At the time of writing this for the WIRC handbook in July 09, the market is the global economy is still floundering and struggling to come of the problems inherited as a consequence of the global meltdown engineered by the financial wiz kids of wall street. In almost everyone’s mind the words of Warren Buffet rings loud that the Derivatives are weapons of mass destruction. World over the central bankers are fighting a raging battle to prop up their respective economies in a bid to stem the consequences of a faltering economy. Modern finance would be unrecognisable without the existence of Derivatives. These financial products have many uses including, speculation. In fact they are appropriately suited for speculation because of leverage and the speculators by inducing depth in the markets enable hedgers to offload their unwanted risk. The initial investment in these products are either nil or much lower than what is required for investments yielding similar cash flows. Speculation is, unfortunately, tempting and this has led many organisations to lose heavily resulting from inappropriate use of derivative or outright misuse of them. It is easy to point out that the losses stem from taking a position on the market to exploit their view of the future movement in the market and these expectations going awry. The misuse or abuse leading to large losses including the famous Barings case have given a reputation ot derivatives being contracts in which a large amount of money is lost. History repeats are the sub prime crisis is a most recent example of the same. Many Indian companies also incurred large losses or were facing huge potential losses (market to market losses) and some have already provided for them. Many have avoided the provisions preferring to litigate instead.

Simply stated these are products whose value change in response to changes in the prices of some other products often called an underlying. Such underlying could be anything whose value is fairly measurable. These products could be simple in structure or complex exotic in nature. The more complex the product the more indecipherable they become and if one were to trade or enter into such products, one would do so at one’s peril. Most losses reported arise from such exotic or leveraged products the consequences of which were never clearly understood by the users. When losses hit them, they invariably end up alleging the bankers misrepresented the nature of the products, including the leading multinational companies.

Derivative products are now available with all kinds of underlying. We have equity derivatives in the form of equity and index futures and options, financial derivatives in the form of forward contracts, financial futures, swaps, interest rate futures, option on currencies etc. There are commodity and weather derivatives, bond and interest rate derivatives etc. Innovation it appears is seemingly limitless leading to various permutations and combinations using these derivatives.

The market players are speculators, hedgers and arbitragers. For speculators the derivatives market is highly attractive due to the very low initial investment that is required. Speculators are very important to the market for without them adequate liquidity may not exist in the market. To speculate in the spot market she has to invest in the underlying scrip and hold it for the duration of her expectation and sell the same at a later date to realise her gain. If she has to short the underlying she would have to borrow the same at very high cost in the form of margins which inhibit the utilisation of money at her hands. On the other hand for a small margin she can lock into a derivatives position like futures or options and if her guess comes right she can enjoy a very high return. Shorting is simply selling the derivative and hence a very easy task. Let us say one person is bullish on Infosys whose market price is currently 2000. If he buys the share he will pay 2000 and if the share goes to 2500 he makes a gain of 500 which is 25% absolute return. On the other hand he might buy Infosys future at a price say 2100/-. [Note the price is for a futures contract with 16 days to maturity] His initial investment for this at 10% would be 200. When Infosys goes up to 2500, Infosys future might go up to 2560. [With 10 days for the contract maturity] He can sell his futures and gain 460. This gain is 130% in absolute terms. The gain could be higher if the futures price is at a discount to spot and later corrects itself to be higher than spot. In a normal market, futures prices are generally higher than the spot prices except for bond futures where the reverse rule would apply. The future would be at a discount in all cases where the intervening income is higher than the funding cost of the underlying.

While the leveraged gain is tempting, it must be understood that the losses would be equally magnified. If you buy in the spot market you might decide to hold on to the script in case of adverse movement, but in derivatives market on maturity it becomes necessary to settle the gain or loss (except in purchased options.

The generic derivative products are captured above. Other products are often a combination of the above to suit particular requirements. Each derivative serves a particular purpose in the management of risk and each offers an opportunity for both arbitrage and speculation. It is normal to begin all discussions on derivatives with forward contracts since they are the easiest to understand and apply. From Forwards we move to Futures which are nothing but forward contracts that are traded on an exchange. Swaps on the other hand can be viewed as a series of forward contract bundled together. FRA or Forward Rate Agreements are nothing but forward contracts on interest rates. Options are a breed in themselves since they are the only product that offers a right without any obligation. Hence they are shown as a separate category.

