3.5.3.A Deemed cost

A number of the transition exemptions permit an entity to establish a deemed cost that may differ from the historical cost carrying amount under its previous financial reporting framework. The implications of deemed cost are discussed at 5.5 below. For a UK company's (or LLP's) statutory accounts, the deemed cost, in many cases, will need to comply with either the alternative accounting rules or the fair value accounting rules, as applicable. Example 32.2 at 3.5 above illustrates that where a revaluation policy is adopted by a UK company (or LLP), a statutory revaluation reserve is established, where required by the alternative accounting rules. However, even if, for example, a UK company (or LLP) records an item of property, plant and equipment at a deemed cost equal to its fair value at the date of transition or treats a revaluation under its previous financial reporting framework as a deemed cost at the date of the revaluation (see 5.5 below), application of the alternative accounting rules may require the company (or LLP) to establish (or maintain an existing) statutory revaluation reserve.

3.5.3.B Financial instruments held at fair value

Where financial instruments are measured at fair value under the fair value accounting rules, certain fair value movements are required to be recognised in other comprehensive income and accumulated in the statutory fair value reserve. See Chapter 6 at 10.3. The most common examples relate to fair value movements arising on: cash flow hedges (see Chapter 10 at 10.8), exchange differences in respect of monetary items forming part of a net investment in a foreign operation (and hedges of a net investment in a foreign operation) (see Chapter 10 at 10.9), and, where IAS 39 is applied to the recognition and measurement of financial instruments, available-for-sale financial assets. [IAS 39.45(d)]. As discussed in Chapter 6 at 10.3, our view is that the fair value accounting rules also apply to investments in debt instruments accounted at fair value through other comprehensive income in accordance with IFRS 9. [IFRS 9.4.1.2.A, IFRS 9.5.7.1(d), 5.7.10-11]. This is because the accounting is similar to that for an available for sale financial asset. Therefore, fair value movements arising on such debt instruments should also be reflected in the statutory fair value reserve. A statutory fair value reserve may sometimes be required for a cash flow hedge on transition, even where hedge accounting is not being used going forward. This will, however, depend on whether IAS 39, or IFRS 9, or Sections 11 and 12 are being used. See 5.16 below for a discussion of the transition provisions for hedge accounting.

By contrast, in our view, accounting for investments in equity instruments at fair value through other comprehensive income in accordance with IFRS 9, [IFRS 9.4.1.4, 5.7.1(b), IFRS 9.5.7.5-6], makes use of the alternative accounting rules and fair value movements should be reflected in the statutory revaluation reserve (see Chapter 6 at 10.2).

Where a financial liability is designated at fair value through profit or loss in accordance with IFRS 9, fair value changes attributable to changes in the credit risk of the liability are accounted in other comprehensive income (unless that treatment would create or enlarge an accounting mismatch). [IFRS 9.4.2.2, 5.7.1(c), 5.7.7-9]. Recording such fair value gains and losses attributable to changes in credit risk in other comprehensive income in accordance with IFRS 9 will usually be a departure from the requirement of paragraph 40 of Schedule 1 to the Regulations (which requires fair value gains and losses to be included in the profit and loss account, except where the financial instrument is a hedging instrument or an available for sale security) for the overriding purpose of giving a true and fair view. [FRS 102.A3.12C]. This is discussed further at Chapter 6 at 10.3.

Whether or not adjustments are taken to retained earnings or another category of equity, particular care needs to be taken in evaluating whether such adjustments are realised or not for the purposes of determining the distributable profits of a UK company. TECH 02/17BL provides guidance. See also Chapter 1 at 5.5 and 6.8.

3.5.3.C Investment property – transitional adjustments

Under FRS 102 (as amended by the Triennial review 2017), investment property must be carried at fair value through profit or loss (except for investment property rented to another group entity, where a policy choice is made to transfer the investment property to property, plant and equipment and apply the cost model). [FRS 102.16.1, 1A, 4A-4B, 7]. In a UK company's (or LLP's) statutory accounts, this accounting makes use of the fair value accounting rules.

It is possible that a first-time adopter previously accounted for investment property using the cost model as a policy choice under EU-adopted IFRS (or FRS 101). Where the fair value model is applied to the investment property under FRS 102, the adjustment of the carrying amount to fair value at the date of transition should be included in retained earnings (or transferred to a separate non-distributable reserve) as the revaluation applies the fair value accounting rules.

It is also possible that a first-time adopter previously accounted for investment property rented to another group entity at fair value through profit or loss under EU-adopted IFRS (or FRS 101) but, on transition to FRS 102, makes a policy choice to transfer the investment property to property, plant and equipment and to apply the cost model. If this is the case, the investment property will need to be restated to original cost or deemed cost on transition (see 3.5.3.A above and 5.5 below). [FRS 102.1.19A, Appendix III.40B-40C]. Where a deemed cost is used on transition for such investment properties to be accounted using the cost model, a statutory revaluation reserve may arise, where the deemed cost exceeds the depreciated historical cost of such properties (see 5.5 below).

On transition, deferred tax should be provided on any revaluation in accordance with Section 29 – Income Tax, as this is generally a timing difference recognised on or prior to transition. Deferred tax relating to investment property that is measured at fair value shall be measured using the tax rates and allowances that apply to sale of the asset, except for investment property that has a limited useful life and is held within a business model whose objective is to consume substantially all of the economic benefits embodied in the property over time. [FRS 102.29.6, 16].

3.5.5.A Previous IFRS or FRS 101 reporter applying IFRS 9 under its previous financial reporting framework

An entity already applying IFRS 9 under its previous financial reporting framework is likely to continue to apply IFRS 9 to the recognition and measurement of financial instruments if it transitions to FRS 102 in a subsequent accounting period. However, the only transition provisions in Section 35 relating to financial instruments address derecognition of financial assets and financial liabilities (see 4.1 below) and hedge accounting (see 5.16 below). [FRS 102.35.9(a), 10(t)].

As discussed at 3.5.1 above, in our view, the transitional provisions of accounting standards would not apply on first-time adoption of FRS 102 (unless specifically included within Section 35). However, we doubt that the FRC intended that an entity already applying IFRS 9 (or indeed IAS 39, for an accounting period beginning before 1 January 2018) under its previous financial reporting framework should change their accounting treatment when continuing to apply the same accounting policy choice on transition from EU-adopted IFRS or FRS 101 to FRS 102.

As explained at 3.5.1 above, consistent accounting policies should be used in the opening statement of financial position and for all periods presented in an entity's first FRS 102 financial statements. [FRS 102.10.7, 35.8]. Therefore, comparatives would need to be presented under IFRS 9. However, this should not generally cause difficulty even if a first-time adopter had used the modified retrospective approach (and not restated comparatives) in the accounting period where IFRS 9 was first applied under its previous financial reporting framework (i.e. IFRS or FRS 101). If the entity transitions to FRS 102 in the following period, the prior year comparative will reflect the amounts presented in the initial period of application of IFRS 9 under its previous financial reporting framework.

The situation is less clear concerning IFRS 9's requirements on hedge accounting as a previous IFRS or FRS 101 reporter was required (with certain exceptions) to apply these prospectively from the date of initial application of IFRS 9. [IFRS 9.7.2.15, 7.2.17, 7.2.21-26]. Hedge accounting is also addressed by a specific transition provision in Section 35 (see 5.16.3 below). However, for many entities, the existing hedging relationships under IAS 39 may have continued under IFRS 9 (after consideration of rebalancing), with no accounting adjustments to the hedge accounting required to opening equity on initial application of IFRS 9. Where adjustments on transition to IFRS 9's hedge accounting requirements were reflected in opening equity (for example to reflect IFRS 9's accounting for the ‘costs of hedging’, where only the hedging option's intrinsic value was designated) or on rebalancing hedges, the question arises as to whether these adjustments should be reflected at the date of transition. Generally, we believe that the adjustments made to opening equity on initial application of IFRS 9 under the previous financial reporting framework would be reflected at the date of transition. In addition, we believe the effects of rebalancing hedges at the date of initial application of IFRS 9 should continue to be reflected in profit or loss in the same way as under IFRS 9. [IFRS 9.7.2.25(b)].

Entities applying IFRS 9 are permitted to choose an accounting policy to continue to apply the hedge accounting provisions of IAS 39 (together with IFRIC 16 – Hedges of a Net Investment in a Foreign Operation) on initial application of IFRS 9. [IFRS 9.7.2.21]. This concession is located in the section on transition for hedge accounting in IFRS 9 but is more in the nature of an accounting policy choice available within the standard. In addition, while this chapter refers to applying IFRS 9 to the recognition and measurement of financial instruments, FRS 102 strictly refers to ‘the recognition and measurement provisions of IFRS 9 – Financial Instruments (as adopted by the EU) and IAS 39 (as amended by IFRS 9).’ [FRS 102.11.2, 12.2]. Therefore, we believe that an entity already applying IFRS 9 and applying IAS 39 to its hedges can continue to adopt this accounting policy on transition to FRS 102. If the entity changes its policy to apply IFRS 9's hedge accounting requirements on transition to FRS 102, the same issues arise as discussed at 3.5.5.B below.

3.5.5.B Previous IFRS or FRS 101 reporter applying IAS 39 under its previous financial reporting framework

If a first-time adopter had applied IAS 39 under its previous financial framework but changes to IFRS 9 on transition to FRS 102, it will need to apply IFRS 9 retrospectively, subject to the transition provisions on derecognition of financial instruments (see 4.1 below) and on hedge accounting (see 5.16.3 below).

For some entities, application of IFRS 9 may cause implementation difficulties and limit the ability to make designations of financial instruments.

For many entities, the existing hedging relationships under IAS 39 may continue under IFRS 9 (after consideration of rebalancing), with no accounting adjustments to the hedge accounting required to the opening statement of financial position under FRS 102. See Chapter 49 of EY International GAAP 2019 for further discussion of IFRS 9's requirements on hedge accounting.

