FRS 102 Section 12: other financial instruments

Section 12 of FRS 102 covers financial instruments that are not basic: derivatives such as interest rate swaps, forward currency contracts and options, and loans or investments whose returns are linked to things like profits, equity prices or leveraged rates. They are measured at fair value at each reporting date with changes in profit or loss, unless an exception applies. A company that documents a qualifying hedge can use hedge accounting to match the timing of gains and losses.

What falls into Section 12?

Paragraph 12.3 says Section 12 applies to all financial instruments except those covered by Section 11 and a list of exclusions, including investments in subsidiaries, associates and joint ventures, an entity’s own equity, employee benefit plans, insurance contracts, share based payments and financial guarantee contracts. Paragraph 11.6 gives the usual examples of instruments that are not basic:

• derivatives, such as options, rights, warrants, futures, forward contracts and interest rate swaps;
• asset backed securities, repurchase agreements and securitised receivables;
• instruments designated as hedging instruments under Section 12; and
• loan commitments that can be settled net in cash.

Loans that fail the conditions in paragraph 11.9 also end up here, for example a loan with interest set as a share of the borrower’s profits, and paragraph 11.11 adds investments in convertible debt. The tests are explained on the page on FRS 102 Section 11.

Two less obvious categories are caught. Paragraph 12.4 brings in contracts to buy or sell non financial items, such as commodities, if their terms could cause a loss unrelated to the item’s price, exchange rates or a counterparty default. Paragraph 12.5 brings in contracts that can be settled net in cash, unless they were entered into and continue to be held for the entity’s own expected purchase, sale or usage requirements. Under paragraph 12.3(f), leases are excluded unless non typical terms could cause a loss to the lessor or lessee.

How are Section 12 instruments measured?

Paragraph 12.7 measures an instrument at fair value on initial recognition, which is normally the transaction price. Transaction costs are not added where the instrument will be measured at fair value through profit or loss. Paragraph 12.8 then requires fair value at each reporting date, with changes in profit or loss, except for:

• unquoted equity investments whose fair value cannot otherwise be measured reliably, which are held at cost less impairment;
• hedging instruments in a designated cash flow or net investment hedge, where part of the movement goes through other comprehensive income; and
• instruments that company law does not allow to be measured at fair value through profit or loss, which are measured at amortised cost.

The third exception catches mainly liabilities. Paragraph A3.12A explains that paragraph 36 of Schedule 1 to the Regulations prohibits fair value measurement of certain financial instruments unless they could be designated at fair value under UK adopted international accounting standards. The example in Section 11 of a loan with profit linked interest shows the consequence: the lender measures it at fair value, but the borrower may have to measure it at amortised cost. Paragraph 12.9 says that if a reliable fair value stops being available for an unquoted instrument, its last reliable fair value becomes its cost.

How is fair value worked out?

Paragraph 12.10 points to Section 2A. Paragraph 2A.2 sets the objective: the price at which an orderly transaction to sell the asset or transfer the liability would take place between market participants at the measurement date. Paragraph 2A.15 sets the order of evidence: first an unadjusted quoted price in an active market, then the price of a recent orderly transaction, and only then another valuation technique. Paragraph 2A.16 lists the market, cost and income approaches; the income approach includes present value techniques and option pricing models. Paragraph 2A.14 says the fair value of a liability due on demand is not less than the amount payable on demand, discounted from the first date it could be required.

What is hedge accounting and why use it?

A typical case is a company with a variable rate bank loan that takes out an interest rate swap to fix its interest cost. The loan is a basic instrument at amortised cost, but the swap is a derivative at fair value through profit or loss. Without hedge accounting, every movement in interest rate expectations moves the swap’s value and the reported profit, even though the economic effect of the loan and swap together is a fixed cost. Hedge accounting is optional. Paragraph 12.15 says an entity may apply it if the conditions in paragraph 12.18 are met.

There is also a policy choice at a higher level. Paragraph 12.2 lets an entity apply the recognition and measurement rules of IAS 39 or IFRS 9, with the disclosures of Sections 11 and 12, instead of Sections 11 and 12 in full. Paragraph 12.15A also permits the IAS 39 rules for a fair value hedge of the interest rate exposure of a portfolio.

What conditions must a hedge meet?

