26 November 2007
Thanks alot for your efforts..i reaaly dont remember the month in which it was given..but i really require it urgently i would have been grateful to you if you could send me those accounting entries of Derivatives as soon as possible.
26 November 2007
ACCOUNTING OF INDEX FUTURES TRANSACTIONS
This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock Index Futures. Stock Index Futures are provided more coverage as these have been introduced recently and would be of immediate benefit to practitioners.
International perspective is also provided with a short discussion on fair value accounting. The implications of Accounting practices in the US (FASB-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Note for Accounting of Index Futures in December 2000. The guidelines provided here in this Section below are in accordance with the contents of this Guidance Note.
INDIAN ACCOUNTING PRACTICES
Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be issued by the Institute of Chartered Accountants of India.
Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract to establish the amount of the reporting currency required or available at the settlement date of transaction. Accounting Standard 11 provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognised as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognised as income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment and interest. As on 1st December 1999, it appears to the company that the US $ may be dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The forward rate may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract (US $ 3,00,000 * Rs. 44)
Rs 1,32,00,000 Amount payable had the forward contract not been in place (US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000 Gain arising out of the forward exchange contract Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the transaction should be recognised as income or expense over the life of the contract. In the above example, the difference between the spot rate and forward rate as on 1st December is Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of the forward contract should be apportioned on time basis. In the given example, the time ratio would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-2000 and the balance Rs. 30,000 should be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot rate on the date of forward contract be accounted. As a result, the benefits or losses accruing due to the forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $ 1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of this loss in the financial year 1999-2000.
Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock index future. Both the Bombay Stock Exchange and the National Stock Exchange have introduced index futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed Futures upto 3 months expiry. For example, in the month of September 2000, an investor can buy September Series, October Series and November Series. The September Series will expire on the last Thursday of September. From the next day (i.e. Friday), the December Series will be quoted on the exchange.
Accounting of Index Futures
Internationally, ‘fair value accounting’ plays an important role in accounting for investments and stock index futures. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Simply stated, fair value accounting requires that underlying securities and associated derivative instruments be valued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provides that the current investments should be carried in the financial statements as lower of cost and fair value determined either on an individual investment basis or by category of investment. Current investment is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date of investment. Any reduction in the carrying amount and any reversals of such reductions should be charged or credited to the profit and loss account.
On the disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to the profit and loss statement.
In countries where local accounting practices require valuation of underlying at fair value, size=2 index futures (and other derivative instruments) are also valued at fair value. In countries where local accounting practices for the underlying are largely dependent on cost (or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of Indian accounting practices currently not recognising fair value, it is widely expected that stock index futures will also be accounted based on prudent accounting conventions. The Institute is finalising a Guidance Note on this area, which is expected to be shortly released.
The accounting suggestions provided in the Indian context in the following paragraphs should be read in this perspective. The suggestions contained are based on the author’s personal views on the subject.
Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National Stock Exchange have set up independent derivatives segments, where select broker-members have been permitted to operate. These broker-members are required to satisfy net worth and other criteria as specified by the SEBI Committees.
Each client who buys or sells stock index futures is first required to deposit an Initial Margin. This margin is generally a percentage of the amount of exposure that the client takes up and varies from time to time based on the volatility levels in the market. At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the Balance Sheet.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level).
Example
Mr. 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. 4,850
Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract on the Bombay Stock Exchange).
The accounting entry will be :
Initial Margin Account Dr 28,050 To Bank 28,050
If the daily settlement prices of the above Sensex Futures were as follows:
Date
04/09/00 05/09/00 06/09/00 07/09/00 08/09/00 Oct. Series
4520 4510 4480 4500 4490 Nov. Series
4850 4800 -- -- --
Let us assume that Mr X he sold the November Series contract at Rs 4,810.
The amount of ‘Mark-to-Market Margin Money’ Sensex receivable/payable due to increase/decrease in daily settlement prices is as below. Please note that one Contract on the Bombay Stock Exchange implies 50 underlying Units of the Sensex.
Date October Series November Series Receive Pay Receive Pay 4th September 2000 1,000 - - - 5th September 2000 - 500 - 2,500 6th September 2000 - 1,500 - - 7th September 2000 1,000 - - - 8th September 2000 - 500 - -
The amount of ‘Mark-to-Market Margin Money’ received/paid will be credited/debited to ‘Mark-to-Market Margin Account’ on a day to day basis. For example, on the 4th of September the following entry will be passed:
Bank A/c Dr. 1,000 To Mark-to-market Margin A/c 1,000
TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the November Series Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on 6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin Account so that this Account is reduced to zero. The Mark to Margin Account will contain transactions pertaining to this Futures Series. This component will also be reversed on 6th Sept 2000.
Bank Account Dr 15,050 Loss on November Series Dr 2,000 Initial Margin 14,550 Mark to Market Margin 2,500
Margins maintained with Brokers
Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients should pay them slightly higher margins than that demanded by the exchange and use this extra collection to pay up daily margins as and when required.
If a client is called upon to pay further daily margins or receives a refund of daily margins from his broker, the client would again account for this payment or refund in the Balance Sheet. The margins paid would get reflected as Assets in the Balance Sheet and refunds would reduce these Assets.
The client could square up any of his transactions any time. If transactions are not squared up, the exchange would automatically square up all transactions on the day of expiry of the futures series. For example, an October 2000 future would expire on the last Thursday, i.e. 26th October 2000. On this day, all futures transactions remaining outstanding on the system would be compulsorily squared up.
Recognition of Profit or Loss
A basic issue which arises in the context of daily settlement is whether profits and losses accrue from day to day or do they accrue only at the point of squaring up. It is widely believed that daily settlement does not mean daily squaring up. The daily settlement system is an administrative mechanism whereby the stock exchanges maintain a healthy system of controls. From an accounting perspective, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be recognised in the Profit & Loss Account of the period in which the squaring up takes place.
