CFM57290 - Derivative contracts: hedging: Regulation 9: interest rate contracts
Regulation 9: interest rate contracts
As with currency contracts (CFM57080) and commodity contracts (CFM57200) IAS 39 requires interest rate contracts to be brought into account at fair value, either through the profit and loss account, or where the restrictive rules for showing that there is an effective cash flow hedge are met, through the statement of changes in equity or similar statement.
Under UK GAAP as it applies for 2004 and earlier periods, interest rate contracts are usually kept ‘off balance sheet’, often by being combined with the hedged item, usually a loan, to create a ‘synthetic’ asset or liability.
Under this type of accounting only periodic payments due under the contract are brought into account as part of the ‘interest’ gain or loss on the synthetic item. Where the contract is a forward contract then a premium or discount on entry into the contract may be brought into account over the period of the contract, and in the case of a cross currency swap, exchange gains and losses will be recognised when the contract is retranslated at balance sheet dates.
For example, a company may have borrowed money at a rate of interest linked to LIBOR, but at the same time have entered into an interest rate swap under which it receives variable rate payments and makes fixed rate payments (see CFM13320). In effect, the company has converted variable rate borrowing to fixed rate borrowing. A very common method of accounting for such an arrangement under ‘old’ UK GAAP is to show the loan as a liability on the balance sheet, but not to recognise the swap separately. In the profit and loss account, the net payments made or received by the company under the swap are amalgamated with the actual interest payments, so its overall finance cost consists of the fixed interest rate plus any margin taken by the bank on the swap.
In broad terms, Regulation 9 allows a company to continue to use this type of ‘synthetic liability’ accounting (or ‘synthetic asset’ accounting where a creditor loan relationship is hedged) for tax purposes. It achieves this by disregarding any fair value profits or losses on a company’s interest rate contracts, and instead applying an ‘appropriate accruals basis’. Any credits or debits arising from amounts being ‘recycled’ from equity to profit and loss account (see CFM57280) are also disregarded.
‘Interest rate contract’ is given a broad meaning by Regulation 9 and includes, for example, cross-currency swaps. CFM57300 deals with the scope of Regulation 9, and CFM57310 with the meaning of ‘interest rate contract’.
CFM57320 looks at what is meant by an ‘appropriate accruals basis’.
CFM57330+ gives examples of the operation of Regulation 9.
