Derivatives are initially recognised at fair value on the date on which a derivative contract is entered into and are subsequently re-measured at their fair value. Changes in the fair value are recognised immediately in the profit and loss account. Fair values are obtained from quoted market prices in active markets, including recent market transactions, and valuation techniques, including discounted cash flow models and options pricing models, as appropriate. All derivatives are carried as assets when the fair value is positive and as liabilities when the fair value is negative.
The best evidence of the fair value of a derivative at initial recognition is the transaction price (i.e. the fair value of the consideration given or received) unless the fair value of that instrument is evidenced by comparison with other observable current market transactions in the same instrument (i.e. without modification or repackaging) or based on a valuation technique whose variables include only data from observable markets.
When unobservable market data has an impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognised immediately in the profit and loss account but over the life of the transaction on an appropriate basis, or when the inputs become observable, or when the derivative matures or is closed out.
Embedded derivatives that are not closely related to their host contracts and meet the definition of a derivative are separated and fair valued through the profit and loss account.
ABI, 299 ABI, 299
FRS 26, 43, 46
FRS 26, AG64
FRS 26, 102 hedges of a net investment in a foreign operation (where the gain or loss on the effective portion of the
hedging instrument is taken through the statement of total recognised gains and losses to match the gain or loss on net assets).
Qualifying hedges
FRS 26, 73 For hedge accounting purposes, only instruments that involve a party external to the reporting entity (i.e.
external to the group, segment or individual entity that is being reported on) can be designated as hedging instruments. Although individual entities within a consolidated group or divisions within an entity may enter into hedging transactions with other entities within the group or divisions within the entity, any such intragroup transactions are eliminated on consolidation. Therefore, such hedging transactions do not qualify for hedge accounting in the consolidated financial statements of the group. However, they may qualify for hedge accounting in the individual or separate financial statements of individual entities within the group or in segment reporting provided that they are external to the individual entity or segment that is being reported on.
FRS 26, 88 A hedge relationship qualifies for hedge accounting if, and only if, all of the following conditions are met;
at the inception of the hedge there is formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge. That documentation shall include identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged and how the entity will assess the hedging instrument's effectiveness in offsetting the exposure to changes in the hedged item's fair value or cash flows attributable to the hedged risk; the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows
attributable to the hedged risk, consistently with the originally documented risk management strategy for that particular hedging relationship;
for cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss; the effectiveness of the hedge can be reliably measured; and
the hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated.
Disclosure of hedging transactions
FRS 29, 22 For each type of hedging relationship the following should be disclosed:
(a) a description of each type of hedge;
(b) a description of the financial instruments designated as hedging instruments and their fair values at the reporting date; and
(c) the nature of the risks being hedged.
FRS 29, 23 The following additional disclosures are required for cash flow hedges:
(a) the periods when the cash flows are expected to occur and when they are expected to affect profit or loss; (b) a description of any forecast transaction for which hedge accounting had previously been used, but which
is no longer expected to occur;
(c) the amount that was recognised in equity during the period;
(d) the amount that was removed from equity and included in profit or loss for the period, showing the amount included in each line item in the income statement; and
(e) the amount that was removed from equity during the period and included in the initial cost or other carrying amount of a non-financial asset or non-financial liability whose acquisition or incurrence was a hedged highly probable forecast transaction.
FRS 29, 24
(i) on the hedging instrument; and
(ii) on the hedged item attributable to the hedged risk.
(b) the ineffectiveness recognised in profit or loss that arises from cash flow hedges; and
(c) the ineffectiveness recognised in profit or loss that arises from hedges of net investments in foreign operations.
Proforma-Gen Limited has no designated hedging relationships.
Embedded derivatives
FRS 26, 10 An embedded derivative is a component of a hybrid (combined) instrument that also includes a non-derivative
host contract.
FRS 26, 11 An embedded derivative shall be separated from the host contract and accounted for as a derivative under FRS
26 if, and only if:
(a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract;
(b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
(c) the hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in profit or loss (i.e. a derivative that is embedded in a financial asset or financial liability at fair value through profit or loss is not separated).
FRS 26, 2(e) The above requirements apply to derivatives embedded in an insurance contract unless the embedded derivative
is itself an insurance contract.
FRS 26, 11 If an embedded derivative is separated, the host contract shall be accounted for under FRS 26 if it is a financial
instrument and in accordance with other appropriate Standards if it is not a financial instrument.
FRS 26, 11A Notwithstanding the above, if a contract contains one or more embedded derivatives, an entity may designate
the entire hybrid (combined) contract as a financial asset or financial liability at fair value through profit or loss unless:
(a) the embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or
(b) it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost.