Accounting for Derivatives

The taxation of derivatives is tied closely to the content of the financial statements of companies that use derivative contracts. Financial statements are generally relevant for tax purposes, firstly, because tax legislation relies on accounting practice as a basis for arriving at profits or losses, and secondly, because the courts have held that the calculation of profits or losses for UK tax purposes commences with a consideration of the accounts prepared in accordance with correct principles of commercial accounting. Statute and case law, however, override accounting practice for tax purposes.

The sources of accounting practice in relation to the taxation of derivative contracts are the Companies Act, the British Bankers’ Association’s SORP on Derivatives, UK accounting standards, and publications of the accounting profession.

The Companies Act 1985

The Companies Act 1985 (superseded by the Companies Act 2006) prescribed the format of accounts, the extent of disclosure required, and the principles to be applied for determining accounting policies, for companies incorporated in the United Kingdom. The Act also made separate provision for the financial statements of banks.

Section 226(1) of the Act provided that a balance sheet and a profit and loss account must be prepared for every company. Section 226(2) provided that “The balance sheet shall give a true and fair view of the state of affairs of the company as at the end of the financial year; and the profit and loss of account shall give a true and fair view of the profit and loss of the company for the financial year.” Section 226(5) provided that “If in special circumstances compliance with any of these provisions is inconsistent with the requirement to give a true and fair view, the directors shall depart from that provision to the extent necessary to give a true and fair view. Particulars of any such departure, the reasons for it and its effects shall be given in a note to the accounts.”

Schedule 4 of the Act sets out the rules for determining the form and content of the accounts of companies. Paragraphs 10 to 14 of the Schedule detail the accounting principles of “going concern”, “consistency”, “prudence”, “accruals”, and the prohibition against setting off. Thus a company is presumed to be carrying on business as a “going concern”, accounting policies are to be applied consistently from year to year, the amount of any item is to be “determined on a prudent basis, and in particular only profits realised at the balance sheet date shall be included in the profit and loss account”; “all income and charges relating to the financial year to which the accounts relate shall be taken into account, without regard to the date of receipt or payment”; and “in determining the aggregate amount of any item the amount of each individual asset or liability that falls to be taken into account shall be determined separately.”

Schedule 9 of the Act contains special provision for the accounts of banking companies and groups. The Schedule, which embodies the rules of the European Union Bank Accounts Directive, governs the financial statements of banks that are incorporated in the United Kingdom. The Schedule contains an number of rules and principles that are relevant to accounting for derivative contracts. The Schedule requires assets and liabilities to be valued in accordance with “historical cost accounting rules”, but it also allows for certain “alternative accounting rules”. It draws a distinction between “fixed assets“ and “current assets”, defines “financial fixed assets”, and provides that assets that are not held as “financial fixed assets”, are to be valued under historical cost accounting rules at the lower of cost and net realisable value, while it permits “transferable securities“ to be valued at the lower of cost or market value or carried at current value.

The Schedule requires a range of disclosures regarding a bank’s “financial assets” and “financial liabilities”. “Contingent liabilities” and “commitments” must be shown as memorandum items, and “unmatured forward transactions” must be disclosed in notes. The usual practice, however, is for the values of these transactions to be recorded off-balance sheet until maturity, when the cash flows that occur on settlement are recorded. Schedule 9 permits the practice of recording off-balance sheet instruments at market value, or where there is no quoted market value, then at “fair value“. Because the carrying of a portfolio of securities or off-balance sheet instruments at market value and the taking of fluctuations in value directly to the profit and loss account appear to contradict the accountancy principle of “prudence”, the practice is sometimes to carry the assets at the lower of cost and net realisable value and only to recognise profits when securities are sold. Where a bank is involved in activities that involve risk and generate income, but are reported by it “off-balance sheet”, Schedule 9 requires only general disclosure of unmatured forward transactions “by reference to an appropriate system of classification”, with an indication whether the transaction has been entered into for hedging or dealing purposes. Schedule 9 does not lay down any valuation method that is specific to derivatives, but it does prescribe the balance sheet treatment of foreign exchange transactions, although not how such transactions should be shown in the profit and loss account. Paragraph 45 of the Schedule provides that the amounts to be included in a bank’s balance sheet in respect of assets and liabilities denominated in foreign currencies should be in sterling, after translation at an appropriate spot exchange rate prevailing at the balance sheet date. An appropriate exchange rate prevailing on the date of purchase may, however, be used for “financial fixed assets”, if they are not hedged by either the spot or forward currency markets. Uncompleted foreign currency transactions should be translated at an appropriate forward exchange rate prevailing at the balance sheet date. These requirements do not apply to assets or liabilities held, or transactions entered into, for hedging purposes, or to assets or liabilities that are hedged. Paragraph 46 provides that any difference between the amount to be included in respect of an asset or liability under paragraph 45, and the book value after translation, is to be taken to the profit and loss account. But for assets held as “financial fixed assets” and hedging transactions in relation to such assets, the difference may be deducted from or credited to a non-distributable reserve. Paragraph 72(1) of the Schedule requires a bank to disclose information regarding “unmatured forward contracts” outstanding at the balance sheet date, the categories of the transactions in question, and whether any contract has been concluded for the purpose of hedging the effects of fluctuations in interest rates, exchange rates and market prices, or whether they have been entered into for dealing purposes. Under Schedule 9, a bank is required to disclose “interest receivable”, including income resulting from the amortisation of a forward exchange contract entered into as a hedge against a foreign currency asset or liability. The Schedule also requires the disclosure of dealing profits and losses on transactions in “financial instruments”, including mark to market profits and losses on financial instruments.

As to the setting off of assets and liabilities under the Companies Act, Schedule 4 paragraph 5 and Schedule 9 paragraph 5 provide: “Amounts in respect of items representing assets or income may not be offset against amounts in respect of items representing liabilities or expenditure, or vice versa.” Schedule 4 paragraph 14 and Schedule 9 paragraph 21 state: “In determining the aggregate amount of any item the amount of each individual asset or liability that falls to be taken into account shall be determined separately.” Although the set off of assets against liabilities in the balance sheet (or income against expenditure in the profit and loss account) is prohibited by Schedules 4 and 9, this prohibition has been interpreted to mean that a bank may nevertheless “net” different balances with the same customer, where it is legally entitled to do so. The process of “netting” is regarded merely as a means of arriving at a customer’s balance, rather than the setting off of assets and liabilities. Thus transactions with positive values are only netted off against transactions with negative values, where the company is in a position to demand a net settlement and has an enforceable legal right to do so. The conditions under which netting may take place are set out in FRS 5 Reporting the substance of transactions, which defines “offset” as the process of aggregating debit and credit balances and including only the net amount in the balance sheet. FRS 5 notes that in order to present the commercial effect of transactions, separate assets and liabilities should not be offset, but it says that offset is permissible and indeed necessary between related debit and credit balances that are not separate assets and liabilities. For offset to apply, the following conditions must be met: firstly, the parties must owe each other determinable monetary amounts, denominated either in the same currency or in different freely convertible currencies; secondly, one party must have the ability to insist on a net settlement; and thirdly, that ability must be assured beyond doubt. The standard does not require the disclosure of amounts that have been offset.

