Description
Due to the inherent complexity of the instruments both in definition and in financial implications have caused the delay in issue of specific accounting guidelines for such products.
Derivatives & Various Accounting Standards – Issues & Challenges
Introduction
During the last few years, a number of new financial instruments have assumed significance in the Indian economy. With rapid globalization, this trend is likely to accelerate in future. Derivatives are a kind of financial instruments whose values change in response to the change in specified interest rates, security prices and commodity prices, index of prices or rates, or similar variables. Typical examples of derivatives are futures and forward contracts, swaps and option contracts. The financial derivatives have been the new entrants into the ever growing financial instruments family, especially in India. Due to the inherent complexity of the instruments both in definition and in financial implications have caused the delay in issue of specific accounting guidelines for such products. The Indian accounting standards are still in a formative stage in this area with AS l l (Accounting for the Effects of Changes in Foreign Exchange Rates), „Guidance Note on Accounting for Equity Index Futures? and „Guidance Note on Accounting for Equity Index Options and Equity Stock Options as the only specific guidelines from ICAI for the accounting of derivative instruments. International and US standards are in an advanced stage of evolution in this area and have specific accounting standards to deal with derivatives.
Derivatives as per various Accounting Standards
The International Financial Reporting Standards (IFRS) defines derivative instruments as a financial instrument? ? ? Whose value changes in response to a specified variable or underlying rate That requires no or little net investment; and That is settled at a future date
The US GAAP defines it as ? ? Similar to IFRS except that the terms of derivative contract should require or permit net settlement Eg. Options/Forwards to buy unlisted equity investments fall within IFRS definition, not US GAAP Whereas the Indian GAAP states that a derivative includes
? ?
A security derived from debt instrument, share, loan, whether secured/unsecured, risk instrument or contract for differences or any other form of security A contract which derives its value from prices, index of prices, underlying securities
Accounting Standards: Introduction
The economic and financial environment in India in last few years has led to increasing attention towards accounting standards. AS?s are used as means for ensuring potent and transparent financial reporting by corporate. Huge cross border financial transaction has generated interest in the generally accepted accounting principles in developed countries. IASs/IFRS is used as an instrument of uniform language by business to safeguard the interest of international investors. ICAI is the premier accounting body in the country, took upon itself the leadership role by establishing Accounting Standard Board, more than 25 years ago, to fall in line with the international expectations. Accounting Standards: Definition
Accounting Standard is a principle that governs the treatment of accounting transactions as they should appear in the financial statements of an entity, and is approved and monitored by a professional or government body. The basic idea of Accounting Standards is to bring about uniformity in the accounting process and thereby make the financial statements of different entities comparable. Accounting Standards-setting in India
The Institute of Chartered Accountants of India (ICAI) being a member body of the IASC, constituted the Accounting Standards Board (ASB) on 21st April, 1977, with a view to harmonize the diverse accounting policies and practices in use in India. After the avowed adoption of liberalization and globalization as the corner stone?s of Indian economic policies in early „90s, and the growing concern about the need of effective corporate governance of late, the Accounting Standards have increasingly assumed importance.
While formulating accounting standards, the ASB takes into consideration the applicable laws, customs, usages and business environment prevailing in the country. The ASB also gives due consideration to International Financial Reporting Standards (IFRSs)/ International Accounting Standards (IASs) issued by IASB and tries to integrate them, to the extent possible, in the light of conditions and practices prevailing in India. Accounting Standards in India At present 32 Accounting standards are issued. AS 1 AS 2 AS 3 AS 4 Disclosure of Accounting Policies Valuation of Inventories Cash Flow Statements Contingencies and Events Occurring after the Balance Sheet Date Net Profit or Loss for the Period, Prior Period Items and changes in Accounting AS 5 AS 6 AS 7 AS 8 AS 9 AS 10 AS 11 AS 12 AS 13 AS 14 AS 15 AS 16 AS 17 AS 18 AS 19 AS 20 AS 21 Policies Depreciation Accounting Construction Contracts Accounting for Research and Development Revenue Recognition Accounting for Fixed Assets The Effects of Changes in Foreign Exchange Rates Accounting for Government Grants Accounting for Investments Accounting for Amalgamations Employee Benefits Borrowing Costs Segment Reporting Related Party Disclosures Leases Earnings Per Share Consolidated Financial Statements
AS 22 AS 23 AS 24 AS 25 AS 26 AS 27 AS 28 AS 29 AS 30 AS 31 AS 32
Accounting for Taxes on Income Accounting for Investments in Associates in Consolidated Financial Statement Discontinuing Operations Interim Financial Reporting Intangible Assets Financial Reporting of Interests in Joint Ventures Impairment of Assets Provisions, Contingent Liabilities and Contingent Assets Financial Instruments: Recognition and Measurement Financial Instruments: Presentation Financial Instruments: Disclosures
As can be seen from the above table, the accounting standards concerned with derivative instruments are AS 11 and AS 32. Accounting Standard 11 – The Effects of Changes in Foreign Exchange Rates Objective An enterprise may carry on activities involving foreign exchange in two ways. It may have transactions in foreign currencies or it may have foreign operations. In order to include foreign currency transactions and foreign operations in the financial statements of an enterprise, transactions must be expressed in the enterprise?s reporting currency and the financial statements of foreign operations must be translated into the enterprise?s reporting currency. The principal issues in accounting for foreign currency transactions and foreign operations are to decide which exchange rate to use and how to recognize in the financial statements the financial effect of changes in exchange rates. Scope 1. This Statement should be applied: a. In accounting for transactions in foreign currencies; and
b. In translating the financial statements of foreign operations. 2. This Statement also deals with accounting for foreign currency transactions in the nature of forward exchange contracts. It is important to note that only forward exchange contracts fall under derivative classification Forward Exchange Contracts 1. An enterprise may enter into a forward exchange contract or another financial instrument that is in substance a forward exchange contract, which is not intended for trading or speculation purposes, to establish the amount of the reporting currency required or available at the settlement date of a transaction. The premium or discount arising at the inception of such a forward exchange contract should be amortized as expense or income over the life of the contract. Exchange differences on such a contract should be recognized in the statement of profit and loss in the reporting period in which the exchange rates change. Any profit or loss arising on cancellation or renewal of such a forward exchange contract should be recognized as income or as expense for the period. The risks associated with changes in exchange rates may be mitigated by entering into forward exchange contracts. Any premium or discount arising at the inception of a forward exchange contract is accounted for separately from the exchange differences on the forward exchange contract. The premium or discount that arises on entering into the contract is measured by the difference between the exchange rate on the date of the inception of the forward exchange contract and the forward rate specified in the contract. Exchange difference on a forward exchange contract is the difference between (a) the foreign currency amount of the contract translated at the exchange rate on the reporting date, or the settlement date where the transaction is settled during the reporting period, and (b) the same foreign currency amount translated on a later date of inception of the forward exchange contract and the last reporting date. 2. A gain or loss on a forward exchange contract to which the above paragraph does not apply should be computed by multiplying the foreign currency amount of the forward exchange contract by the difference between the forward rate available on the reporting date for the remaining maturity of the contract and the contracted forward rate (or the