While books are written on each of these products it is indeed a challenge to capture the essence of each product and its accounting rules in a short space.

Is a contract to buy (sell) a specified underlying on a future date, but the price for which is agreed on the date of the contract. On the date of the contract there is no exchange of cash flows. The payment agreed is exchanged for the underlying on the date of the maturity of the contract. The forward price generally tends to be higher than the current price. An ideal forward price without an opportunity for arbitrage would be the Spot Price + Cost of Carry (including the interest cost) less the future value of any intervening income.

Forward contracts are very useful to eliminate uncertainty about future movement in the prices of the underlying. These are used extensively in the currency market to lock in the local currency value for future cash flows contracted in a foreign currency. The contract is obligatory and default on the maturity has the same consequences as any credit default event. Hence whether the spot has moved in favour or against the purchaser of the forward contract the buyer has to settle on the contract and take the gain or loss resulting from price movements.

AS 11 is the standard dealing with accounting for forward contracts.(Revised and effective from 01.04.2004). The standard is restricted to foreign exchange forward contracts only. Hence it is tempting to argue that there is no prescribed accounting for other forward contracts and consequently they can be kept outside the books. The alternative argument (which should be the more forceful argument) is that there cannot be two different methods for accounting similar transactions. Therefore the same rules must apply.

The revised standard brings into focus the concept of hedge accounting. Forward contracts are distinguished between those entered into for purposes of hedging and others which are specifically for trading or speculation. In Hedging forward contracts the premium is bifurcated and amortised as in the past. The remaining amount which represents the spot price is marked to market on each reporting date and gain or loss is charged to the income statement. This will help in countering any impact on the profit and loss account due to revaluing the underlying asset or liability at the spot rate on the reporting date. By way of illustration consider a case of an exporter raising an invoice for 25000 dollars on 1st March, 20XX. The amount is due and receivable in 90 days. Other information provided is as under:

Date	Spot	Forward (1st June 2007)
1st March, XX	46.1	46.4
31st March, XX	46.5	46.9
1st June, XX	46.3	46.3

Before we discuss the accounting some of the necessary computations are detailed in the Table below:

		Rs.
Sale Value	25000*46.1	11,52,500
Forward Value	25000*46.4	11,60,000
31.03. gain on sales	25000*(46.5-46.1)	10000
31.03. Loss on Forward Contract	25000*(46.1-46.5)	10000
Forward Premium	11.6 lakhs -11.525 lakhs	7500
31.03 amortisation of premium	1/3rd of 7500	2500
1st June cash realised from bank		11,60,000
1.06 loss on book debt & gain on forward contract	25000*(46.3-46.5)	5000

The Accounting would be structured as under:

Date	Particulars	Debit	Credit
1.03.05	Customers Account	11,52,500
	Sales		11,52,500
1.03.05	Forward Rupees Receivable	11,60,000
	Forward dollars payable		11,52,500
	Forward premium Amortisable		7,500
31.03.05	Customers Accounts	10,000
	Exchange gain		10,000
31.03.05	Exchange Loss	10,000
	Forward dollars payable		10,000
1.06.05	Exchange Loss	5000
	To Customers Account		5000
1.06.05	Forward dollars payable	5000
	To Exchange Gain		5000
1.06.05	Bank Account	11,60,000
	Customers Account		11,52,500
	Forward Rupees Receivable		7,500
1.06.05	Forward Dollars Deliverable	11,60,600
	Forward Rupees Receivable		11,60,600

The accounting entry for forward contract (entry No. 2) is optional. Without recording that entry it is possible to simply recognise the gain or loss on the forward contract on 31st March and 1st June.

On the other hand if the forward contract was not hedging the exposure as above, the accounting is slightly different. On 1st March the premium is not recognised as amortisable. On 31st March the forward rate prevalent for the same maturity is compared with the original forward contract rate and any gain or loss is transferred to the income account. The revised contract rate is 46.9 against the forward rate of 46.4. Hence there is a loss of 50 paise per dollar on the forward contract. The total loss of Rs. 12,500/- is debited to the profit and loss account and corresponding credit could be to forward contract payable account. On 1st June the forward contract will be closed out on settlement. However to settle the same it is necessary to purchase the amount from the market at the prevailing spot rate which is 46.3. There is altogether a gain of 60 paise. 10 Paise from the spot purchase price and sale price of 46.4 and 50 paise of loss recorded on 31st March, which has now turned into profit. Hence a total of 15,000 will be credited to the income account. 12,500 from the forward contract payable account since it is no longer payable and 2500 from the gain on the purchase and sale of dollar on 1st June.