If a series of transactions were to take place and the client is unable to identify which particular transaction was squared up, the client could follow the First In First Out method of accounting. For example, if the October series of SENSEX futures was purchased on 11th October and again on 12th October and sold on 16th October, it will be understood that the 11th October purchases are sold first. The FIFO would be applied independently for each series for each stock index future. For example, if November series of NIFTY are also purchased and sold, these would be tracked separately and not mixed up with the October series of SENSEX.
Accounting at Financial Year End
In view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognised at the year end, while unrealised profits would not be recognised.
A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit or loss in this accounting period.
Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a provision towards losses in his Profit or Loss Account in this accounting period.
In the next year, the Nifty future is actually sold for Rs 2,10,000.
At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next financial year.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting Standard Board, US defines the criteria /attributes which an instrument should have to be called as derivative and also provides guidance for accounting of derivatives. The Standard is facing tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:
A derivative’s cash flows or fair value must fluctuate or vary based on the changes in an underlying variable. The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying. The contract can be readily settled by net cash payment
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognised in the year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging instrument, the gain or loss on the derivative instrument is required to be recognised as profit or loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are called Fair Value Hedges. The gain or loss on such derivative instruments as well as the off setting loss or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures contract would compensate the loss or gain on the portfolio. Both the gains and losses will be recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will offset each other and hence will not have any impact on the current earnings. However, if the hedge is not a perfect hedge, there would be a difference between the gain and the compensating loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be transferred to current earnings of the same period or the periods during which the forecasted transaction affects the earnings. The remaining gain or loss on the derivative instrument if any shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a hedge transaction, the company should at the inception of the transaction:
Designate the hedge relationship Document such relationship Identifying hedge item, hedge instrument and risks being hedged Expect hedge to be highly effective Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognised that not all hedging transactions can be perfect. There can be a degree of ineffectiveness which should be recognized. The Statement requires that the assessment of effectiveness must be consistent with risk management strategies documented for that particular hedge relationship. Further the assessment of effectiveness is required whenever financial statements or earnings are reported.
26 November 2007
ACCOUNTING OF INDEX FUTURES TRANSACTIONS
This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock Index Futures. Stock Index Futures are provided more coverage as these have been introduced recently and would be of immediate benefit to practitioners.
International perspective is also provided with a short discussion on fair value accounting. The implications of Accounting practices in the US (FASB-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Note for Accounting of Index Futures in December 2000. The guidelines provided here in this Section below are in accordance with the contents of this Guidance Note.
INDIAN ACCOUNTING PRACTICES
Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be issued by the Institute of Chartered Accountants of India.
Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract to establish the amount of the reporting currency required or available at the settlement date of transaction. Accounting Standard 11 provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognised as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognised as income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment and interest. As on 1st December 1999, it appears to the company that the US $ may be dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The forward rate may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract (US $ 3,00,000 * Rs. 44)
Rs 1,32,00,000 Amount payable had the forward contract not been in place (US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000 Gain arising out of the forward exchange contract Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the transaction should be recognised as income or expense over the life of the contract. In the above example, the difference between the spot rate and forward rate as on 1st December is Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of the forward contract should be apportioned on time basis. In the given example, the time ratio would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-2000 and the balance Rs. 30,000 should be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot rate on the date of forward contract be accounted. As a result, the benefits or losses accruing due to the forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $ 1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of this loss in the financial year 1999-2000.
Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock index future. Both the Bombay Stock Exchange and the National Stock Exchange have introduced index futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed Futures upto 3 months expiry. For example, in the month of September 2000, an investor can buy September Series, October Series and November Series. The September Series will expire on the last Thursday of September. From the next day (i.e. Friday), the December Series will be quoted on the exchange.
Accounting of Index Futures
Internationally, ‘fair value accounting’ plays an important role in accounting for investments and stock index futures. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Simply stated, fair value accounting requires that underlying securities and associated derivative instruments be valued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provides that the current investments should be carried in the financial statements as lower of cost and fair value determined either on an individual investment basis or by category of investment. Current investment is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date of investment. Any reduction in the carrying amount and any reversals of such reductions should be charged or credited to the profit and loss account.
On the disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to the profit and loss statement.
In countries where local accounting practices require valuation of underlying at fair value, size=2 index futures (and other derivative instruments) are also valued at fair value. In countries where local accounting practices for the underlying are largely dependent on cost (or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of Indian accounting practices currently not recognising fair value, it is widely expected that stock index futures will also be accounted based on prudent accounting conventions. The Institute is finalising a Guidance Note on this area, which is expected to be shortly released.
The accounting suggestions provided in the Indian context in the following paragraphs should be read in this perspective. The suggestions contained are based on the author’s personal views on the subject.
Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National Stock Exchange have set up independent derivatives segments, where select broker-members have been permitted to operate. These broker-members are required to satisfy net worth and other criteria as specified by the SEBI Committees.
Each client who buys or sells stock index futures is first required to deposit an Initial Margin. This margin is generally a percentage of the amount of exposure that the client takes up and varies from time to time based on the volatility levels in the market. At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the Balance Sheet.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level).
Example
Mr. 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. 4,850
Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract on the Bombay Stock Exchange).
The accounting entry will be :
Initial Margin Account Dr 28,050 To Bank 28,050
If the daily settlement prices of the above Sensex Futures were as follows:
Date
04/09/00 05/09/00 06/09/00 07/09/00 08/09/00 Oct. Series
4520 4510 4480 4500 4490 Nov. Series
4850 4800 -- -- --
Let us assume that Mr X he sold the November Series contract at Rs 4,810.
The amount of ‘Mark-to-Market Margin Money’ Sensex receivable/payable due to increase/decrease in daily settlement prices is as below. Please note that one Contract on the Bombay Stock Exchange implies 50 underlying Units of the Sensex.
