Accounting Standards and Guidance

FRC Financial Reporting Standards (FRSs)

UK/Irish accounting framework (effective for periods beginning on or after 1 Jan 2015)

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland

Section 12 Other Financial Instruments Issues

Appendix to Section 12

Example 2 Cash flow hedge accounting – Hedge of variability in cash flows in a floating rate loan due to interest rate risk

This example illustrates the accounting for a cash flow hedge of interest rate risk associated with a floating rate loan. The entity borrows money at a floating rate and enters into an interest rate swap with the effect of paying a fixed rate overall.

12A.3

On 1 January 20X5, an entity borrows CU10,000,000 from a bank at a floating rate of 3-month LIBOR plus 2.5 per cent. The interest is payable annually in arrears on 31 December. The loan is repayable on 31 December 20X7.

On 1 January 20X5 the entity also enters into an interest rate swap with a third party, under which it receives 6-month LIBOR and pays a fixed rate of interest of 4.5 per cent. The notional amount of the swap is CU10,000,000. The swap is settled annually in arrears on 31 December and expires on 31 December 20X7.

The LIBOR rates on the loan and the interest rate swap are reset and fixed annually in advance on 31 December based on the expected LIBOR rates applicable at that time. Note that in practice the loan and swap interest rates would be reset more frequently than assumed for the purpose of simplification in this example.

The entity hedges the variability of the interest rate payments on the bank loan based on 3-month LIBOR. It should be noted that because the entity receives interest based on 6-month LIBOR under the interest rate swap, ineffectiveness will arise because the expected cash flows of the hedged item and the hedging instrument differ. The fair value of the interest rate swap may be affected by other factors that cause ineffectiveness, for example counter party credit risk, but these have been disregarded in this example.

There are no transaction costs.

The entity's financial year ends on 31 December.

This example assumes that the qualifying conditions for hedge accounting in paragraph 12.18 are met from 1 January 20X5.

The table in paragraph 12A.5 summarises the impact of hedge accounting on the interest rate swap, profit or loss and other comprehensive income.

The table below sets out the applicable LIBOR rates, interest payments and swap settlements. The fair values of the interest rate swap and the hedged item shown in the table are shown for illustrative purposes only.

Note that in practice, when forecasted variable interest rate payments are the hedged item, the fair value of a hypothetical swap, that would be expected to perfectly offset the hedged cash flows, is used as a proxy of the fair value of the hedged item. The hypothetical derivative in this scenario is a fixed to floating interest rate swap with terms that match those of the loan and a fixed rate of 4.3 per cent, which for the purpose of this example, is the interest rate where the fair value of the hypothetical swap is nil at the inception of the hedging relationship.

	1 Jan 20X5	31 Dec 20X5	31 Dec 20X6	31 Dec 20X7
Actual 3-month LIBOR	4.3%	5%	3%	n/a
Actual 6-month LIBOR	4.5%	4.9%	3.2%	n/a
Interest payments based on 3-month LIBOR	n/a	CU10m × (4.3% + 2.5%)= CU680,000	CU10m × (5% + 2.5%)= CU750,000	CU10m × (3% + 2.5%)= CU550,000
*Interest rate swap (hedging instrument)*
Fair value	nil	CU78,000	(CU89,000)^†	(CU130,000)^‡
Fair value change	nil	CU78,000 – 0= CU78,000	(CU89,000) – CU78,000= (CU167,000)	(CU130,000) – (CU40,000)^§ – (CU89,000)= (CU1,000)
Swap settlement receipts/ (payments) based on 6-month LIBOR	n/a	CU10m × (4.5% – 4.5%)= nil	CU10m × (4.9% – 4.5%)= CU40,000	CU10m × (3.2% – 4.5%)= (CU130,000)
*Hedged item*
Fair value	nil	(CU137,000)	CU59,000	CU130,000

In accordance with paragraph 12.23(a), the cash flow hedge reserve is adjusted to the lower of (in absolute amounts) the cumulative gain on the hedging instrument (ie the interest rate swap), which equals its fair value, of CU78,000 and the cumulative change in fair value of the hedged item, which equals its fair value of (CU137,000).

In accordance with paragraph 12.23(b), the gain of CU78,000 on the interest rate swap is recognised in other comprehensive income.

(2)

The fixed interest element on the hypothetical swap is CU430,000, the same amount as the variable rate component. The variability of the 3-month LIBOR did therefore not affect profit or loss during the period. The reclassification adjustment in accordance with paragraph 12.23(d)(ii) is nil. (Note that no accounting entry is shown below.)

Note A:

For illustrative purposes the accounting entry for interest payments is shown below. Note that in practice the accrual and payment of interest may be recorded in separate accounting entries.

Accounting entries:

Note that the accounting entries shown are only those relevant to demonstrate the effects of hedge accounting. In practice other accounting entries would be required, eg an entry to recognise the loan liability.

