Under FRS 102, a company can apply hedge accounting to an interest rate swap or a forward currency contract only from the date it has documented the hedge, identified the risk, the hedged item and the hedging instrument, and recorded what could make the hedge ineffective. The hedging instrument must be with a party outside the group. Without that documentation, the derivative’s fair value movements go straight to profit or loss.

How does this fit with the rest of Section 12?

The rules on derivatives, the three types of hedge and the disclosures are explained in FRS 102 Section 12: other financial instruments. This page applies those rules to the two hedges most UK companies actually take out, a bank interest rate swap and a forward currency contract. It also sets out what the documentation needs to contain and how the hedge is taxed.

Hedge accounting is optional. Paragraph 12.15 says an entity may apply it if the conditions in paragraph 12.18 are met. Those conditions are that the relationship contains only an eligible instrument and item, it is consistent with the entity’s risk management objectives, there is an economic relationship, and the relationship and the causes of ineffectiveness are documented. Paragraph 12.18A describes an economic relationship as one where the values of the item and the instrument are expected typically to move in opposite directions in response to the same risk.

Which interest rate hedges qualify?

Variable rate loan swapped to fixed. This is a cash flow hedge. Paragraph 12.19(b) uses this very case as its example: a hedge of variability in cash flows such as all or some future interest payments on variable rate debt. The swap’s effective gain or loss goes through other comprehensive income into a cash flow hedge reserve and is released as the interest is charged.

Fixed rate loan swapped to variable. This is a fair value hedge under paragraph 12.19(a). The swap’s movement goes to profit or loss and the loan’s carrying amount is adjusted for the hedged interest rate risk (paragraph 12.20). Because the loan is measured at amortised cost, paragraph 12.22 requires that adjustment to be amortised to profit or loss using a recalculated effective interest rate.

Caps and collars. Paragraph 12.17(c) excludes written options, but paragraph 12.17C allows a combination that is not a net written option, giving a zero cost interest rate collar as the example. A purchased cap is not a written option and can be designated.

Partial hedges. Paragraph 12.17A allows a proportion of an instrument to be designated, for example 50% of its nominal amount. Paragraph 12.16C allows a component of the hedged item, including one or more selected contractual cash flows or a specified part of the nominal amount. A swap covering the first five years of a ten year loan, or half its balance, can therefore still qualify.

Which currency hedges qualify?

Forecast purchases and sales. Paragraph 12.16 allows a highly probable forecast transaction to be the hedged item, so a forward contract taken out to buy dollars for next quarter’s stock purchases can be a cash flow hedge. Once the purchase order is signed it becomes a firm commitment, and paragraph 12.19A allows the currency risk of a firm commitment to be treated as either a fair value hedge or a cash flow hedge.

Spot only designation. Paragraph 12.17A(c) allows the spot element of a forward contract to be designated and the forward element excluded. The excluded part then stays in profit or loss at fair value, but the hedged part tracks the underlying exposure more closely.

Foreign currency borrowings. Paragraph 12.17B allows the currency risk component of a non derivative financial instrument to be a hedging instrument for currency risk. A company with euro sales can designate a euro loan as the hedge of those future receipts.

Overseas subsidiaries. A net investment in a foreign operation with a different functional currency can be hedged under paragraph 12.24. Gains and losses in equity are not reclassified to profit or loss when the operation is sold.

Debtors and creditors already on the balance sheet. Paragraph 30.10 already puts exchange differences on monetary items through profit or loss, and a forward contract is also measured through profit or loss, so the two often offset without any hedge accounting. Currency translation is explained in foreign currency transactions.

What about hedges arranged within a group?

Paragraph 12.17(b) requires the hedging instrument to be a contract with a party external to the reporting entity. A subsidiary that takes out a swap with the group treasury company can apply hedge accounting in its own individual accounts, but in the consolidated accounts the external bank contract must be designated instead.

