Old rules: derivative contracts: basic rules pre FA 2004: accruals and MTM compared
Accruals versus mark to market accounting
This guidance applies to periods of account beginning before 1 January 2005
The following simplified example illustrates the differences between an authorised mark to market basis and an authorised accruals basis.
At 1 January in Year 1, Deepstar plc intends to issue £11,000,000 12-month debt at 31 December in Year 2. Concerned that interest rates will rise, the company decides to hedge its position by entering into a forward contract to sell zero coupon gilts (maturing for £11,550,000 on 31 December in Year 3) for £11,000,000 on 31 December in Year 2. If rates increase the extra interest costs will be offset by a corresponding gain on the forward contract.
At 11 January Year 1 interest rates (and forward interest rates) are 5%. However, by 31 December Year 1 rates (and forward rates) have increased to 10%. At 31 December Year 1 the forward contract would be expected to give rise to a profit on 31 December Year 2 of £500,000 (since sale proceeds under the contract will be £11,000,000 and the expected cost of gilts at that date will be £10,500,000). Note that the expected cost is derived by discounting the £11,550,000 proceeds on maturity using the interest rate projected to apply at the relevant future date, i.e. £11,550,000/110 x 100.
Accordingly at 31 December Year 1 an independent person would pay Deepstar £454,545 for the forward contract being the value of the right to receive a £500,000 profit in a year’s time.
If the contract is marked to market, the company would record the £454,545 profit at 31 December Year 1. If an accruals method was used no profit would be recognised at 31 December Year 1. Instead the profit on the contract would be spread over the life of the debt issued on 31 December Year 2, probably as an offset against interest payable. Note that the £500,000 profit received as a result of the increase in interest rates exactly matches the additional funding cost on the £11,000,000 borrowing (on the assumption that interest rates do not change and the profit on the contract is invested at that rate).