The BBA SORP on Derivatives

The British Bankers’ Association Statement of Recommended Practice on Derivatives is a recommendation to members of the BBA, and is intended to apply to the financial statements of banks incorporated in the UK and the Republic of Ireland, and to the consolidated financial statements of British and Irish banking groups. Although it is intended to be authoritative and persuasive, a bank is not bound by it nor is it obliged to disclose the fact or nature of any departure from it. With regard to taxation, the fact that SORP recommendations are not followed does not mean that the accounting treatment used is unacceptable for tax purposes, only that it may be subject to Inland Revenue inquiries. Inland Revenue has stated that where the accounting standards recommended by a SORP are followed to the letter, they are likely to be accepted by it for tax purposes.

The SORP refers to interest rate, equity and commodity-related derivative contracts, including forwards, futures, swaps and options, and other financial instruments with similar characteristics, such as interest rate caps and floors. The SORP has two objects. Firstly, it aims to ensure that derivatives held for “trading’ purposes, including all customer and proprietary transactions and hedges thereof, are measured at “fair value” and that resulting profits and losses are taken to the profit and loss account and recognised immediately, thus ensuring that all profits and losses arising from “trading” in derivatives are included in reported profits, irrespective of whether the transactions run beyond the balance sheet date. Secondly, it aims to restrict the use of “accruals basis” accounting to derivatives held as hedges, that is, to those derivative contracts that form part of a bank’s “non-trading” risk management strategy.

The SORP therefore requires that all of a bank’s derivative transactions should be categorised in one of two categories:

Because this categorisation determines the accounting treatment, each category must be clearly identified in the accounting system. The SORP recommends a presumption that a derivative should be regarded as a “trading transaction”, unless the bank can demonstrate that it constitutes a “non-trading transaction”.

The valuation and income recognition rules of the SORP are intended to prevent premature profit or revenue recognition, in line with the “accruals&rddquo; or “prudence” accounting concepts. The “accruals” concept provides that revenue and costs should be recognised as they are earned or incurred, and not when payment is received or made. Revenue and costs should be matched with one another, provided that their relationship can be established or justifiably assumed or recognised in accordance with the period to which they relate. The “prudence” concept provides that profits and revenues should not be anticipated, but should be recognised only when they are realised in the form of cash or other assets, the cash realisation of which can be assessed with reasonable certainty. Where the “accruals” concept is inconsistent with the “prudence” concept, the “prudence” concept prevails.

For a transaction to qualify as a “hedge” or “non-trading transaction”, it should, according to the SORP, match or eliminate risk from potential movements in interest rates, exchange rates, market value and/or credit quality inherent in the assets, liabilities, positions or cash flows being hedged. The SORP says that derivatives should only be classified as “non-trading transactions” in appropriate circumstances, and these transactions should be clearly identified and their purpose properly documented at the outset, and there should be an ongoing assessment of the status of each transaction in order to confirm that it does indeed manage risk to the extent anticipated. Derivative contracts classified as “non-trading transactions” should be measured on an accruals basis, in the same way as that used for the underlying asset, liability, position or cash flow.

The SORP describes “hedging” as a continuous process which seeks to control risk. If a hedged position changes, or a hedge proves to be ineffective, the bank may take corrective action by replacing an existing hedging transactions or entering into a new one. This process inevitably results in the reclassification of hedge transactions from “non-trading” to “trading”, and where this occurs the procedure for reclassified transactions should be followed. The SORP also permits a hedge to relate only to a portion of an asset, liability, position or cash flow being hedged, or only to a predetermined portion of a total risk. A hedge may also relate to a part only of the period during which the hedged risk endures, or to exposures resulting from a change in a position. A “hedged position” may cover a single transaction or a group of transactions, or off-balance sheet exposures, including commitments and contingent liabilities, or specified anticipated future transactions that are expected with reasonable certainty to arise in the normal course of the bank’s business. If the transaction being hedged is an anticipated transaction, the SORP provides that it should only be classified as a “non-trading” transaction where the main characteristics of the transaction that it is anticipated will be hedged, including the timing and the expected terms of the transaction, are documented.

The SORP notes that if a bank wishes to hedge a position or exposure in its “non-trading” book, it usually does so by entering into an internal transaction with a separately managed trading unit, rather than with a third party, because this enables the bank to retain control and reduce transaction costs. The SORP allows transactions of this kind to be characterised as “hedges”, provided that the trading unit acts as a mere conduit to the market, and that the terms of the transaction are arm’s length and satisfy the hedge criteria. The transactions should be accounted for at “fair value” in the trading unit, and on an “accruals” basis in the non-trading book.

Whether a hedge should be classified as “trading” or “non-trading”, is determined at the business unit level, irrespective of whether the business unit in question is a separate entity within the group, or a division within a single company. Hedge transactions carried out at group level in order to control group risk, must, however, be classified at group level. The overriding factor in determining the effectiveness of a hedge, however, is assessed at group level, and not at business unit level. In determining whether a derivative should be classified as “non-trading”, the organisational and financial limits of the business unit responsible for the transaction should be taken into account. The overriding consideration, however, is whether the strategy has been effective at group level.

If a “non-trading” hedge transaction proves to be ineffective, then, unless corrective action is taken, the hedge should be reclassified as a “trading” transaction. The following rules apply to the reclassification of transactions: Where the underlying hedged asset, liability, or position has been derecognised, or the hedged cash flow has occurred, the SORP recommends that related “non-trading” transactions should be remeasured at “fair value”, on their reclassification as “trading transactions”. In the same way as the derecognised item, the gains and losses generated by the related non-trading item, including any associated deferred income or expense balances, should be recognised in full immediately. In other cases, reclassified non-trading derivative transactions should be remeasured at “fair value” on reclassification, and the resulting gains and losses should be amortised over the life of the underlying asset, liability, position or cash flow. If in the exceptional case in which the bank anticipates that a group of transactions and their hedges will result in aggregate net losses, those losses should be recognised in full immediately. If a transaction is reclassified from “trading” to “non-trading”, the “fair value” on the date of reclassification should be taken to be the cost of the “non-trading” derivative transaction.