However, entities will need to consider the following implementation issues in relation to hedge accounting on transition to FRS 102:

• It will be necessary to ensure that all the qualifying criteria for hedge accounting under IFRS 9 are met at the date of transition (except that the entity may complete the designation and documentation of the hedging relationship after the date of transition but before the date of authorisation of the financial statements) in order for hedge accounting for existing hedging relationships to continue from the date of transition. [IFRS 9.6.4.1, FRS 102.35.10(t)(iv)]. Otherwise, hedge accounting will need to be discontinued prospectively from the date of transition. [IFRS 9.6.5.6, 6.5.7, 6.5.10].
• If new hedging relationships are identified under IFRS 9 (that were not identified under IAS 39), the opening statement of financial position would not reflect the hedging relationship. However, hedge accounting could be established prospectively from the date all qualifying criteria for hedge accounting under IFRS 9 are met (subject to the concession over the timing of designation and documentation allowed for in the transition provision), which might be prospectively from the date of transition or a later date. [FRS 102.35.10(t)(iv)]. See 5.16.3 below.
• Under IAS 39, a hedging relationship that failed the effectiveness tests would have been required to be discontinued. [IAS 39.88, 91(b), 101(b)]. Under IFRS 9, the retrospective effectiveness test has been withdrawn, although the qualifying criteria for hedge accounting include ongoing effectiveness requirements such as the existence of an economic relationship between the hedged item and the hedging instrument. [IFRS 9.6.4.1(c)]. In these circumstances, the opening statement of financial position of the entity would continue to reflect the discontinuance of the past hedging relationship but, if all the qualifying criteria (subject to the concession over the timing of designation and documentation allowed for in the transition provision) are met at the date of transition, the entity could re-establish hedge accounting prospectively from the date of transition. [FRS 102.35.10(t)(iv)]. See 5.16.3 below.
• An entity changing from IAS 39 to IFRS 9 on adoption of FRS 102 may also need to adjust the hedge ratio of the hedging relationship (‘rebalancing’) in its hedge documentation. It would appear that the effects of any rebalancing would be reflected in profit or loss following the date of transition. This is the same position as would be the case if an ongoing IFRS reporter moved from IAS 39 to IFRS 9. [IFRS 9.7.2.25(b)]. IFRS 9's requirements for rebalancing of hedges are discussed in Chapter 49 at 8.2 of EY International GAAP 2019.
• The hedge accounting under IAS 39 differs, or may differ, under IFRS 9 where the intrinsic value of an option (or the spot element of a forward contract) was designated as a hedging instrument. IFRS 9 also permits an entity to exclude the foreign currency basis spread when designating a financial instrument as a hedging instrument (but this was not permitted under IAS 39).

  Under IAS 39, where the time value of an option or the forward element of a foreign currency contract was excluded from the hedging relationship, fair value movements on those elements were recognised in profit or loss. Under IFRS 9, where the time value of an option is excluded from the hedging relationship, the fair value movements on the time value of the option are first recognised in other comprehensive income (and a separate component of equity), with the subsequent treatment depending on the nature of the hedged transaction. A similar treatment may be elected on a hedge-by-hedge basis for the fair value movements attributable to the forward element of foreign currency contracts (and foreign currency basis spread). [IAS 39.74, IFRS 9.6.5.15-16]. IFRS 9's accounting for ‘costs of hedging’ is discussed in Chapter 49 at 7.5 of EY International GAAP 2019.

  In our view, the transitional provisions in IFRS 9 do not apply to a first-time adopter. However, where the time value of an option or the forward element of a foreign currency contract was excluded from the hedging relationship under IAS 39, the above accounting for ‘costs of hedging’ (where applied for such hedging relationships under IFRS 9) would be applied retrospectively on first-time adoption. This is because there is no change to the hedging relationship, just to the underlying accounting. Consequently, amounts previously reflected in profit or loss (and that are therefore in retained earnings at the date of transition) under the entity's previous financial reporting framework will (for an option) and may (for a foreign currency contract) be reclassified into a separate component of equity on transition (and subsequently be reclassified as a basis adjustment on the later recognition of a non-financial item, or to profit or loss, as appropriate).

  Since IAS 39 did not permit the exclusion of foreign currency basis spread from a hedging relationship, it would appear that the transition provisions may not allow retrospective application of IFRS 9's accounting for ‘costs of hedging’. The transition provisions in Section 35 (see 5.16.3 below), [FRS 102.35.10(t)(iv)], do not allow retrospective designation of hedging relationships prior to the date of transition. Therefore, such adjustments would not be reflected in the opening statement of financial position under FRS 102. To separate the foreign currency basis spread would mean a different hedging relationship would be required to be designated under IFRS 9. However, in our view, this hedging relationship could be reflected prospectively from transition, if all the qualifying criteria for hedge accounting (subject to the concession over the timing of designation and documentation allowed for in the transition provision) were met by the date of approval of the financial statements.

For the same reasons as described at 3.5.5.A above, we believe that the entity could continue to apply IAS 39 to its hedges as this is permitted as an accounting policy choice by IFRS 9.

4.1.5.A Financial assets – what is derecognition?

Generally, it will be clear whether a financial asset has been derecognised under IAS 39 or IFRS 9 and therefore must not be re-recognised on transition to FRS 102. However, Section 35 does not specifically address whether derecognition of a part of a financial asset or continued recognition of an asset to the extent of its continuing involvement are regarded as derecognition for the purposes of paragraph 35.9(a).

IAS 39 and IFRS 9 require an entity to determine whether the derecognition requirements are to be applied to a part of a financial asset (or a part of a group of financial assets) or a financial asset (or a group of similar financial assets) in its entirety. [IAS 39.16, IFRS 9.3.2.2]. Situations where parts of a financial asset are capable of derecognition under IAS 39 or IFRS 9 include: specifically identified cash flows (e.g. the interest cash flows of a debt instrument, commonly referred to as an interest rate strip), a fully proportionate share of the cash flows (e.g. 90% share of all cash flows of a debt instrument), and a fully proportionate share of specifically identified cash flows (e.g. 90% of the interest cash flows from a financial asset). [IAS 39.16(a), IFRS 9.3.2.2(a)].

Section 11, unlike IAS 39 and IFRS 9, does not refer to derecognition of parts of a financial asset (although it does so in respect of parts of a financial liability). [FRS 102.11.33, 36, 12.14]. Nevertheless, in our view, specifically identified cash flows or a fully proportionate share of all or of specifically identified cash flows would meet the definition of a financial asset. Therefore, derecognition of a part of a financial asset in accordance with IAS 39 or IFRS 9 would be regarded as derecognition of a financial asset for the purposes of the transition exception in paragraph 35.9(a). Consequently, the part of the original financial asset derecognised would not be reinstated on transition to FRS 102.

IAS 39 and IFRS 9 state that if the entity neither transfers nor retains substantially all the risks and rewards of ownership of the financial asset but has retained control, it shall continue to recognise the financial asset to the extent of its continuing involvement. IAS 39 and IFRS 9 set out how the continuing involvement in the asset (or part of the asset) and the associated liability should be measured. [IAS 39.20(c)(ii), 30-35, IFRS 9.3.2.6(c)(ii), 3.2.16-3.2.21]. See Chapter 48 at 5.3 and 5.4 of EY International GAAP 2019. It would seem unlikely that an entity with assets (or parts of assets) recognised to the extent of the continuing involvement would choose to apply Sections 11 and 12, since these sections do not set out rules for accounting for such arrangements (see Chapter 10 at 9.2.4.B). However, it would not appear that recognising an asset (or part of an asset) to the extent of its continuing involvement could be regarded as derecognition for the purposes of paragraph 35.9(a). Accordingly, if Sections 11 and 12 are applied to the recognition and measurement of financial instruments, in our view, the accounting for the continuing involvement would need to be retrospectively restated.

4.1.5.B Financial liabilities

IAS 39 and IFRS 9 address derecognition of financial liabilities, including when an exchange of debt between an existing borrower and lender, or modification of the terms of existing debt gives rise to derecognition. Hence, it will be clear whether a financial liability has been derecognised under IAS 39 or IFRS 9 prior to the date of transition and therefore must not be re-recognised on transition to FRS 102.

IAS 39, IFRS 9 and Sections 11 and 12 require an entity to derecognise a financial liability (or part of a financial liability) only when it is extinguished (i.e. when the obligation specified in the contract is discharged, is cancelled or expires). [FRS 102.11.36-38, 12.14, IAS 39.39-42, IFRS 9.3.3.1-4]. Sections 11 and 12 contain the same basic requirements on accounting for exchanges of a financial liability between an existing borrower and lender and the modification of terms of an existing financial liability as IAS 39 and IFRS 9, but not the related application guidance. [IAS 39.AG57-63, IFRS 9.B3.3.1-7]. In particular, the application guidance in IAS 39 and IFRS 9 covers the evaluation of whether an exchange or modification of debt has substantially different terms, and the accounting for an exchange or modification. As discussed in Chapter 10 at 9.4.2, we believe an entity applying Sections 11 and 12 as an accounting policy choice under FRS 102 may, but is not required to, apply this application guidance.

An entity previously applying IAS 39 or IFRS 9 that exchanged or modified debt with the same lender in circumstances where the terms of the exchanged or ‘modified’ debt are not ‘substantially different’ would not have accounted for the extinguishment of the original financial liability. [IFRS 9.3.3.2, IAS 39.40]. On initial application of FRS 102, there is no exemption from measuring the exchanged or ‘modified’ debt that continues to be recognised in accordance with the requirements of Sections 11 and 12. The measurement adjustments, if any, required on transition for exchanged or ‘modified’ debt will depend on the accounting previously adopted under IAS 39 or IFRS 9, as discussed further below, and on the accounting adopted under Sections 11 and 12.

The application guidance in both IAS 39 and IFRS 9 address the treatment of costs or fees associated with the exchange or modification of a financial liability that is not accounted as an extinguishment – requiring that the costs or fees are adjusted against the carrying amount of the liability, and amortised over the remaining term of the modified liability. [IAS 39.AG62, IFRS 9 Appendix B.3.3.6].

Under IFRS 9, the modified contractual cash flows of a financial liability (that is not accounted as an extinguishment following an exchange or modification), will be discounted at the original effective interest rate, with an adjustment to the carrying amount of the financial liability and profit or loss. However, IAS 39 does not provide conclusive guidance as to whether an adjustment is made to the carrying amount of the financial liability for such changes in contractual cash flows (or whether the effective interest rate must be changed). [IFRS 9.3.3.2, 5.4.3, BC4.252-253]. See Chapter 48 at 6.2 of EY International GAAP 2019 for further discussion of IFRS 9's requirements on exchange or modification of debt by the original lender.

FRS 102 does not provide any specific guidance on the subsequent accounting where it is determined that an exchange or modification of a financial liability is not an extinguishment of the original financial liability. Even following the clarification of the accounting for such a modification under IFRS 9, the later Triennial review 2017 did not clarify the accounting under FRS 102. In light of this, we believe that entities may apply judgement and adopt an appropriate accounting policy in accounting for changes to the contractual cash flows and for costs or fees for exchange or modification of financial liabilities that are not deemed to be an extinguishment of the original financial liability. For example, under the hierarchy in Section 10, an entity might look to accounting treatments adopted by IFRS reporters applying IAS 39 or IFRS 9. See Chapter 10 at 9.4.2.

