CFM57010 - Derivative contracts: hedging: introduction

Introduction to hedging

This guidance applies to periods of account beginning on or after 1 January 2005

IAS 39 and FRS 26 require all derivative contracts to be accounted for using fair value accounting (see CFM20000+). Under UK GAAP, for entities not applying FRS 26 it was (and remains) common for derivative contracts that were hedging one or more risks of an asset, liability or transaction, to be ‘off balance sheet’. The asset, liability or transaction being hedged by the derivative, and the derivative itself, may have been accounted for as a single item. For tax purposes, this equated to accounting for the derivative contract on an authorised accruals basis.

‘Off balance sheet’ accounting was particularly used where a company wished to hedge a future transaction. For example, an aerospace manufacturing company is likely to have most of its revenues in US dollars. It can anticipate the likely receipts over a future period and may wish to hedge its exchange rate risk by taking out a forward currency contract. Under ‘old’ UK GAAP, it would not recognise such contracts in its balance sheet. But when the sales revenues were received, they may be booked using the exchange rate implied in the forward contract, not the spot rate ruling at the date of the transaction. Any gain or loss accruing between the date the contract was entered into and the date of booking would be automatically included in the sales revenue.

Similarly, a company using an interest rate swap to convert floating rate borrowing into fixed rate would not, under ‘old’ UK GAAP, show the swap in its balance sheet. It would simply show an interest cost in its accounts that equated to the cost of fixed rate borrowing.

In contrast, under FRS 26 or IAS 39 all derivatives are on the balance sheet even if they are accounted for as a hedge. Hedge accounting is only possible where strict conditions, particularly as to the effectiveness of the hedge, are met - see CFM27000+.

Companies may in consequence be exposed to considerable volatility in their taxable profits because of fair value changes in derivatives. This can happen not only where the conditions for hedge accounting are not met, but even in cases where they are. CFM57020 illustrates the potential problem in relation to a cash flow hedge: the basic rule in CTA09/S595(2) brings all fair value movements on the derivative into tax, even where the impact of such changes on the profit and loss account is deferred by initially taking fair value changes to equity.

Regulations were laid in December 2004 to address these problems by modifying the tax treatment of derivative contracts in certain cases where they function as a hedge. Broadly, the modifications aim to restore the position under ‘old UK GAAP’. These regulations are the Loan Relationships and Derivative Contracts (Disregard and Bringing into Account of Profits and Losses) Regulations 2004 (SI 2004/3256), a title commonly shortened to ‘the Disregard Regulations’. These have been modified by amending regulations on several occasions (SI 2005/2012, SI 2005/3374, SI 2006/3236, SI 2007/948, SI 2007/3431 and SI 2009/1886) taking effect from different dates.