The SORP states that in determining the “fair value” on the balance sheet date of derivatives held as “trading transactions”, market quotes should be taken to represent fair value. Where there are no market quotes, a value should be constructed either from quoted prices for the derivative’s components, or by using modelling techniques. Any valuation method should, based on the bank’s experience, be one that produces a reasonable and prudent approximation of market price. The method should be applied consistently, but should be reviewed in the light of current market conditions, if there have been no recent trades in that instrument. If over-the-counter derivative contracts are valued by way of comparison with inter-bank prices, those prices should be adjusted to take account of counterparty credit quality. If value is based on market quotes, they should be adjusted to allow for close-out costs, direct administrative costs, and any other adjustments that might be necessary in order to determine the portfolio’s fair value. In general, “fair value” should thus be based on quoted market prices, where available, and should take into account credit risk and future transaction costs; adjustments may be needed where there is no liquid market. “Fair value” should also take into account counterparty credit quality, market liquidity, close-out costs, and direct administrative costs. If it is thought that a quoted market price may not be achievable on account of the size of the transaction, then in determining “fair value”, the market price should be adjusted. The SORP provides that in the absence of a market price for an instrument, but where there is an active market for components of the instrument, then a price for the whole instrument may be constructed based on the prices of its component parts; the method used should be a method that has in the past given a reasonable and prudent approximation to market prices where there is an active market; where there is no market for an instrument, it should be valued according to an internal valuation model; an appropriate discount for “long” positions or a premium for “short” positions should be applied to the quoted price, where it is thought that the market price may not be achievable; this includes situations where the market is neither deep nor liquid, or the position is so big that it could not be closed out at the quoted price. If it is doubtful whether a counterparty to an off-balance sheet transaction will meet its settlement obligations, a provision should be made for this eventuality, based on the cost of replacing the transaction and the probable future movement in the cost of the transaction in the period to maturity. In practice, some banks categorise whole portfolios of instruments as either “trading” or “hedging”, to avoid the problem of having to label each transaction separately. Inland Revenue accepts that although market prices are quoted with a bid-offer spread, banks often use mid-market prices, because as active market participants they are in a position to dispose of their positions easily, while less active participants may use the lower of bid or offer prices.

As regards the recognition of derivative contracts in the balance sheets of banks, the SORP says that “trading” derivatives measured at “fair value” and should be included, if positive, in the balance sheet under “Other assets”, and if negative, under “Other liabilities”.

There is a link between a bank’s derivative contracts and a bank’s “off-balance sheet business”. The off-balance sheet business of a bank is any business of the bank that results in commitments or obligations and income expectations that are contingent on events that are outside the bank’s control, so that the business is not captured in the bank’s balance sheet under conventional accounting procedures. Several types of banking activity in relation to derivative contracts constitute “off balance sheet business” because they create contingent commitments, including swap and hedging transactions. A “contingent commitment” is one which may, but will not necessarily, lead to a balance sheet entry in the future.

The “netting” of transactions with positive values against those with negative values may only be carried out where the bank has the ability to insist on a net settlement, which is assured beyond doubt, that is, it has a legal right which would survive the insolvency of the counterparty. The SORP notes that although derivatives are largely excluded from the scope of FRS 5 Reporting the substance of transactions, the SORP recommends that the FRS 5 offsetting rules should be used to determine whether assets and liabilities arising from derivatives should be netted. According to the SORP, netting of positive and negative fair values of derivatives should be required where the bank has a legal right to offset that would survive the insolvency of the counterparty. This would include derivative contracts transacted under master and bilateral netting agreements, provided that the agreements are supported by legal opinions confirming that the netting arrangements would be enforceable under the laws of each relevant jurisdiction, and in the case of groups of companies, against each legal entity involved. The SORP says that cash collateral should also be offset, if it meets the offset criteria, and is held against identifiable transactions.

The main differences between the SORP and FRS13 are that the SORP covers credit derivatives with the exception of credit derivatives that constitute “financial guarantees”; the SORP’s definition of trading transactions includes “close-out” costs; the SORP provides that active participants should take future costs into account; and the SORP provides that credit risk maturity analysis of exposures arising from over-the-counter and non-margined exchange traded contacts by “maturity banding” should be based on replacement cost, rather than on net replacement cost.

Financial Reporting Standard 13

Under the company law of the United Kingdom, all companies incorporated in the UK must prepare their financial statements in accordance with applicable UK accounting standards. Accounting standards are developed and published in the United Kingdom by the UK Accounting Standards Board.

The accounting standard that applies to derivative contracts is FRS 13 Derivatives and other financial instruments: disclosures. FRS 13 covers only disclosures in relation to derivatives, and does not deal with the recognition or measurement of derivatives or other financial instruments. It assumes the use of some accounting practices for illustration purposes, but does not make their use compulsory.

FRS 13 Paragraph 15 requires disclosure of the company’s directors’ main financial risk management and treasury policies, including their policies on any fixed-floating split, maturity profile and currency profile of financial assets and liabilities; the extent to which foreign currency financial assets and financial liabilities are hedged to the functional currency of the business unit; the extent to which foreign currency borrowings and other financial instruments are used to hedge foreign currency net investments, and any other hedging undertaken. Paragraph 14 provides that instruments used for financing, for risk management or hedging and for trading or speculation must be disclosed separately from one another.

Paragraph 21 states that if a company uses financial instruments as “hedges”, it should describe:

A “hedge” is defined as an instrument that individually, or with other instruments, has a value or cash flow that is expected, wholly or partly, to move inversely with changes in the value or cash flows of the position being hedged. FRS 13 says that an entity may use financial assets and financial liabilities as hedges to manage its risk profile, and when it does so, the instruments should be accounted for with “hedge accounting”, under which changes in “fair value” of the hedge are not recognised in the profit and loss account immediately as they arise. Instead, they are either not recognised at all, or they are recognised and carried forward in the balance sheet. When the hedged transaction occurs, the gain or loss on the hedge is either used to adjust the amount at which the hedged item is reflected in the financial statements, or it is recognised in the profit and loss account at the same time as the hedged item. FRS 13 says that where “hedge accounting” is used for financial assets and liabilities, the following information must be provided about gains and losses on those assets and liabilities:

The required disclosures do not include gains or losses on hedges that have been accounted for by adjusting the carrying amount of a fixed asset recognised in the balance sheet. This latter rule is intended as a pragmatic response to the practical difficulties involved in recording gains and losses on hedges that have been accounted for by adjusting the carrying amount of a fixed asset, and which are then recognised in the profit and loss account through the depreciation charge.