5.2.1.A Considerations on restatement of business combinations

If the exemption from restating pre-transition business combinations is not applied, the requirements of Section 19 (see Chapter 17) would need to be applied retrospectively. This might be an onerous exercise that might require undue use of hindsight. For example, restatement would require:

• reassessment as to whether the previous financial reporting framework classification of the business combination (as an acquisition by the legal acquirer, reverse acquisition by the legal acquiree, or merger accounting) was appropriate;
• a fair value exercise to be performed, at the date of the business combination, if the purchase method is required. Any adjustments to assets and liabilities may also impact deferred tax and non-controlling interest;
• an adjustment to non-controlling interest arising on a business combination, if this had been initially recognised at fair value under IFRS, as permitted as an accounting policy choice on a transaction-by-transaction basis. [IFRS 3.19, Appendix B.44-45]. This treatment is not permitted under Section 19, which would require the non-controlling interest to be initially recognised at the non-controlling interest's share of the net amount of the identifiable assets, liabilities and contingent liabilities recognised and measured in accordance with Section 19 at the acquisition date (see Chapter 17 at 3.8); [FRS 102.9.13(d), 19.14A] and
• the amounts recognised in the business combination to be restated under Section 19 and, subsequently, to be accounted for under FRS 102.

The application of the purchase method in Section 19 differs in certain respects from acquisition accounting under IFRS 3 – Business Combinations. See Chapter 17 at 3 for details of application of the purchase method under Section 19.

In particular, retrospective application of Section 19 may result in changes to the recognition of intangible assets compared to the entity's previous financial reporting framework. The extent of any differences to IFRS may depend on what policy the entity applies to the recognition of intangible assets, following amendments made to FRS 102 in the Triennial review 2017. [FRS 102.18.8]. In addition, FRS 102 requires that the expected future economic benefits attributable to the intangible asset are probable and the fair value of the intangible asset is measured reliably whereas under IFRS, the probability recognition and reliable measurement criteria are always considered to be satisfied. [IAS 38.33]. See Chapter 17 at 2.8 and 3.7.1.A.

Section 19 has a general requirement that the acquiree's identifiable assets and liabilities (and contingent liabilities) – providing their fair value can be measured reliably – are measured at their acquisition-date fair values (with recognition and measurement exceptions for deferred tax assets and liabilities, employee benefit assets and liabilities and share-based payment transactions, where the requirements in the relevant section of FRS 102 dealing with these items are followed). [FRS 102.19.14-21]. These requirements may differ from those in the entity's previous financial reporting framework. For example, IFRS 3 requires that the identifiable assets and liabilities (and contingent liabilities) are measured at their acquisition-date fair values in accordance with IFRS 13 – Fair Value Measurement. However, there are also specific exceptions to the recognition and measurement principles. [IFRS 3.10, 18-31, IFRS 13.5]. If a business combination is restated under Section 19, the adjustments to the fair values of the identifiable assets and liabilities (and contingent liabilities) at the date of the business combination (including any changes to deferred tax and non-controlling interest) are reflected as an adjustment to goodwill. Therefore, applying Section 19 to the business combination would mean restatement of goodwill arising on the acquisition, adjusted for any subsequent amortisation and impairment.

Where the exemption not to restate business combinations is taken, any adjustments to the assets and liabilities acquired or assumed (including related deferred tax, which is required on the differences between the values recognised for assets (other than goodwill) and liabilities acquired in a business combination and the amounts at which those assets and liabilities will be assessed for tax [FRS 102.29.11] – see Chapter 26 at 6.6) are reflected in retained earnings (or if appropriate, another category of equity). [FRS 102.35.9]. See 5.2.3.C below. Where the business combination involves a purchase of trade and assets reflected in the individual financial statements of a UK company, recognising additional deferred tax liabilities on fair value adjustments, but not adjusting goodwill, would have an adverse effect on the company's distributable reserves. This was a particular concern for previous UK GAAP reporters transitioning to FRS 102.

Example 32.3 at 5.2.6 illustrates the impact of applying the transition exemption and retrospectively restating the business combination in accordance with Section 19 of FRS 102 for a previous IFRS reporter.

5.2.3.A Classification of business combination

If a first-time adopter does not restate a business combination then it would keep the same classification of the business combination (as an acquisition by the legal acquirer, reverse acquisition by the legal acquiree, merger accounting or pooling of interests) as in its financial statements under its previous financial reporting framework. However, if a transaction is restated in accordance with Section 19, the classification of the business combination may change.

5.2.3.B Recognition and derecognition of assets and liabilities

A first-time adopter that applies the transition exemption should recognise all assets and liabilities at the date of transition that were acquired or assumed in a past business combination, other than:

• financial assets and financial liabilities that fall to be derecognised under the derecognition transition exception in paragraph 35.9(a) (see 4.1 above);
• assets (including goodwill) and liabilities that were not recognised in the acquirer's consolidated statement of financial position in accordance with its previous financial reporting framework that also would not qualify for recognition as an asset or liability under FRS 102 in the separate (or individual) statement of financial position of the acquiree; and
• intangible assets previously subsumed within goodwill.

The entity must exclude items it recognised under its previous financial reporting framework that do not qualify for recognition as an asset or liability under FRS 102 (subject to the derecognition transition exception for financial assets and financial liabilities).

In our view, a first-time adopter may derecognise intangible assets on transition if these do not meet the criteria followed for recognition of intangible assets on a business combination under FRS 102. This is the case even though, for an ongoing FRS 102 reporter, adoption of the new requirements relating to recognition of intangible assets acquired on a business combination is reflected prospectively (see discussion at 3.5.1 above).

No adjustment is made to the carrying amount of goodwill. Any resulting change is recognised by adjusting retained earnings (or another category of equity). [FRS 102.35.8, 9(a), 10(a)].

5.2.3.C Measurement of assets and liabilities

In essence, the approach to recognising and measuring assets and liabilities is to apply FRS 102 retrospectively (subject to the exceptions and exemptions taken at the date of transition), but without revisiting the fair value exercise. This means that where assets and liabilities acquired or assumed in a past business combination were not recognised under the entity's previous financial reporting framework, these should normally be reflected at the amounts that would be recognised in the separate or individual financial statements of the acquiree and no adjustments are made to goodwill. The previous financial reporting framework carrying amounts as at the date of the acquisition are treated as a deemed cost for the purposes of cost-based depreciation and amortisation. This does not preclude the deemed cost exemptions available on transition from being subsequently applied to assets acquired in the business combination that are still held at the date of transition (see 5.5 below).

FRS 102 requires that, where the transition exemption is used, no adjustments are made to the carrying amount of goodwill at the date of transition. [FRS 102.35.10(a)]. However, 5.2.4 below sets out situations where it may be necessary to adjust the carrying amount of goodwill, notwithstanding this prohibition.

A first-time adopter should also consider the following implementation issues on measuring assets acquired and liabilities assumed in business combinations:

1. Subsequent measurement of assets and liabilities under FRS 102 not based on cost – Where FRS 102 requires subsequent measurement of some assets and liabilities on a basis that is not based on original cost, such as fair value (e.g. certain financial instruments) or on specific measurement bases (e.g. share-based payment or employee benefits), a first-time adopter must measure these assets and liabilities on that basis in its opening FRS 102 statement of financial position, even if they were acquired or assumed in a past business combination. Any resulting change is recognised by adjusting retained earnings (or another category of equity).
2. Previous financial reporting framework carrying amount as deemed cost – The carrying amounts in accordance with the entity's previous financial reporting framework of assets acquired and liabilities assumed in the business combination, immediately after the business combination, are their deemed cost in accordance with FRS 102 at that date. If FRS 102 requires a cost-based measurement of those assets and liabilities at a later date that deemed cost should be the basis for cost-based depreciation or amortisation from the date of the business combination (i.e. the carrying amounts under the previous financial reporting framework at the date of the business combination are ‘grandfathered’ as at that date).

   A first-time adopter would not use the provisionally determined fair values of assets acquired and liabilities assumed (that were later finalised under its previous financial reporting framework) in applying the business combinations exemption. In any case, goodwill is adjusted retrospectively at the date of transition for the changes to the provisional fair values under FRS 101 / EU-adopted IFRS. While neither Section 35 nor IFRS 1 explicitly addresses this issue, this is consistent with how the related transition exemption in Appendix C of IFRS 1 has been applied in practice.

   By contrast, under its previous financial reporting framework, the entity may have amortised intangible assets or depreciated property, plant and equipment from the date of the business combination. If this amortisation or depreciation is not in compliance with FRS 102 (or indeed the asset was not amortised or depreciated under the entity's previous financial reporting framework, but this is required under FRS 102 – see the discussion on intangible assets at 5.2.4.F below), this is not ‘grandfathered’ under the business combination exemption. If the amortisation or depreciation methods and rates are not acceptable and the difference has a material impact on the financial statements, a first-time adopter must adjust the accumulated amortisation or depreciation on transition (see 5.5.2 below).

3. Measurement of items not recognised under the entity's previous financial reporting framework– If an asset acquired or liability assumed in a past business combination was not recognised under the entity's previous financial reporting framework, this does not mean that such items have a deemed cost of zero in the opening FRS 102 statement of financial position. Instead, the acquirer normally recognises and measures those items in its opening statement of financial position on the basis that FRS 102 would require in the statement of financial position of the acquiree. Conversely, if an asset or liability was subsumed in goodwill in accordance with the entity's previous financial reporting framework but would have been recognised separately under Section 19, that asset or liability remains in goodwill unless FRS 102 would require its recognition in the financial statements of the acquiree. However, intangible assets previously subsumed within goodwill under the entity's previous financial reporting framework are not separately recognised. [FRS 102.35.10(a)]. Financial assets and financial liabilities that are derecognised in accordance with the derecognition transition exception (see 4.1 above) are not recognised. [FRS 102.35.9(a)].
4. Measurement of non-controlling interests and deferred tax – The measurement of non-controlling interests (see also 4.3 above) and deferred tax follows from the measurement of other assets and liabilities. Consequently, deferred tax and non-controlling interests should be recalculated after all assets acquired and liabilities assumed have been adjusted under Section 35.

   The recognition and measurement of deferred tax is addressed in Section 29. Section 29 must be applied retrospectively as no transition exemptions or exceptions apply. In particular, first-time adopters will need to consider what deferred tax would have been recognised at the date of the business combination, as adjusted by subsequent movements in timing differences recognised under Section 29.

   Any resulting change in the carrying amount of deferred taxes and non-controlling interest is recognised by adjusting retained earnings or another category of equity.