forward rate last used to measure a gain or loss on that contract for an earlier period). The gain or loss so computed should be recognized in the statement of profit and loss for the period. The premium or discount on the forward exchange contract is not recognized separately. In recording of a forward exchange contract intended for trading or speculation purposes, the premium or discount on the contract is ignored and on each balance sheet date, the value of the contract is marked to its current market value and the gain or loss on the contract is recognized. Amendment of AS 11 ? ? Companies will be allowed to capitalize forex losses on capital assets instead of charging to revenue. Companies can create a special reserve or transitory account to park MTM forex losses and amortize up to March 31, 2011. Issues with Amended AS 11 ? Any accounting principle that permits either capitalization of costs, or allows restatement of carrying amount based on revaluation, invariably prescribes a ceiling level that capitalization should not exceed the fair market value (recoverable amount) – which is absent in this case. ? By exercising the option available an enterprise will be able to accumulate the exchange losses in the foreign currency monetary item translation reserve. This accounting model will only assist in improving the book profits, EPS, and in declaring dividends even if liquidity may not permit. ? The ICAI does not appear to have brought out any corresponding modification in its pronouncement, in line with this Gazette Notification. All non-corporate entities, partnership or otherwise, are still expected to comply with AS 11 as pronounced by the ICAI. Perhaps, one is led to believe that all non-corporate stands completely insulated from exchange rate volatility about which there is a hue and cry. ? Para 46 is a transitional provision. Transition is a point-in-time when a Standard is introduced for the first time. Transitional provisions ought to address the accounting
needs up to the transition date and not beyond. Para 46 that introduces a change from a „retrospective date? of December 7, 2006, extends to companies which may raise foreign currency at a future date. To provide discretionary relief in the garb of a transitional provision, making it effective both prospectively and retrospectively, cannot be deemed to be a step in the right direction. Bharti Airtel – A Case Study 4QFY09 ? During the year, effective April 1, 2008, the company has adopted the treatment prescribed in AS 11 „Effect of Changes in Foreign exchange Rates? notified in the companies (AS) Rules 2006 dated Dec 7, 2006. Instead of capitalizing / decapitalizing such fluctuations, as per policy hitherto followed, the company has charged/credited such fluctuations directly to the P&L account. ? Had the company continued with its earlier policy, net profit after tax would have been higher by Rs. 354.95 crore and Rs. 1255.07 crore for the quarter and year ended March 31, 2009, respectively, for the company and the net profit after tax would have been higher by Rs. 372.5 crore and Rs. 1302.44 crore for the quarter and year ended March 31, 2009, respectively, for the company. 3QFY09 ? As reported in the last quarter, the company has followed the accounting policy to adjust foreign exchange fluctuation on loans/liability for fixed assets till June 30, 2008, as per the requirement of Schedule VI of the Companies Act, 1956 based on legal advice. During the nine months period, effective April 1, 2008, the Company has adopted the treatment prescribed in AS 11 „Effect of Change in Foreign exchange Rates? notified in the companies AS Rules 2006 dated Dec 7, 2006. Instead of capitalizing/decapitalizing such fluctuation as per policy hitherto ? Had the company continued with its earlier policy, net profit after tax would have been higher by Rs. 245.09 cr and Rs. 900 .12 cr for the quarter and nine months ended Dec 31, 2008, respectively for the company and the net profit after tax would have been higher by
Rs. 248.42 cr and Rs. 929.94 cr for the quarter and nine months ended Dec 31, 2008, respectively for the company. Initially it seems that Bharti Airtel was reluctant to adopt AS 11 to finalize its accounts. As a result, during the first two quarters of FY09 the company adopted Schedule VI of Companies Act of 1956 to prepare its income statement. Now it has been widely accepted that adoption of Schedule VI is not a wise accounting policy. The company realized this and shifted to the AS 11 notified in the companies (AS) Rules 2006 dated Dec 7, 2006 with effect from 3QFY09. In the earlier system the company could not book its losses under profit and loss account. Consequently the losses had to be capitalized. This resulted in concealing the fact that the organization was incurring losses. This fact was not shown in books of accounts. Naturally it is not possible to know accurately the real position of the company. Therefore it is regarded that maintenance of accounts under schedule VI is not fair system of accounting policies. When the company shifted to AS 11 format it got greater freedom to book the losses, if any, in its income statement. There is no need to go in for capitalization process which is unfair. This would enable to understand the real position of the company. The forex loss suffered by the company came to limelight with the adoption of AS 11. Although the company is making profit, its net profit tends to be low as it is incurring forex loss. This has lead to a fall in its operating profit also. Had the company gone ahead with Schedule VI system then company would have minimized its loss in books of accounts. However, on account of a shift in favour of AS 11 the company had to have a loss of Rs. 248.42 cr during the 3QFY09 and the loss increased to Rs. 372.5 crore during the 4QFY09. This implies that, in reality the company?s loss position mounted substantially causing depletion in its net profit and EBITDA. For the FY09 the company?s loss on forex account amounted to Rs. 1302.44 crore. Needless to say, although adoption of AS 11 is a conservative system in reality, its adoption is a judicious and wise policy decision taken by the management of the company. It can be inferred from this assessment that the management has proved its quality very meticulously by being conservative in its approach towards accounting practices. The company has deliberately given
up the age old system of inflating the profits of the company by resorting to capitalization of losses in profit and loss account. Let us now turn to the reaction of capital market towards the company. It is true that since there is decline in net profit EPS obviously decreases. Consequent upon this the stock price gets settled at a lower range. In other words the price of the share on stock exchange is not inflated one. It also implies that the share price of this company is not susceptible to unusual and artificial down swing. In fact when the profit position of the company is exhibited as per the norms of AS 11 the interest of the investor in stock market is automatically insulated or protected. It can be concluded that Bharti Airtel has adopted wise accounting system and the company stands testimony for quality and efficient management. Naturally its credit rating has to be high and the company must be treated as a premium unit.
Accounting Standard 30: Financial Instruments: Recognition and Measurement Objective The objective of this Standard is to establish principles for recognizing and measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items.
Scope 1. This Standard should be applied by all entities to all types of financial instruments 2. This Standard should be applied to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a nonfinancial item in accordance with the entity's expected purchase, sale or usage requirements. 3. There are various ways in which a contract to buy or sell a non-financial item can be settled net in cash or another financial instrument or by exchanging financial instruments. These include:
a. when the terms of the contract permit either party to settle it net in cash or another financial instrument or by exchanging financial instruments; b. when the ability to settle net in cash or another financial instrument, or by exchanging financial instruments, is not explicit in the terms of the contract, but the entity has a practice of settling similar contracts net in cash or another financial instrument or by exchanging financial instruments (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse); c. when, for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer's margin; and d. When the non-financial item that is the subject of the contract is readily convertible to cash. Initial Measurement IFRS & US GAAP All derivatives are recognized on balance sheet ass either financial assets or liabilities. They are initially measured at fair value on acquisition date. Indian GAAP Only certain types of derivatives are recognized as either financial assets or liabilities. Subsequent Measurement IFRS and US GAAP All derivatives at fair value, with changes recognized in P&L account except for derivatives used in cash flow or net investment hedges.