In practice, in determining whether a transaction constitutes a “hedge” under FRS 13, three criteria must be satisfied:

A hedge may relate to a portion of the item being hedged, or only to a predetermined proportion of risks, or to a specific period of risk exposure, or to a series of exposures that result from changes in earlier positions.

In practice, where a hedge is used as part of the general management of the balance sheet, and relates to an aggregate of groups of assets and liabilities, and not to individual underlying items, it is referred to as a “general hedge”. A “rolling hedge”, on the other hand, is a hedge of the ongoing risk of a series of underlying items. The period of a hedge instrument usually extends at least to the date on which it is anticipated that the underlying item will mature, because if the hedge expired before that date, there would be a period during which the underlying risk would not be hedged, which would be the period from the date on which the hedge transaction was closed out to the date on which the underlying item matured. To deal with this situation, a single hedge can be replaced with a succession of hedging instruments. If the underlying item is terminated, the hedge instrument no longer qualifies as a hedge, it must be valued at “fair value” immediately, transferred to the company’s “trading portfolio”, and any profit or loss that results from valuing it at “fair value” must be recognised in the profit and loss account immediately. However, if the hedge merely ceases to be effective, or it is replaced by a more effective hedge, and the underlying item is retained, the hedge must still be valued and transferred to the trading portfolio, but the resulting profit or loss must be amortised over the remaining period of the hedged item.

A range of interest rate disclosures are required by FRS 13. These are that the aggregate carrying amount of financial liabilities must be analysed, by principal currency, showing those liabilities that are at fixed interest rates, those at floating interest rates, and those in respect of which no interest is payable. This implies that interest rate swaps, currency swaps, forward contracts and other derivative contracts the effect of which is to alter the interest or currency basis of the company’s financial liabilities must be disclosed.

For example, if a company has contracted a floating rate loan and has also contracted an interest rate swap that has the economic effect of replacing the floating rate borrowings with a fixed rate borrowing, the borrowings should be disclosed as a fixed rate borrowing.

Reclassifications may be accounted for in a number of ways, but FRS 13 only requires disclosure to the extent that gains and losses that arose in previous accounting periods are recognised, on reclassification, in the profit and loss account. FRS 13 thus states that if a financial asset or financial liability was previously accounted for as a hedge, and it is reclassified and is no longer a hedge, and as a result gains or losses that arose in previous accounting periods have been recognised in the current period’s profit and loss account, those gains and losses should be disclosed.

FRS 13 provides that the “fair value” of a “financial asset” or “financial liability” must be disclosed, irrespective of whether it is held as a hedge. But if an item is a hedge, then according to FRS 13 it may be useful to indicate the link between the hedge and the hedged item, and to explain whether the “fair value” of the hedged item is also disclosed. If the estimated difference between the carrying amount of a financial asset or financial liability and its “fair value” is not material, the carrying amount may be taken to be the “fair value”. If the financial asset or liability is unique and there are no comparable instruments in existence and its future cash flows are difficult to predict reliably, then its “fair value” need not be disclosed.

FRS 13 defines “fair value” in relation to a financial asset or financial liability as the amount at which that asset or liability could be exchanged in an arm’s length transaction between informed and willing parties, other than in a forced or liquidation sale. Underlying the concept of “fair value” is the presumption that the entity is a “going concern’ and has no intention of or need to liquidate or wind up its operations, or undertake any transactions on adverse terms.

For example, if the entity is able to dispose of a large position in an orderly way over a period of time, and therefore does not have to accept a discount to the market price, the quoted market price will be the “fair value”.

The entity’s subjective circumstances should be taken into account in determining the fair values of its financial assets and financial liabilities.

For example, if the entity has committed to sell an asset for cash in the immediate future, the “fair value” of that asset is the amount that the entity expects to receive from the sale.

“Fair value” may of course also be based on market information. There are four kinds of markets in which financial instruments can be bought, sold, or originated, and the information regarding market prices varies from market to market:

FRS 13 says that quoted market prices are usually the best evidence of “fair value” of financial instruments. If more than one quoted market price is available, the price in the most active market for transactions of the relevant size should be used. When no current bid and offer prices are available, the price of the most recent transaction may provide evidence of “fair value”, provided that there has been no significant change in economic circumstances between the transaction date and the reporting date. If activity in the market is infrequent, if the market is not well-established, or if traded volumes are small relative to the total number of instruments in use in the market, then quoted market prices may not reflect the “fair value” of the instrument. Or if there is no quoted market price, “fair value” may have to be estimated. Methods of estimating “fair value” include by reference to the current market value for a similar instrument, discounted cash-flow analysis, and option pricing models. One method of applying discounted cash flow analysis is to discount the cash flows at a rate equal to the prevailing market rate of interest for similar financial instruments.

Where the determination of “fair value” is problematic, a range of amounts within which the fair value of the instrument is reasonably believed to lie should be disclosed. For some short-term financial instruments, the carrying amount in the financial statements may be taken to be the fair value, because of the short time between origination and realisation. Some financial instruments, for example, interest rate swaps and foreign currency contracts, may be customised and may therefore have no quoted market price. It may be possible to estimate fair value from quoted market prices of similar instruments, adjusted to take account of such customisation. Alternatively, the fair value estimate may be based on the estimated current replacement cost of the instrument. For customised options, a number of option pricing models can be used, and the use of such models to estimate “fair value” is permissible under FRS 13.

With regard to banks, FRS 13 states that the a bank’s “trading book” comprises all the assets and liabilities held or issued as part of its trading in financial assets and financial liabilities. A bank’s assets and liabilities that are not held in its trading book are “non-trading book assets and liabilities”.

FRS 13 observes that the “trading activities“ of a bank include:

A bank’s “non-trading book” comprises all of the assets and liabilities that are not in the trading book, including structural and strategic positions. A bank’s “non-trading activities” consist of:

FRS 13 requires a bank to disclose derivative financial instruments whose effect is to alter the interest basis of “non-trading book assets and liabilities”. The background to this requirement is that a significant dimension of interest rate risk arises from the currency in which assets and liabilities are denominated.