   Some IFRS reporters may have included non-controlling interest at fair value when accounting for the business combination under IFRS 3. [IFRS 3.19, Appendix B.44-45]. This may exceed the non-controlling interest based on the proportionate share of the subsidiary's identifiable assets, liabilities (and contingent liabilities) which would be the measurement basis used under FRS 102 at the date of the business combination. [FRS 102.9.13(d), 19.14A]. Consequently some of the goodwill recognised under IFRS would relate to the non-controlling interest. Given that goodwill is not restated where the transition exemption in paragraph 35.10(a) is taken, we believe that it is appropriate that non-controlling interest – which represents the equity in a subsidiary not attributable, directly or indirectly, to its parent [FRS 102 Appendix I] – continues to include this attributed goodwill.

5.2.4.A Impairment of goodwill

Section 35 does not require an impairment review of goodwill to be performed as at the date of transition. However, there are no exemptions in Section 35 from applying Section 27, which requires that an entity must assess at each reporting date whether there is any indication of impairment. FRS 102 prohibits the reversal of impairment losses relating to goodwill. [FRS 102.35.7, 27.24, 28].

For example, an entity may uplift the carrying amount of property, plant and equipment to fair value at the date of transition (by adopting a revaluation policy under FRS 102 or using the deemed cost exemption to state an item of property, plant or equipment at fair value as at the date of transition [FRS 102.35.10(c)] – see 5.5 below). As a consequence, the total carrying amount of the acquired net assets including goodwill may exceed the recoverable amount of the relevant cash-generating unit(s) (or groups of cash-generating unit(s)) to which the goodwill is allocated. (Where this allocation cannot be performed on a non-arbitrary basis, Section 27 sets out the approach to be used). Consequently, an impairment of goodwill (and potentially other assets in the cash generating unit(s)) would be recognised. See Chapter 24 at 5.

Section 35 states that no adjustments shall be made to the carrying amount of goodwill at the date of transition (or earlier date from which the first-time adopter restates business combinations under Section 19). [FRS 102.35.10(a)]. However, it would be inappropriate to recognise an impairment loss on the first day of the comparative period of the FRS 102 financial statements when that impairment already existed at the date of transition itself. Therefore, if there is an indicator of impairment at transition, the goodwill should be reviewed for impairment at the date of transition.

Any impairment losses identified at the date of transition would be reflected in retained earnings in accordance with paragraph 35.8, unless the impairment is allocated to revalued assets (such as property, plant and equipment) where the impairment is accounted as a revaluation decrease in accordance with other sections of FRS 102 and reduces a revaluation surplus on that asset included in the revaluation reserve (see Chapter 6 at 10.2, Chapter 15 at 3.6 and Chapter 24 at 6). [FRS 102.27.6].

5.2.4.B Transition accounting for contingent consideration

Contingent consideration should be remeasured under the general principles in FRS 102 as there are no exemptions under Section 35. FRS 102 requires that the acquirer includes the estimated amount of contingent consideration (reflecting the time value of money, if material) in the cost of the combination at the acquisition date if the adjustment is probable and can be measured reliably. Subsequent changes to the estimate are also reflected as adjustments to the cost of the business combination (with the unwinding of any discount reflected as a finance cost in profit or loss in the period it arises). [FRS 102.19.12-13B]. See Chapter 17 at 3.6.2.

The requirements of IFRS for accounting for contingent consideration differ significantly from those in FRS 102. In particular, IFRS 3 requires that contingent consideration classified as equity shall not be remeasured and its subsequent settlement shall be accounted for within equity. Other contingent consideration is measured at fair value at each reporting date and changes in fair value are recognised in profit or loss. [IFRS 3.39-40, 58]. Therefore, it is likely that a previous IFRS or FRS 101 reporter will need to remeasure contingent consideration classified as a liability (or asset) on transition to FRS 102 to reflect the amounts that are probable (and can be measured reliably) rather than the fair value. The situation with contingent consideration classified as equity is more complicated since FRS 102's requirements on contingent consideration arising from a business combination do not distinguish between contingent consideration classified as equity or as a liability. As explained further in Chapter 17 at 3.6.5, in our view, contingent consideration classified as equity is remeasured for changes in the number of equity instruments to be issued (and valued using the fair value at the date of exchange, i.e. the date of acquisition), with adjustments reflected in the cost of combination (and hence goodwill). The estimated amount of contingent consideration classified as equity is not remeasured for subsequent changes in the entity's share price.

Consequently, while paragraph 35.10(a) specifies that no adjustments should be made to goodwill (where the transition exemption is used), Section 19 requires goodwill to be adjusted for changes in the amount of estimated contingent consideration. However, the amount of goodwill recognised by a previous IFRS or FRS 101 reporter would not reflect adjustments to the fair value of contingent consideration made subsequent to the acquisition (unless these qualified as measurement period adjustments). [IFRS 3.39-40, 45, 58]. The question therefore arises as to whether a first-time adopter is permitted to adjust goodwill as at the date of transition to reflect the estimated contingent consideration, measured in accordance with Section 19 at that date. Although a conflict between paragraph 35.10(a) and Section 19 arises, in our view, goodwill is not adjusted as at the date of transition, and therefore any resulting change to the estimated contingent consideration is recognised by adjusting retained earnings (or another category of equity) at that date. This view recognises that paragraph 35.10(a) takes precedence. [FRS 102.35.7, 10(a)]. This situation differs in certain respects from the situation discussed at 5.2.4.C below with denominating goodwill in a foreign currency as the accounting just changes the same goodwill from being viewed as denominated in the functional currency to a foreign currency (rather than remeasuring the goodwill to a different amount, based on estimated contingent consideration).

The interaction between the requirements on contingent consideration and those on financial instruments is rather complicated. Sections 11 and 12 of FRS 102, where applied to the recognition and measurement of financial instruments, scope out the accounting by the acquirer for contracts for contingent consideration in a business combination – and instead refer to Section 19. [FRS 102.12.3(g)]. Consequently, goodwill must be adjusted prospectively for re-measurements of contingent consideration that are made subsequent to the date of transition.

An entity that chooses to apply IAS 39 or IFRS 9 to the recognition and measurement of financial instruments, applies the scope of the relevant standard to its financial instruments. [FRS 102.11.2, 12.2]. IAS 39 and IFRS 9 specifically address contingent consideration classified as a financial liability that is recognised in a business combination to which IFRS 3 applies. [IAS 39.9(aa), IFRS 9.4.2.1]. However, the requirements on accounting for contingent consideration are found primarily in IFRS 3 and so do not apply to entities reporting under FRS 102. [IFRS 3.39-40, 58, IFRS 9.4.2.1(c)]. Therefore, such an entity should also normally apply the requirement in paragraph 19.12 that contingent consideration is recognised where the adjustments to consideration are probable and can be measured reliably, with subsequent adjustments to goodwill.

5.2.4.C Goodwill on a pre-transition business combination that is a foreign operation (where not restated under Section 19)

Section 35 is not explicit on how to treat goodwill relating to an acquisition of a foreign operation in a business combination that is not restated under Section 19.

While paragraph 35.10(a) specifies that no adjustments should be made to goodwill, Section 30 – Foreign Currency Translation – requires goodwill arising on the acquisition of a foreign operation to be translated. [FRS 102.30.23]. Where a conflict between paragraph 35.10(a) and Section 30 arises, management will need to use judgement to determine an appropriate policy and this may be an area where diversity in practice will emerge. A previous IFRS or FRS 101 reporter will in any event be translating foreign currency goodwill; however, there may be elements of goodwill which were regarded as functional currency goodwill (and not retranslated on an ongoing basis) on transition to IFRS or FRS 101. [IAS 21.23.47, IFRS 1 Appendix C2-C3].

In our view, paragraph 35.10(a) does not preclude management regarding the goodwill as foreign currency goodwill and retranslating the goodwill at the date of transition (and thereafter at each reporting period). An alternative view which could meet the requirements of paragraph 35.10(a) to preserve the carrying amount of goodwill (expressed in the functional currency of the reporting entity) and to comply with Section 30, would be taking the functional currency carrying amount of the goodwill at the date of transition, translating it into the underlying currency of the acquired operations at the transition date exchange rate and thereafter regarding the goodwill as foreign currency goodwill to be retranslated at each reporting period. Another alternative view is that the requirement relates to preserving the carrying amount of the goodwill (i.e. in the reporting entity's functional currency); this view takes a literal reading of the transition exemption in paragraph 35.10(a) and considers that this takes precedence over Section 30's requirements.

5.2.4.D Negative goodwill

FRS 102's accounting requirements for negative goodwill (see Chapter 17 at 3.9.3) differ significantly from those in IFRS 3 where the negative goodwill is recognised immediately in profit or loss. [FRS 102.19.24, IFRS 3.34].

The transition exemption in paragraph 35.10(a) addresses goodwill, requiring that no adjustment shall be made to the carrying value of goodwill. Goodwill is defined as ‘future economic benefits arising from assets that are not capable of being individually identified and separately recognised’ rather than simply as a residual (see Chapter 17 at 3.9). Therefore, goodwill is not the same as the ‘excess over cost of acquirer's interest in the net fair value of acquiree's identifiable assets, liabilities and contingent liabilities’ (negative goodwill). On the other hand, negative goodwill is not strictly an asset or liability (as defined) and so arguably does not fall within the requirement to restate the opening financial position. [FRS 102.35.7].

In our view, an entity that applies the transition exemption in paragraph 35.10(a) not to restate business combinations is not required to reinstate negative goodwill that was recognised immediately in profit or loss under IFRS. Moreover, for the reasons explained in Chapter 17 at 3.9.3, it may often be the case that negative goodwill would have been fully amortised by the date of transition had FRS 102 been applied. However, an entity would need to consider carefully whether any accumulated credit in retained earnings represented by negative goodwill is a realised profit in accordance with the guidance in TECH 02/17BL, as this may not always be the case.

5.2.4.E Goodwill previously deducted from equity

There may be historic circumstances where, under the entity's previous financial framework, some goodwill has been eliminated against reserves. In our view, where the exemption not to restate pre-transition business combinations in accordance with Section 19 is taken, the requirement that no adjustment shall be made to the carrying value of goodwill means that there is no change to the amount of goodwill recognised as an asset (i.e. the goodwill remains eliminated against equity). [FRS 102.35.10(a)]. Effectively under FRS 102, such goodwill does not exist for accounting purposes. FRS 102 does not permit or require recycling of goodwill previously deducted from equity to profit or loss when the related operation is disposed of or closed.

5.2.4.F Goodwill and intangible asset amortisation

FRS 102 requires that goodwill and intangible assets be amortised on a systematic basis over a finite useful life using an amortisation method that reflects the expected pattern of consumption of economic benefits. A straight-line basis is used if the entity cannot determine that pattern reliably. If an entity is unable to make a reliable estimate of the useful life of goodwill or an intangible asset, the useful life shall not exceed ten years. [FRS 102.18.19-22, 19.23]. See Chapter 16 at 3.4.3 and Chapter 17 at 3.9.2 for a fuller discussion.