Indian GAAP Forward exchange contracts intended for trading or speculation purposes are carried at fair value with unrealized losses/gains recognized in the P&L statement, Else the premium is amortized over the life of the contract and the exchange differences on such contracts are recognized in the income statement in the reporting period in which the exchange rate changes. Issues & Comparison IFRS Indian GAAP
All financial assets, liabilities & derivatives are There is no definition of financial instrument. recognized in financial statements when these Currently, derivatives are not required to be meet the definition & criteria of financial recognized in balance sheet except of forward instrument. exchange derivatives and certain others. Eg. – Commodity derivatives, weather
derivatives Governed by IAS 39 Financial Instrument - Governed by AS 11, 13 (accounting for Recognition & Measurement investments)
AS 30 - Financial Instruments -Recognition & Measurement mandatory requirements
commencing from 1st April, 2011
Hedge Accounting For hedge accounting detailed guidance is available under IFRS and US GAAP, while there is no specific guidance in Indian GAAP available for hedge accounting. Hedge accounting is permitted under IFRS and US GAAP provided that an entity meets stringent qualifying criteria in relation to documentation and hedge effectiveness. Both frameworks require documentation of the entity?s risk management objectives and how the effectiveness of the hedge will be assessed. Hedge instruments should be highly effective in offsetting the exposure of the hedged item to changes in the fair value or cash flows, and the effectiveness of the hedge is measured reliably on a continuing basis under both frameworks. In terms of classification of a hedge the two standards namely FAS 133 and IAS 39 differ marginally. However, this does not change the accounting treatment significantly. Both FAS 133 and IAS 39 allow three classes of hedges as follows: 1. Fair value hedge 2. Cash-flow hedge 3. Foreign currency hedge
Fair Value Hedge A fair value hedge is the one that safeguards changes in the value of an asset or liability or an unrecognized firm commitment (the last one only for FAS 133), for instance, a hedge created by a portfolio manager to safeguard the value of his portfolio of securities by shorting Index Futures. In such a hedge the gains and losses on both the derivative and the hedged item are recognized in the Profit & Loss Account as income (or expense) for the period. These gains and losses arise due to re- measuring of fair value and include hedging ineffectiveness.
Cash Flow Hedge A cash-flow hedge is the one that safeguards variation in a forecasted cash-flow, for instance, a hedge created by an enterprise to safeguard variable interest outflow on its Libor linked borrowing by a swap of Libor linked interest payments with fixed interest payment. IAS 39 includes unrecognized firm commitment to buy or sell an asset at a fixed price also as a cashflow hedge.
Effectiveness of a hedge assumes significant importance in accounting of a cash-flow hedge. Effective portion of a derivative is the one that fulfils the objective of safeguarding the variations in the value of the hedged item. The method used for assessing the hedging effectiveness of a derivative must be defined at the time of setting- up the hedge.
In accounting for a cash-flow hedge the main consideration is to carry forward the gains or losses of the effective portion. These are meant to offset the change in the value of hedged item at a later date. The gains and losses on the ineffective portion and excluded portion are written off as the income or loss of the current period. The accumulated profits and gains on the effective portion of the derivative keep accumulating in a special reserve in the equity in the balance sheet. FAS 133 identifies these as part of „Other Comprehensive Income?. The accumulated amount of such unrealized gains is reclassified as profits in the period in which the hedged forecasted transaction affects the earnings. In case the forecasted transaction results in creation of an asset/liability then this accumulated gain is applied for adjusting the value of such asset/ liability.
Foreign Currency Hedge Foreign currency hedge safeguards exposure of an asset, liability or forecasted transaction to foreign exchange rate fluctuations. FAS 133 recognizes four classes of foreign currency hedges whereas IAS 39 recognizes only one. FAS 133 classifications of foreign currency hedge are as follows: ? Net investment in foreign operations: This is a hedge to safeguard the translation risk faced by an enterprise because of foreign exchange exposure to its net investment in foreign operations in a foreign country. IAS 39 also recognizes hedge of a net investment in a foreign entity separately (in fact this is the only classification recognized by IAS 39 apart from fair value and cash flow hedges). Accounting for gains or losses for this class of hedge is done in a similar manner as that for a cash-flow hedge both in IAS 39 and FAS 133.
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Unrecognized firm commitment involving foreign currency exposure: An unrecognized firm commitment, in general, is classified by IAS 39 as a cash-flow hedge. FAS 133, on the other hand, classifies an unrecognized firm commitment without foreign exchange exposure as a fair value hedge.
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Available-for-sale securities with foreign exchange exposure: Financial instruments are categorized into four classes by IAS 39 and three classes by the corresponding US standard FAS 115. The three classes namely „held for trading? securities, „held to maturity? securities, and „available for sale? securities are common to both whereas the class „loans and receivables originated by enterprise? is specific to IAS 39. The residual securities which cannot be classified into any of the other classes are classified as „available for sale? securities. Investments in other enterprises that are neither for shortterm profits nor for being held till maturity (primarily applicable to the debt securities) are likely to be put into this class. Those „available for sale? securities that cause foreign exchange exposure to the enterprise and are hedged by a derivative are classified by FAS 133 into this class of foreign currency hedge. IAS 39 implicitly classifies such hedge as fair value hedge. The accounting treatment in both the standards is similar to a fair value hedge.
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Foreign currency dominated forecasted transactions: These hedges, though not separately classified by IAS 39, implicitly get classified into general forecasted transactions. In either standard (IAS 39 and FAS 133) the accounting is similar to cashflow hedge where gains or losses on the effective portion of the hedging instrument are allowed to be deferred.
The comparison between US GAAP and IFRS for the above hedges is summarized in the following table: IFRS Hedging instruments are measured at fair value. Hedged item Fair Value Hedge is adjusted in P&L for changes in its fair value due to its risks. Gains & Losses are initially deferred to equity and later Cash Flow Hedge released to P&L. Gains/Losses on financial instruments to hedge an asset/liability may be included in cost of non financial assets/liabilities(Basis adjustment) Similar to IFRS except basis adjustment which is not allowed Similar to IFRS US GAAP
Hedges of net investments in foreign operations
Similar to cash flow hedge. Initially deferred to equity and gains/losses transferred to P&L on disposal or partial disposal of foreign operations. Similar to IFRS
Accounting treatment in the books of the client Accounting treatment for the initial margin payment is common for all the four types of equity derivatives. Further the accounting treatment for equity index option is explained.
