Derivative contracts: accounting conditions: definition of derivative
Meaning of ‘derivative’ in FRS 25
FRS 25 refers to the definition of a derivative in FRS 26. There it is defined as a financial instrument or other contract which
- is settled at a future date,
- requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors and
- has a value that changes in response to a change in an underlying variable.
There is more about the accounting definition at CFM24040 onwards.
The bulk of derivative contracts entered into by companies involve ‘plain vanilla’ interest rate or currency swaps or forwards, credit derivatives and derivatives over shares, share indices or bonds. These will all satisfy the CTA09/S579(1)(a) accounting condition.
Some relevant contracts may meet the three bullet points above but fall outside of the scope of FRS 26 - normally because they do not qualify as financial instruments.
Thus the ‘accounting test’ is not the sole determinant of whether a contract qualifies as a derivative contract or not. For example, contracts requiring payments based on climatic or other physical variables may be outside the scope of FRS 26 but weather derivatives will nevertheless satisfy S579 because they are specifically brought in by S579(2)(b) - see CFM50280. (Weather/climatic derivatives are within the scope of FRS 26 from 1 January 2007 unless they are insurance contracts as defined by Appendix C to FRS 26).