Derivative contracts: hedging: introduction
Introduction to hedging
Old UK GAAP and FRSSE
Under Old UK GAAP (where FRS 26 had not been adopted) it was common for derivative contracts that were hedging one or more risks of an asset, liability or transaction, to be ‘off balance sheet’, typically recognised at historic cost of nil. The asset, liability or transaction being hedged by the derivative, and the derivative itself, may have been accounted for as a single item. For tax purposes, this equated to accounting for the derivative contract on an authorised accruals basis.
‘Off balance sheet’ accounting was particularly used where a company wished to hedge a future transaction. For example, an aerospace manufacturing company is likely to have most of its revenues in US dollars. It can anticipate the likely receipts over a future period and may wish to hedge its exchange rate risk by taking out forward currency contracts. Under Old UK GAAP (excluding FRS 26), it would not recognise such contracts in its balance sheet. But when the sales revenues were received, they may be booked using the exchange rate implied in the particular forward contract, not the spot rate ruling at the date of the transaction. Any gain or loss accruing between the date the contract was entered into and the date of booking would be automatically included in the sales revenue.
Similarly, a company using an interest rate swap to convert floating rate borrowing into fixed rate would not, under Old UK GAAP (excluding FRS 26) show the swap in its balance sheet. It would simply show an interest cost in its accounts that equated to the cost of fixed rate borrowing.
New UK GAAP and IAS
In contrast, under IFRS, New UK GAAP, and Old UK GAAP (where FRS 26 has been adopted) all derivatives are measured on the balance sheet at their fair value even if they are accounted for as a hedge. Hedge accounting is only possible where certain conditions, such as the nature of the hedging instrument and the documentation of the hedge, are met - see CFM27000+.
Companies could in consequence, without special rules, be exposed to considerable volatility in their taxable profits because of fair value changes in derivatives. This can happen not only where the conditions for hedge accounting are not met, but even in cases where they are. There was a particular problem in relation to a cash flow hedge: the basic rule in CTA09/S595(2) brings all fair value movements on the derivative into tax, even where the impact of such changes on amounts recognised to profit or loss is deferred by initially taking fair value changes to a separate cash flow hedging reserve.
Regulations were laid in December 2004 to address these problems by modifying the tax treatment of derivative contracts in certain cases where they function as a hedge. Broadly, the modifications aim to restore the position under Old UK GAAP (excluding FRS 26). These regulations are the Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations 2004 (SI 2004/3256), a title commonly shortened to ‘the Disregard Regulations’. The operation of the rules will depend on the type of hedge, whether it is designated as such for accountancy and whether the company has ‘elected in’ (or previously ‘elected out’) to the particular regulation that applies to that type of hedge. These have been modified by amending regulations on several occasions (SI 2005/2012, SI 2005/3374, SI 2006/3236, SI 2007/948, SI 2007/3431 and SI 2009/1886, SI 2014/3188, SI 2014/3325) taking effect from different dates. A historical overview is given at CFM57030.
An overview of derivative contracts can be found at CFM13010+.
An overview of the accounting treatment for hedging can be found at CFM27000+.