Accounting for Initial Margin: The initial margin paid by the clients to the trading member is debited in the “Initial Margin Equity Derivative Instruments Account?. Any further initial margin amount paid /received is debited/ credited in the account. On the balance sheet date the balance in the account is shown as deposit under the current asset head. The following example shows the entries which should be done for initial margin
Illustration: Suppose Mr. X enters into certain Equity Derivative Instruments contracts on March 28, 20x3. The Initial Margin on these contracts is Rs. 30,000. The Margin for the subsequent days is as follows: – On 29th March, 20x3 Rs. 35,000 – On 30th March, 20x3 Rs. 25,000 – On 31st March, 20x3 Rs. 27,000 Suggested accounting treatment: Following entries will be passed for the payment / receipt of Initial Margin Date Debited Account Debited Amount 28/03/03 Initial Margin - Equity Derivative Inst. A/c 29/03/03 Initial Margin - Equity Derivative Inst. A/c 30/3/03 Bank A/c Rs. 10000 Initial Margin Equity Derivative Inst. A/c 31/03/03 Initial Margin - Equity Derivative Inst. A/c Rs. 2000 Bank A/c Rs.2000 Rs.10000 Rs. 5000 Bank A/c Rs. 5000 Rs. 30000 Bank A/c Credit Account Credit Amount Rs. 30000
Thus a total of Rs. 27000 (30000+5000-10000+2000) is credited from the client account and is debited in the “Initial margin -Equity Derivative Inst A/c” .The same is disclosed in the balance sheet as follows : Current Assets Initial Margin - Equity Derivative Instruments A/c Rs. 27,000 Accounting Treatment for Equity Index Options: Accounting entries for premium payment and final settlement are done as follows Illustration: Suppose Mr. X further purchases following Options from Mr. Y:
Date of purchase
Type of the options contract
Expiry date
Premium Contract per Multiplier(No of
Strike Price (Rs.)
unit(Rs.) units)
28th March, 2003
S&P CNX NIFTY- 29-MayCall 03
15
200
880
28th March, 2003
S&P CNX NIFTY- 29-MayPut 03
20
200
885
Premium Payment
Accounting entries done in the books of buyer and seller are shown in the tables below. In the first event, accounting entries for “Initial Margin payment” is shown. In second event accounting entries made for “out of money call option” (Strike price Rs.880 and the Spot price Rs. 875) is illustrated. As the call is out of money, the option is not exercised by the buyer and premium paid is written off as an expense in the buyer?s book and is realized as an income in seller?s book. In the third event the call option is „in the money? (strike price Rs.880, Spot price Rs.890).The call option is exercised by the buyer and the net profit is shown as an income in the buyer?s book and as an expense in the seller?s book. Similarly accounting entries are done for the in the money and out of the money put option in event 4 and 5.
Accounting Entries done for Buyer (Mr. X)
Accounting Entries done for Seller (Mr. Y)
Event Treatment Premium on option collected Premium is Call Option recognized as an K=880,S=875 income on expiry of option Loss on the exercise of option paid Call Option K=880,S=890 Premium is recognized as an income Loss on the exercise of option paid Put Option K=885,S=875 Premium is recognized as an income Premium is Put Option recognized as an K=885,S=890 income Date 28/3/03 Debited Account Bank A/C Equity Index option premium A/C P&L A/C ( Expense) Equity Index option premium A/C P&L A/C(expense) Equity Index option premium A/C Equity Index option premium A/C Debited Credit Account Credit Amount Amount Equity Index 7000 7000 option premium A/C 3000 P&L A/C (Income) 3000
29/5/03
29/5/03
2000
Bank A/C P&L A/C (Income) Bank A/C P&L A/C (Income) P&L A/C (Income)
2000
29/5/03
3000
3000
29/5/03
2000
2000
29/5/03
4000
4000
29/5/03
4000
4000
Accounting for open options at the end of an accounting period Buyer and seller follow the financial year as the accounting year and options entered in one period are settled in another. A provision should be made for the amount by which premium paid exceeds the premium prevailing on the balance sheet date.
Illustration: Suppose the balance sheet date is 31st Mar 2003 but the Option expiry date is May 2003.The strike price and the premium on the 31 march is as follows: – Call option K=Rs. 880, Closing rate of premium = Rs.6 per unit – Put Option K=Rs. 885, Closing rate of premium = Rs.28 per unit Accounting entries: Buyer Books. Net provision required to be made in the books of account would be computed as follows:
Call Option May 20x3 Strike Price Rs. 880 • Premium paid • Less: Premium on the balance sheet date • Provision required Put Option May 20x3 Strike Price Rs. 885 • Premium paid • Less: Premium as on the balance sheet date • Provision required Net provision to be made in the books of account: Extracts from the Balance Sheet Current Assets: Equity Index Options Premium Account Less: Provision for Loss on Equity Index Options
Rs. 3,000 Rs. 1,200 Rs. 1,800 Rs. 4000 Rs. 5600 Rs. -1600 Rs. 200
Rs.7,000 (200) Rs.6,800
Accounting entries: Seller books
Call Option May 20x3 Strike Price Rs. 880 Premium as on the balance sheet date Less: Premium received Provision required Put Option May 20x3 Strike Price Rs. 885 Premium as on the balance sheet date Less: Premium received Provision required Net provision to be made in the books of account: (Since the net difference is negative.) Extracts from the Balance Sheet Current Liabilities and Provisions: Equity Index Options Premium Account Provision for Loss on Equity Index Options
Rs. 1,200 Rs. 3,000 Rs. -1,800 Rs. 5,600 Rs. 4,000 Rs. 1,600 NIL
Rs 7000 NIL
Conclusion After a thorough study of various Accounting Standards for derivative instruments, it can be concluded that IFRS is more stringent compared to other Accounting Standards like US GAAP or Indian GAAP. Though Indian GAAP had no specific accounting guidelines for reporting of derivative instruments, adherence to AS 11 and AS 30 is a step in right direction with respect to reporting for derivative instruments. Even the „new? accounting standard, AS 30, leaves much to be desired for various derivative instruments such as weather derivatives, carbon credit derivatives and commodity derivatives. References ? Report on „Identifying Value Drivers – A structural Analysis and Study of Accounting of Forex Losses? by Mr. Sanjesh Jain, student at T. A. Pai Management Institute Manipal, as a part of MIP Project, Batch 2008-10. ? ? Article titled „IFRS & Indian GAAP – A Comparison? issued by Deloitte India. Article titled „Similarities and Differences – A comparison of IFRS, US GAAP and Indian GAAP? by PriceWaterHouseCoopers in November 2007. ? ? ? Business Standard; Article: „Top companies ignore ICAI rule on forex loss treatment’; Monday, Jun 08, 2009 Informed forum for Management Accounting; Article: Breather for India Inc a AS 11 deferred to 2011; Thursday Mar 26, 2009 The Hindu Business Line o Article: 'Accounting norm changes help major cos boost earnings' by Vidya Bala ; Monday, Jun 01, 2009 o Article: 'Should accounting be driven by economic conditions? "; Thursday, Mar 19, 2009 o Article: 'Who will gain from AS-11 change? ' by Vidya Bala ; Sunday, Apr 12, 2009 o Article: „Accounting for derivative await panel approval?; May 16, 2008
o Article: „Accounting of derivative losses?; Thursday, April 17, 2008
? ?http://www.derivativesindia.com/scripts/account/index.asp
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Due to the inherent complexity of the instruments both in definition and in financial implications have caused the delay in issue of specific accounting guidelines for such products.
