CFM24200 - Accounting for corporate finance: Derivative contracts: what is a derivative financial instrument

This guidance applies for IFRS, New UK GAAP and Old UK GAAP (including FRS 26).

Derivative: definition

The relevant accounting standards within the above accounting frameworks all contain definitions of derivatives which are all similar or identical to that in IAS 39, which defines a derivative as a financial instrument or other contract within the scope of IAS 39 with all three of the following characteristics:

(a)	its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’);
(b)	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; and
(c)	it is settled at a future date.

There are some examples in CFM24210 which illustrate this definition.

The definition covers the kind of instruments normally thought of as derivatives, such as forward contracts (see CFM13140), futures (CFM13160), options (CFM13190), swaps (CFM13230) and interest rate caps, collars and floors (CFM13340 and CFM13350).

All derivatives that are within the scope of the relevant financial instruments standards are measured at fair value. Changes in fair value are recognised in the income statement except for those designated and effective as hedging instruments in a cash flow or net investment hedge (see CFM27000+). However, not every contract that falls within the basic definition of a derivative will be within the scope of the financial instruments standard - see CFM24220.

Most derivatives stand alone. But some financial instruments (e.g. a convertible bond held by a company) are hybrid instruments that combine a non-derivative host contract with an embedded derivative. There is more about embedded derivatives at CFM25030.

The question of whether a contract does or does not meet the definition of a derivative can be complex. HMRC staff should consult an HMRC advisory accountant when they are in any doubt about whether a financial instrument meets the definition of a derivative or not.