Date October Series November Series Receive Pay Receive Pay 4th September 2000 1,000 - - - 5th September 2000 - 500 - 2,500 6th September 2000 - 1,500 - - 7th September 2000 1,000 - - - 8th September 2000 - 500 - -
The amount of ‘Mark-to-Market Margin Money’ received/paid will be credited/debited to ‘Mark-to-Market Margin Account’ on a day to day basis. For example, on the 4th of September the following entry will be passed:
Bank A/c Dr. 1,000 To Mark-to-market Margin A/c 1,000
TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the November Series Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on 6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin Account so that this Account is reduced to zero. The Mark to Margin Account will contain transactions pertaining to this Futures Series. This component will also be reversed on 6th Sept 2000.
Bank Account Dr 15,050 Loss on November Series Dr 2,000 Initial Margin 14,550 Mark to Market Margin 2,500
Margins maintained with Brokers
Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients should pay them slightly higher margins than that demanded by the exchange and use this extra collection to pay up daily margins as and when required.
If a client is called upon to pay further daily margins or receives a refund of daily margins from his broker, the client would again account for this payment or refund in the Balance Sheet. The margins paid would get reflected as Assets in the Balance Sheet and refunds would reduce these Assets.
The client could square up any of his transactions any time. If transactions are not squared up, the exchange would automatically square up all transactions on the day of expiry of the futures series. For example, an October 2000 future would expire on the last Thursday, i.e. 26th October 2000. On this day, all futures transactions remaining outstanding on the system would be compulsorily squared up.
Recognition of Profit or Loss
A basic issue which arises in the context of daily settlement is whether profits and losses accrue from day to day or do they accrue only at the point of squaring up. It is widely believed that daily settlement does not mean daily squaring up. The daily settlement system is an administrative mechanism whereby the stock exchanges maintain a healthy system of controls. From an accounting perspective, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be recognised in the Profit & Loss Account of the period in which the squaring up takes place.
If a series of transactions were to take place and the client is unable to identify which particular transaction was squared up, the client could follow the First In First Out method of accounting. For example, if the October series of SENSEX futures was purchased on 11th October and again on 12th October and sold on 16th October, it will be understood that the 11th October purchases are sold first. The FIFO would be applied independently for each series for each stock index future. For example, if November series of NIFTY are also purchased and sold, these would be tracked separately and not mixed up with the October series of SENSEX.
Accounting at Financial Year End
In view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognised at the year end, while unrealised profits would not be recognised.
A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit or loss in this accounting period.
Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a provision towards losses in his Profit or Loss Account in this accounting period.
In the next year, the Nifty future is actually sold for Rs 2,10,000.
At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next financial year.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting Standard Board, US defines the criteria /attributes which an instrument should have to be called as derivative and also provides guidance for accounting of derivatives. The Standard is facing tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:
A derivative’s cash flows or fair value must fluctuate or vary based on the changes in an underlying variable. The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying. The contract can be readily settled by net cash payment
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognised in the year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging instrument, the gain or loss on the derivative instrument is required to be recognised as profit or loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are called Fair Value Hedges. The gain or loss on such derivative instruments as well as the off setting loss or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures contract would compensate the loss or gain on the portfolio. Both the gains and losses will be recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will offset each other and hence will not have any impact on the current earnings. However, if the hedge is not a perfect hedge, there would be a difference between the gain and the compensating loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be transferred to current earnings of the same period or the periods during which the forecasted transaction affects the earnings. The remaining gain or loss on the derivative instrument if any shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a hedge transaction, the company should at the inception of the transaction:
Designate the hedge relationship Document such relationship Identifying hedge item, hedge instrument and risks being hedged Expect hedge to be highly effective Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognised that not all hedging transactions can be perfect. There can be a degree of ineffectiveness which should be recognized. The Statement requires that the assessment of effectiveness must be consistent with risk management strategies documented for that particular hedge relationship. Further the assessment of effectiveness is required whenever financial statements or earnings are reported.
26 November 2007
ACCOUNTING OF INDEX FUTURES TRANSACTIONS
This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock Index Futures. Stock Index Futures are provided more coverage as these have been introduced recently and would be of immediate benefit to practitioners.
International perspective is also provided with a short discussion on fair value accounting. The implications of Accounting practices in the US (FASB-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Note for Accounting of Index Futures in December 2000. The guidelines provided here in this Section below are in accordance with the contents of this Guidance Note.
INDIAN ACCOUNTING PRACTICES
Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be issued by the Institute of Chartered Accountants of India.
Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract to establish the amount of the reporting currency required or available at the settlement date of transaction. Accounting Standard 11 provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognised as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognised as income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment and interest. As on 1st December 1999, it appears to the company that the US $ may be dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The forward rate may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract (US $ 3,00,000 * Rs. 44)
Rs 1,32,00,000 Amount payable had the forward contract not been in place (US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000 Gain arising out of the forward exchange contract Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the transaction should be recognised as income or expense over the life of the contract. In the above example, the difference between the spot rate and forward rate as on 1st December is Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of the forward contract should be apportioned on time basis. In the given example, the time ratio would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-2000 and the balance Rs. 30,000 should be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot rate on the date of forward contract be accounted. As a result, the benefits or losses accruing due to the forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $ 1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of this loss in the financial year 1999-2000.
Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock index future. Both the Bombay Stock Exchange and the National Stock Exchange have introduced index futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed Futures upto 3 months expiry. For example, in the month of September 2000, an investor can buy September Series, October Series and November Series. The September Series will expire on the last Thursday of September. From the next day (i.e. Friday), the December Series will be quoted on the exchange.
Accounting of Index Futures
Internationally, ‘fair value accounting’ plays an important role in accounting for investments and stock index futures. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Simply stated, fair value accounting requires that underlying securities and associated derivative instruments be valued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provides that the current investments should be carried in the financial statements as lower of cost and fair value determined either on an individual investment basis or by category of investment. Current investment is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date of investment. Any reduction in the carrying amount and any reversals of such reductions should be charged or credited to the profit and loss account.