The Institute of Chartered Accountants of India has already introduced a standard AS 30 dealing with accounting for financial instruments. This standard is set to become optional for accounting period starting from 1st April, 2009 and Mandatory for periods starting from 1st April, 2011. The accounting for forward contracts would then undergo a change. This is discussed later collectively under the revised accounting for derivatives.

Futures, are nothing but forward contract traded on an exchange. To make the contracts suitable for trading on exchanges, it becomes necessary to standardise the contracts. All exchanges will specify the norms on which the Futures contract trade in their exchange. In particular it will specify how many units of the underlying constitute one contract, the standardised maturity dates, minimum tick size etc. For instance one Nifty Futures contract is for 50 Nifty Index. Likewise one futures contract on Titan Industries is for 206 Shares. All futures for a specified month expire on the last Thursday of the contract month, and tick size for equity shares in the Indian market is generally 5 paise.

The best feature of any Futures contract is that the exchange guarantees performance under the contract. This is achieved by constituting an exchange guarantee corporation to act as the buyer for the seller and the seller for the buyer. This process is known as Novation. To discharge its responsibilities, a margin is collected upfront from the seller and the buyer. Thereafter the contracts are settled on a daily basis. That is the person who loses on the Futures contract will pay the loss into the exchange and the same will be passed on to the counter party who gained on the contract.

Various kinds of Futures contract are traded on the exchanges. We have Commodity Futures, Equity Futures, Interest Rate Futures, Bond Futures and Index Futures. The broad contract structure for all Futures contracts are the same. However there are subtle specifics that change from contract to contract. For instance in the case of commodity contract what is permitted to be delivered may be more than one variety whereas the contract that trades is a specific grade. In the case of many Interest rate Futures price quotation is always 100 minus the interest rate. In the case of bond futures, one must understand the concept of deliverable bond and cheapest to deliver.

Pending implementation of the new Standard AS 30, the accounting is governed by a Guidance Note prescribing accounting for equity and index futures. The Guidance Note deals with accounting stage wise from origination to termination of a Futures contract. These are:

Description	Accounting Treatment
Initial Cash Margin	Kept in a separate account to be designated as Initial margin on Index futures or equity futures account. Carried forward under current Assets till settlement or exit.
Initial Non Cash Margin	It is permissible that Initial margin is paid by deposit of securities instead of cash. Then disclose by a way of note.
Variation Margin	This is the daily profit and loss that is settled by the exchange or paid into the exchange. It is to be captured in a separate account designated as the MTM Index or equity futures margin.
Gain or Loss	Gain received (the credit of the MTM margin) is carried forward as current liability. Provision is made for loss (the debit in the MTM account) The provision is adjusted from MTM margin under current asset. Provision to be made for each contract separately.
Final Settlement	On settlement [whether on expiry or before] there is either a profit or loss. If loss, the final loss is accounted after adjusting the provision already made. If profit, the entire profit including the MTM credit is transferred to the income account. If more than one contract in the same series are outstanding and only a portion is closed out then profit or loss is determined using weighted average method and not by FIFO method.
Settlement by delivery	If the settlement by delivery is permitted (which is not the case in India now, but is expected later) then the accounting is slightly different. The seller will recognise the contract price as sale consideration and the buyer will use the contract price as the purchase consideration. [Note that index cannot be delivered and hence will always be cash settled].

Swaps are custom designed contracts between two counter parties to exchange a series of cash flows over a predefined period of time and at pre-specified intervals. The contract would stipulate all the requirements that determine the exchange of cash flows. In certain cases the exchange of cash flows are net [cash flows in same currency] and in other cases they are gross [different currencies].

The generic swap that trades in the market include a plain vanilla swap which enables one to change from a fixed or a floating rate to the other rate, a currency swap in which there is an exchange of foreign currency against local currency and cross currency swap which has exchange of interest and principle in two different currencies. The usual structure of a cross currency swap is to pay fixed interest and principle in one currency and receive a floating rate and principle in another currency.

