CFM84020 - Old rules: derivative contracts: basic rules pre FA 2004: GAAP

Generally accepted accounting practice

This guidance applies to periods of account beginning before 1 January 2005

A company can be expected to account for its derivative contracts in accordance with GAAP. The treatment specified or recommended by GAAP will in turn depend on whether the company holds the derivative for the purposes of a financial trade, or as a hedge.

A company may hold derivative financial instruments for the purposes of a trade such as banking, insurance or other financial dealing. For these companies GAAP normally values such instruments at their fair value (i.e. on a mark to market basis) in accordance with Statements of Recommended Practice issued by the BBA and ABI and the provisions of the Companies Act 1985.

If the company has become a party to a contract to hedge another transaction, the accounting status of the derivative should follow that of the underlying risk in order that the accounting treatment mirrors the economic purpose.

GAAP may, however, allow alternative treatments in particular circumstances, and accounting opinion will not necessarily be unanimous about how certain derivatives should be treated. Much will depend on the facts in any individual case. HMRC staff should consult their local compliance accountant if they suspect that a company’s method of accounting for a derivative contract is not in accordance with UK GAAP and it makes a material difference to the company’s tax liability.

FRS13 (which is part of UK GAAP) requires the directors to state their policy on the use of derivatives in the notes to the accounts. This makes the reader aware that the company is using derivatives, but will not necessarily identify the actual derivatives used in the accounting period. There is a more detailed discussion of FRS13 at CFM24000+.

Except for certain financial traders such as banks and insurance companies, no accounting standard (apart from SSAP20 in the case of currency contracts) sets out how derivatives should be valued in the accounts and they can be difficult or impossible to spot. In particular, companies may enter into forward contracts, particularly in relation to commodities and other raw materials, to hedge their future costs. The contracts are unlikely to appear on the balance sheet and will only be reflected in the cost of the commodities or materials (see the example at CFM84050).

Financial derivatives are also frequently off balance sheet. For example, a company may enter into a currency swap to hedge a loan. The swap will not give rise to an asset or liability in the balance sheet.

Options premiums carried forward are often included as prepayments in debtors.

In this section of the guidance, references to ‘GAAP’ and ‘UK GAAP’ are to generally accepted accounting practice as it stood for accounting periods beginning before 1 January 2005. For the position in later periods, see CFM51000 onwards.