On the disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to the profit and loss statement.
In countries where local accounting practices require valuation of underlying at fair value, size=2 index futures (and other derivative instruments) are also valued at fair value. In countries where local accounting practices for the underlying are largely dependent on cost (or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of Indian accounting practices currently not recognising fair value, it is widely expected that stock index futures will also be accounted based on prudent accounting conventions. The Institute is finalising a Guidance Note on this area, which is expected to be shortly released.
The accounting suggestions provided in the Indian context in the following paragraphs should be read in this perspective. The suggestions contained are based on the author’s personal views on the subject.
Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National Stock Exchange have set up independent derivatives segments, where select broker-members have been permitted to operate. These broker-members are required to satisfy net worth and other criteria as specified by the SEBI Committees.
Each client who buys or sells stock index futures is first required to deposit an Initial Margin. This margin is generally a percentage of the amount of exposure that the client takes up and varies from time to time based on the volatility levels in the market. At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the Balance Sheet.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level).
Example
Mr. 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. 4,850
Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract on the Bombay Stock Exchange).
The accounting entry will be :
Initial Margin Account Dr 28,050 To Bank 28,050
If the daily settlement prices of the above Sensex Futures were as follows:
Date
04/09/00 05/09/00 06/09/00 07/09/00 08/09/00 Oct. Series
4520 4510 4480 4500 4490 Nov. Series
4850 4800 -- -- --
Let us assume that Mr X he sold the November Series contract at Rs 4,810.
The amount of ‘Mark-to-Market Margin Money’ Sensex receivable/payable due to increase/decrease in daily settlement prices is as below. Please note that one Contract on the Bombay Stock Exchange implies 50 underlying Units of the Sensex.
Date October Series November Series Receive Pay Receive Pay 4th September 2000 1,000 - - - 5th September 2000 - 500 - 2,500 6th September 2000 - 1,500 - - 7th September 2000 1,000 - - - 8th September 2000 - 500 - -
The amount of ‘Mark-to-Market Margin Money’ received/paid will be credited/debited to ‘Mark-to-Market Margin Account’ on a day to day basis. For example, on the 4th of September the following entry will be passed:
Bank A/c Dr. 1,000 To Mark-to-market Margin A/c 1,000
TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the November Series Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on 6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin Account so that this Account is reduced to zero. The Mark to Margin Account will contain transactions pertaining to this Futures Series. This component will also be reversed on 6th Sept 2000.
Bank Account Dr 15,050 Loss on November Series Dr 2,000 Initial Margin 14,550 Mark to Market Margin 2,500
Margins maintained with Brokers
Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients should pay them slightly higher margins than that demanded by the exchange and use this extra collection to pay up daily margins as and when required.
If a client is called upon to pay further daily margins or receives a refund of daily margins from his broker, the client would again account for this payment or refund in the Balance Sheet. The margins paid would get reflected as Assets in the Balance Sheet and refunds would reduce these Assets.
The client could square up any of his transactions any time. If transactions are not squared up, the exchange would automatically square up all transactions on the day of expiry of the futures series. For example, an October 2000 future would expire on the last Thursday, i.e. 26th October 2000. On this day, all futures transactions remaining outstanding on the system would be compulsorily squared up.
Recognition of Profit or Loss
A basic issue which arises in the context of daily settlement is whether profits and losses accrue from day to day or do they accrue only at the point of squaring up. It is widely believed that daily settlement does not mean daily squaring up. The daily settlement system is an administrative mechanism whereby the stock exchanges maintain a healthy system of controls. From an accounting perspective, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be recognised in the Profit & Loss Account of the period in which the squaring up takes place.
If a series of transactions were to take place and the client is unable to identify which particular transaction was squared up, the client could follow the First In First Out method of accounting. For example, if the October series of SENSEX futures was purchased on 11th October and again on 12th October and sold on 16th October, it will be understood that the 11th October purchases are sold first. The FIFO would be applied independently for each series for each stock index future. For example, if November series of NIFTY are also purchased and sold, these would be tracked separately and not mixed up with the October series of SENSEX.
Accounting at Financial Year End
In view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognised at the year end, while unrealised profits would not be recognised.
A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit or loss in this accounting period.
Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a provision towards losses in his Profit or Loss Account in this accounting period.
In the next year, the Nifty future is actually sold for Rs 2,10,000.
At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next financial year.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting Standard Board, US defines the criteria /attributes which an instrument should have to be called as derivative and also provides guidance for accounting of derivatives. The Standard is facing tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:
A derivative’s cash flows or fair value must fluctuate or vary based on the changes in an underlying variable. The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying. The contract can be readily settled by net cash payment
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognised in the year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging instrument, the gain or loss on the derivative instrument is required to be recognised as profit or loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are called Fair Value Hedges. The gain or loss on such derivative instruments as well as the off setting loss or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures contract would compensate the loss or gain on the portfolio. Both the gains and losses will be recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will offset each other and hence will not have any impact on the current earnings. However, if the hedge is not a perfect hedge, there would be a difference between the gain and the compensating loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be transferred to current earnings of the same period or the periods during which the forecasted transaction affects the earnings. The remaining gain or loss on the derivative instrument if any shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a hedge transaction, the company should at the inception of the transaction:
Designate the hedge relationship Document such relationship Identifying hedge item, hedge instrument and risks being hedged Expect hedge to be highly effective Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognised that not all hedging transactions can be perfect. There can be a degree of ineffectiveness which should be recognized. The Statement requires that the assessment of effectiveness must be consistent with risk management strategies documented for that particular hedge relationship. Further the assessment of effectiveness is required whenever financial statements or earnings are reported.
26 November 2007
ACCOUNTING OF INDEX FUTURES TRANSACTIONS
This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock Index Futures. Stock Index Futures are provided more coverage as these have been introduced recently and would be of immediate benefit to practitioners.
