An Overview of Guidance Note on Accounting for Derivative Contracts (Applicable from April 1, 2016)
Accounting treatment for derivative contracts was earlier covered by AS 30, 31 & 32 which was withdrawn in March 2011 owing to revision in IAS 39, Financial Instruments: Recognition and measurement issued by International Accounting Standards Board.
This guidance note is applicable to:
1. Foreign exchange forward contracts that are hedges of highly probable forecast transactions and firm commitments.
2. Other Foreign Currency derivative contracts such as cross-currency interest rate swaps, foreign currency futures, options and swaps if not in the scope of AS 11.
3. Other derivative contracts such as traded equity index futures, traded equity index options, traded stock futures and option contracts. (This point makes this guidance note applicable to Vanilla stock and index options traded by major stock brokers and )
4. Commodity Derivative contracts.
Key Accounting Principles:
1. All Derivatives contracts should be recognized on the balance sheet and measured at fair value
2. If an Entity decides to apply Hedge Accounting as per the guidance note, it should be able to clearly identify:
- Its Risk Management objective
- The risk that is hedging
- How it will measure the derivative instrument if its risk management objective is being met.
Note: Key accounting principles implies that derivatives are to be valued on their fair value unless there is an underlying risk which is being mitigated through the use of derivatives. Thus, Entities which are entering derivative transactions to enjoy gains through price difference have to value their contracts on fair value.
Also, Contracts which are a combination of derivative and underlying would not mean the existence of a risk and accounting has to be done separately and not as a single asset/liability.
Recognition of derivatives on the Balance Sheet at Fair Value:
1. Fair Value represents the "Exit Price" i.e. the price that would be paid to transfer a liability or price that would be received when transferring an asset. Thus, For option contracts price would basically imply the market rate of the contract as traded on the stock exchange
2. Assets and Liabilities have to be measured on gross basis as guidance note does not permit netting off. However, amounts recognized in the statement of profit and loss for derivatives may be presented on a net basis.
Presentation in the financial Statements:
1. Derivatives held for trading and speculation purposes should be reflected as current assets and liabilities. Thus, Options and futures purchased/sold by market intermediaries will have to be shown as current assets/Liabilities and fluctuations in their market prices to be booked as gain/loss in the statement of profit and loss as per the nature of the transaction
2. Derivatives in the nature of Hedges of recognized assets/liabilities to be classified as current or non-current based on the classification of the asset/liability being hedged.
3. Derivatives that are hedged of forecasted transactions and firm commitments to be classified as current or non-current based on settlement dates of derivative contracts.
4. Derivatives which have periodic or multiple settlements such as interest rate swaps should be classified on the basis of due date of the predominant portion of cash flows.