For example, a floating rate asset and a floating rate liability denominated in different currencies might not appear to create an interest rate sensitivity gap, if their current sterling equivalent and repricing dates are the same. There may, however, be significant interest rate exposure if one item is denominated in the currency of a country with high and fluctuating interest rates, while the other is denominated in the currency of a country with low and stable interest rates. The accounts should disclose the significance of such instruments for the bank’s non-trading book interest rate risk, including disclosure of notional principal amounts, the period for which the instruments are operative, and the terms of options contained within the instruments.

In practice, for purposes of income recognition, FRS 13 recognises a difference between derivative instruments that are realisable immediately for cash, and instruments that are not. Where the “fair value” of an instrument has been determined, and the result is a profit or a loss, that profit or loss should be recognised immediately. If a profit or loss is not realisable for cash until maturity, however, the anticipated cash flows should be discounted to net present value. Portion of the net present value of the anticipated future profits is then spread over the remaining life of the transaction in order to cover risks and to match costs of maintaining capital and administering transactions. Income generated by trading instruments is taken to form part of “dealing profits’. Income generated by hedging instruments takes the same character as income generated by the underlying item. Even though a derivative instrument may be recorded off-balance sheet, any unrealised profit or loss resulting from “marking it to market” is included in the balance sheet, under “other assets” or “other liabilities”.

International Accounting Standards

International accounting standards (IASs) issued by the International Accounting Standards Committee and International Financial Reporting Standards issued by the International Accounting Standards Board, do not have any authority within a particular country, unless that country chooses to adopt them. In the United Kingdom, the provision of international standards are supported, with some exceptions, either by incorporation into legislation or into UK accounting standards, but they are not binding. Since 2005, all EU listed companies have been obliged to prepare their consolidated financial statements using IAS instead of national GAAP.

International accounting standards that are relevant to accounting for derivative contracts are IAS 32 and IAS 39. IAS 32 Financial Instruments: Disclosure and Presesntation deals with the classification of “liabilities” and “equity”, and the presentation of interest, dividends and gains and losses on redemption or refinancing, as well as the conditions under which financial assets and financial liabilities can be offset. It covers the disclosure of off-balance sheet and derivatives exposure, in the case of derivatives, mainly in respect of market risk. IAS 32 also requires the disclosure of information about the extent and nature of the financial instruments held by a company, its accounting policies, its exposure to interest rate risk, the maximum permissible credit risk and credit risk concentrations, the “fair value” of each class of financial asset and liability, assets carried at a value in excess of fair value, and details of hedges and of anticipated future transactions.

IAS 39 Financial Instruments: Recognition and Measurement deals with the recognition, derecognition and measurement of financial instruments, including derivatives. It establishes rules for derivatives, limits the use of hedge accounting, and requires derivative instruments to be recognised on the company’s balance sheet at “fair value”. It provides that gains and losses arising from changes in the “fair value” of derivatives should be recognised in the profit and loss account, except where hedge criteria are satisfied. The basic principles of IAS 39 are the “marking to market” of “trading transactions”, and the accounting for hedges in line with the accounting treatment of the item being hedged. It also contains rules for determining when a derivative transaction will qualify as a hedge.

CCAB Technical Report TR 556

The 1984 technical report of the Consultative Committee of Accountancy Bodies, TR 556 Distributable Profits of Banks and Deposit Taking Institutions is relevant to accounting for derivative contracts as it deals with the circumstances in which profits are accepted as having been “realised” for accounting purposes. The Report states that the nature of banking business is such that application of GAAP to banking transaction profits would result in their being regarded as “realised” in circumstances in which such a conclusion would not necessarily apply to other companies.

The report divides the investments of a bank into a number of categories. A bank’s “portfolio investments” are said to consist of fixed and variable interest rate securities and equities, held for investment purposes and to support the bank’s trading activities. For accounting purposes, portfolio investments are to be shown at cost, adjusted for amortisation to maturity of discounts or premiums; or at cost less any permanent diminution in value; or at the lower of cost and market value. Valuation at cost, adjusted for amortisation is regarded as an acceptable accounting practice, because it conforms with the “accruals” concept, by aggregating interest with the proportion of the discount or premium that relates to it. “Write-ups” of portfolio investments resulting from the amortisation of discounts or from the reversal of prior write-downs, are to be taken to the profit and loss account, and can be regarded as “realised” profits. A bank’s “infrastructure investments’ are defined as its investments in subsidiary and associated companies, and trade investments, and the accounting treatment is the same as for non-bank companies. A bank’s “trade investments” that are held for the long term, are to be carried at cost less provision for any diminution in value, but can be revalued.

The Report says that it might be appropriate for a bank’s “dealing assets” to be valued at market value or at the lower of cost and market value, regardless of maturity date. Surpluses arising under either method can form part of “realised profit”. “Forward foreign exchange” is to be given the same treatment as other dealing positions, and profits resulting from the valuation process can be regarded as “realised”. In relation to a bank’s financial futures contracts, the Report says that profits and losses on open trading contracts, determined by reference to market value, can be regarded as “realised”, whereas those on hedging contracts should be suspended and matched with the charges or revenues that they were intended to hedge. Foreign currency dealing investments can be carried in foreign currency at market value or at the lower of cost and market value, and translated into sterling at the closing rate of exchange, and exchange adjustments arising from translation could form part of the period’s “realised profits”. Foreign currency portfolio investments can be carried in foreign currency at market value or at the lower of cost and market value, and translated into sterling at the closing rate of exchange, and exchange adjustments arising from translation can form part of the period’s “realised profits”. Foreign currency portfolio investments can be carried in foreign currency at cost adjusted for amortisation to maturity of discounts or premiums, or at cost less any permanent diminution in value, or at the lower of cost and market value. Portfolio investments which were funded by foreign currency, are to be translated into sterling at the closing rate, and resulting exchange adjustments may be regarded as “realised”. In the case of pools, where portfolio and infrastructure investments are regarded as being financed out of an overall pool of foreign currency and funds, and it is not possible for specific liabilities to be identified with specific assets, the overall exchange adjustments on foreign currency assets and liabilities can be taken to the profit and loss account and regarded as &ldqu;realised”.

ASB Discussion Paper

The Accounting Standards Board’s Discussion Paper Derivatives and other Financial Instruments issued in 1996, proposed that financial instruments should not be measured on an historical cost basis, but rather at “fair value” or “current value”.