International perspective is also provided with a short discussion on fair value accounting. The implications of Accounting practices in the US (FASB-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Note for Accounting of Index Futures in December 2000. The guidelines provided here in this Section below are in accordance with the contents of this Guidance Note.
INDIAN ACCOUNTING PRACTICES
Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be issued by the Institute of Chartered Accountants of India.
Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract to establish the amount of the reporting currency required or available at the settlement date of transaction. Accounting Standard 11 provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognised as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognised as income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment and interest. As on 1st December 1999, it appears to the company that the US $ may be dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The forward rate may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract (US $ 3,00,000 * Rs. 44)
Rs 1,32,00,000 Amount payable had the forward contract not been in place (US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000 Gain arising out of the forward exchange contract Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the transaction should be recognised as income or expense over the life of the contract. In the above example, the difference between the spot rate and forward rate as on 1st December is Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of the forward contract should be apportioned on time basis. In the given example, the time ratio would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-2000 and the balance Rs. 30,000 should be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot rate on the date of forward contract be accounted. As a result, the benefits or losses accruing due to the forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $ 1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of this loss in the financial year 1999-2000.
Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock index future. Both the Bombay Stock Exchange and the National Stock Exchange have introduced index futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed Futures upto 3 months expiry. For example, in the month of September 2000, an investor can buy September Series, October Series and November Series. The September Series will expire on the last Thursday of September. From the next day (i.e. Friday), the December Series will be quoted on the exchange.
Accounting of Index Futures
Internationally, ‘fair value accounting’ plays an important role in accounting for investments and stock index futures. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Simply stated, fair value accounting requires that underlying securities and associated derivative instruments be valued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provides that the current investments should be carried in the financial statements as lower of cost and fair value determined either on an individual investment basis or by category of investment. Current investment is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date of investment. Any reduction in the carrying amount and any reversals of such reductions should be charged or credited to the profit and loss account.
On the disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to the profit and loss statement.
In countries where local accounting practices require valuation of underlying at fair value, size=2 index futures (and other derivative instruments) are also valued at fair value. In countries where local accounting practices for the underlying are largely dependent on cost (or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of Indian accounting practices currently not recognising fair value, it is widely expected that stock index futures will also be accounted based on prudent accounting conventions. The Institute is finalising a Guidance Note on this area, which is expected to be shortly released.
The accounting suggestions provided in the Indian context in the following paragraphs should be read in this perspective. The suggestions contained are based on the author’s personal views on the subject.
Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National Stock Exchange have set up independent derivatives segments, where select broker-members have been permitted to operate. These broker-members are required to satisfy net worth and other criteria as specified by the SEBI Committees.
Each client who buys or sells stock index futures is first required to deposit an Initial Margin. This margin is generally a percentage of the amount of exposure that the client takes up and varies from time to time based on the volatility levels in the market. At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the Balance Sheet.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level).
Example
Mr. 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. 4,850
Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract on the Bombay Stock Exchange).
The accounting entry will be :
Initial Margin Account Dr 28,050 To Bank 28,050
If the daily settlement prices of the above Sensex Futures were as follows:
Date
04/09/00 05/09/00 06/09/00 07/09/00 08/09/00 Oct. Series
4520 4510 4480 4500 4490 Nov. Series
4850 4800 -- -- --
Let us assume that Mr X he sold the November Series contract at Rs 4,810.
The amount of ‘Mark-to-Market Margin Money’ Sensex receivable/payable due to increase/decrease in daily settlement prices is as below. Please note that one Contract on the Bombay Stock Exchange implies 50 underlying Units of the Sensex.
Date October Series November Series Receive Pay Receive Pay 4th September 2000 1,000 - - - 5th September 2000 - 500 - 2,500 6th September 2000 - 1,500 - - 7th September 2000 1,000 - - - 8th September 2000 - 500 - -
The amount of ‘Mark-to-Market Margin Money’ received/paid will be credited/debited to ‘Mark-to-Market Margin Account’ on a day to day basis. For example, on the 4th of September the following entry will be passed:
Bank A/c Dr. 1,000 To Mark-to-market Margin A/c 1,000
TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the November Series Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on 6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin Account so that this Account is reduced to zero. The Mark to Margin Account will contain transactions pertaining to this Futures Series. This component will also be reversed on 6th Sept 2000.
Bank Account Dr 15,050 Loss on November Series Dr 2,000 Initial Margin 14,550 Mark to Market Margin 2,500
Margins maintained with Brokers
Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients should pay them slightly higher margins than that demanded by the exchange and use this extra collection to pay up daily margins as and when required.
If a client is called upon to pay further daily margins or receives a refund of daily margins from his broker, the client would again account for this payment or refund in the Balance Sheet. The margins paid would get reflected as Assets in the Balance Sheet and refunds would reduce these Assets.
The client could square up any of his transactions any time. If transactions are not squared up, the exchange would automatically square up all transactions on the day of expiry of the futures series. For example, an October 2000 future would expire on the last Thursday, i.e. 26th October 2000. On this day, all futures transactions remaining outstanding on the system would be compulsorily squared up.
Recognition of Profit or Loss
A basic issue which arises in the context of daily settlement is whether profits and losses accrue from day to day or do they accrue only at the point of squaring up. It is widely believed that daily settlement does not mean daily squaring up. The daily settlement system is an administrative mechanism whereby the stock exchanges maintain a healthy system of controls. From an accounting perspective, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be recognised in the Profit & Loss Account of the period in which the squaring up takes place.
If a series of transactions were to take place and the client is unable to identify which particular transaction was squared up, the client could follow the First In First Out method of accounting. For example, if the October series of SENSEX futures was purchased on 11th October and again on 12th October and sold on 16th October, it will be understood that the 11th October purchases are sold first. The FIFO would be applied independently for each series for each stock index future. For example, if November series of NIFTY are also purchased and sold, these would be tracked separately and not mixed up with the October series of SENSEX.