Derivatives & Various Accounting Standards – Issues & Challenges
Introduction
During the last few years, a number of new financial instruments have assumed significance in the Indian economy. With rapid globalization, this trend is likely to accelerate in future. Derivatives are a kind of financial instruments whose values change in response to the change in specified interest rates, security prices and commodity prices, index of prices or rates, or similar variables. Typical examples of derivatives are futures and forward contracts, swaps and option contracts. The financial derivatives have been the new entrants into the ever growing financial instruments family, especially in India. Due to the inherent complexity of the instruments both in definition and in financial implications have caused the delay in issue of specific accounting guidelines for such products. The Indian accounting standards are still in a formative stage in this area with AS l l (Accounting for the Effects of Changes in Foreign Exchange Rates), „Guidance Note on Accounting for Equity Index Futures? and „Guidance Note on Accounting for Equity Index Options and Equity Stock Options as the only specific guidelines from ICAI for the accounting of derivative instruments. International and US standards are in an advanced stage of evolution in this area and have specific accounting standards to deal with derivatives.
Derivatives as per various Accounting Standards
The International Financial Reporting Standards (IFRS) defines derivative instruments as a financial instrument? ? ? Whose value changes in response to a specified variable or underlying rate That requires no or little net investment; and That is settled at a future date
The US GAAP defines it as ? ? Similar to IFRS except that the terms of derivative contract should require or permit net settlement Eg. Options/Forwards to buy unlisted equity investments fall within IFRS definition, not US GAAP Whereas the Indian GAAP states that a derivative includes
? ?
A security derived from debt instrument, share, loan, whether secured/unsecured, risk instrument or contract for differences or any other form of security A contract which derives its value from prices, index of prices, underlying securities
Accounting Standards: Introduction
The economic and financial environment in India in last few years has led to increasing attention towards accounting standards. AS?s are used as means for ensuring potent and transparent financial reporting by corporate. Huge cross border financial transaction has generated interest in the generally accepted accounting principles in developed countries. IASs/IFRS is used as an instrument of uniform language by business to safeguard the interest of international investors. ICAI is the premier accounting body in the country, took upon itself the leadership role by establishing Accounting Standard Board, more than 25 years ago, to fall in line with the international expectations. Accounting Standards: Definition
Accounting Standard is a principle that governs the treatment of accounting transactions as they should appear in the financial statements of an entity, and is approved and monitored by a professional or government body. The basic idea of Accounting Standards is to bring about uniformity in the accounting process and thereby make the financial statements of different entities comparable. Accounting Standards-setting in India
The Institute of Chartered Accountants of India (ICAI) being a member body of the IASC, constituted the Accounting Standards Board (ASB) on 21st April, 1977, with a view to harmonize the diverse accounting policies and practices in use in India. After the avowed adoption of liberalization and globalization as the corner stone?s of Indian economic policies in early „90s, and the growing concern about the need of effective corporate governance of late, the Accounting Standards have increasingly assumed importance.
While formulating accounting standards, the ASB takes into consideration the applicable laws, customs, usages and business environment prevailing in the country. The ASB also gives due consideration to International Financial Reporting Standards (IFRSs)/ International Accounting Standards (IASs) issued by IASB and tries to integrate them, to the extent possible, in the light of conditions and practices prevailing in India. Accounting Standards in India At present 32 Accounting standards are issued. AS 1 AS 2 AS 3 AS 4 Disclosure of Accounting Policies Valuation of Inventories Cash Flow Statements Contingencies and Events Occurring after the Balance Sheet Date Net Profit or Loss for the Period, Prior Period Items and changes in Accounting AS 5 AS 6 AS 7 AS 8 AS 9 AS 10 AS 11 AS 12 AS 13 AS 14 AS 15 AS 16 AS 17 AS 18 AS 19 AS 20 AS 21 Policies Depreciation Accounting Construction Contracts Accounting for Research and Development Revenue Recognition Accounting for Fixed Assets The Effects of Changes in Foreign Exchange Rates Accounting for Government Grants Accounting for Investments Accounting for Amalgamations Employee Benefits Borrowing Costs Segment Reporting Related Party Disclosures Leases Earnings Per Share Consolidated Financial Statements
AS 22 AS 23 AS 24 AS 25 AS 26 AS 27 AS 28 AS 29 AS 30 AS 31 AS 32
Accounting for Taxes on Income Accounting for Investments in Associates in Consolidated Financial Statement Discontinuing Operations Interim Financial Reporting Intangible Assets Financial Reporting of Interests in Joint Ventures Impairment of Assets Provisions, Contingent Liabilities and Contingent Assets Financial Instruments: Recognition and Measurement Financial Instruments: Presentation Financial Instruments: Disclosures
As can be seen from the above table, the accounting standards concerned with derivative instruments are AS 11 and AS 32. Accounting Standard 11 – The Effects of Changes in Foreign Exchange Rates Objective An enterprise may carry on activities involving foreign exchange in two ways. It may have transactions in foreign currencies or it may have foreign operations. In order to include foreign currency transactions and foreign operations in the financial statements of an enterprise, transactions must be expressed in the enterprise?s reporting currency and the financial statements of foreign operations must be translated into the enterprise?s reporting currency. The principal issues in accounting for foreign currency transactions and foreign operations are to decide which exchange rate to use and how to recognize in the financial statements the financial effect of changes in exchange rates. Scope 1. This Statement should be applied: a. In accounting for transactions in foreign currencies; and
b. In translating the financial statements of foreign operations. 2. This Statement also deals with accounting for foreign currency transactions in the nature of forward exchange contracts. It is important to note that only forward exchange contracts fall under derivative classification Forward Exchange Contracts 1. An enterprise may enter into a forward exchange contract or another financial instrument that is in substance a forward exchange contract, which is not intended for trading or speculation purposes, to establish the amount of the reporting currency required or available at the settlement date of a transaction. The premium or discount arising at the inception of such a forward exchange contract should be amortized as expense or income over the life of the contract. Exchange differences on such a contract should be recognized in the statement of profit and loss in the reporting period in which the exchange rates change. Any profit or loss arising on cancellation or renewal of such a forward exchange contract should be recognized as income or as expense for the period. The risks associated with changes in exchange rates may be mitigated by entering into forward exchange contracts. Any premium or discount arising at the inception of a forward exchange contract is accounted for separately from the exchange differences on the forward exchange contract. The premium or discount that arises on entering into the contract is measured by the difference between the exchange rate on the date of the inception of the forward exchange contract and the forward rate specified in the contract. Exchange difference on a forward exchange contract is the difference between (a) the foreign currency amount of the contract translated at the exchange rate on the reporting date, or the settlement date where the transaction is settled during the reporting period, and (b) the same foreign currency amount translated on a later date of inception of the forward exchange contract and the last reporting date. 2. A gain or loss on a forward exchange contract to which the above paragraph does not apply should be computed by multiplying the foreign currency amount of the forward exchange contract by the difference between the forward rate available on the reporting date for the remaining maturity of the contract and the contracted forward rate (or the
