Route 102 – One man’s year-long journey……Day 43

To mark this momentous year for UK GAAP, I'm embarking on a mission to work my way through FRS 102, reading a portion on each working day of 2015 and writing a short blog entry on my thoughts and musings (be they few or many).

Day 43 (25 Mar)

A quick post today, as I sit in sun-drenched High Wycombe awaiting today's Accounting Update course. For any of you who made it through yesterday's rather long and detailed post on fair value hedges - well done! A case of chocolate-coated Hobnobs is winging its way to you as we speak...

Now let's do the same thing with cash flow hedges. I'll refer you to the0 example in the section 12 appendix. The scenario is an interest rate swap: an entity has a LIBOR+2.5% variable rate, and hedges this with a swap for a fixed rate. To complicate matters, the actual variable rate is based on 3-month LIBOR whereas the interest swap gives the entity 6-month LIBOR; so there's going to be some hedge ineffectiveness because the two rates will vary a little.

Note that we need a fair value for not only for the swap (the hedging instrument) but also for the variable-rate loan. The example makes clear that, in the real world, one would look at a 'perfect' swap (one which would be expected to match the variable rate cash flows from the hedged item exactly) and use this 'perfect' swap's fair value (since by definition, this is what it is).

The appendix example then sets out the fair values and movements on both items for a series of experienced LIBOR rates, along with the actual interest paid.

12.23 details how the cash flow hedge accounting would work. A hedging reserve is created and adjusted for the lower (in absolute terms) of the movements in the two fair values (the cumulative gain or loss on the hedging instrument on one hand - let's call this gain or loss 'A' - and the cumulative fair value change in the hedged item - let's call this movement 'B'). The portion of 'A' which represents effective hedging is taken to Other Comprehensive Income and the remainder (either the rest of A, or the balance to arrive at B depending on which is the lower) goes to the P&L. The reserve is then accounted for in accordance with 12.23d.

Sounds fun, doesn't it? If you've got a couple of hours, an iron will and a ready supply of Ovaltine, then by all means work your way steadily through the example. You'll feel better for it. That last bit may not be true.

P.S. If you missed the last instalment click here