This helpsheet has been issued by ICAEW’s Technical Advisory Service to help ICAEW members to understand aspects of hedge accounting under FRS 102.

Members may also wish to refer to the following related helpsheet:

• Foreign currency translation under FRS 102

Hedge accounting is not mandatory under FRS 102, however where the conditions are met, an entity may choose to apply it. Hedge accounting is a complex area, however, and specialist valuers are often required to assist in determining fair values or calculating the effectiveness of hedging relationships.

FRS 102 paragraph 12.18 sets out the conditions for hedge accounting. An entity may apply hedge accounting to a hedging relationship from the date all of the following conditions are met:

• The hedging relationship consists only of a hedging instrument and a hedged item (see following sections for discussion);
• The hedging relationship is consistent with the entity’s risk management objectives for undertaking hedges;
• There is an economic relationship between the hedged item and the hedging instrument (i.e. the entity expects that the values of the hedged item and hedging instrument will typically move in opposite directions in response to movements in the same risk, which is the hedged risk – see FRS 102 paragraph 12.18A);
• The entity has documented the hedging relationship so that the risk being hedged, the hedged item and the hedging instrument are clearly identified; and
• The entity has determined and documented causes of hedge ineffectiveness.

For there to be a hedging relationship there needs to be both a hedged item and a hedging instrument.

Hedged item

A hedged item must fall into one of the four categories below as set out by FRS 102 paragraph 12.16.

FRS 102 paragraph 12.16B permits a group of items, including components of items, to be an eligible hedged item provided that all of the following conditions are met:

• It consists of items that are individually eligible hedged items;
• The items in the group share the same risk;
• The items in the group are managed together on a group basis for risk management purposes; and
• It does not include items with offsetting risk positions.

In addition, FRS 102 paragraph 12.16C permits components of an item (including combinations thereof) to be a hedged item. There is, therefore, considerable flexibility in identifying hedged items.

Hedging instrument

A hedging instrument must meet all of the following conditions specified in FRS 102 paragraph 12.17:

• It is a financial instrument measured at fair value through profit or loss;
• It is a contract with a party external to the reporting entity (i.e. external to the group or individual entity that is being reported on); and
• It is not a written option (except as described in paragraph 12.17C).

Examples may include a forward exchange contract or a futures contract.

Again, there is flexibility in identifying hedging instruments. Those meeting the conditions specified above may be hedging instruments in their entirety or proportions thereof, or indeed a combination of such instruments may be used.

Types of hedging relationships

There are three types of hedging relationships under FRS 102 paragraph 12.19:

• Fair value hedge (normally where there is concern over a value in the financial statements, e.g. inventory);
• Cash flow hedge (normally where there is concern over future cash flows); and
• Hedge of a net investment in a foreign operation.

The Appendix to Section 12 within FRS 102 contains a selection of examples of applying hedge accounting. The following sections are brief, high-level overviews of the three types of hedge accounting under Section 12 of FRS 102. The full standard should be referred to for more detailed guidance and requirements.

A fair value hedge is a hedge of the exposure to changes in the fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that are attributable to a particular risk and could affect profit or loss (FRS 102 paragraph 12.19(a)). It is not permitted to fair value hedge a highly probable forecast transaction.

In a fair value hedge there is no change to the accounting treatment of the hedging instrument. However, the accounting treatment of the hedged item changes.

A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction, and could affect profit or loss (FRS 102 paragraph 12.19(b)).

In a cash flow hedge, there is no change to the accounting treatment of the hedged item. However, there is a change in the accounting treatment of the hedging instrument.

Recognised foreign currency denominated liability

If the accounts include a liability denominated in a foreign currency and an entity has taken out a forward exchange contract in order to minimise the risk, cash flow hedging will not help reduce the variability in the profit or loss account.

Whether or not cash flow hedge accounting is used, the liability must be translated at the closing rate at each year end with the exchange difference going through the profit or loss account. Without cash flow hedge accounting, the fair value movement on the foreign exchange contract would go through the profit and loss account too, which helps minimise the overall impact on the profit for the year.

If cash flow hedge accounting is used, however, the effective part of the gain or loss on the foreign exchange contract would go through other comprehensive income (OCI), which therefore delays the impact of the recognition in profit or loss and increases the overall volatility in profit or loss. Therefore, it is often best not to use a cash flow hedge in these circumstances as it does not achieve the aim of hedge accounting, which is to reduce volatility in profits over a period of time (i.e. reduce accounting mismatches).

A net investment in a foreign operation is defined in the FRS 102 glossary as ‘the amount of the reporting entity’s interest in the net assets of that operation’. A foreign operation is defined as ‘an entity that is a subsidiary, associate, joint venture or a branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity’.

Hedge accounting a net investment in a foreign operation will only be available where the underlying assets and liabilities of the foreign operation are reflected in the financial statements. As such, this may occur either:

• In consolidated financial statements (where a subsidiary is included in the consolidation for example); or
• In individual financial statements where the foreign operation is a branch for instance, but not where the foreign operation is a subsidiary, as the underlying assets and liabilities of the foreign operation would not be reflected in the individual financial statements of the parent.

Hedges of a net investment in a foreign operation must be accounted for in a similar fashion to cash flow hedges (see above), with the portion of the gain or loss on the hedging instrument which is deemed to be effective being recognised in other comprehensive income (OCI) and any ineffective portion being recognised in profit or loss. The amounts accumulated in equity are not reclassified from equity to profit or loss on disposal or partial disposal of the foreign operation (FRS 102 paragraph 12.24).

Interest rate benchmarks such as the London Interbank Offered Rate (LIBOR) are being reformed. This gives rise to issues affecting financial reporting in the period before the reform, particularly in relation to hedge accounting. In response, the IASB has amended IFRSs and the FRC made temporary amendments to specific hedge accounting requirements in FRS 102 in December 2019.

The temporary amendments made to Section 12 of FRS 102 apply to periods commencing on or after 1 January 2020 with early adoption permitted. They seek to provide relief during the period of uncertainty before the interest rate benchmark is reformed.

The temporary amendments (set out in the new paragraphs 12.25B to 12.25H) apply only to hedging relationships directly affected by interest rate benchmark reform, i.e. if the reform gives rise to uncertainties about:

(a) The interest rate benchmark designated as a hedge risk; and/or
(b) The timing and/or the amount of the interest rate benchmark-based cash flows of the hedged item and/or the hedging instrument.

The simplifications include requirements to assume that the interest rate benchmark on which the hedged cash flows are based is not altered as a result of interest rate benchmark reform:

• In determining whether a forecast transaction is highly probable;
• In determining whether there is an economic relationship between the hedged item and hedging instrument in the requirement in paragraph 12.18A; and
• In determining whether the hedged future cash flows are expected to occur in the requirement in paragraph 12.25A;

Where an entity takes advantage of the temporary amendments to specific hedge accounting requirements, the new paragraph 12.30 requires disclosure of that fact and the significant interest rate benchmarks to which the entity’s hedging relationships are exposed.

ICAEW members, affiliates, ICAEW students and staff in eligible firms with member firm access can discuss their specific situation with the Technical Advisory Service on +44 (0)1908 248 250 or via webchat.