forward rate last used to measure a gain or loss on that contract for an earlier period). The gain or loss so computed should be recognized in the statement of profit and loss for the period. The premium or discount on the forward exchange contract is not recognized separately. In recording of a forward exchange contract intended for trading or speculation purposes, the premium or discount on the contract is ignored and on each balance sheet date, the value of the contract is marked to its current market value and the gain or loss on the contract is recognized. Amendment of AS 11 ? ? Companies will be allowed to capitalize forex losses on capital assets instead of charging to revenue. Companies can create a special reserve or transitory account to park MTM forex losses and amortize up to March 31, 2011. Issues with Amended AS 11 ? Any accounting principle that permits either capitalization of costs, or allows restatement of carrying amount based on revaluation, invariably prescribes a ceiling level that capitalization should not exceed the fair market value (recoverable amount) – which is absent in this case. ? By exercising the option available an enterprise will be able to accumulate the exchange losses in the foreign currency monetary item translation reserve. This accounting model will only assist in improving the book profits, EPS, and in declaring dividends even if liquidity may not permit. ? The ICAI does not appear to have brought out any corresponding modification in its pronouncement, in line with this Gazette Notification. All non-corporate entities, partnership or otherwise, are still expected to comply with AS 11 as pronounced by the ICAI. Perhaps, one is led to believe that all non-corporate stands completely insulated from exchange rate volatility about which there is a hue and cry. ? Para 46 is a transitional provision. Transition is a point-in-time when a Standard is introduced for the first time. Transitional provisions ought to address the accounting
needs up to the transition date and not beyond. Para 46 that introduces a change from a „retrospective date? of December 7, 2006, extends to companies which may raise foreign currency at a future date. To provide discretionary relief in the garb of a transitional provision, making it effective both prospectively and retrospectively, cannot be deemed to be a step in the right direction. Bharti Airtel – A Case Study 4QFY09 ? During the year, effective April 1, 2008, the company has adopted the treatment prescribed in AS 11 „Effect of Changes in Foreign exchange Rates? notified in the companies (AS) Rules 2006 dated Dec 7, 2006. Instead of capitalizing / decapitalizing such fluctuations, as per policy hitherto followed, the company has charged/credited such fluctuations directly to the P&L account. ? Had the company continued with its earlier policy, net profit after tax would have been higher by Rs. 354.95 crore and Rs. 1255.07 crore for the quarter and year ended March 31, 2009, respectively, for the company and the net profit after tax would have been higher by Rs. 372.5 crore and Rs. 1302.44 crore for the quarter and year ended March 31, 2009, respectively, for the company. 3QFY09 ? As reported in the last quarter, the company has followed the accounting policy to adjust foreign exchange fluctuation on loans/liability for fixed assets till June 30, 2008, as per the requirement of Schedule VI of the Companies Act, 1956 based on legal advice. During the nine months period, effective April 1, 2008, the Company has adopted the treatment prescribed in AS 11 „Effect of Change in Foreign exchange Rates? notified in the companies AS Rules 2006 dated Dec 7, 2006. Instead of capitalizing/decapitalizing such fluctuation as per policy hitherto ? Had the company continued with its earlier policy, net profit after tax would have been higher by Rs. 245.09 cr and Rs. 900 .12 cr for the quarter and nine months ended Dec 31, 2008, respectively for the company and the net profit after tax would have been higher by
Rs. 248.42 cr and Rs. 929.94 cr for the quarter and nine months ended Dec 31, 2008, respectively for the company. Initially it seems that Bharti Airtel was reluctant to adopt AS 11 to finalize its accounts. As a result, during the first two quarters of FY09 the company adopted Schedule VI of Companies Act of 1956 to prepare its income statement. Now it has been widely accepted that adoption of Schedule VI is not a wise accounting policy. The company realized this and shifted to the AS 11 notified in the companies (AS) Rules 2006 dated Dec 7, 2006 with effect from 3QFY09. In the earlier system the company could not book its losses under profit and loss account. Consequently the losses had to be capitalized. This resulted in concealing the fact that the organization was incurring losses. This fact was not shown in books of accounts. Naturally it is not possible to know accurately the real position of the company. Therefore it is regarded that maintenance of accounts under schedule VI is not fair system of accounting policies. When the company shifted to AS 11 format it got greater freedom to book the losses, if any, in its income statement. There is no need to go in for capitalization process which is unfair. This would enable to understand the real position of the company. The forex loss suffered by the company came to limelight with the adoption of AS 11. Although the company is making profit, its net profit tends to be low as it is incurring forex loss. This has lead to a fall in its operating profit also. Had the company gone ahead with Schedule VI system then company would have minimized its loss in books of accounts. However, on account of a shift in favour of AS 11 the company had to have a loss of Rs. 248.42 cr during the 3QFY09 and the loss increased to Rs. 372.5 crore during the 4QFY09. This implies that, in reality the company?s loss position mounted substantially causing depletion in its net profit and EBITDA. For the FY09 the company?s loss on forex account amounted to Rs. 1302.44 crore. Needless to say, although adoption of AS 11 is a conservative system in reality, its adoption is a judicious and wise policy decision taken by the management of the company. It can be inferred from this assessment that the management has proved its quality very meticulously by being conservative in its approach towards accounting practices. The company has deliberately given
up the age old system of inflating the profits of the company by resorting to capitalization of losses in profit and loss account. Let us now turn to the reaction of capital market towards the company. It is true that since there is decline in net profit EPS obviously decreases. Consequent upon this the stock price gets settled at a lower range. In other words the price of the share on stock exchange is not inflated one. It also implies that the share price of this company is not susceptible to unusual and artificial down swing. In fact when the profit position of the company is exhibited as per the norms of AS 11 the interest of the investor in stock market is automatically insulated or protected. It can be concluded that Bharti Airtel has adopted wise accounting system and the company stands testimony for quality and efficient management. Naturally its credit rating has to be high and the company must be treated as a premium unit.
Accounting Standard 30: Financial Instruments: Recognition and Measurement Objective The objective of this Standard is to establish principles for recognizing and measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items.
Scope 1. This Standard should be applied by all entities to all types of financial instruments 2. This Standard should be applied to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a nonfinancial item in accordance with the entity's expected purchase, sale or usage requirements. 3. There are various ways in which a contract to buy or sell a non-financial item can be settled net in cash or another financial instrument or by exchanging financial instruments. These include:
a. when the terms of the contract permit either party to settle it net in cash or another financial instrument or by exchanging financial instruments; b. when the ability to settle net in cash or another financial instrument, or by exchanging financial instruments, is not explicit in the terms of the contract, but the entity has a practice of settling similar contracts net in cash or another financial instrument or by exchanging financial instruments (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse); c. when, for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer's margin; and d. When the non-financial item that is the subject of the contract is readily convertible to cash. Initial Measurement IFRS & US GAAP All derivatives are recognized on balance sheet ass either financial assets or liabilities. They are initially measured at fair value on acquisition date. Indian GAAP Only certain types of derivatives are recognized as either financial assets or liabilities. Subsequent Measurement IFRS and US GAAP All derivatives at fair value, with changes recognized in P&L account except for derivatives used in cash flow or net investment hedges.
