FRS 102 Summary – Section 12 – Other Financial Instruments issues

Section 12 – Other Financial Instruments issues

Summary

Section 12 deals with more complex financial instruments and transactions which do not come within the scope of Section 11 and also have similar exceptions to Section 11 (as detailed in Section 11 of the guide) which are detailed in Section 12.3. In addition to Section 11 exclusions the below are also excluded from Section 12:

– Contracts for contingent consideration in a business combination (see Section 19 Business Combinations and Goodwill). This exemption applies only to the acquirer; and

– Any forward contract between an acquirer and a selling shareholder to buy or sell an acquiree that will result in a business combination at a future acquisition date. The term of the forward contract should not exceed a reasonable period normally necessary to obtain any required approvals and to complete the transaction.

A derivative financial instrument is a financial instrument or other contract with all three of the following characteristics:

• its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the ‘underlying’), provided in the case of a non-financial variable that the variable is not specific to a party to the contract;
• it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and

(c) it is settled at a future date.

What is new?

For companies that did not adopt FRS 26 under old GAAP the whole standard is new.

Derivative financial instruments are required to be recognised initially at fair value on the statement of financial position and subsequently at fair value, with changes reported in the profit and loss. The only exceptions to this measurement requirement are: certain hedging instruments and investments in equity instruments which are not publicly traded and whose fair value cannot be reliably measured.

Under old GAAP there was no such requirement other than Company law requirements to have them disclosed in a note to the financial statements. This will result in significant volatility to the profit/loss of entities year on year unless hedge accounting is adopted.

Section 12 allows companies to apply hedge accounting. There was no concept of hedge accounting for non FRS 26 adopters. In order to apply hedge accounting the entity needs to have designated and documented the hedging relationship, and needs to expect that the hedge will be highly effective in offsetting the designated hedged risk (Section 12.18). Section 16.16B deals with certain exclusions for use of hedge accounting for intra group transactions.

Guidance on derecognition and impairment are the same as what has been detailed in Section 11.

What is different?

FRS 26 adopters:

• No concept of embedded derivatives;
• Hedge accounting under FRS 102 is simpler;
• The disclosure requirements in Section 11 and Section 12 is less onerous that FRS 29; and
• Under FRS 102, assets which have been individually assessed for impairment and found not to be impaired do not subsequently need to be included in a collective assessment of impairment.

Other standards which impact Section 12 where differences arise:

Section 29 – Income tax – Likely to be deferred tax on any transition adjustments which arise as a result of fair valuing at the date of transition. Also likely that tax will be payable /refundable on adjustments that fell out for tax purposes on transition.

Section 22 – Liability and equity – The liability component of a compound financial instrument (i.e. preference shares issued which meet the definition of a liability and is convertible to equity) is to be accounted for in line with Section 11 and Section 12.

What are the key points?

• Derivative financial instruments will need to be fair valued and recognised on the statement of financial position. For non FRS 26 adopters under old GAAP these were not recognised and instead disclosed. Examples of derivative financial instruments are: forward currency contracts, interest rate swaps, put and call options etc.
• Hedge accounting can be utilised if it meets the conditions specified in Section 12.18. An instrument is a hedging instrument provided all the following conditions are met:

1. It is financial instrument measured at fair value through the profit and loss.
2. It is a contract with an external party to the reporting entity; and
3. It is not a written option, except as described in Section 12.17C.

• There are three types of hedges as defined in Section 12.19, namely; a) Fair value hedge, b) cash flow hedge and c) hedge of a net investment in a foreign operation.
• Where a fair value hedge exists the gain/loss is posted to the profit and loss account.
• Where a cash flow hedge or a net investment in foreign operation exists, the gain/loss on the hedging instrument is posted to other comprehensive income to the extent that this offsets against the loss/gain posted on the hedged item with the ineffective portion posted to the profit and loss account.
• For the net investment in foreign operation hedge the cumulative gain or loss posted on the hedging instrument relating to the effective portion of the hedge that has been accumulated in equity shall not be reclassified from equity to the profit and loss on disposal or partial disposal of the foreign operation (Section 12.14).
• An entity can choose to discontinue hedge accounting provided the entity has documented its election and provided the hedging instrument has expired/is sold/terminated or exercised or the conditions no longer exist (Section 12.25).
• Section 12.26 to Section 12.29A deals with the disclosure requirements which are extensive.
• No concept of an embedded derivative.

What do accountants need to do?

Be aware of the requirements for accounting for derivative financial instruments (e.g. forward contracts, interest rate swap etc) and advise clients accordingly.

Review their client portfolio for companies where forward contracts and other derivatives exist and advise clients of the need to get these fair valued so that they can be taken on to the balance sheet.

Advise clients impacted of the volatility this section may cause to the results if hedge accounting is not adopted.

Advise impacted clients on how to apply hedge accounting where the option is adopted.

Advise clients on the need for tax adjustments on transition to be included in the 2015 tax computation and beyond where items have fallen out for tax purposes as a result of the opening balance sheet being restated to show fair value of financial instruments which is non-permanent in nature.

Review contracts for options (put or call) and assess whether the subject of the contract is for own use or not. Where it is not for own use they should be fair valued.

What do companies need to do?

Review contracts entered into to assess if a derivative exists to determine if the standard is applicable. Review contracts for options (put or call) and assess whether the subject of the contract is for own use or not. Where it is not for own use they should be fair valued.

Where a derivative exists, arrange for such a derivative to be fair valued so that the transition adjustments can be determined.

Assess whether it is possible to apply hedge accounting at the date of transition.