The Paper noted that financial instruments were at that time being measured in several different ways, with “historical cost accounting” being the most widely used method, with some use of “current value” accounting. The Paper expresses the view that “historical cost accounting” is not suitable for all financial instruments, because only the initial outlay on the instrument is recorded in the accounts, until the instrument is realised by sale or payment of a cash flow, with unrealised gains and losses resulting from interim changes in value being ignored. This situation, says the Paper, gives rise to the following problems:

The Paper accordingly proposed that all financial instruments should be measured at “current value”, and all gains and losses recognised as they occur, with some changes in value being reported in the profit and loss account, and others in the Statement of Total Recognised Gains and Losses.

The Paper makes a number of observations about hedge accounting. It says that hedge accounting had developed as a practice whereby gains and losses on an instrument that was characterised as a “hedge” were deferred, and included in the profit and loss account in the same period as those on the “hedged position”. Under hedge accounting, the hedge has to be linked to the hedged position on a one-to-one basis, and the purpose of the hedge is to reduce the risk associated with the hedged position. Hedge accounting is used to deal with measurement anomalies, recognition anomalies, and uncontracted future transactions. An example of the use of hedge accounting to compensate for “measurement anomalies” occurs where a company that owns shares concluded a forward contract to protect against a fall in the value of the shares. Under hedge accounting, gains and losses on the forward contract, whether realised or unrealised, are omitted from reported profits until the shares were sold and any loss or gain on their disposal was recognised. Without the use of hedge accounting, if the shares are recognised at cost and the forward contract is recognised at current value, a gain on the shares would be ignored, while an offsetting loss on the forward contract would be recorded. The result would be that the company’s accounts would show volatile profits and a non-existent risk. The use of hedge accounting corrects for the measurement anomaly that arises where a derivative, measured at current value, was used to hedge an asset or liability that was measured at cost. “Recognition anomalies” occur where a company hedges its commitment under a fixed price contract.

For example, a company that has an operating lease in a foreign country might be obliged to pay rentals in foreign currency; it may be concerned that the exchange rate might weaken and cause the sterling cost of the rentals to increase, and for this reason it might conclude a foreign currency forward contract to protect against the risk. In other words, the lease creates a liability that fluctuates in amount as exchange rates change. Under historical cost accounting, any gains and losses on the lease are not recognised.

Hedge accounting is used to defer any gain or loss on the forward contract until the period in which the lease rentals are recorded as an expense. Hedge accounting thus compensates for the recognition anomaly that arises where gains and losses on a derivative mitigate losses and gains on an asset or liability that are not recognised. Hedge accounting is also used in order to hedge uncontracted but anticipated future transactions.

For example, if a company anticipates that in a future period it will make sales denominated in foreign currency, in order to protect itself from a strengthening in the exchange rate which would have the effect of reducing the sterling value of future sales, it contracts a forward foreign currency contract in order to “lock in” the current exchange rate. At the end of the period, there might be a gain or loss on the hedge, although the transaction being hedged would not yet have occurred. Under hedge accounting, any gain or loss on the hedge would be deferred and recorded in the profit and loss account, in the subsequent period to that in which the hedged sales occurred. The company would therefore be hedging an uncontracted future transaction.

The use of hedge accounting in this case does not compensate for an anomaly in the accounting framework, but reflects the recognition by management that the business is a “going concern” and the foresight of management in looking beyond the historic transactions in the accounting to the future cash flows that the business will generate.

The discussion paper identified the following problems caused by hedge accounting:

The discussion paper identified four options for the execution of hedge accounting:

As regards “historical cost accounting”, the Paper says that its advantages are that it is widely used, it is familiar, and there is the argument in its favour that it reflects actual transactions and actual costs that have been incurred, it results in a profit profile that is smoother and easier to predict, it does not take into account unrealised gains and losses, and it avoids valuation problems. The drawbacks of historical cost accounting are that it is liable to the criticism that it does not show the true nature of transactions or real gains and losses, that it disguises results that are truly volatile, that it delays real volatile disclosure until the asset is realised, that it allows the entity to control the volatility of its reported profits by choosing when to realise and thus report gains, and losses; and unrealised gains and losses resulting from changes in the value of instruments are ignored, while under “current value accounting” unrealised gains and losses are accorded the same importance as realised gains and losses. The Paper notes that the proponents of current value accounting argue that realisation is not an appropriate event for reporting gains and losses on financial instruments, because of the ease with which gains and losses can be realised, often only requiring a telephone call; in other words, realisation is not an economically significant event. This is clear for instruments that are traded in a liquid market, but even in relation to untraded instruments, such as fixed rate borrowings that cannot be redeemed easily, gains and losses resulting from movements in market prices can be realised in cash by using derivatives to “lock into or out of” the current market price.

For example, if a company has fixed interest rate borrowings, and market interest rates rise, the company can realise its gain by concluding a swap at off-market rates, and under the swap it would receive the fixed rate of interest payable on the borrowing and would pay floating rates, in return for an up-front premium.

It was argued that basing the recognition of profit on “realisation” allows a company to manage reported profits by deciding which gains and losses to realise, for example, by selling financial instruments in a bad profits year in order to increase reported profits. It was also argued that it is not always clear when realisation occurs, for example, the payment of margins on a futures contract could be regarded as “realisation”, or alternatively, “realisation” could be regarded as occurring when the futures position is “closed out”, or it could be said because of the ease with which financial instruments can be sold, that all gains and losses on them should be regarded as “realised”.

The Paper says that historical cost accounting does not take account of the incidence of “active risk management”, which involves the purchase and sale of instruments in response to changes in market price and market views. Instead of passively holding instruments to maturity, associated risks are actively managed by the use of derivatives or the sale of the instrument.

For example, where a company with fixed rate borrowings believes that interest rates will fall, and it enters into an interest rate swap agreement in order to convert its borrowings to floating rate borrowings, and if rates do fall, the company could “close out” some or all of the swap positions, thereby realising a gain, in the belief that rates are about to rise. The company could repeat this process many times, each time adjusting its interest rate position in response to movements in rates and views about the direction of the market for loans.

Historical cost accounting also creates a need for hedge accounting, whereby the recognition of gains and losses on a hedge are deferred until the period in which the gains and losses on the hedged position are recognised. If financial instruments are measured at current values, the need for hedge accounting diminishes.