In most cases the counter party is a banker who is usually a market maker in swaps. Swaps can be used to reduce cost of borrowing, manage risk, align asset liability mismatch or take exposure in a desired currency or interest rate.

Currently the practice for accounting swaps is divergent. Swap gains on closing out a contract is normally taken to the income statement while a potential loss is not accounted. It must however be stated that the divergent practice is not possible within the same organisation. The contracts are not marked to market. Other complications arising from interest settlement based on rates set in arrears are being dealt with by different parties differently. Various types of swaps are entered into in the Indian financial market. In a typical interest rate swap one party pays a fixed interest rate and the other party pays a floating rate. The floating rate therefore has to be an acceptable benchmark. Benchmarks used in the Indian market include OIS or the Overnight Index Swap which either pays or receives the NSE daily Mibor, Mifor - the rupee interest rate derived from the spot and forward prices, 10 year G sec bench mark rate, CMT or constant maturity treasury etc. All kinds of currency swaps are also entered into.

Reserve Bank of India has directed specific accounting approach to be used by banks. All swaps which are part of market making activities are to be marked to market and gain or loss recognised in the income statement. As for hedging swaps, the RBI recommends that they use accrual basis of accounting.

Swap accounting under the new standard is dealt with later.

FRA at they are popularly known in the market are nothing but forward contract on interest rate and helps in locking into an interest rate for short periods. In a FRA contract, the FRA dealer will agree to either receive or pay a fixed interest against an agreed floating rate. For instance one could enter into a FRA to pay a fixed interest of say 7% against 6 month Mibor. The amount payable and receivable is to be determined with reference to a Notional Principle amount which could be say Rs. 100 Lakhs. The contract will start at a future date and will have a stated duration like three months or six months etc. The FRA quotation will indicate the time of starting and the time of ending. A FRA quotation of 3 X 9 FRA at 6.8/7.0 means a FRA dealer is willing to give the floating rate which could be six month Libor or Mibor etc. and receive 7% or alternatively he is willing to pay a fixed interest of 6.8% and receive the corresponding floating rate. In this case the FRA commences three months from the date of contract and terminates at the end of 9 months from the date of contract. Hence the FRA period which is the difference between the two periods indicated is a six month FRA. While the ending period is indicated, it has no significance after the commencement date. The cash payable or receivable is exchanged on the day FRA starts. Thereafter parties to the FRA have no further obligation. The contract being on the same currency the difference is settled between the parties. Since the settlement takes place upfront at the commencement of FRA, the net amount payable is discounted to the present value at the current floating rate.

Currently there is no guidance for the accounting on FRA. It is plain logic that FRA contracts being interest rates payable from the future will have an implication only from the date of commencement of the FRA. Settlement received on the date of commencement of the FRA needs to be amortised over the life of the FRA for hedge contract since the underlying interest which was covered will similarly be amortised. For speculative FRA contracts the premium received or paid will be accounted in the income statement as gain or loss.

The accounting requirement under new AS 30 is discussed later.

Options are wonderful product in themselves if only because they are the only contracts that provide the buyer of the option with a right without any corresponding obligation. Hence it provides protection while affording an opportunity to ride on the gains. For instance if an exporter has a receivable amount of 25000 US dollars, due three months hence he could enter into a forward contract to sell the dollar at the current forward price of say 46.8. Instead he could enter into a option to sell the dollar at the price of say 46.8 and pay an option premium of 30 paise. Now if the rupee trades below 46.8 he will certainly exercise his put option and sell the rupee for the price of 46.8. On the other hand if rupee were to fall to 47.25 on the maturity date he can simply ignore his option contract and sell the dollars at the current market price of 47.25.

When you enter into an option contract to buy any underlying asset it is called a call option and the right to sell is called a put option. In India option contracts are available in currencies, equities & equity index. Currency options are OTC contracts and Index and equity options are exchange traded. Currency options being OTC contracts are deliverable contracts. That is you can ask the counter party, your banker, to actually deliver dollars against your contract. On the other hand options in Index and equity are cash settled, that is the profit or loss is settled in cash. Index options are European options meaning they can be exercised only on the maturity date, while equity options are American namely they can be exercised on any date after the date of the contract.

Many exotic varieties of options are offered by banks in India to Indian clients.