Indian GAAP Forward exchange contracts intended for trading or speculation purposes are carried at fair value with unrealized losses/gains recognized in the P&L statement, Else the premium is amortized over the life of the contract and the exchange differences on such contracts are recognized in the income statement in the reporting period in which the exchange rate changes. Issues & Comparison IFRS Indian GAAP
All financial assets, liabilities & derivatives are There is no definition of financial instrument. recognized in financial statements when these Currently, derivatives are not required to be meet the definition & criteria of financial recognized in balance sheet except of forward instrument. exchange derivatives and certain others. Eg. – Commodity derivatives, weather
derivatives Governed by IAS 39 Financial Instrument - Governed by AS 11, 13 (accounting for Recognition & Measurement investments)
AS 30 - Financial Instruments -Recognition & Measurement mandatory requirements
commencing from 1st April, 2011
Hedge Accounting For hedge accounting detailed guidance is available under IFRS and US GAAP, while there is no specific guidance in Indian GAAP available for hedge accounting. Hedge accounting is permitted under IFRS and US GAAP provided that an entity meets stringent qualifying criteria in relation to documentation and hedge effectiveness. Both frameworks require documentation of the entity?s risk management objectives and how the effectiveness of the hedge will be assessed. Hedge instruments should be highly effective in offsetting the exposure of the hedged item to changes in the fair value or cash flows, and the effectiveness of the hedge is measured reliably on a continuing basis under both frameworks. In terms of classification of a hedge the two standards namely FAS 133 and IAS 39 differ marginally. However, this does not change the accounting treatment significantly. Both FAS 133 and IAS 39 allow three classes of hedges as follows: 1. Fair value hedge 2. Cash-flow hedge 3. Foreign currency hedge
Fair Value Hedge A fair value hedge is the one that safeguards changes in the value of an asset or liability or an unrecognized firm commitment (the last one only for FAS 133), for instance, a hedge created by a portfolio manager to safeguard the value of his portfolio of securities by shorting Index Futures. In such a hedge the gains and losses on both the derivative and the hedged item are recognized in the Profit & Loss Account as income (or expense) for the period. These gains and losses arise due to re- measuring of fair value and include hedging ineffectiveness.
Cash Flow Hedge A cash-flow hedge is the one that safeguards variation in a forecasted cash-flow, for instance, a hedge created by an enterprise to safeguard variable interest outflow on its Libor linked borrowing by a swap of Libor linked interest payments with fixed interest payment. IAS 39 includes unrecognized firm commitment to buy or sell an asset at a fixed price also as a cashflow hedge.
Effectiveness of a hedge assumes significant importance in accounting of a cash-flow hedge. Effective portion of a derivative is the one that fulfils the objective of safeguarding the variations in the value of the hedged item. The method used for assessing the hedging effectiveness of a derivative must be defined at the time of setting- up the hedge.
In accounting for a cash-flow hedge the main consideration is to carry forward the gains or losses of the effective portion. These are meant to offset the change in the value of hedged item at a later date. The gains and losses on the ineffective portion and excluded portion are written off as the income or loss of the current period. The accumulated profits and gains on the effective portion of the derivative keep accumulating in a special reserve in the equity in the balance sheet. FAS 133 identifies these as part of „Other Comprehensive Income?. The accumulated amount of such unrealized gains is reclassified as profits in the period in which the hedged forecasted transaction affects the earnings. In case the forecasted transaction results in creation of an asset/liability then this accumulated gain is applied for adjusting the value of such asset/ liability.
Foreign Currency Hedge Foreign currency hedge safeguards exposure of an asset, liability or forecasted transaction to foreign exchange rate fluctuations. FAS 133 recognizes four classes of foreign currency hedges whereas IAS 39 recognizes only one. FAS 133 classifications of foreign currency hedge are as follows: ? Net investment in foreign operations: This is a hedge to safeguard the translation risk faced by an enterprise because of foreign exchange exposure to its net investment in foreign operations in a foreign country. IAS 39 also recognizes hedge of a net investment in a foreign entity separately (in fact this is the only classification recognized by IAS 39 apart from fair value and cash flow hedges). Accounting for gains or losses for this class of hedge is done in a similar manner as that for a cash-flow hedge both in IAS 39 and FAS 133.
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Unrecognized firm commitment involving foreign currency exposure: An unrecognized firm commitment, in general, is classified by IAS 39 as a cash-flow hedge. FAS 133, on the other hand, classifies an unrecognized firm commitment without foreign exchange exposure as a fair value hedge.
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Available-for-sale securities with foreign exchange exposure: Financial instruments are categorized into four classes by IAS 39 and three classes by the corresponding US standard FAS 115. The three classes namely „held for trading? securities, „held to maturity? securities, and „available for sale? securities are common to both whereas the class „loans and receivables originated by enterprise? is specific to IAS 39. The residual securities which cannot be classified into any of the other classes are classified as „available for sale? securities. Investments in other enterprises that are neither for shortterm profits nor for being held till maturity (primarily applicable to the debt securities) are likely to be put into this class. Those „available for sale? securities that cause foreign exchange exposure to the enterprise and are hedged by a derivative are classified by FAS 133 into this class of foreign currency hedge. IAS 39 implicitly classifies such hedge as fair value hedge. The accounting treatment in both the standards is similar to a fair value hedge.
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Foreign currency dominated forecasted transactions: These hedges, though not separately classified by IAS 39, implicitly get classified into general forecasted transactions. In either standard (IAS 39 and FAS 133) the accounting is similar to cashflow hedge where gains or losses on the effective portion of the hedging instrument are allowed to be deferred.
The comparison between US GAAP and IFRS for the above hedges is summarized in the following table: IFRS Hedging instruments are measured at fair value. Hedged item Fair Value Hedge is adjusted in P&L for changes in its fair value due to its risks. Gains & Losses are initially deferred to equity and later Cash Flow Hedge released to P&L. Gains/Losses on financial instruments to hedge an asset/liability may be included in cost of non financial assets/liabilities(Basis adjustment) Similar to IFRS except basis adjustment which is not allowed Similar to IFRS US GAAP
Hedges of net investments in foreign operations
Similar to cash flow hedge. Initially deferred to equity and gains/losses transferred to P&L on disposal or partial disposal of foreign operations. Similar to IFRS
Accounting treatment in the books of the client Accounting treatment for the initial margin payment is common for all the four types of equity derivatives. Further the accounting treatment for equity index option is explained.