The advantages of “current value accounting” identified by Paper are that current values reflect economic events of the current year, but not those of other years – they isolate events of the current accounting period from those of prior accounting periods. Current values are the best measure of the company’s financial position at the year-end – they provide an up-to-date measure of its position. Current values overcome the problem of derivatives that have a nil cost not being recorded in the books at all, under historical cost accounting. Current values reported corporate decisions to buy and hold financial instruments as and when those events occur. Current value accounting is the best way to predict future cash flows, because it represents a contemporary view of the value of contracted future cash flows. They reflect the market’s current assessment of amounts of contracted cash flows, discounted to take account of current interest rates and risk that contracted cash flows will not occur. Current values are used to monitor credit risk, because they reflect the economic loss to a company of the default of a counterparty, namely, the cost of replacing the instrument. Moreover, current values are even more critical for financial instruments than for non-financial assets and liabilities. The reasons for this are that financial instruments are close to cash and are really contracts for cash flows; physical assets, on the other hand, have no direct identification with specific contracted cash flows, and only generate cash indirectly. For example, trading stock must be sold in order to generate cash; plant and machinery must be used to produce goods which must then in turn be sold. A drawback of current value accounting is that for most companies, assets are likely to be non-financial, and measured on a cost basis, while liabilities are likely to be financial instruments. The valuation of financial instruments with current value accounting would result in the measurement of assets and liabilities in different ways.

Hedge accounting, says the Paper, is a special accounting treatment that alters the normal accounting for a hedge, so that gains and losses on it are included in the profit and loss account in the same period as the gains and losses on the hedged position. Hedge accounting is used in one of three situations:

The Paper points out that if financial instruments are measured at “current value”, the need for hedge accounting to deal with measurement differences would disappear, and all gains and losses would be recorded as they occur. But hedge accounting would still be relevant for future transactions, namely those occurring to correct for recognition differences, and those connected with existence differences.

The Paper accordingly lays down criteria aimed at limiting the use of hedge accounting, and preventing its abuse. The criteria are:

As regards the actual accounting for hedges, and assuming that hedge accounting is indeed used, the Paper favours one of two methods:

Under both methods, derivatives regarded as “hedges’ would be clearly visible and recorded at their current value in the balance sheet, while deferred gains or losses would be clearly disclosed.

In the event of hedge accounting not being used, the Paper proposes the following forms of disclosure: hedges should be measured like other financial instruments at current value, with gains and losses being reported in the profit and loss account as they arise. The company’s operating and financial review or a note to the accounts should then explain gains and losses reported in the current year that the company believed mitigated risks that it expects to arise on future transactions. Disclosure would show both gains and losses reported in the current year that relate to hedges of future years’ transactions, and gains and losses reported in any previous year that relate to hedges of current year transactions. The calculation would be: profit (as reported in the profit and loss account) less gains reported in profits that relate to hedges of future transactions, plus gains included in prior years’ profits that relate to hedges of current year’s transactions = “adjusted hedged profit or loss”.

Where future transactions are hedged, companies should be required to disclose a description of those transactions; the time period that is expected to elapse before they would occur; a description of the instruments used to hedge them; and in relation to gains and losses included in the current year’s profits that relate to hedges of future transactions, the expected time when they will be recognised in “adjusted hedged profit or loss”.

With regard to the estimation or determination of current values, the Paper says that the main methods of determining them are:

The Paper observes that for many forms of financial instruments, current value would be similar to cost, and in such cases cost could be used as an estimated value. All financial instruments should be measured on a current value basis, using a best estimate where valuation was problematic.

The valuation principles set down in the Paper in relation to derivatives include the following: either a quoted price is to be used, where it is available (bid price for an asset, offer price for a liability, and mid-market price where the company is an active market participant); where there is more than one quoted price, the price in the most active market for transactions of the relevant size should be used; or current value should be estimated based on quoted prices of similar instruments (adjusted to take account of instrument-related differences), or technical valuation models such as discounted cash flow analysis or accepted option pricing models should be used to fix value. Where discounted cash flow analysis is used, the rate should be a risk-adjusted rate, taking into account where practicable the prevailing market interest rate for an instrument with the same terms and conditions, including term, currency, the time for which the interest rate is fixed, prepayment risk, and in the case of an asset, the debtor’s creditworthiness.

JWG Consultation Paper

The Consultation Paper of the Joint Working Group of Standard-Setters Financial Instruments and Similar Items issued in 2000 proposed that all financial instruments, including derivatives, should be recorded in financial statements at “fair value”. The main proposals in the Paper are:

The Paper notes that the basis on which a company recognised income and expenditure had a direct effect on its tax liability. The tax issue was the timing differences between the receipt of income and the incurring of the expenses necessary to generate that income. The Paper recalls that there is an overriding Companies Act requirement that only “realised” profits can be included in the profit and loss account, and a sub-rule that a company should ensure that there is “matching” of income with related expenses and rewards for risk, with the period to which it relates. But, says the Paper, matching cannot be applied where it leads to the creation of balance sheet assets and liabilities which cannot be supported in their own right, for example, a “provision for likely costs”, which does not represent a definite obligation.

For banks, “matching” could result in both theoretical and practical difficulties. Unless dealing positions are “marked to market”, says the Paper, the choice when to sell assets or “close out” positions could significantly affect the allocation of profit between accounting periods. The aim of the SORPs and FRS 18 Accounting Policies was to achieve greater consistency in income recognition by banks. A bank is also obliged to have regard to the “substance over form” principle, which is an application of the fundamental principle of FRS 5 Reporting the substance of transactions that a company’s financial statements should report the substance of the transactions to which it was a party. In other words, transactions are to be presented in accordance with their economic reality, so as to reflect the nature and motives of each operation, rather then their mere legal form. With the use of “mark to market” accounting, value adjustments to a bank’s dealing instruments should be taken immediately to the profit and loss account.

The Paper notes that there are different views about whether profits determined on a ”mark to market” basis constitute “realised profits” for accounting purposes. The background to this issue is that Companies Act 1985 Schedule 9 paragraph 19(a) provides that only profits that are “realised” at the balance sheet date are to be included in the profit and loss account, and that Companies Act 1985 section 262(3) states that “realised profits” are those profits that are determined in accordance with UK GAAP. The Paper says that the profit arising from the revaluation of a security is generally accepted to be “realised” for purposes of the Companies Act, and that this acceptance is based on three source authorities:

A non-banking company, however, could only adopt “mark to market” accounting for securities, by invoking the “true and fair override”. The Paper points out that most securities traders apply mark to market accounting and the BBA SORP on Derivatives recommends it for the securities trading subsidiaries of banks.