Accounting at Financial Year End
In view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognised at the year end, while unrealised profits would not be recognised.
A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit or loss in this accounting period.
Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a provision towards losses in his Profit or Loss Account in this accounting period.
In the next year, the Nifty future is actually sold for Rs 2,10,000.
At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next financial year.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting Standard Board, US defines the criteria /attributes which an instrument should have to be called as derivative and also provides guidance for accounting of derivatives. The Standard is facing tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:
A derivative’s cash flows or fair value must fluctuate or vary based on the changes in an underlying variable. The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying. The contract can be readily settled by net cash payment
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognised in the year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging instrument, the gain or loss on the derivative instrument is required to be recognised as profit or loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are called Fair Value Hedges. The gain or loss on such derivative instruments as well as the off setting loss or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures contract would compensate the loss or gain on the portfolio. Both the gains and losses will be recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will offset each other and hence will not have any impact on the current earnings. However, if the hedge is not a perfect hedge, there would be a difference between the gain and the compensating loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be transferred to current earnings of the same period or the periods during which the forecasted transaction affects the earnings. The remaining gain or loss on the derivative instrument if any shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a hedge transaction, the company should at the inception of the transaction:
Designate the hedge relationship Document such relationship Identifying hedge item, hedge instrument and risks being hedged Expect hedge to be highly effective Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognised that not all hedging transactions can be perfect. There can be a degree of ineffectiveness which should be recognized. The Statement requires that the assessment of effectiveness must be consistent with risk management strategies documented for that particular hedge relationship. Further the assessment of effectiveness is required whenever financial statements or earnings are reported.
26 November 2007
ACCOUNTING OF INDEX FUTURES TRANSACTIONS
This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock Index Futures. Stock Index Futures are provided more coverage as these have been introduced recently and would be of immediate benefit to practitioners.
International perspective is also provided with a short discussion on fair value accounting. The implications of Accounting practices in the US (FASB-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Note for Accounting of Index Futures in December 2000. The guidelines provided here in this Section below are in accordance with the contents of this Guidance Note.
INDIAN ACCOUNTING PRACTICES
Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be issued by the Institute of Chartered Accountants of India.
Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract to establish the amount of the reporting currency required or available at the settlement date of transaction. Accounting Standard 11 provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognised as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognised as income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment and interest. As on 1st December 1999, it appears to the company that the US $ may be dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The forward rate may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract (US $ 3,00,000 * Rs. 44)
Rs 1,32,00,000 Amount payable had the forward contract not been in place (US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000 Gain arising out of the forward exchange contract Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the transaction should be recognised as income or expense over the life of the contract. In the above example, the difference between the spot rate and forward rate as on 1st December is Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of the forward contract should be apportioned on time basis. In the given example, the time ratio would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-2000 and the balance Rs. 30,000 should be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot rate on the date of forward contract be accounted. As a result, the benefits or losses accruing due to the forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $ 1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of this loss in the financial year 1999-2000.
Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock index future. Both the Bombay Stock Exchange and the National Stock Exchange have introduced index futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed Futures upto 3 months expiry. For example, in the month of September 2000, an investor can buy September Series, October Series and November Series. The September Series will expire on the last Thursday of September. From the next day (i.e. Friday), the December Series will be quoted on the exchange.
Accounting of Index Futures
Internationally, ‘fair value accounting’ plays an important role in accounting for investments and stock index futures. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Simply stated, fair value accounting requires that underlying securities and associated derivative instruments be valued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provides that the current investments should be carried in the financial statements as lower of cost and fair value determined either on an individual investment basis or by category of investment. Current investment is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date of investment. Any reduction in the carrying amount and any reversals of such reductions should be charged or credited to the profit and loss account.
On the disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to the profit and loss statement.
In countries where local accounting practices require valuation of underlying at fair value, size=2 index futures (and other derivative instruments) are also valued at fair value. In countries where local accounting practices for the underlying are largely dependent on cost (or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of Indian accounting practices currently not recognising fair value, it is widely expected that stock index futures will also be accounted based on prudent accounting conventions. The Institute is finalising a Guidance Note on this area, which is expected to be shortly released.
The accounting suggestions provided in the Indian context in the following paragraphs should be read in this perspective. The suggestions contained are based on the author’s personal views on the subject.
Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National Stock Exchange have set up independent derivatives segments, where select broker-members have been permitted to operate. These broker-members are required to satisfy net worth and other criteria as specified by the SEBI Committees.
Each client who buys or sells stock index futures is first required to deposit an Initial Margin. This margin is generally a percentage of the amount of exposure that the client takes up and varies from time to time based on the volatility levels in the market. At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the Balance Sheet.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level).
Example
Mr. 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. 4,850
Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract on the Bombay Stock Exchange).
The accounting entry will be :
Initial Margin Account Dr 28,050 To Bank 28,050
If the daily settlement prices of the above Sensex Futures were as follows:
Date
04/09/00 05/09/00 06/09/00 07/09/00 08/09/00 Oct. Series
4520 4510 4480 4500 4490 Nov. Series
4850 4800 -- -- --
Let us assume that Mr X he sold the November Series contract at Rs 4,810.
The amount of ‘Mark-to-Market Margin Money’ Sensex receivable/payable due to increase/decrease in daily settlement prices is as below. Please note that one Contract on the Bombay Stock Exchange implies 50 underlying Units of the Sensex.
Date October Series November Series Receive Pay Receive Pay 4th September 2000 1,000 - - - 5th September 2000 - 500 - 2,500 6th September 2000 - 1,500 - - 7th September 2000 1,000 - - - 8th September 2000 - 500 - -
The amount of ‘Mark-to-Market Margin Money’ received/paid will be credited/debited to ‘Mark-to-Market Margin Account’ on a day to day basis. For example, on the 4th of September the following entry will be passed:
Bank A/c Dr. 1,000 To Mark-to-market Margin A/c 1,000
TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the November Series Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on 6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin Account so that this Account is reduced to zero. The Mark to Margin Account will contain transactions pertaining to this Futures Series. This component will also be reversed on 6th Sept 2000.
