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Accounting For Derivative Contracts

Published on Fri, May 15,2015 | 23:30, Updated at Fri, May 15 at 23:34Source : Moneycontrol.com 

By: Keyur Dave, Director, Grant Thornton India LLP

Background & Practices On Derivatives

Derivatives is one subject, which has always been difficult in terms of its understanding and accounting. Indian Companies were always struggling with the lack of clear accounting guidance on derivatives. In the absence of adequate guidance, there were wide practices applied by different companies for derivatives accounting and its application for hedge accounting. Limited guidance is available in the notified Accounting Standard (AS) 11, “The Effects of Changes in Foreign Exchange Rates” with respect to exchange difference on all forward contracts. AS 11 also suggests hedge accounting with forward as derivative, however it is applied only for recognized asset and liability. Thus question was always open as how to apply accounting treatment for derivatives other than forwards.  

Companies accepted the shelter of Institute of Chartered Accountants of India’s (ICAI) announcement issued in March 2008 for accounting on derivatives other than forwards, by providing for all marked to market (MTM) losses in the income statement and ignoring all gains keeping in view the principle of prudence as enunciated in AS 1 “Disclosure of Accounting Policies”.

ICAI issued further clarification in 2011, that companies may follow guidance provided under AS 30 “Financial Instruments: Recognition and Measurement”, to the extent it is not contradictory to any notified AS. ICAI had issued AS 30 in 2008 which includes accounting guidance on derivatives and hedge accounting but this AS was never notified by the Ministry of Corporate Affairs (MCA). Based on this clarification, many companies started adopting various accounting treatment on derivatives based on AS 11, AS 1, AS 30 and for hedge accounting, companies followed AS 11, and principal based guidance provided in AS 30, where AS 11 is not applicable.

Let us have a look at various practices on accounting for derivatives in the absence of guidance on all derivative contracts in notified AS.

 

Derivative type

Objective of derivative

Application of hedge accounting[1]

Covered by AS 11

Accounting treatment

Forward contract

To cover the risk on probable forecast transaction

Not applied

Yes

Forward contract is covered by AS 11 but it is not for recognized asset or liability, hence AS 11 hedge is not applicable, companies may account for both MTM gain or MTM losses in the income statement

Option contract

To cover the risk on recognize asset or liability

Not applied

No

Companies calculate MTM gain or loss on all option contracts on a totality basis. Companies may account for MTM losses (after considering net gains) in the income statement and if it MTM gains (after considering net losses) companies may ignore the same. Thus rather accounting for individual gain or losses on each instrument, companies may account on an overall basis

CCIRS

To cover the risk of foreign currency loans and its interest payment

Not applied in substance

No

Accounted entire loan as if the loan is an Indian Rupee loan, since all the cash outflow under foreign currency are covered by derivative contract. Thus may not be in substance hedge accounting, given that exchange gain or losses on foreign currency losses and corresponding gain or losses on derivatives are simply ignored

Futures

To cover the risk of changes in fair value on firm commitment

Applied

No

Accounted MTM gains or losses on derivatives in the income statement, and also corresponding MTM gains or losses on firm commitment in the income statement. Point to be noted that hedge documentation and effectiveness was not assessed adequately as per AS 30, given that companies have adopted hedge accounting principal guidance from AS 30

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

[1] Hedge accounting is a privileged accounting except when companies are within the parameter of AS 11, where it is mandatory to follow the requirement of AS 11

 

Steps By ICAI

Recently MCA notified the roadmap on Ind AS[2] which is applicable to Indian corporates in a phased manner and first covers companies with more than Rs 250 crores in net worth and all listed companies. For these companies, guidance for derivatives and hedge accounting has been prescribed by Ind-AS 109, “Financial Instruments”. The question now remains as how to align those companies which are not covered by Ind-AS?

Based on this thought process, ICAI has issued a Guidance Note (GN) on “Accounting for Derivative Contract” which includes guidance on recognition, measurement, presentation and disclosure for all derivatives except forward contracts, since those are covered by AS 11. The GN also covers accounting for a hedge and its documentation. Principally, the GN now provides a comparison platform for all companies.

Scope Of GN

The GN applies to all entities that do not apply Ind-AS. It does not include embedded derivatives, forward contracts (covered by AS 11) and it also does not override the guidance issued by regulators like Reserve bank of India (RBI) and Insurance Regulatory and Development Authority (IRDA) which applies to Banks, NBFCs, National Housing Bank and Insurance entities.

What Has Changed?

All derivative contracts should be recognized on the balance sheet and measured at fair value, if not adopted hedge accounting. This means that under the application of GN, all derivatives are marked to market and changes in their fair value are recognized in the income statement. If companies have applied for hedge accounting then special accounting treatment needs to be applied depending on which type of hedge is followed by a company.

If an entity decides to follow hedge accounting, it should do the following:-

1.       Identify its risk management objective, the risk that it is hedging

2.       Risk effects on the income statement

3.       Does the derivative meet the risk management objective

4.       How it will measure derivative instruments if risk management objective is being met

5.       Probability of occurring future cash flow in case of highly probable forecast transaction

6.       Disclose accounting policy, risk management objective in the financial statement

7.       Formal documentation at inception  

Many companies have also accounted for a hedge by accepting that RBI has permitted the contract to enter into the derivative with the objective that the hedge is sufficient condition to accept, that it qualifies for hedge. However, this is certainly not accepted under this GN and a company has to follow all necessary steps to follow hedge accounting.

 

Presentation of derivative contracts

Classification

Basis of classification

Current

Intended for trading or speculative purpose

Current or non-current

Applied hedge, then based on classification of recognized asset or liability

Current or non-current

Applied hedge, then based on settlement date / maturity date of forecasted transactions and firm commitment

Current or non-current

Derivatives which have periodic or multiple settlements. Classification for such instruments based on predominant portion of their cash flows are due for settlement as per contractual terms

 

 

 

 

 

 

 

 

The GN does not permit any netting off of assets and liabilities except under cash flow hedge as basis adjustment. There are various disclosure requirements brought in by the GN such as what the financial risks are, why the derivatives are purchased, methodology of fair value of derivative, risk management policies etc

Transition Provision       

The GN is effective from the accounting period beginning on or after April 1, 2016. Early application is encouraged. The GN applies to all derivative contracts covered by it and outstanding on effective date. Measurement as per the GN should be applied and any cumulative impact (net of tax) should be recognized in reserves and disclosed separately.

 

[1] Hedge accounting is a privileged accounting except when companies are within the parameter of AS 11, where it is mandatory to follow the requirement of AS 11

[2] Converged Accounting standards, which are based on International Financial Reporting Standards (IFRS)

 
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