04 May 2020

The coronavirus pandemic exposes entities to a wide range and magnitude of risks. In order to manage these entities could use a number of different hedging activities.

What does FRS 102 say?

Under FRS 102 entities can apply hedge accounting so that the assets, liabilities and firm commitments are measured on a basis different from their normal treatment under FRS 102.

Applying hedge accounting

FRS 102 (section 12) describes the three types of hedging relationships:

  • cash flow hedges;
  • fair value hedges; and
  • hedges of a net investment in a foreign operation.

An entity can discontinue hedge accounting whenever it wishes, provided it has documented its election to do so. Hedge accounting must, however, be discontinued if:

  • the hedging instrument has expired or is sold, terminated or exercised; or
  • the qualifying conditions for hedge accounting are no longer met. (paragraph 12.25)

In a cash flow hedging relationship one of the prescribed conditions is that the forecast transaction must be highly probable to be an eligible hedged item. Accordingly, cash flow hedge accounting must be discontinued when the hedged future cash flows are no longer expected to occur within the original time period or a relatively short period thereafter. The cash flow hedge reserve should be reclassified to profit or loss immediately. Hedge accounting should be discontinued prospectively from the date of discontinuation of the hedging relationship.

A forecast transaction that is no longer highly probable may still be expected to occur. If the future cash flows are still expected to occur, then the amount remains in the cash flow hedge reserve until the future cash flows occur. However, if the amount is a loss and the entity expects that all or a portion will not be recovered in one or more future periods, it should immediately reclassify the amount that is not expected to be recovered into profit or loss as a reclassification adjustment.

Hedge ineffectiveness

In a cash flow hedge, if the cumulative gain or loss on the hedging instrument is more than the cumulative change in the fair value of the expected future cash flows on the hedged item attributable to the hedged risk, then the difference is recognised in profit or loss as ineffectiveness.

Hedge accounting disclosures

FRS 102 requires entities to have extensive disclosures on hedge accounting. In particular:

  • the periods when the cash flows are expected to occur and when they are expected to affect profit or loss;
  • a description of any forecast transaction for which hedge accounting had previously been used, but which is no longer expected to occur;
  • the amount of the change in fair value of the hedging instrument that was recognised in other comprehensive income during the period;
  • the amount, if any, that was reclassified from equity to profit or loss for the period; and
  • the amount, if any, of any hedge ineffectiveness recognised in profit or loss for the period.

Practical impact and interpretation for preparers

As a result of the current economic situation it is expected that hedge accounting might be affected in a number of ways including:

  • changes to whether a forecast transaction is highly probable; 
  • differences in the effectiveness of the hedge; and
  • more hedge instruments being used, and more hedge accounting being applied.

The realisation and timing of forecast transactions might change which will affect the hedge relationships eg a forecast purchase of raw materials being delayed.

The credit risk of the derivative financial instruments could significantly increase in the future, resulting in potential implications on hedge ineffectiveness.

Hedge accounting

Highly probability criteria

If there is a delay in the timing of future delivery or payment, entities need to evaluate whether the original highly probable forecast transaction still exists, or a new highly probable forecast transaction is going to occur instead.

If the highly probable forecast transaction does not exist anymore, entities need to terminate the hedge relationship prospectively and reclassify the related amounts from the cash flow hedge reserve to profit or loss.

Hedge ineffectiveness

When entities conclude that there is only a delay in the highly probable forecast transaction, but it still exists, there would be an impact on the recorded ineffectiveness. If the maturity of the hedging instrument was originally longer than the duration of the forecast transaction, entities might need to reduce the level of ineffectiveness recorded in profit or loss. 

If the expected hedged cash flows arise earlier than originally forecasted and the hedging instrument’s maturity is longer than the timeframe of the hedged cash flows, entities might need to record additional ineffectiveness in profit or loss. Entities are required to designate hedging instruments for their entire period for which they are outstanding, so entities are not allowed to redesignate the cash flow hedge relationship for a shorter period even if the expected cash flows are expected to be realised earlier.

Credit risk

The hypothetical derivative approach is a widely used method for measuring hedge ineffectiveness. The hypothetical derivative is a derivative whose changes in fair value perfectly offset the changes in fair value of the hedged item for variations in the risk being hedged. The critical terms of the hypothetical derivative match those of the hedged item (eg notional, underlying, maturity, repayment periods) and the hypothetical derivative’s counterparty is free from credit risk.

Therefore, a significant increase in the credit risk of the derivative financial instrument might cause additional ineffectiveness. Provided that the derivative instrument is not collateralised, a significant deterioration of the credit standing of the issuer of the derivative instrument would have a disproportionate effect and potentially additional ineffectiveness because:

  • the change of the fair value of the derivative instrument would be affected by the credit deterioration; and 
  • the change of the fair value of the hedged item would not be affected.


Entities need to evaluate what additional disclosures should be made as a result of the changes in the expected cash flows, credit risk and hedge ineffectiveness.

Our advice

Evaluate the appropriateness of current risk management strategies, objectives and the potential implications on hedge accounting.

  • Consider what further hedging strategies should be taken to mitigate any potential risks.
  • Evaluate the entity’s ability to prepare highly probable forecasts and consider whether the hedged forecasts are still highly probable and whether the hedge relationships need to be discontinued. 
  • Evaluate credit risk to assess its potential impact on hedge ineffectiveness.
  • Reconsider any further potential sources of ineffectiveness in the hedge relationships.
  • Assess what further information should be gathered for disclosure purposes.

For more information please contact Paul Merris and Lee Marshall.

Lee Marshall
Lee Marshall
Partner, Head of accounting and business advisory
Lee Marshall
Lee Marshall
Partner, Head of accounting and business advisory