Bank Account Dr 15,050 Loss on November Series Dr 2,000 Initial Margin 14,550 Mark to Market Margin 2,500
Margins maintained with Brokers
Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients should pay them slightly higher margins than that demanded by the exchange and use this extra collection to pay up daily margins as and when required.
If a client is called upon to pay further daily margins or receives a refund of daily margins from his broker, the client would again account for this payment or refund in the Balance Sheet. The margins paid would get reflected as Assets in the Balance Sheet and refunds would reduce these Assets.
The client could square up any of his transactions any time. If transactions are not squared up, the exchange would automatically square up all transactions on the day of expiry of the futures series. For example, an October 2000 future would expire on the last Thursday, i.e. 26th October 2000. On this day, all futures transactions remaining outstanding on the system would be compulsorily squared up.
Recognition of Profit or Loss
A basic issue which arises in the context of daily settlement is whether profits and losses accrue from day to day or do they accrue only at the point of squaring up. It is widely believed that daily settlement does not mean daily squaring up. The daily settlement system is an administrative mechanism whereby the stock exchanges maintain a healthy system of controls. From an accounting perspective, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be recognised in the Profit & Loss Account of the period in which the squaring up takes place.
If a series of transactions were to take place and the client is unable to identify which particular transaction was squared up, the client could follow the First In First Out method of accounting. For example, if the October series of SENSEX futures was purchased on 11th October and again on 12th October and sold on 16th October, it will be understood that the 11th October purchases are sold first. The FIFO would be applied independently for each series for each stock index future. For example, if November series of NIFTY are also purchased and sold, these would be tracked separately and not mixed up with the October series of SENSEX.
Accounting at Financial Year End
In view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognised at the year end, while unrealised profits would not be recognised.
A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit or loss in this accounting period.
Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a provision towards losses in his Profit or Loss Account in this accounting period.
In the next year, the Nifty future is actually sold for Rs 2,10,000.
At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next financial year.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting Standard Board, US defines the criteria /attributes which an instrument should have to be called as derivative and also provides guidance for accounting of derivatives. The Standard is facing tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:
A derivative’s cash flows or fair value must fluctuate or vary based on the changes in an underlying variable. The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying. The contract can be readily settled by net cash payment
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognised in the year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging instrument, the gain or loss on the derivative instrument is required to be recognised as profit or loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are called Fair Value Hedges. The gain or loss on such derivative instruments as well as the off setting loss or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures contract would compensate the loss or gain on the portfolio. Both the gains and losses will be recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will offset each other and hence will not have any impact on the current earnings. However, if the hedge is not a perfect hedge, there would be a difference between the gain and the compensating loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be transferred to current earnings of the same period or the periods during which the forecasted transaction affects the earnings. The remaining gain or loss on the derivative instrument if any shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a hedge transaction, the company should at the inception of the transaction:
Designate the hedge relationship Document such relationship Identifying hedge item, hedge instrument and risks being hedged Expect hedge to be highly effective Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognised that not all hedging transactions can be perfect. There can be a degree of ineffectiveness which should be recognized. The Statement requires that the assessment of effectiveness must be consistent with risk management strategies documented for that particular hedge relationship. Further the assessment of effectiveness is required whenever financial statements or earnings are reported.
26 November 2007
ACCOUNTING OF INDEX FUTURES TRANSACTIONS
This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock Index Futures. Stock Index Futures are provided more coverage as these have been introduced recently and would be of immediate benefit to practitioners.
International perspective is also provided with a short discussion on fair value accounting. The implications of Accounting practices in the US (FASB-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Note for Accounting of Index Futures in December 2000. The guidelines provided here in this Section below are in accordance with the contents of this Guidance Note.
INDIAN ACCOUNTING PRACTICES
Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be issued by the Institute of Chartered Accountants of India.
Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial instrument that is in substance a forward exchange contract to establish the amount of the reporting currency required or available at the settlement date of transaction. Accounting Standard 11 provides that the difference between the forward rate and the exchange rate at the date of the transaction should be recognised as income or expense over the life of the contract. Further the profit or loss arising on cancellation or renewal of a forward exchange contract should be recognised as income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment and interest. As on 1st December 1999, it appears to the company that the US $ may be dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The forward rate may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract (US $ 3,00,000 * Rs. 44)
Rs 1,32,00,000 Amount payable had the forward contract not been in place (US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000 Gain arising out of the forward exchange contract Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the transaction should be recognised as income or expense over the life of the contract. In the above example, the difference between the spot rate and forward rate as on 1st December is Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of the forward contract should be apportioned on time basis. In the given example, the time ratio would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-2000 and the balance Rs. 30,000 should be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot rate on the date of forward contract be accounted. As a result, the benefits or losses accruing due to the forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $ 1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of this loss in the financial year 1999-2000.
Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock index future. Both the Bombay Stock Exchange and the National Stock Exchange have introduced index futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed Futures upto 3 months expiry. For example, in the month of September 2000, an investor can buy September Series, October Series and November Series. The September Series will expire on the last Thursday of September. From the next day (i.e. Friday), the December Series will be quoted on the exchange.
Accounting of Index Futures
Internationally, ‘fair value accounting’ plays an important role in accounting for investments and stock index futures. Fair value is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Simply stated, fair value accounting requires that underlying securities and associated derivative instruments be valued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provides that the current investments should be carried in the financial statements as lower of cost and fair value determined either on an individual investment basis or by category of investment. Current investment is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date of investment. Any reduction in the carrying amount and any reversals of such reductions should be charged or credited to the profit and loss account.
On the disposal of an investment, the difference between the carrying amount and net disposal proceeds should be charged or credited to the profit and loss statement.
