CFM50230 - Derivative contracts: accounting conditions: meaning of derivative
CTA09/S579
| The definition of a derivative contract requires that it is a {relevant contract | CFM50300}, meets the accounting conditions and does not have excluded underlying subject matter. |
The main accounting condition is satisfied if the contract is treated as a derivative under the relevant accounting standard. This will either be FRS25 or its replacement FRS102.
Meaning of ‘derivative’ under FRS 102 (from 2015)
FRS102 applies for periods from 1 January 2015 and replaces FRS25 from that date. The glossary of FRS102 defines a derivative as being a financial instrument or other contract which:
- has a value that changes in response to the change in an underlying variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract,
- 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
- is settled at a future date.
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.
Meaning of ‘derivative’ under FRS 25 (2004 - 2014)
For periods commencing before 1 January 2015 the relevant accounting standard is FRS25. FRS25 referred to the definition of a derivative in FRS 26. There it is defined as a financial instrument or other contract which
- has a value that changes in response to a change in an underlying variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract,
- 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
- is settled at a future date.
Some relevant contracts may meet the three bullet points above but fall outside of the scope of FRS 26. The main exclusions from being within the scope of FRS26 are:
- The company’s own equity instruments, and the equity components of compound financial instruments
contracts to buy or sell a non-financial item that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements
Minor differences in the wording of the definitions
The definitions of a derivative is essentially the same in each of IAS39, IFRS9, FRS26 and FRS102.
The only difference between FRS25 and the definitions in IAS39 / IFRS9 is that the words “within the scope of this Standard (see paragraphs 2–7)” are replaced by an analogous reference to the relevant paragraphs of IAS39 / IFRS9.
FRS102 contains no wording equivalent to “within this standard”. However, the requirement for tax, in S579(1)(a), is that the contracts should be “treated for accounting purposes as a derivative”. Under FRS102, a relevant contract is only treated for as a derivative if either its falls to be a derivative under Section 12 for non-basic financial instruments, or the company chooses to apply IAS39/IFRS9 instead and the instrument falls to be treated as a derivative under those standards.
Section 12 contains a list of exclusions from the scope of the section which is broadly equivalent to the exclusions from FRS26. In particular, there are exclusions for:
- the company’s own equity instruments and the equity component of a compound financial instrument
- contracts to buy or sell a non-financial item that (i) do not impose risks that are not typical for such contracts and (ii) were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements
It follows that any difference between FRS102 and FRS26/IAS39/IFRS9 is one of nuance, and unlikely to be of practical significance.