CFM24010 - Accounting for corporate finance: derivative contracts: introduction

Introduction

Since the 1970s, the use by companies of derivative contracts and instruments to manage financial risk has become increasingly common (see more background in CFM13000).

In addition, many financial (and other) institutions now use derivative financial instruments for trading or speculative purposes. The use of derivatives can result in large losses due to the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the price of the underlying asset. However, investors could also lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets.

These developments have presented a major worldwide challenge to accounting authorities and to traditional accounting practices. Historically in the UK, company legislation was based on the historic cost accounting model and the revenue realisation principle - both of which had their roots in manufacturing industry.

This guidance looks at how accounting standards in this area developed in the UK, what those standards were, and how the position has changed as a result of the adoption of International Accounting Standards (IAS).

For guidance on when and in what circumstances IAS are adopted see CFM20010.

Guidance on how IAS has affected the accounting treatment of derivatives is at CFM24200+.

The focus of the guidance is on entities which are not financial institutions and on the use of derivatives to manage risk, rather than for speculative purposes.