As regards hedge transactions, the Paper says that the application of hedging criteria might cause an instrument that would otherwise have been marked to market, to be carried instead at cost, with a corresponding effect on the profit and loss account. The categorisation or otherwise of off-balance sheet instruments as “hedges” could thus cause distortion in income recognition. The Paper contains proposals on hedge accounting, which if implemented, would cause most hedge accounting to disappear, because under the proposals, all financial instruments would be carried at “fair value”, and all gains and losses would be recognised immediately. The Paper also proposes a total ban on hedges of unrecognised anticipated future transactions.

ICAEW Technical Report 25/00

The ICAEW Technical Report Tech 25/00 The Determination of Realised Profits and Distributable Profits in the Context of the Companies Act 1985, states as a basic principle that “realised profits” are mainly those which comprise cash or other assets the ultimate cash realisation of which can be assessed with reasonable certainty. An amount receivable is to be recognised if the debtor is capable of settling the receivable within a reasonable period of time, and will be capable of settling when called upon to do so, unless there is an intention or expectation that the receivable will not be settled.

The Report points out that SSAP 2 Disclosure of Accounting Policies had said with regard to “realised profits and losses” that as “revenue and profits are not anticipated, but are recognised by inclusion in the profit and loss account only when realised in the form of either cash or of other assets the ultimate cash realisation of which can be assessed with reasonable certainty . . . provision is made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is a best estimate in the light of the information available.” FRED 21 Accounting Policies acknowledged the “cash realisation” test of SSAP 2, but concluded that “the description of realisation in SSAP 2 is itself now out of date, since markets have developed so that it is often possible to be reasonable certain that a gain exists, and to measure it with sufficient reliability, even if no disposal has occurred.”

The Report says that the concepts of “realised profit” and “realised loss” have been developed from SSAP 2. Thus “realised profits” are mainly those which met the criterion of “cash or other assets the ultimate cash realisation of which can be assessed with reasonable certainty.” But the Report says that this statement recognises that there had been changes in the financial and economic environment, as well as in GAAP, since the issue of SSAP 2, and therefore the concept of “realisation” had been extended to include “marked to market” gains as realised profits in certain circumstances. A profit was “realised” only when it arises from a transaction where the consideration received by the company is “qualifying consideration”; or an event which results in “qualifying consideration” being received by the company; or as consideration received by the company previously becomes “qualifying consideration”, or the use of the “mark to market” method of accounting for current assets and liabilities; or the translation of a monetary asset or liability denominated in a foreign currency.

The Report said that “realised losses” constitute all losses that are regarded as realised losses, except where the law, accounting standards, or the technical statement provide otherwise. The Report includes as an “instance of realised loss” a loss arising from the use of the “mark to market” method of accounting for current assets and liabilities. As regards the concept of “profit”, the Report says that it comprises “gains” as defined in the Accounting Standard Board’s Statement of Principles for Financial Reporting, as well as other amounts that are treated in law as profits. Consideration that constitutes “profit” is defined as cash, or a current asset for which there is a liquid market, or the release of all or part of a liability of the company, or the settlement or assumption by a third party of all or part of a liability of the company; or an amount receivable in any of the aforegoing forms of consideration, where the amount is capable of being measured reliably, and the debtor is capable of settling the receivable within a reasonable period of time and would be capable of settling when called upon to do so, unless there is an intention or expectation that the receivable will not be settled. The expression “current asset for which there is a liquid market” is described by the Report as an active market, evidenced by frequent transactions, that exist for that asset, or an asset that is capable of being readily disposed of without negotiation at a readily ascertainable price and without curtailing or disrupting the business, provided that the market has sufficient depth to absorb the asset without a significant effect on the amount at which the asset is recorded.

With regard to hedging, the Report says that where a hedged asset or liability and a hedging instrument are accounted for as a “hedge”, that is, effectively as a single asset or liability, the treatment as “realised” of any profit or loss is determined in accordance with criteria in the report, solely by reference to the net exposure on the hedged asset or liability.

FRED 23

FRED 23 Financial Instruments: Hedge Accounting, released in 2002, proposes the introduction of an accounting standard that would establish definite principles for the use of hedge accounting in relation to financial instruments. The FRED defines a “hedge” or “hedging transaction” as a contract that has a value or cash flow that is expected to move inversely with changes in the value or cash flows arising from another contract or exposure, called the “hedged item”, the net effect of which would be to mitigate some or all of the risk associated with the hedged item.

FRED 23 proposes that a financial instrument should only qualify for hedge accounting if it is held as a “hedge instrument” in a hedge that meets both “hedge relationship criteria” and “hedge effectiveness criteria”. The proposed “hedge relationship criteria” are that at the inception of the hedge, there is formal documentation of the hedging relationship and the company’s risk management objective and strategy in undertaking the hedge. Such documentation should include identification of the hedging instrument and the related hedged item, the nature of the risk being hedged, and an explanation of how the company will assess the effectiveness of the hedge. The effectiveness of the hedge must be capable of being reliably measured, and if a forecast or anticipated transaction is being hedged, it must be highly probable and represent an exposure that could impact reported profit or loss. The “hedge effectiveness criteria” are that the hedge must have been expected at the outset to be highly effective in achieving the hedging objective, and that it has been assessed on an ongoing basis and determined to have actually been highly effective throughout the financial reporting period.

Where hedge accounting is applied, FRED 23 proposes that any ineffective portion of the gain or loss on the hedging instrument should be recognised immediately in the profit and loss account. A hedging instrument will cease to qualify for hedge accounting if the hedge no longer meets the hedge criteria, or if the hedging instrument expires, or is sold, terminated or exercised. When that occurs, any gain or loss on the hedging instrument is to be recognised in the profit and loss account.

FRED 30

FRED 30 Financial Instruments: Disclosure and Presentation, Recognition and Measurement, issued in 2002, proposes the withdrawal of FRS 13 and the introduction of two new accounting standards based on IAS 32 and IAS 39.

FRED 30 defines the term “derivative” as a financial instrument or other contract which has the following characteristics:

With regard to the measurement of derivatives, FRED 30 proposes that companies that elect to apply “fair value’ accounting rules be required to measure derivatives at “fair value’, and recognise immediately in the profit and loss account all changes in the “fair value’ of financial instruments. Two types of hedge are identified in FRED 30: “fair value hedges” and “cash flow hedges&rdqo;. With regard to hedge accounting, FRED 30 proposes that gains and losses on cash flow hedging instruments should be reported on the balance sheet amongst assets and liabilities, and should be described as “gains and losses arising on effective cash flow hedges not yet recognised in the profit and loss account”, until the hedge matures.