Ref		Debit	Credit
(1)	Interest rate swap	CU78,000
	Other comprehensive income		CU78,000
(A)	Profit or loss	CU680,000
	Cash		CU680,000

31 December 20X6

(1)

In accordance with paragraph 12.23(a), the cash flow hedge reserve is adjusted to the lower of (in absolute amounts) the cumulative loss on the hedging instrument (ie the interest rate swap) which equals its fair value of (CU89,000) and the cumulative change in fair value of the hedged item, which equals its fair value of CU59,000. The cash flow hedge reserve moves from CU78,000 to (CU59,000), a change of (CU137,000).

In accordance with paragraph 12.23(b), a loss of CU137,000 on the interest rate swap is recognised in other comprehensive income, as this part of the loss is fully off-set by the change in the cash flow hedge reserve. The remainder of the loss on the interest rate swap of CU30,000 is recognised in profit or loss, as required by paragraph 12.23(c).

(2)

The fixed interest element on the hypothetical swap is CU430,000, whilst the variable rate component is CU500,000. The variability of the 3-month LIBOR affects profit or loss during the period by CU70,000. Accordingly, the reclassification adjustment in accordance with paragraph 12.23(d)(ii) is CU70,000.

Note A:

For illustrative purposes the accounting entry for interest payments is shown below. Note that in practice the accrual and payment of interest may be recorded in separate accounting entries.

Note B:

For illustrative purposes the accounting entry for the settlement of the swap is shown below.

Accounting entries:

Ref		Debit	Credit
(1)	Other comprehensive income	CU137,000
	Profit or loss	CU30,000
	Interest rate swap		CU167,000
(2)	Other comprehensive income	CU70,000
	Profit or loss		CU70,000
(A)	Profit or loss	CU750,000
	Cash		CU750,000
(B)	Cash	CU40,000
	Interest rate swap		CU40,000

31 December 20X7

(1)

In accordance with paragraph 12.23(a), the cash flow hedge reserve is adjusted to the lower of (in absolute amounts) the cumulative loss on the hedging instrument (ie the interest rate swap) which equals the fair value of (CU130,000) and the cumulative change in fair value of the hedged item, which equals its fair value of CU130,000.

The cash flow hedge reserve moves from (CU129,000) to (CU130,000), a change of (CU1,000). In accordance with paragraph 12.23(b), the loss of CU1,000 on the interest rate swap is recognised in other comprehensive income.

(2)

The fixed interest element on the hypothetical swap is CU430,000, whilst the variable rate component is CU300,000. The variability of the 3-month LIBOR affects profit or loss during the period by (CU130,000). Accordingly, the reclassification adjustment in accordance with paragraph 12.23(d)(ii) is (CU130,000).

Note A:

For illustrative purposes the accounting entry for interest payments is shown below. Note that in practice the accrual and payment of interest may be recorded in separate accounting entries.

Note B:

For illustrative purposes the accounting entry for the settlement of the swap is shown below.

Accounting entries:

Ref		Debit	Credit
(1)	Other comprehensive income	CU1,000
	Interest rate swap		CU1,000
(2)	Profit or loss	CU130,000
	Other comprehensive income		CU130,000
(A)	Profit or loss	CU550,000
	Cash		CU550,000
(B)	Interest rate swap	CU130,000
	Cash		CU130,000

12A.5

The table below summarises the effects of the accounting entries shown in paragraph 12A.4 on the interest rate swap, profit or loss and other comprehensive income.

Description	Interest rate swap	Other comprehensive income	Profit or loss

*31 December 20X5*
Opening balance	nil	nil^†	–
Interest on the loan			CU680,000
Interest rate swap fair value movement	CU78,000	(CU78,000)	–
Closing balance	CU78,000	(CU78,000)^†	–

*31 December 20X6*
Opening balance	CU78,000	(CU78,000)^†	–
Interest on the loan			CU750,000
Interest rate swap fair value movement	(CU167,000)	CU137,000	CU30,000
Settlement receipt interest rate swap	(40,000)	–	–
Reclassification from cash flow hedge reserve	–	CU70,000	(CU70,000)
Closing balance	(CU129,000)	CU129,000^†	–
*31 December 20X7*
Opening balance	(CU129,000)	CU129,000^†	–
Interest on the loan			CU550,000
Interest rate swap movement	(1,000)	1,000	–
Settlement payment interest rate swap	CU130,000	–	–
Reclassification from cash flow hedge reserve	–	(CU130,000)	CU130,000
Closing balance	nil	nil^†	–

^†: This valuation is determined before the receipt of the cash settlement of CU40,000 due on 31 December 20X6.

^‡: This valuation is determined before the payment of the cash settlement of CU130,000 due on 31 December 20X7.

^§: CU40,000 is the settlement of the interest rate swap as at 31 December 20X6 which affects the fair value of the swap, but is not included in the fair value of the swap at 31 December 20X6 of CU89,000.

^†: This is the balance of the cash flow hedge reserve.