Under IFRS, the acquirer measures goodwill at the amount recognised at the acquisition date less any accumulated impairment losses. [IFRS 3 Appendix B.63]. Consequently, goodwill is not amortised.

A first-time adopter may also need to consider the following implementation issues:

1. Adjustments to goodwill lives where no restatement of business combinations under Section 19 – Where an entity is not restating the business combination in accordance with Section 19, paragraph 35.10(a) requires that no adjustment is made to the carrying amount of goodwill. Consequently, the requirement in FRS 102 to amortise goodwill over a finite life is accounted for prospectively.

   The Basis for Conclusions to FRS 102 states that ‘FRS 102 does not permit goodwill to have an indefinite useful life, unlike current FRS. On transition to FRS 102, entities that previously determined that goodwill had an indefinite useful life will need to reassess goodwill to determine its remaining useful life, and subsequently amortise the goodwill over that period.’ [FRS 102.BC.B35.1].

   This does not appear to distinguish between goodwill relating to past business combinations restated in accordance with Section 19 and goodwill that is not restated, but we believe it is intended to apply only where the exemption in paragraph 35.10(a) not to restate business combinations is taken.

   Therefore, an IFRS or FRS 101 reporter is required to reassess the remaining useful life of the goodwill, as at the date of transition and to amortise the goodwill prospectively.

2. Restatement of business combinations in accordance with Section 19 – Where a first-time adopter restates a business combination in accordance with Section 19 and has previously ascribed a finite useful life to goodwill, any adjustment to that useful life is accounted for prospectively over the remaining revised useful life determined under FRS 102 as a change in estimate (see 4.2 above).

   Where, however, an indefinite useful life was used under the entity's previous financial reporting framework (as required under IFRS), amortisation should be adjusted for retrospectively from the date of the business combination. This is because this is a change in accounting policy (not a change in estimate) and the requirement in paragraph 35.10(a) that no adjustment shall be made to the carrying amount of goodwill does not apply. On transition to FRS 102, however, goodwill and intangible assets must be amortised over a finite useful life. Therefore, in our view, a move from an indefinite useful life to a finite useful life for goodwill is required to be retrospectively effected – such that the goodwill at transition represents the carrying amounts after adjusting for amortisation on the basis of the finite useful life determined under FRS 102.

3. Intangible assets – There are no special transition requirements for intangible assets (other than goodwill) and therefore FRS 102's requirements are applied retrospectively. [FRS 102.35.7].

   Where an entity amortised an intangible asset over a longer finite useful life than ten years under its previous financial reporting framework, it can continue to use that useful life, where it continues to be a reliable estimate of the useful life. In particular, it would be difficult to argue that the useful life of the intangible asset should simply default to a ten year life. Any changes to the useful life would need to be justified by reference to a change in circumstances (unless the previous life was objectively in error) and be recognised prospectively as a change in estimate (see 4.2 above). However, if an entity ascribed an indefinite useful life to an intangible asset under its previous financial reporting framework, in our view, the intangible asset must be amortised retrospectively over its new finite useful life since this is a change in accounting policy (FRS 102 does not permit use of an indefinite useful life).

   The above conclusions apply to all intangible assets, whether acquired separately or in a business combination (and do not depend on whether the business combination is restated in accordance with Section 19 or not).

5.2.5.A Changes in scope of consolidation compared to the previous financial reporting framework

Section 9 of FRS 102 states that ‘a subsidiary is an entity that is controlled by the parent’. The definition of ‘a subsidiary’ in Section 9 is generally consistent with (although not identical to) the definition of ‘a subsidiary undertaking’ included in section 1162 of the CA 2006. However, Section 9 contains additional guidance on ‘control’ – in relation to currently exercisable options or convertible instruments; where control is exercised through an agent; and Special Purpose Entities – as well as an extended definition of subsidiaries held exclusively for resale (which are excluded from consolidation). [FRS 102.9.4-9.12, s1162, s1162 (LLP)].

IFRS 10 has a similar definition that ‘a subsidiary is an entity that is controlled by another entity’. [IFRS 10 Appendix A]. However, IFRS 10 and FRS 102 differ in the wording of the definition of ‘control’ (and associated guidance) and exclusions from the scope of consolidation. [FRS 102.9.4-6A]. In many cases, both standards lead to the same determination of whether an entity is or is not a subsidiary. However, a first-time adopter should consider Section 9's requirements on control and the exclusions from the scope of consolidation (discussed in Chapter 8 at 3.3 and 3.4) in order to determine whether any changes are required compared to its previous financial reporting framework. [FRS 102.9.4-12].

5.2.5.B Previously unconsolidated subsidiaries

If, under its previous financial reporting framework, an FRS 102 first-time adopter did not consolidate a subsidiary that it is required to consolidate under FRS 102, it must retrospectively apply FRS 102 to the carrying amounts of the assets and liabilities of that subsidiary, subject to the transition exceptions and transition exemptions set out in Section 35. [FRS 102.35.7].

FRS 102 does not explain how a first-time adopter should consolidate a subsidiary for the first time (whether because the reporting entity did not consider the entity to be a subsidiary under its previous financial reporting framework or did not prepare consolidated financial statements). However, as set out below, management should apply the requirements of paragraph 35.10(r) (which addresses the accounting for a subsidiary on transition, where a parent becomes a first-time adopter of FRS 102 later than its subsidiary – see 5.15.2 below) and may want to consider paragraphs IG 27 to IG 30 of IFRS 1 (which provide further implementation guidance discussed below) to the extent that these do not conflict with FRS 102.

If an entity becomes a first-time adopter later than its subsidiary, the entity shall in its consolidated financial statements, measure the assets and liabilities of the subsidiary at the same carrying amounts as in the financial statements of the subsidiary, after adjusting for consolidation adjustments and for the effects of the business combination in which the entity acquired the subsidiary. [FRS 102.35.10(r)]. Where the subsidiary has not previously adopted FRS 102, the reference above to the ‘same carrying amounts’ is to the amounts FRS 102 would require in the statement of financial position of the subsidiary. [IFRS 1.IG 27(a)].

The amounts of goodwill, assets and liabilities recognised in respect of the subsidiary will depend on whether it was acquired in a business combination or not, and if it was so acquired, whether the business combination is restated in accordance with Section 19 or not. [FRS 102.35.10(a)].

1. Subsidiary acquired in a business combination: entity uses the transition exemption in paragraph 35.10(a) not to restate past business combinations –

   Where the business combination is not restated in accordance with Section 19, paragraph 35.10(a) is applied to accounting for the business combination (see 5.2 generally). Section 35 does not explain how to implement paragraph 35.10(a) where the subsidiary has not been previously consolidated (so that no goodwill has been reflected in the consolidated financial statements). In such cases, the entity should adopt an appropriate policy. For example, even if consolidated financial statements were not prepared by the entity under its previous financial reporting framework, the amount of the goodwill, assets and liabilities that would have been recognised had the subsidiary been consolidated under its previous financial reporting framework may be known or determinable (for example, if the amounts were already available for the purposes of group reporting). The CA 2006 also requires the determination of goodwill, as at the date of the acquisition, where a subsidiary undertaking is acquired and accounted for using the acquisition method. [6 Sch 9, 3 Sch 9 (LLP)]. However, this will not always be the case and, on the basis that no goodwill was reflected in the entity's previous financial reporting framework financial statements, a view could be taken that the transition adjustments to derecognise the cost of investment and recognise the assets and liabilities of the subsidiary may be reflected in retained earnings (or other category of equity), following the general requirements in Section 35. In some cases, the impracticability exemption in paragraph 35.11 may be relevant to the accounting for the business combination (see 3.5.4 above). [FRS 102.35.11].

   This differs from the requirement in Appendix C4(j) in IFRS 1 to establish a deemed cost of goodwill, being the difference between the carrying amount of the investment and the assets and liabilities of the subsidiary that would be required in the subsidiary's own IFRS financial statements. [IFRS 1 Appendix C.4(j)]. While pragmatic, this will result in a deemed cost of goodwill which will rarely represent the true goodwill under a previous financial reporting framework, will give a different answer for goodwill depending on the measurement basis used for the investment in the subsidiary in the parent's separate financial statements, and appears to conflict with paragraph 35.10(a)'s requirement that no adjustment is made to the carrying value of goodwill at the date of transition.

   Other assets acquired and liabilities assumed since the business combination and still held at the acquirer's date of transition are reported at:

   • the carrying amounts that FRS 102 would require in the subsidiary's own statement of financial position; or
   • where the subsidiary has already adopted FRS 102 before its parent, the amounts included in the subsidiary's statement of financial position in its FRS 102 financial statements,

   after adjusting for consolidation procedures. [FRS 102.35.10(r), IFRS 1.IG 27(a), 30(a)].

2. Subsidiary acquired in a business combination restated under Section 19 – Where the previously unconsolidated subsidiary was acquired in a business combination restated under Section 19, the goodwill and fair values of the identifiable net assets recognised at the date of the business combination would be retrospectively restated. The first-time adopter would need to restate either all pre-transition business combinations or all later business combinations (and apply the requirements of FRS 102 in respect of non-controlling interests from the same date). [FRS 102.35.9(e), 10(a)].

   Other assets acquired and liabilities assumed since the business combination and still held at the acquirer's date of transition are reported at:

   • the carrying amounts that FRS 102 would require in the subsidiary's own statement of financial position; or
   • where the subsidiary has already adopted FRS 102 before its parent, the amounts included in the subsidiary's statement of financial position in its FRS 102 financial statements,

   after adjusting for consolidation procedures. [FRS 102.35.10(r), IFRS 1.IG 27(a), 30(a)].

3. Subsidiary not acquired in a business combination – The first-time adopter would adjust the carrying amounts of the subsidiary's assets and liabilities to the amounts that FRS 102 would require in the subsidiary's own statement of financial position (or where the subsidiary has already adopted FRS 102 before its parent, the amounts included in its statement of financial position in its FRS 102 financial statements), after adjusting for consolidation procedures. [FRS 102.35.10(r), IFRS 1.IG 27(a)].

   Where the subsidiary was not acquired in a business combination, no goodwill is recognised. [IFRS 1.IG 27(c)]. Instead, any difference between the carrying amounts and the net identifiable assets determined above is treated as an adjustment to retained earnings at the date of transition.

5.2.5.C Previously consolidated entities that are not subsidiaries

A first-time adopter may have consolidated an investment under its previous financial reporting framework that does not meet the definition of a subsidiary under FRS 102. In such a case, the entity should first determine the appropriate classification under FRS 102 (for example, as an associate, jointly controlled entity or financial asset) and then apply Section 35's requirements.

