Derivative contracts: accounting conditions: alternative accounting requirement
Financial assets or liabilities that are not derivatives: CTA09/S579(1)(b)
A relevant contract satisfies the accounting conditions if it is not treated as a derivative solely because it does not meet the requirement in paragraph 9(b) of FRS 26 issued in December 2004 by the ASB, but is nevertheless treated for accounting purposes either as a financial asset or (more rarely) a financial liability in itself, or as forming part of a financial asset or liability.
This applies in accounting periods beginning on or after 1 January 2005 and ending on or after 17 August 2005. For earlier periods, see CFM84000+.
Paragraph 9(b) of FRS 26 requires, in order for an instrument to be a derivative, that it 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. See below for an example of an instrument that fails this requirement.
This applies to any relevant contract, no matter what its underlying subject matter. It may, for example, apply to certain combinations of options that are accounted for as financial assets, but where no individual option is accounted for as a derivative financial instrument. HMRC staff should consult their local HMRC accountant in any case where it is claimed, or it appears, that a relevant contract - particularly a contract forming part of a structured product - is not accounted for as a derivative.
A company enters into a £50 million 2-year interest rate swap, under which it receives fixed rate payments and pays variable rate payments. However, it prepays its obligation under the swap by making, at the inception of the contract, a lump sum payment representing the value of the stream of variable rate payments at current market rates. It continues to receive the fixed rate payments over the life of the contract.
Although this may be described as a swap, it is not treated as a derivative. The company has, in essence, paid a capital sum for a fixed annuity. The amount it would have to pay for such an annuity contract varies with interest rates; but the company has made an initial investment equal to the full price.
Amendment for accounting periods ending on or after 12 March 2008
For periods of account ending on or after 12 March 2008, FA02/SCH26/PARA3(1)(b)(ii) was amended so that the stipulation that the relevant contract ‘is treated’ as forming, or forming part of, a financial asset or liability was removed. So the requirement is simply that the contract for accounting purposes is or forms part of a financial asset (CTA09/S579(1)(b)(ii)). This change was in response to claims that although a relevant contract satisfies the accounting definition of a financial asset, the fact that it has been treated in the accounts as an investment means that it is not ‘treated as’ a financial asset.