Paragraph 12.16A also limits hedged items to transactions with external parties, with three exceptions: unconsolidated subsidiaries, the currency risk of intragroup monetary items whose exchange differences are not fully eliminated on consolidation, and the currency risk of highly probable intragroup transactions that affects consolidated profit or loss.

What must the hedge documentation contain?

Paragraph 12.18(d) and (e) require documentation that clearly identifies the risk being hedged, the hedged item and the hedging instrument, together with the causes of hedge ineffectiveness. In practice a one or two page memo for each hedge should record:

Item Example for a loan swap
Risk management objective Fix interest cost on 70% of term debt, consistent with the board’s treasury policy
Hedged item Interest payments on £2 million of the term loan from the bank for five years
Hedged risk Changes in the benchmark interest rate
Hedging instrument Pay fixed, receive floating swap with the bank, deal reference and notional
Type of hedge Cash flow hedge
Economic relationship Matching notional, floating rate index, reset dates and maturity
Causes of ineffectiveness Loan prepayment, timing mismatch on resets, any credit adjustment in the swap value
Date conditions met The date the memo is approved

Paragraph 12.18 permits hedge accounting from the date all the conditions are met. A memo written at the year end cannot apply hedge accounting to earlier months, so a company that hedged in economic terms can still report volatile profits for that period. For a forecast transaction, keep the budget or order history that shows the transaction is highly probable.

What does a currency hedge look like in the numbers?

Illustration only. A UK retailer plans to buy $500,000 of stock in three months and documents a cash flow hedge using a forward contract. At its year end, before the purchase, the forward has a gain of £8,000 and the cumulative change in the present value of the hedged payment is £8,500 in the opposite direction.

Under paragraph 12.23(a) the cash flow hedge reserve is set at the lower of the two absolute amounts, £8,000, so the whole gain goes to other comprehensive income and nothing is ineffective. When the stock is bought, paragraph 12.23(d)(i) removes the £8,000 from the reserve and deducts it from the cost of the stock. The benefit reaches profit or loss through cost of sales when the stock is sold, in the same period as the purchase it protected. Without hedge accounting the £8,000 would have been credited to profit or loss in the earlier year. See other comprehensive income for presentation.

When does hedge accounting stop?

Paragraph 12.25 requires it to stop when the instrument expires, is sold, terminated or exercised, or the conditions are no longer met, and permits voluntary discontinuation if the election is documented. Discontinuation is prospective. Under paragraph 12.25A, if a hedged forecast purchase is no longer expected to happen, the reserve is reclassified to profit or loss immediately; if it is still expected but no longer highly probable, the reserve stays until the cash flows affect profit or loss.

How are hedges taxed?

Derivatives are taxed under the derivative contracts rules, with timing adjusted by the Disregard Regulations (SI 2004/3256). HMRC’s Corporate Finance Manual at CFM57071 explains that for periods of account beginning on or after 1 January 2015 the default is to follow profit or loss. For a designated cash flow hedge, amounts in other comprehensive income are not taxed until they are transferred to profit or loss or capitalised into an asset, and ineffectiveness is taxed as it arises. An undesignated hedge follows profit or loss, including its fair value volatility.

A company can instead elect into regulations 7 (currency contracts), 8 (debt and commodity contracts) and 9 (interest rate contracts), which disregard the fair value movements and bring amounts back in line with the hedged item (CFM57075). CFM57370 explains that the election must be made in writing to HMRC within set time limits, with an initial lock in period. CFM57360 notes that it cannot be applied to only some contracts of the same type.

What mistakes come up most often?

  • Writing the documentation after the year end and applying hedge accounting from the trade date.
  • Designating a swap with a group company as the hedging instrument in the consolidated accounts.
  • Treating a sold cap or a net written collar as a hedging instrument.
  • Applying cash flow hedge accounting to purchases that were never highly probable.
  • Forgetting to adjust the cost of stock or equipment for the reserve when the hedged purchase happens.
  • Assuming the tax follows the cash flow hedge reserve without checking whether a regulation 7, 8 or 9 election is in place.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.