The requirements of FRS 102 should be applied retrospectively subject to any transition exceptions and exemptions available and, where applicable, the use of the impracticability exemption available in paragraph 35.11 (see 3.5.4 above). [FRS 102.35.7, 11].

5.16.1.A Key differences on hedge accounting between Section 12, IAS 39 and IFRS 9

An entity previously applying IAS 39 or IFRS 9 that chooses to apply a different accounting policy choice to the recognition and measurement of financial instruments on transition to FRS 102 will need to consider both the different transition provisions and the ongoing requirements for hedge accounting. An appreciation of the differences between Section 12, IAS 39 and IFRS 9 would be important when determining which accounting policy choice to make and assessing what, if any, adjustments are required.

Some key differences between Section 12, IAS 39 and IFRS 9 – which may give rise to adjustments when applying a different accounting policy choice under FRS 102 include:

• more hedging relationships may be eligible under Section 12 or IFRS 9 (compared to IAS 39) so new relationships could be designated, where the specified conditions are met. An example is that Section 12 and IFRS 9 both permit the identification of a separately identifiable and reliably measurable risk component of a non-financial hedged item. [FRS 102.12.16, 12.16C, IFRS 9.6.3.1, 6.3.7, Appendix B.6.3.8-15]. See Chapter 10 at 10.2.2 and Chapter 49 at 2.2 of EY International GAAP 2019.
• Section 12 has simpler requirements than the hedge accounting requirements of IAS 39 or IFRS 9. For example, in determining whether the qualifying conditions for hedge accounting continue to apply, [FRS 102.12.18-18A], there is no retrospective or prospective effectiveness assessment.

  However, there can be some situations for which Section 12 is more restrictive, in particular compared to IFRS 9. For example, Section 12 requires that if a group of items (including components of an item) are designated as the hedged item in a hedge relationship, those items must share the same risk and cannot contain offsetting positions. [FRS 102.12.16, 16B]. IFRS 9 does not have these restrictions in all circumstances, although for risk management purposes, the items in the group must be managed together on a group basis. [IFRS 9.6.6.1]. Therefore, more complex hedging relationships can be found under IFRS 9. IFRS 9 would permit a cash flow hedge of a net position attributable to foreign exchange risk (for example, because of forecast foreign purchases and sales) where certain conditions are met, [IFRS 9.6.6.1(d)]. This would not be permitted under Section 12. See Chapter 10 at 10.2.3.

• Following the Triennial review 2017, Section 12 now allows designation of the intrinsic value of an option as a hedging instrument (previously, options were required to be designated as a hedging instrument in their entirety). Similarly, an entity may separate the spot risk element of a foreign currency contract and exclude the forward element. Both IFRS 9 and IAS 39 allow designation of the intrinsic value of an option and the spot element of a forward contract. [IAS 39.74, IFRS 9.6.2.4(a)-(b), FRS 102.12.7A(c)].

  Where the intrinsic value of the option or the spot risk element of a foreign currency contract is designated as the hedging instrument, the fair value movements on the time value of the option (or on the forward element of the forward contract) are recognised in profit or loss under Section 12 and IAS 39 (as these fall outside the hedging relationship). This differs from IFRS 9, which requires that the fair value movements on the time value of an option are initially recognised as ‘costs of hedging’ in other comprehensive income. IFRS 9 also allows (but does not require) an entity to elect on a hedge-by-hedge basis a similar accounting for the ‘costs of hedging’ (as applied to the time value of the option) for the forward element of a foreign currency contract. [IFRS 9.6.5.15-6.5.16]. This accounting will reduce profit and loss volatility compared to Section 12 and IAS 39. See Chapter 10 at 10.3 and Chapter 49 at 7.5 of EY International GAAP 2019.

• Section 12 (like IAS 39) does not allow for separation of foreign currency basis spreads when designating a hedging relationship. [FRS 102.12.17A]. This is permitted by IFRS 9 which also allows (but does not require) an entity to elect on a hedge-by-hedge basis to account for the ‘costs of hedging’ in the same way as for time value of options. [IFRS 9.6.5.16]. See Chapter 49 at 7.5 of EY International GAAP 2019.
• An entity applying IFRS 9 may be required to rebalance the hedge ratio on transition (and on an ongoing basis), with an adjustment in profit or loss. [IFRS 9.6.4.1(c)(iii), 6.5.5]. See Chapter 49 at 8.2 of EY International GAAP 2019. This is not the case if applying Section 12, as rebalancing is not a feature of Section 12. As a consequence, some hedges may show more ongoing ineffectiveness under Section 12 compared to IFRS 9, but the hedge accounting will be simpler.
• IFRS 9 does not permit an entity to voluntarily discontinue a hedge relationship whereas an entity may document an election to do so under Section 12, providing more flexibility over subsequent accounting for hedging relationships. [FRS 102.12.25, IFRS 9.6.5.6]. See Chapter 10 at 10.10 and Chapter 49 at 8.3 of EY International GAAP 2019.
• An entity applying Section 12 on transition to FRS 102 has a choice of whether to reflect existing or past hedging relationships meeting specified conditions in the opening statement of financial position (see 5.16.2 below). [FRS 102.10(t)(i)-(ii)]. This flexibility is not available when applying IAS 39 or IFRS 9 on transition to FRS 102 (see 5.16.3 below). As discussed at 5.16.2.B below, the choices made on transition will impact the future results.

It is not the intention of this discussion to provide a list of all the differences in the hedge accounting requirements of Section 12, IAS 39, and IFRS 9. See Chapter 49 at 14 of EY International GAAP 2019 for a summary of differences between hedge accounting under IAS 39 and IFRS 9. See also Chapter 10 at 2.2.3 for differences between hedge accounting in Section 12 and IFRS.

5.16.2.A Optional exemption – hedge accounting

An entity may use one or more of the following exemptions in preparing its first financial statements that conform to FRS 102: [FRS 102.35.10(t)(i)-(iii)]

1. A hedging relationship existing on the date of transition

   A first-time adopter may choose to apply hedge accounting to a hedging relationship of a type described in paragraph 12.19 (i.e. a cash flow hedge, a fair value hedge or a hedge of a net investment in a foreign operation) which exists on the date of transition between a hedging instrument and a hedged item, provided:

   • the conditions for hedge accounting set out in paragraphs 12.18(a)-(c) (i.e. the existence of an economic relationship between an eligible hedging instrument and eligible hedged item, where the hedging relationship is consistent with the entity's risk management objectives for undertaking hedges) are met on the date of transition to FRS 102; and
   • the conditions of paragraphs 12.18(d) and (e) (i.e. documentation of the hedge relationship and the determination of, and documentation of the causes of, hedge ineffectiveness) are met no later than the date the first financial statements that comply with FRS 102 are authorised for issue.

   This choice applies to each hedging relationship existing on the date of transition.

   Hedge accounting as set out in Section 12 of FRS 102 may commence from a date no earlier than the conditions of paragraphs 12.18(a) to (c) are met.

   In a fair value hedge, the cumulative hedging gain or loss on the hedged item from the date hedge accounting commenced to the date of transition shall be recognised in retained earnings (or if appropriate, another category of equity).

   In a cash flow hedge and net investment hedge, the lower of the following (in absolute amounts) shall be recognised in equity (in respect of cash flow hedges in the cash flow hedge reserve):

   1. the cumulative gain or loss on the hedging instrument from the date hedge accounting commenced to the date of transition; and
   2. the cumulative change in fair value (i.e. the present value of the cumulative change of expected future cash flows) on the hedged item from the date hedge accounting commenced to the date of transition.

   See 5.16.2.D below for discussion of the transition provisions applicable to existing hedging relationships.

2. A hedging relationship that ceased to exist before the date of transition because the hedging instrument has expired, was sold, terminated or exercised prior to the date of transition

   A first-time adopter may elect not to adjust the carrying amount of an asset or liability for previous financial reporting framework effects of a hedging relationship that has ceased to exist.

   A first-time adopter may elect to account for amounts deferred in equity in a cash flow hedge under a previous financial reporting framework, as described in paragraph 12.23(d) (which sets out the subsequent accounting for amounts accumulated in the cash flow hedge reserve), from the date of transition. Any amounts deferred in equity in relation to a hedge of a net investment in a foreign operation under a previous financial reporting framework shall not be reclassified to profit or loss on disposal or partial disposal of the foreign operation.

   See 5.16.2.C below for discussion of the transition provisions applicable to past hedging relationships.

3. A hedging relationship that commenced after the date of transition

   A first-time adopter may elect to apply hedge accounting to a hedging relationship of a type described in paragraph 12.19 (i.e. a cash flow hedge, a fair value hedge or a hedge of a net investment in a foreign operation) that commenced after the date of transition between a hedging instrument and a hedged item, starting from the date the conditions of paragraphs 12.18(a) to (c) are met. This is provided that the conditions of paragraphs 12.18(d) and (e) (conditions on hedge documentation) are met no later than the date the first financial statements that comply with FRS 102 are authorised for issue.

   The choice applies to each hedging relationship that commenced after the date of transition.

5.16.2.B General comments

The elections described at 5.16.2.A above provide considerable flexibility for an entity applying Section 12 to begin, cease, or continue hedge accounting on transition to FRS 102. These allow entities to apply a degree of hindsight in deciding whether or not to apply hedge accounting (and to cherry pick which hedging relationships to hedge account), since they provide a relief on the timing of completing hedge documentation for both existing hedging relationships at the date of transition (see 5.16.2.D below) and those entered into after the date of transition. The FRC was mindful of this possible exploitation of the transitional arrangements, nevertheless, on balance, it believed that in the interests of the majority of entities, especially entities that have not applied hedge accounting before, flexibility should take precedence over restrictions aimed at preventing abuse. [FRS 102.BC.B11.63].

However, once a hedge accounting relationship has been documented in line with paragraphs 12.18(d) and (e) (conditions on hedge documentation), any subsequent election to discontinue the hedge accounting must be documented and takes effect prospectively. [FRS 102.12.25].

The transition provision distinguishes between the situation where a hedging relationship exists or does not exist on the date of transition. The hedging relationship exists where there is a cash flow hedge, fair value hedge or hedge of a net investment of a foreign operation, and the hedging instrument and hedged item both exist at the date of transition. A hedging relationship, therefore, does not exist where the hedging instrument is terminated (even if there is still a hedged item).