Paragraph 12.18 allows hedge accounting from the date all of these are met:

1. the relationship consists only of an eligible hedging instrument and an eligible hedged item;
2. it is consistent with the entity’s risk management objectives;
3. there is an economic relationship, meaning the values are expected typically to move in opposite directions in response to the same risk (paragraph 12.18A);
4. the relationship is documented so that the risk, hedged item and hedging instrument are clearly identified; and
5. the causes of hedge ineffectiveness are determined and documented.

Under paragraph 12.17, the hedging instrument must be measured at fair value through profit or loss, be with a party outside the reporting entity, and not be a written option, except a combination such as a zero cost collar that is not a net written option. Paragraph 12.16 allows the hedged item to be a recognised asset or liability, a firm commitment, a highly probable forecast transaction or a net investment in a foreign operation, if it is reliably measurable. Because hedge accounting runs from the date the conditions are met, documentation prepared at the year end cannot apply it to earlier months.

How do the three types of hedge work?

Paragraph 12.19 sets out three types:

• Fair value hedge. Under paragraph 12.20 the gain or loss on the hedging instrument goes to profit or loss, and the hedging gain or loss on the hedged item adjusts its carrying amount and also goes to profit or loss, so the two offset.
• Cash flow hedge. Under paragraph 12.23 a cash flow hedge reserve in equity is adjusted to the lower, in absolute terms, of the cumulative gain or loss on the hedging instrument and the cumulative change in fair value of the hedged item. The effective part goes through other comprehensive income; the rest is ineffectiveness in profit or loss. The reserve is later reclassified to profit or loss when the hedged cash flows affect it, or included in the cost of a non financial asset.
• Net investment hedge. Paragraph 12.24 treats this like a cash flow hedge, but the amount in equity is not reclassified to profit or loss on disposal of the foreign operation.

Illustration only. A company swaps the interest on a £1 million variable rate loan into a fixed rate and documents a cash flow hedge from the start. At the year end the swap is a liability with a fair value of £20,000, and the cumulative change in the present value of the hedged interest payments is £18,000. The cash flow hedge reserve is set at £18,000, the lower amount, through other comprehensive income. The remaining £2,000 is ineffectiveness charged to profit or loss. Without hedge accounting, the whole £20,000 would have been charged to profit or loss.

When does hedge accounting stop?

Paragraph 12.25 lets an entity discontinue hedge accounting voluntarily if it has documented that election, and requires it to stop when the hedging instrument expires, is sold, terminated or exercised, or the conditions in paragraph 12.18 are no longer met. Discontinuation is always prospective. Under paragraph 12.25A, if hedged cash flows are no longer expected to occur, the cash flow hedge reserve is reclassified to profit or loss immediately; if they are still expected, it stays until they affect profit or loss.

What must be disclosed?

Paragraph 12.26 requires the Section 11 disclosures to cover Section 12 instruments too. For hedges, paragraph 12.27 requires a description of each type of hedge, the hedging instruments and their fair values, and the risks hedged. Paragraphs 12.28 and 12.29 add the amounts recognised in profit or loss and other comprehensive income, amounts reclassified and any ineffectiveness. A small company using Section 1A must still give the company law disclosures in paragraphs 1AC.22 and 1AC.23: the significant assumptions behind fair values, the fair value and change in value for each category, and for each class of derivative the extent and nature of the instruments, including significant terms. See FRS 102 Section 1A.

What are the common mistakes?

• Leaving a bank swap or forward contract off the balance sheet because no cash has changed hands.
• Assuming hedge accounting applies automatically, without the documentation required by paragraph 12.18.
• Measuring a borrowing with profit linked interest at fair value when company law requires amortised cost for the issuer.
• Treating every commodity purchase contract as a derivative, without considering the own use exception in paragraph 12.5.
• Applying a hedge retrospectively from the date the swap was taken out when the documentation came later.

For the standard as a whole, see FRS 102 explained.

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Related Accountapedia entries

• Hedge accounting under FRS 102
• Forward currency contracts in small company accounts
• Measuring unquoted equity investments
• Accounting for listed shares held by a company
• FRS 102 Section 2A: fair value measurement
• FRS 102 Section 26: share based payment
• IFRS 7 financial instruments disclosures
• Loans and financial instruments under FRS 105
• IFRS 12 disclosure of interests in other entities
• The 12 year time limit for offshore tax

Sources

• Financial Reporting Council: FRS 102 September 2024 tmKYWO6

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.