Accounting for corporate finance: derivative contracts: introduction
Since the 1970s, the use by companies of derivative contracts and instruments to manage financial risk has become increasingly common (see more background in CFM13000).
In addition, many financial (and other) institutions now use derivative financial instruments for trading, or sometimes speculative purposes. The use of derivatives can result in large losses due to the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the price of the underlying asset. However, investors could also lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets. Even in cases where derivatives are intended to mitigate certain risks, they can give rise to exposures to new risks.
These developments have presented a major worldwide challenge to accounting authorities and to traditional accounting practices. Historically in the UK, company legislation was based on the historic cost accounting model and the revenue realisation principle - both of which had their roots in manufacturing industry.
This guidance looks at the accounting for derivatives by companies applying IFRS, New UK GAAP and FRS 26 under Old UK GAAP. For further detail on these terms see CFM20010.
For brief guidance on accounting for derivatives by companies who apply Old UK GAAP (excluding FRS 26) or the FRSSE see CFM22010.
The focus of the guidance is on entities which are not financial institutions and on the use of derivatives to manage risk, rather than for speculative purposes.