The transition provision permits but does not require an entity to reflect existing hedging relationships meeting the specified conditions in the opening statement of financial position (see 5.16.2.A(i) above and 5.16.2.D below). This choice is available on a hedge-by-hedge basis. While the transition provision is not explicit on this matter, we also consider that an entity can choose whether or not to reflect certain past hedging relationships in the opening statement of financial position on a hedge-by-hedge basis (see 5.16.2.A(ii) above and 5.16.2.C below).

Where the elections are not taken, FRS 102's requirements are retrospectively applied and the hedge accounting adjustments made under an entity's previous financial reporting framework would therefore need to be eliminated to retained earnings (or other category of equity) on transition.

The way in which an entity accounts for past and existing hedging relationships on transition will, to a large extent, dictate the effect on its ongoing FRS 102 financial statements. For example, an entity's future results will for a cash flow hedge be different depending on whether the entity decides to reflect an existing hedging relationship in the opening statement of financial position (by establishing a cash flow hedge reserve) or not. Amounts accumulated in a cash flow hedge reserve at the date of transition will be reclassified from equity to profit or loss at a later date (or, for a hedge of a forecast transaction for a non-financial asset or non-financial liability adjust the initial cost or carrying amount of the asset or liability). However, if a previous IFRS reporter does not reflect a hedging relationship recognised under IFRS, it will transfer the cash flow hedge reserve previously recognised at the date of transition directly to retained earnings (and there would be no subsequent recycling from equity).

Similarly, an entity's future results would be affected depending on whether an existing fair value hedge is reflected in the opening statement of financial position or not. For short-term hedges (e.g. of anticipated sales and inventory purchases) these effects are likely to work their way out of the FRS 102 financial statements relatively quickly. However, for some hedges (e.g. hedges of long-term borrowings) an entity's results may be affected for many years. See further discussion of the choices available at 5.16.2.C and 5.16.2.D below.

5.16.2.C Accounting for past hedging relationships

Where the conditions in the transition provision in paragraph 35.10(t)(ii) (see 5.16.2.A(ii) above) are met, the entity could choose to reflect a past hedging relationship in the opening statement of financial position. [FRS 102.35.10(t)(ii)].

The transition provision sets out optional exemptions that apply to a hedging relationship that ceased to exist before the date of transition because the hedging instrument has expired, was sold, terminated or exercised prior to the date of transition. Therefore, the transition provision does not address situations where the hedging relationship still existed on transition, but for which hedge accounting had ceased prior to transition (e.g. the designation of the hedge was revoked, the hedge ceased to be effective, or the forecasted transaction in a cash flow hedge ceased to be highly probable but was still expected to occur). Such situations are addressed at 5.16.2.D below.

Certain implementation issues associated with the transition provision on past relationships are discussed below:

1. A first-time adopter may elect not to adjust the carrying amount of an asset or liability for previous financial reporting framework effects of a hedging instrument that has ceased to exist. [FRS 102.35.10(t)(ii)].

   Therefore, where hedging gains (losses) from a hedge of a forecast purchase or committed purchase of inventory or property, plant and equipment have been included in the carrying amount of the asset before the date of transition, there is no requirement to adjust the carrying amount of the asset to eliminate the effects of hedging gains (losses) as at the date of transition.

   Also, if an entity previously applying IAS 39 or IFRS 9 had applied fair value hedge accounting for a fixed to floating interest rate swap (now terminated) hedging a fixed rate loan (that still exists), no change is needed to the hedge accounting adjustments made to the loan, as at the date of transition.

   Section 35 does not spell out the subsequent accounting. In our view, this establishes a deemed carrying amount for the item and no further adjustments to the carrying amount for ongoing hedging gains and losses are made from the date of transition. However, as for a discontinuance, we consider that any adjustment to the carrying amount (arising from fair value hedge accounting) of a hedged financial instrument carried at amortised cost using the effective interest method shall be amortised to profit and loss. [FRS 102.12.22, 25A]. This requirement is similar to the corresponding requirements in IAS 39 and IFRS 9. [IAS 39.91, 92, IFRS 9.6.5.6, 6.5.7, 6.5.10].

2. Not all past hedging relationships are permitted to be reflected in the opening statement of financial position, even if the hedged item still exists. For example, if a previous FRS 105 reporter had deferred a gain or loss arising on termination of a hedging instrument in the statement of financial position to be recognised as the hedged item (which still exists) affected profit or loss, the deferred balance would be eliminated against retained earnings as at the date of transition (see 5.16 above). This is because the deferred balance does not represent an asset or liability and is not covered by the transition provision (see (a) above).
3. A first-time adopter may elect to account for amounts deferred in equity in a cash flow hedge under a previous financial reporting framework, as described in paragraph 12.23(d) (which sets out the subsequent accounting for amounts accumulated in the cash flow hedge reserve) from the date of transition. [FRS 102.35.10(t)(ii)].

   This is consistent with the ongoing requirements for discontinued cash flow hedges in Section 12 (see Chapter 10 at 10.10). This situation is likely to arise where the first-time adopter previously applied IAS 39 or IFRS 9, for example:

   • Where a floating to fixed interest rate swap (now terminated) hedged a floating rate loan (that still exists), the amounts deferred in equity in the cash flow hedge would not change as at the date of transition (where this election is taken). Instead, the deferred amounts are subsequently reclassified to profit or loss, as required by paragraph 12.23(d). If the hedged future cash flows are no longer expected to occur as at the date of transition, the deferred amounts in equity need to be reclassified immediately to retained earnings as at that date. [FRS 102.12.25A]. This election, in effect, allows the existing treatment on discontinuation previously followed under IAS 39 or IFRS 9 to endure.
   • Where gains and losses were deferred in equity in relation to a cash flow hedge of a forecast transaction that subsequently resulted in the recognition of a non-financial asset or a non-financial liability (e.g. a purchase of a non-financial asset such as property, plant and equipment or inventory).

     The transition provision refers to paragraph 12.23(d), which requires inclusion of the associated gains and losses previously recognised through other comprehensive income in the initial cost or other carrying amount of the asset or liability (this treatment, often referred to as a ‘basis adjustment’, was also available by choice in IAS 39 and is required under IFRS 9). Therefore, it appears that a first-time adopter that has already recognised the non-financial asset or liability prior to the date of transition would need to retrospectively adjust its carrying amount on transition to reflect the equivalent of a basis adjustment in order to comply with paragraph 12.23(d), if this treatment had not been followed under its previous financial reporting framework.

4. The transition provision clarifies that amounts deferred in equity in relation to a hedge of a net investment in a foreign operation under an entity's previous financial reporting framework are not reclassified to profit or loss on disposal or partial disposal of the foreign operation (consistent with the requirements of paragraph 12.24 of FRS 102 (see Chapter 10 at 10.9), but different to the requirements of IFRS). [FRS 102.12.24, IAS 21.48-48B].

The transition provision does not spell out the accounting treatment where an entity does not take up the elections it permits for now ceased hedging relationships. However, entities that elect not to apply the FRS 102 hedge accounting requirements have to comply with the applicable measurement requirements for assets and liabilities set out elsewhere in FRS 102 from the date of transition. [FRS 102.BC.B11.64]. In our view, if the first-time adopter chose not to apply these exemptions, this means that the old hedge accounting would be reversed and the previously hedged items would need to be held in the opening FRS 102 statement of financial position at the appropriate carrying amount on application of FRS 102 without regard to any previous hedge accounting (with an adjustment to retained earnings or, if appropriate, another category of equity). Similarly, the amounts relating to a cash flow hedge that were previously deferred in a cash flow hedge reserve would be reclassified to retained earnings or, if appropriate, another category of equity. [FRS 102.35.8].

5.16.2.D Hedging relationships existing at the date of transition

The exemption for existing hedging relationships in paragraph 35.10(t)(i) (see 5.16.A(i) above) applies to hedging relationships of a type described in paragraph 12.19 (i.e. a cash flow hedge, fair value hedge, or hedge of a net investment in a foreign operation) (see Chapter 10 at 10.6), meeting the eligibility and documentation conditions for hedge accounting required by the transition provision. See Chapter 10 at 10.2 to 10.4.

It is clear from the context that a hedging relationship can only exist at the date of transition if there is both an eligible hedged item and hedging instrument at that date. If the hedging instrument has ceased to exist before the date of transition, the transition provision on past hedging relationships may apply (see 5.16.2.C above).

A first-time adopter has two possibilities for hedging relationships existing at the date of transition:

1. choose not to (or is not permitted to) hedge account – This applies if the conditions in (b) below are met (but the entity chooses not to hedge account) or if the conditions in (b) below are not met; or
2. choose to apply hedge accounting – Where one of the three permitted types of hedging relationship exists at the date of transition, the first-time adopter may choose to apply hedge accounting provided:
   • the conditions in paragraphs 12.18(a) to (c) (i.e. the existence of an economic relationship between an eligible hedging instrument and eligible hedged item, where the hedging relationship is consistent with the entity's risk management objectives for undertaking hedges – see Chapter 10 at 10.4) are met on the date of transition; and
   • the conditions of paragraphs 12.18(d) and (e) (i.e. documentation of the hedging relationship and the determination, and documentation of causes of ineffectiveness – see Chapter 10 at 10.4.4) are met not later than the date the first FRS 102 financial statements are authorised for issue.

This choice applies to each hedging relationship existing on the date of transition. [FRS 102.35.10(t)(i)].

Because Section 12 does not have the same requirements as IAS 39 for ongoing effectiveness tests, this means that even if hedge accounting under IAS 39 ceased because the hedge relationship failed the effectiveness test (but the entity continued with the hedge economically), arguably hedge accounting could be reinstated in the opening FRS 102 statement of financial position, where the above conditions are met. However, if hedge accounting ceased because a forecasted transaction in a cash flow hedge was no longer highly probable, the hedging relationship would not meet the criteria in paragraph 12.18(a) and hedge accounting could not be reinstated.

Where the entity does not re-establish hedge accounting for an existing hedging relationship or the conditions to apply hedge accounting on transition are not met, the question arises as to whether the entity can continue to reflect the hedge accounting under its previous financial reporting framework for the discontinued hedge in the statement of financial position and apply Section 12's requirements for discontinuance of hedge accounting prospectively from the date of transition (which would generally result in similar accounting to that already applied under IAS 39 or IFRS 9). Entities that elect not to apply the FRS 102 hedge accounting requirements have to comply with the applicable measurement requirements for assets and liabilities set out elsewhere in FRS 102 from the date of transition. [FRS 102.BC.B11.64]. Where the elections to reflect the hedge accounting in the opening statement of financial position have not been taken, the FRC presumably intended that FRS 102 is applied retrospectively to the measurement of the hedged item and hedging instrument, without any regard to the hedge accounting provisions. The hedging relationship is not reflected in the opening FRS 102 statement of financial position and the hedge accounting adjustments under the previous financial reporting framework are eliminated to retained earnings (or, if appropriate, another component of equity) at the date of transition. [FRS 102.35.8].

