CFM50280 - Derivative contracts: accounting conditions: alternative accounting requirement

CTA09/S579(1)(b)

The definition of a derivative contract requires that it is a relevant contract, meets the accounting conditions and does not have excluded underlying subject matter.

Financial assets or liabilities that are not derivatives only because the initial investment is not small

The second alternative of the accounting conditions is passed by certain financial assets and liabilities that are not accounted for as derivatives solely because the initial investment in the contract is not small. Such instruments might to be referred to for regulatory purposes as quasi-derivatives; their value changes in response to changes in value of the underlying.

A relevant contract satisfies the second alternative of the accounting conditions if it is not treated as a derivative solely because it did not meet the requirement (b) of the definition of a derivative at paragraph 9 of FRS 26, 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 requirement (b) was 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.

For periods beginning on or after 1 January 2015, FRS25 is no longer applicable. But FRS102 (see CFM50220) take a similar approach and the application of such standards as replacement for FRS25/26 is required by S579(5).

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.

Example of a contract that might fall within S579(1)(b)

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, in accordance with the terms of the contract, it chooses to make a lump sum at the inception of the contract. The lump sum payment represents the present value of the stream of variable rate payments that it would have had to make under the swap. 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 or made a loan repayable in equal instalments comprising elements of interest and principal.

The company has made an initial investment equal to the full value present value of the future stream of receipts so the initial investment cannot be said to be small in relation to the amount normally payable for such a type of contract; it is that amount. So the instrument would be accounted for (for instance, under FRS25 or FRS102) as a financial asset but not as a derivative.

Further guidance

For accounting periods beginning before 1 January 2005 or ending before 17 August 2005, see CFM84000+.