138 - Accounting for Derivatives

8/7/2019 138 - Accounting for Derivatives

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By :Chetna V. Popatkar

Division A, Roll No.0138.


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Agenday Definition of Derivatives

y Types of Derivatives

y Methods of accounting for derivativesy Indian practices

yAccounting at the year end

yAccounting as per IFRS standards

y Conclusion


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DEFINITIONy Derivatives are financial products, such as futures

contracts forward contracts, options, and swaps are the

most common types of derivatives. Since derivativesare contracts, almost anything can be used as aderivative's underlying asset which could be stocks,bonds, commodities, currencies, interest rates, and

market indexes.y Derivatives generally are used to hedge risk but also

can be used for speculative purposes.


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TYPES OF DERIVATIVESy Futures contract

Is a standardized contract between two parties to buy orsell a specified asset (eg. oranges, oil, gold) of standardized

quantity and quality at a specified future date at a priceagreed today (thefutures price). These contracts are tradedon a futures exchange.

y Forward contract

A contract that specifies the price and quantity of an assetto be delivered in future .Forward contracts are tradedover the counter.


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y Option

A financial derivative that represents a contract soldby one party (option writer) to another party (option

holder). The contract offers the buyer the right, butnot the obligation, to buy or sell a security or anotherfinancial asset at an agreed-on price during a certainperiod or on a specific date.

y Swap

A swap is an agreement between two parties toexchange future cash f lows. A contract in which twoparties agree to exchange periodic interest payments.


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METHOD OF ACCOUNTING FOR DERIVATIVES

y When one enters into a derivative contract, the main issues

relating to its accounting are its recognition, classification,impairment, de-recognition and hedging. Henceaccounting for derivatives is laid as per accountingstandards of ICAI and as per IFRS accounting standards.


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y 1.Derivatives of one year whichcomplete/terminate/expire in subsequent year wouldnot be recorded at all and would remain off balance

sheet items.y 2. On marked-to-market basis: An initial margin is

paid and at the end of each trading day, the marginaccount is adjusted to reflect the gain/loss on a dailybasis.

y 3. When there is a loss due to an unfavorable pricefluctuation of an asset, which is hedged using aderivative is compensated by a profit . This method isonly used for hedging.


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INDIAN ACCOUNTING PRACTICESy Daily Mark to Market

Every evening, the closing price would be compared

with the closing price of the previous evening andprofit or loss computed by the exchange.

The exchange would collect or pay the difference to themember-brokers on a daily basis.

The broker could further pay the difference to hisclients on a daily basis.


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y ExampleMr. X purchases following two lots of Sensex Futures

Contracts on 4th Sept. 2000 :

October 2000 Series 1 Contract @ Rs. 4,500

November 2000 Series 1 Contract @ Rs. 4,850y Mr. X will be required to pay an Initial Margin before

entering into these transactions. Suppose the InitialMargin is 6%, the amount of Margin will come to Rs 28,050

(50 Units per Contract on the BSE

).Initial Margin AccountDr 28,050

To Bank 28,050


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yAt the close of each trading day, the broker is requiredto debit you for mark to market losses and credit you

for mark to market profits.y The ICAI has taken a stand that these profits and

losses will not be taken to the profit and loss accounton a daily basis.

y

These amounts, whether paid or received, will bereflected under Current Assets in the Balance Sheetalong with the Initial Margin amount earlier reflected.


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Foreign Exchange ForwardsyAS. provides that the difference between the forward

rate and the exchange rate at the date of the

transaction should be recognised as income or expenseover the life of the contract.

y Further the profit or loss arising on cancellation orrenewal of a forward exchange contract should be

recognised as income or as expense for the period.


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Stock Index Futuresy Each client who buys or sells stock index futures is first

required to deposit an Initial Margin.

yThis margin is generally a % of the amount ofexposure that the client takes up and varies from timeto time based on the volatility levels in the market.

yAt the point of buying or selling index futures, the

payment made by the client towards Initial Marginwould be reflected as an Asset in the Balance Sheet.


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Accounting at Financial Year EndIf the net impact of the contracts has an unrealizedprofit, no further accounting is required.

yHowever, if the net impact is a loss, the enterprise isrequired to provide for such losses. Thus, theenterprise will on the hand debit the Profit & Loss

Account and on the other hand create a liability

towards this unrealized loss.


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y Example : A client has bought

Sensex futures Rs 2,00,000 on 1st March

Nifty futures Rs 2,50,000 on 7th March.On 31st of March, their market values is Rs 2,20,000and Rs 2,35,000 respectively. He has not squared upthese transactions as on 31st March.

y Unrealized profit of Rs 20,000 on the Sensex futuresand an unrealised loss of Rs 15,000 on the Niftyfutures. Hence no accounting will be required.


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y Accounting for Derivatives as per FAS 133The IFRS standard requires that every derivative

instrument should be recorded in the Balance Sheet asassets or liability at fair value.

It is important to understand the purpose of theenterprise while entering into the transaction relating

to the derivative instrument. If it is not used as anhedging instrument, the gain or loss on the derivativeinstrument is required to be recognised as profit orloss in current earnings.


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y Conclusion

Indian accounting is based on traditional prudence

where profits are not recognised till realization. Thispractice, though sound in general, appears to beinconsistent with reality in a highly liquid and vibrantarea like derivatives.


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Thank

you

138 - Accounting for Derivatives

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