Hedge accounting as set out in Section 12 may commence from a date no earlier than the conditions of paragraphs 12.18(a) to (c) are met. [FRS 102.35.10(t)(i)]. This would appear to allow first-time adopters some flexibility over choosing when hedge accounting commences from. If hedge accounting commences at the date of transition, there will be no amounts deferred in equity for a cash flow hedge or hedge of net investment in a foreign operation, and no adjustments made to the carrying amount of the hedged item for a fair value hedge. If hedge accounting commences from the date of inception of the hedging relationship, this is likely to avoid the ineffectiveness that might result where the hedging instrument has a non-zero fair value at the commencement of hedge accounting.

The choice whether or not to hedge account for existing hedging relationships meeting the above conditions is available whatever the entity's previous financial reporting framework and also whether or not the entity previously applied hedge accounting to that existing relationship. The nature of the adjustments required, however, may well depend on what previous accounting was followed. Where an entity previously applying IAS 39 or IFRS 9 chooses to continue to hedge account for a hedging relationship permitted under Section 12, there may often be no adjustment required on transition but differences may occur, for example:

• Section 12 does not allow for rebalancing a hedging relationship (as required under IFRS 9); and where this has occurred, it is possible that differences in the level of ineffectiveness may occur from the date at which the hedging relationship is established under Section 12;
• the accounting for the ‘costs of hedging’ where the entity designates the time value of options or the spot risk of forward currency contracts in a hedging relationship under Section 12 differs, or may differ, from that followed under IFRS 9. See 5.16.1.A above.

Where an entity chooses to apply hedge accounting to a hedging relationship existing at the date of transition, the transition provisions (see 5.16.2.A(i) above) describe how a fair value hedge, cash flow hedge or net investment hedge should be reflected at the date of transition. The intention here appears to be to reflect the same adjustments as at the date of transition, as if hedge accounting under FRS 102 had been applied from the date chosen to commence hedge accounting, using the transition exemption. Therefore, in accordance with paragraph 12.23(d), the effects of reclassifications required from the cash flow hedge reserve where the hedged item would have affected profit or loss in prior periods (had hedge accounting under FRS 102 been applied) would be reflected in retained earnings at the date of transition. See Chapter 10 at 10.7-9.

For a UK company (or an LLP) preparing statutory accounts in accordance with FRS 102, the fair value accounting rules in the Regulations (and LLP Regulations) (see Chapter 6 at 10.3) require that the cash flow hedge reserve is included in the statutory fair value reserve. [1 Sch 40-41, 1 Sch 40-41 (LLP)].

5.16.2.E Subsequent accounting for existing hedging relationships

Where an existing hedging relationship is reflected in the opening FRS 102 statement of financial position, [FRS 102.35.10(t)(i)], (see 5.16.2.A(i) and 5.16.2.D above) or a hedging relationship that commences after the date of transition is hedge accounted, [FRS 102.35.10(t)(iii)], (see 5.16.2.A(iii) above), an entity may:

• continue hedge accounting – where the hedging relationship continues to comply with the conditions for hedge accounting in Section 12 (and meets the documentation requirements set out in the transition provisions); [FRS 102.12.18] or
• discontinue hedge accounting prospectively – where an entity subsequently elects to discontinue hedge accounting; the hedging instrument has expired, is sold or terminated; or the conditions for hedge accounting cease to be met. [FRS 102.12.25].

The entity accounts for the continuance or discontinuance of hedge accounting in accordance with Section 12 (see Chapter 10 at 10).

5.16.3.A Mandatory requirement – hedge accounting

The transition provisions for hedge accounting relating to a first-time adopter choosing to apply IAS 39 or IFRS 9 to the recognition and measurement of financial instruments are set out in paragraph 35.10(t)(iv). While positioned within the list of transition exemptions in Section 35, the wording of the transition provision means that it sets out mandatory requirements for hedge accounting where IAS 39 or IFRS 9 is applied. [FRS 102.35.10(t)(iv)]. This differs to the situation where a first-time adopter applies Section 12, where there is a choice whether or not to apply the transition exemptions for hedge accounting (see 5.16.2 above). [FRS 102.35.10(t)(i)-(ii)].

Most FRS 102 reporters will have previously applied IFRS or FRS 101. As explained at 3.5.5.A, adjustments are not generally expected to be required at the date of transition where the same accounting standard (IAS 39 or IFRS 9) is applied to the recognition and measurement of financial instruments under FRS 102. Considerations where an entity previously applied IAS 39 to the accounting for hedges under its previous financial framework but chooses to apply IFRS 9 under FRS 102 are discussed at 3.5.5.B above. The transition requirements are likely to have more effect on the opening statement of financial position where the entity has not previously applied IFRS or FRS 101 – for example, entities previously reporting under FRS 105.

A first-time adopter that applies IAS 39 or IFRS 9 to the recognition and measurement of financial instruments under FRS 102 shall apply the transitional requirements applicable to hedge accounting in paragraphs B4 to B6 of IFRS 1 (see 5.16.3.B below), except that the designation and documentation of a hedging relationship may be completed after the date of transition, and no later than the date the first financial statements that comply with FRS 102 are authorised for issue, if the hedging relationship is to qualify for hedge accounting from the date of transition. [FRS 102.35.10(t)(iv)].

A first-time adopter, that has entered into a hedging relationship as described in IAS 39 or IFRS 9 in the period between the date of transition and the reporting date for the first financial statements that comply with FRS 102, may elect to apply hedge accounting prospectively from the date all qualifying conditions for hedge accounting in IAS 39 or IFRS 9 are met, except that an entity shall complete the formal designation and documentation of a hedging relationship no later than the date the first financial statements that comply with FRS 102 are authorised for issue. [FRS 102.35.10(t)(iv)].

The requirements under IAS 39 and IFRS 9 for designation and documentation of hedging relationships are discussed in Chapter 49 at 5.1 and 14 of EY International GAAP 2019. The ongoing requirements under IAS 39 and IFRS 9 for hedge accounting where the qualifying conditions are met (and for discontinuance of hedging relationships, where the qualifying conditions are not met) are discussed generally in Chapter 49 of EY International GAAP 2019.

The concession on timing of completion of the designation and documentation of the hedging relationship is discussed at 5.16.3.C below.

5.16.3.B Requirements of paragraphs B4 to B6 of IFRS 1

The requirements of paragraphs B4 to B6 of IFRS 1 (which are applied subject to the concession over the timing of completion of the designation and documentation of the hedging relationship) are as follows.

As required by IAS 39 or IFRS 9, at the date of transition, an entity shall: [IFRS 1 Appendix.B4]

• measure all derivatives at fair value; and
• eliminate all deferred losses and gains arising on derivatives that were reported in accordance with previous GAAP as if they were assets and liabilities.

An entity shall not reflect in its opening statement of financial position a hedging relationship of a type that does not qualify for hedge accounting (under the relevant IFRS that is followed). [IFRS 1 Appendix B.5]. Entities can only designate one of three types of hedging relationships – a fair value hedge, a cash flow hedge or a hedge of a net investment in a foreign operation. For hedges of foreign currency risk of a firm commitment, an entity may designate either a fair value hedge or a cash flow hedge. [IAS 39.86-87, IFRS 9.6.5.2-4].

Paragraph B5 gives various examples of ineligible types of hedging relationships (which differ depending on whether IAS 39 or IFRS 9 is applied). The requirements on eligible types of hedging relationships for IAS 39 and IFRS 9 are discussed further in Chapter 49 at 2 to 5 and 14 of EY International GAAP 2019.

If before the date of transition, an entity had designated a hedging relationship that was of an eligible type for hedge accounting, but the hedging relationship does not meet all the conditions for hedge accounting in IAS 39 (or IFRS 9), the entity shall apply paragraphs 91 and 101 of IAS 39 (or paragraphs 6.5.6 and 6.5.7 of IFRS 9) to discontinue hedge accounting prospectively immediately after transition. Transactions entered into before the date of transition to IFRS shall not be retrospectively designated as hedges. [IFRS 1 Appendix B.6].

While paragraphs B4 to B6 now refer only to IFRS 9, in the context of their application under Section 35, our view is that these should be read to include references to IAS 39 as this standard remains available for use under FRS 102.

The implementation guidance in IFRS 1 on accounting for cash flow hedges, fair value hedges and net investment hedges is not referred to by the transition provision. [FRS 102.35.10(t)(iv)]. However, most first-time adopters of FRS 102 will have applied IFRS or FRS 101 in their last set of financial statements. For a previous IFRS or FRS 101 reporter, paragraphs B4 to B6 of IFRS 1 should provide sufficient guidance.

Chapter 5 at 4.4 to 4.7 of EY International GAAP 2019 provides further guidance on IFRS 1's transition requirements for hedge accounting.

5.16.3.C Concession on designation and documentation of hedging instruments

A hedging relationship not specifically identified under an entity's previous financial reporting framework may meet the conditions for hedge accounting under IFRS 9 or IAS 39 as at the date of transition to FRS 102 or at a later date (except that the entity completes the designation and documentation of the hedging relationship after the date of transition but before the date of approval of the financial statements). In such circumstances, we consider that the transition provisions would allow hedge accounting prospectively from the date of transition (or from that later date) but that the hedging relationship should not be reflected in the opening FRS 102 statement of financial position. In essence, whereas IFRS 1 would have required the designation and documentation to be in place by the date of transition in order to hedge account prospectively from the date of transition for such a relationship, the transition provision in FRS 102 extends the deadline for completing the designation and documentation to the date of authorisation of the financial statements.

As the designation and documentation of hedging relationships (which will include how effectiveness is to be assessed), [IAS 39.88(a), IFRS 9.6.4.1(b)], are only required to be completed by the date of authorisation of the first FRS 102 financial statements, the first-time adopter must likewise have more time to perform the effectiveness assessments required. Under IFRS 9, the entity must continue to assess the ongoing effectiveness requirements, whereas both retrospective and prospective effectiveness tests are required under IAS 39. [IAS 39.88(b), (e), IFRS 9.6.4.1(c)]. Clearly, these effectiveness tests will need to be completed and satisfied at the latest by the date of authorisation of the first FRS 102 financial statements.

This concession over the timing of completion of designation and documentation is optional. Therefore, an entity may still account for a hedging relationship from the date all the requirements (including designation and documentation) for hedge accounting are met. However, this concession may still be helpful to a previous IFRS or FRS 101 reporter that applied IAS 39 in its most recent IFRS financial statements and instead applies IFRS 9 on first-time adoption of FRS 102 (particularly where the documentation needs to be improved to meet IFRS 9's requirements).