Accounting for Initial Margin: The initial margin paid by the clients to the trading member is debited in the “Initial Margin Equity Derivative Instruments Account?. Any further initial margin amount paid /received is debited/ credited in the account. On the balance sheet date the balance in the account is shown as deposit under the current asset head. The following example shows the entries which should be done for initial margin
Illustration: Suppose Mr. X enters into certain Equity Derivative Instruments contracts on March 28, 20x3. The Initial Margin on these contracts is Rs. 30,000. The Margin for the subsequent days is as follows: – On 29th March, 20x3 Rs. 35,000 – On 30th March, 20x3 Rs. 25,000 – On 31st March, 20x3 Rs. 27,000 Suggested accounting treatment: Following entries will be passed for the payment / receipt of Initial Margin Date Debited Account Debited Amount 28/03/03 Initial Margin - Equity Derivative Inst. A/c 29/03/03 Initial Margin - Equity Derivative Inst. A/c 30/3/03 Bank A/c Rs. 10000 Initial Margin Equity Derivative Inst. A/c 31/03/03 Initial Margin - Equity Derivative Inst. A/c Rs. 2000 Bank A/c Rs.2000 Rs.10000 Rs. 5000 Bank A/c Rs. 5000 Rs. 30000 Bank A/c Credit Account Credit Amount Rs. 30000
Thus a total of Rs. 27000 (30000+5000-10000+2000) is credited from the client account and is debited in the “Initial margin -Equity Derivative Inst A/c” .The same is disclosed in the balance sheet as follows : Current Assets Initial Margin - Equity Derivative Instruments A/c Rs. 27,000 Accounting Treatment for Equity Index Options: Accounting entries for premium payment and final settlement are done as follows Illustration: Suppose Mr. X further purchases following Options from Mr. Y:
Date of purchase
Type of the options contract
Expiry date
Premium Contract per Multiplier(No of
Strike Price (Rs.)
unit(Rs.) units)
28th March, 2003
S&P CNX NIFTY- 29-MayCall 03
15
200
880
28th March, 2003
S&P CNX NIFTY- 29-MayPut 03
20
200
885
Premium Payment
Accounting entries done in the books of buyer and seller are shown in the tables below. In the first event, accounting entries for “Initial Margin payment” is shown. In second event accounting entries made for “out of money call option” (Strike price Rs.880 and the Spot price Rs. 875) is illustrated. As the call is out of money, the option is not exercised by the buyer and premium paid is written off as an expense in the buyer?s book and is realized as an income in seller?s book. In the third event the call option is „in the money? (strike price Rs.880, Spot price Rs.890).The call option is exercised by the buyer and the net profit is shown as an income in the buyer?s book and as an expense in the seller?s book. Similarly accounting entries are done for the in the money and out of the money put option in event 4 and 5.
Accounting Entries done for Buyer (Mr. X)
Accounting Entries done for Seller (Mr. Y)
Event Treatment Premium on option collected Premium is Call Option recognized as an K=880,S=875 income on expiry of option Loss on the exercise of option paid Call Option K=880,S=890 Premium is recognized as an income Loss on the exercise of option paid Put Option K=885,S=875 Premium is recognized as an income Premium is Put Option recognized as an K=885,S=890 income Date 28/3/03 Debited Account Bank A/C Equity Index option premium A/C P&L A/C ( Expense) Equity Index option premium A/C P&L A/C(expense) Equity Index option premium A/C Equity Index option premium A/C Debited Credit Account Credit Amount Amount Equity Index 7000 7000 option premium A/C 3000 P&L A/C (Income) 3000
29/5/03
29/5/03
2000
Bank A/C P&L A/C (Income) Bank A/C P&L A/C (Income) P&L A/C (Income)
2000
29/5/03
3000
3000
29/5/03
2000
2000
29/5/03
4000
4000
29/5/03
4000
4000
Accounting for open options at the end of an accounting period Buyer and seller follow the financial year as the accounting year and options entered in one period are settled in another. A provision should be made for the amount by which premium paid exceeds the premium prevailing on the balance sheet date.
Illustration: Suppose the balance sheet date is 31st Mar 2003 but the Option expiry date is May 2003.The strike price and the premium on the 31 march is as follows: – Call option K=Rs. 880, Closing rate of premium = Rs.6 per unit – Put Option K=Rs. 885, Closing rate of premium = Rs.28 per unit Accounting entries: Buyer Books. Net provision required to be made in the books of account would be computed as follows:
Call Option May 20x3 Strike Price Rs. 880 • Premium paid • Less: Premium on the balance sheet date • Provision required Put Option May 20x3 Strike Price Rs. 885 • Premium paid • Less: Premium as on the balance sheet date • Provision required Net provision to be made in the books of account: Extracts from the Balance Sheet Current Assets: Equity Index Options Premium Account Less: Provision for Loss on Equity Index Options
Rs. 3,000 Rs. 1,200 Rs. 1,800 Rs. 4000 Rs. 5600 Rs. -1600 Rs. 200
Rs.7,000 (200) Rs.6,800
Accounting entries: Seller books
Call Option May 20x3 Strike Price Rs. 880 Premium as on the balance sheet date Less: Premium received Provision required Put Option May 20x3 Strike Price Rs. 885 Premium as on the balance sheet date Less: Premium received Provision required Net provision to be made in the books of account: (Since the net difference is negative.) Extracts from the Balance Sheet Current Liabilities and Provisions: Equity Index Options Premium Account Provision for Loss on Equity Index Options
Rs. 1,200 Rs. 3,000 Rs. -1,800 Rs. 5,600 Rs. 4,000 Rs. 1,600 NIL
Rs 7000 NIL
Conclusion After a thorough study of various Accounting Standards for derivative instruments, it can be concluded that IFRS is more stringent compared to other Accounting Standards like US GAAP or Indian GAAP. Though Indian GAAP had no specific accounting guidelines for reporting of derivative instruments, adherence to AS 11 and AS 30 is a step in right direction with respect to reporting for derivative instruments. Even the „new? accounting standard, AS 30, leaves much to be desired for various derivative instruments such as weather derivatives, carbon credit derivatives and commodity derivatives. References ? Report on „Identifying Value Drivers – A structural Analysis and Study of Accounting of Forex Losses? by Mr. Sanjesh Jain, student at T. A. Pai Management Institute Manipal, as a part of MIP Project, Batch 2008-10. ? ? Article titled „IFRS & Indian GAAP – A Comparison? issued by Deloitte India. Article titled „Similarities and Differences – A comparison of IFRS, US GAAP and Indian GAAP? by PriceWaterHouseCoopers in November 2007. ? ? ? Business Standard; Article: „Top companies ignore ICAI rule on forex loss treatment’; Monday, Jun 08, 2009 Informed forum for Management Accounting; Article: Breather for India Inc a AS 11 deferred to 2011; Thursday Mar 26, 2009 The Hindu Business Line o Article: 'Accounting norm changes help major cos boost earnings' by Vidya Bala ; Monday, Jun 01, 2009 o Article: 'Should accounting be driven by economic conditions? "; Thursday, Mar 19, 2009 o Article: 'Who will gain from AS-11 change? ' by Vidya Bala ; Sunday, Apr 12, 2009 o Article: „Accounting for derivative await panel approval?; May 16, 2008
o Article: „Accounting of derivative losses?; Thursday, April 17, 2008
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