In countries where local accounting practices require valuation of underlying at fair value, size=2 index futures (and other derivative instruments) are also valued at fair value. In countries where local accounting practices for the underlying are largely dependent on cost (or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of Indian accounting practices currently not recognising fair value, it is widely expected that stock index futures will also be accounted based on prudent accounting conventions. The Institute is finalising a Guidance Note on this area, which is expected to be shortly released.
The accounting suggestions provided in the Indian context in the following paragraphs should be read in this perspective. The suggestions contained are based on the author’s personal views on the subject.
Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National Stock Exchange have set up independent derivatives segments, where select broker-members have been permitted to operate. These broker-members are required to satisfy net worth and other criteria as specified by the SEBI Committees.
Each client who buys or sells stock index futures is first required to deposit an Initial Margin. This margin is generally a percentage of the amount of exposure that the client takes up and varies from time to time based on the volatility levels in the market. At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the Balance Sheet.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level).
Example
Mr. 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. 4,850
Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract on the Bombay Stock Exchange).
The accounting entry will be :
Initial Margin Account Dr 28,050 To Bank 28,050
If the daily settlement prices of the above Sensex Futures were as follows:
Date
04/09/00 05/09/00 06/09/00 07/09/00 08/09/00 Oct. Series
4520 4510 4480 4500 4490 Nov. Series
4850 4800 -- -- --
Let us assume that Mr X he sold the November Series contract at Rs 4,810.
The amount of ‘Mark-to-Market Margin Money’ Sensex receivable/payable due to increase/decrease in daily settlement prices is as below. Please note that one Contract on the Bombay Stock Exchange implies 50 underlying Units of the Sensex.
Date October Series November Series Receive Pay Receive Pay 4th September 2000 1,000 - - - 5th September 2000 - 500 - 2,500 6th September 2000 - 1,500 - - 7th September 2000 1,000 - - - 8th September 2000 - 500 - -
The amount of ‘Mark-to-Market Margin Money’ received/paid will be credited/debited to ‘Mark-to-Market Margin Account’ on a day to day basis. For example, on the 4th of September the following entry will be passed:
Bank A/c Dr. 1,000 To Mark-to-market Margin A/c 1,000
TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the November Series Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on 6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin Account so that this Account is reduced to zero. The Mark to Margin Account will contain transactions pertaining to this Futures Series. This component will also be reversed on 6th Sept 2000.
Bank Account Dr 15,050 Loss on November Series Dr 2,000 Initial Margin 14,550 Mark to Market Margin 2,500
Margins maintained with Brokers
Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients should pay them slightly higher margins than that demanded by the exchange and use this extra collection to pay up daily margins as and when required.
If a client is called upon to pay further daily margins or receives a refund of daily margins from his broker, the client would again account for this payment or refund in the Balance Sheet. The margins paid would get reflected as Assets in the Balance Sheet and refunds would reduce these Assets.
The client could square up any of his transactions any time. If transactions are not squared up, the exchange would automatically square up all transactions on the day of expiry of the futures series. For example, an October 2000 future would expire on the last Thursday, i.e. 26th October 2000. On this day, all futures transactions remaining outstanding on the system would be compulsorily squared up.
Recognition of Profit or Loss
A basic issue which arises in the context of daily settlement is whether profits and losses accrue from day to day or do they accrue only at the point of squaring up. It is widely believed that daily settlement does not mean daily squaring up. The daily settlement system is an administrative mechanism whereby the stock exchanges maintain a healthy system of controls. From an accounting perspective, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be recognised in the Profit & Loss Account of the period in which the squaring up takes place.
If a series of transactions were to take place and the client is unable to identify which particular transaction was squared up, the client could follow the First In First Out method of accounting. For example, if the October series of SENSEX futures was purchased on 11th October and again on 12th October and sold on 16th October, it will be understood that the 11th October purchases are sold first. The FIFO would be applied independently for each series for each stock index future. For example, if November series of NIFTY are also purchased and sold, these would be tracked separately and not mixed up with the October series of SENSEX.
Accounting at Financial Year End
In view of the underlying securities being valued at lower of cost or market value, a similar principle would be applied to index futures also. Thus, losses if any would be recognised at the year end, while unrealised profits would not be recognised.
A global system could be adopted whereby the client lists down all his stock index futures contracts and compares the cost with the market values as at the financial year end. A total of such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the transaction. This would be accounted net of the provision towards losses (if any) already effected in the previous year at the time of closing of the accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit or loss in this accounting period.
Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a provision towards losses in his Profit or Loss Account in this accounting period.
In the next year, the Nifty future is actually sold for Rs 2,10,000.
At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next financial year.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting Standard Board, US defines the criteria /attributes which an instrument should have to be called as derivative and also provides guidance for accounting of derivatives. The Standard is facing tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:
A derivative’s cash flows or fair value must fluctuate or vary based on the changes in an underlying variable. The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying. The contract can be readily settled by net cash payment
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognised in the year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging instrument, the gain or loss on the derivative instrument is required to be recognised as profit or loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are called Fair Value Hedges. The gain or loss on such derivative instruments as well as the off setting loss or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures contract would compensate the loss or gain on the portfolio. Both the gains and losses will be recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will offset each other and hence will not have any impact on the current earnings. However, if the hedge is not a perfect hedge, there would be a difference between the gain and the compensating loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be transferred to current earnings of the same period or the periods during which the forecasted transaction affects the earnings. The remaining gain or loss on the derivative instrument if any shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a hedge transaction, the company should at the inception of the transaction:
Designate the hedge relationship Document such relationship Identifying hedge item, hedge instrument and risks being hedged Expect hedge to be highly effective Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognised that not all hedging transactions can be perfect. There can be a degree of ineffectiveness which should be recognized. The Statement requires that the assessment of effectiveness must be consistent with risk management strategies documented for that particular hedge relationship. Further the assessment of effectiveness is required whenever financial statements or earnings are reported.
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