution manages as capital. Some regard some financial liabilities (e.g. some forms of subordinated debt) as part of capital. Others regard capital as excluding some components of equity (e.g. components arising from cash flow hedges);
    3. any changes in the above from the previous period;
    4. whether during the period the financial institution complied with any externally imposed capital requirements to which it is subject;
    5. when the financial institution has not complied with such externally imposed capital requirements, the consequences of such non-compliance.

    A financial institution must base all these disclosures on the information provided internally to key management personnel. [FRS 102.34.31].

    A financial institution may manage capital in a number of ways and be subject to a number of different capital requirements. For example, a conglomerate may include entities that undertake insurance activities and banking activities and those entities may operate in several jurisdictions. When an aggregate disclosure of capital requirements and how capital is managed would not provide useful information or would distort a financial statement user's understanding of the financial institution's capital resources, the financial institution should disclose separate information for each capital requirement to which the entity is subject. [FRS 102.34.32].

Reporting cash flows on a net basis

12. Where a statement of cash flows is presented, cash flows arising from each of the following activities may be reported on a net basis:
    1. cash receipts and payments for the acceptance and repayment of deposits with a fixed maturity date;
    2. the placement of deposits with and withdrawal of deposits from other financial institutions; and
    3. cash advances and loans made to customers and the repayment of those advances and loans. [FRS 102.34.33].

11.2.5 Disclosures applicable to all entities reporting under UK company law

The Small Companies Regulations, the Regulations, the LLP (SC) and LLP Regulations require various disclosures in respect of financial instruments. Entities reporting under such regulations, including qualifying entities, will be required to disclose the following in addition to those discussed at 11.2.2 to 11.2.4 above:

1. the amount of fixed asset or current asset investments ascribable to listed investments; [1 Sch 54(1), 3 Sch 72]
2. the aggregate amount of listed investments where this is different from the amount recorded in the financial statements (and both market value and stock exchange value if market value is higher); [1 Sch 54(2)]

The following must be disclosed where financial instruments are recorded at fair value:

3. significant assumptions underlying any valuation models and techniques used where the fair value has been determined using generally accepted valuation techniques and models; [1 Sch 55(2)(a), 2 Sch 66(2)(a), 3 Sch 73(2)(a)]
4. the purchase price, the items affected and the basis of valuation (insurers only); [3 Sch 73(2)(b)]
5. the fair value of each category of financial instrument and the changes in value reported in profit and loss or credited/debited to the fair value reserve; [1 Sch 55(2)(b), 2 Sch 66(2)(b), 3 Sch 73(2)(c)]
6. for each class of derivatives, the extent and nature of the instruments including significant terms and conditions that may affect the amount, timing and uncertainty of future cash flows; [1 Sch 55(2)(c), 2 Sch 66(2)(c), 3 Sch 73(2)(d)]
7. where any amount is transferred to or from the fair value reserve, there must be stated in tabular form, the amount of the reserve at the beginning and end of the reporting period, the amount transferred to/from the reserve in the year and the source and application of the amounts so transferred. [1 Sch 55(3), 2 Sch 66(3), 3 Sch 72(3)].

We believe the disclosure requirements included in (iii) and (v) above will in most cases be satisfied by disclosure requirements in FRS 102 discussed at 11.2.2(ii), 11.2.2(iii) and 11.2.2(v) above.

In addition, entities should disclose:

8. the fair values of any derivatives not included at fair value together with the extent and nature of the derivatives. [1 Sch 56, 2 Sch 67, 3 Sch 74]. This disclosure requirement would apply, for example, in the case of a derivative where the underlying investment is an equity instrument for which fair value cannot be reliably measured;
9. the fair value of instruments that could be measured at fair value but are measured at a higher amount (i.e. amortised cost) and reasons for not making a provision for diminution in value, together with the evidence that provides a basis for recoverability of the amount in the financial statements; [1 Sch 57, 2 Sch 68, 3 Sch 75]
10. for each item within fixed assets, the balance at the beginning and end of the year, the effect of any revision of the amount in respect of any assets made during that year on any basis, acquisitions and disposals during that year, any transfers of fixed assets in and out of that item of the balance sheet; [1 Sch 51, 2 Sch 62, 3 Sch 69]
11. for the aggregate of all items shown under ‘creditors’ in the company's balance sheet, the aggregate of the following amounts:
    1. the amount of any debts which fall due after five years from the date of the balance sheet which are payable other than by instalments; and
    2. the amount of any debts which are payable in instalments, the amount of any instalments which fall due for payment after the end of five years;
    3. for each debt falling to be taken into account in (a) and (b) above, the terms of payment or repayment and the rate of any interest payable on the debt. If the number of debts is such that, in the opinion of the directors, compliance with this requirement would result in excessive length, it is sufficient to provide a general indication of the terms of payment or repayment and the rates of any interest payable on those debts. [1 Sch 61, 3 Sch 79].
12. if any debentures were issued during the year, the following information must be given:
    1. the classes of debentures issued; and
    2. the amount issued and the consideration received in respect of each class of debenture. [1 Sch 50, 2 Sch 61, 3 Sch 68].