The guidance note referred to under Futures is a composite guidance note covering both options and futures. The broad approach is the same as in the case of futures subject to the nuances of the accounting for premium and provision for loss by the seller. The accounting is best dealt with separately for buyer and the seller and is tabulated below:

Description	Accounting Treatment
Accounting for Buyer:
At inception payment of premium	Premium is debited to option premium account and carried forward as current assets.
On each reporting date.	On each reporting date the potential loss (difference between the premium paid and the current premium) is provided for. Gain is not recognised. The loss provision is adjusted from the premium and the net amount is carried forward
On Termination or maturity	If the option is exercised then the gain is recognised as income while the balance of premium if any is written off as expenditure.
Multiple option	In the case of multiple contracts provision is made in totality for all options on the same underlying. The provision is for the net amount. If an option is both written and bought then the loss provision will be net of any gain even though unrealised.
Delivery of underlying	A call option buyer will account for the security bought at the strike price, while a put option buyer will account for the sale at the strike price. The premium is expensed out.
Option Seller:
At the Initiation	The premium received will be accounted in option premium account and carried forward as a liability.
On each reporting date	The potential loss which is the difference between the option premiums will be provided for and shown as current liability.
Multiple option	As discussed for a buyer.
On Termination or Maturity	Profit or gain will simply be the premium received. Hence this amount will be transferred from the current liabilities to income account. Simultaneously if any loss provision is also carried forward the same will also be transferred to income statement.
Settlement by Delivery	For a written call option the security sale will be accounted at the strike price and for put option the purchase of the security will be accounted at the strike price. The premium will be expensed out.

The Institute of Chartered Accountants have issued three important Accounting Standards related to accounting for financial instruments. Derivatives accounting and its presentation is covered by these standards. The standards will be recommendatory from 1st April, 2009 and are slated to go mandatory from 1st April, 2011. These new standards are AS 30, AS 31 and AS 32. AS 30 deals with recognition and measurement of the financial instruments including derivatives and AS 31 deals with presentation and AS 32 deals with disclosures. The standards are generally perceived as complicated and very lengthy. Compliance with the standard is bound to be a challenge more so, when it becomes mandatory. It is possible that the regulators might force the standards to be mandatory earlier than envisaged. The Institute of Chartered Accountants has mandated that companies must provide for marked to market losses on their derivatives without recognising the gains. This might prompt companies to adopt the standard ahead of it becoming mandatory. This is likely to be so when non adoption might result in distorting the true and fair view of the financial position.

While it is not possible to reproduce the entire standard or to deal with them in detail, an attempt is made to sensitise the reader to the nuances of the standard and direct him to the actual standards for a more detailed understanding of the requirements. The standard provides for a rather wide definition of derivative and includes a financial instrument or other contract. Hence a derivative contract may be other than a financial instrument including those we don’t commonly associate with a derivative. The three primary aspects required for a instrument or a contract to be classified as a derivative are a) its value should change in response to change in the price of an underlying b) initial investment is either nil or very little as compared to other types of contracts that would provide similar cash flows and c) it is settled in the future.

Derivatives are classified either as hedging derivatives or non hedging derivatives. The generic principle is that all derivatives contracts must be recognised in the accounts. Fair value is the best method for their recognition. If the derivative is a non hedging derivative then the changes in the fair value would be recognised in the income statement. Thus if a company based in India and maintaining its books in Indian Rupees enters into swap transaction to pay US dollars and receive Indian Rupees, the contract will be a non hedging derivative. The marked to market gain or loss on the contract must be captured in the income statement. Any loss on the derivative would result in losses for the company and any gain would boost the bottom line.

Considering the fact that non hedging derivatives can impact the income statement, with the Implementation of the standard, corporate’s may be reluctant to enter into such transactions. It is also necessary for them to be able to claim hedge accounting for their derivatives. To be able to do so they must ensure compliance with a strict set of conditions. These include:

(a) At the initiation of the derivative contract, it must be formally designated as hedging a risk and documented appropriately. The document must clearly indicate which underlying is being hedged, what is the nature of the risk that is being hedged, how the hedge effectiveness will be measured.

(b) The hedge is expected to be highly effective and is in fact highly effective at the inception of the contract and on re-evaluation at each measurement date.

(c) The effectiveness of the hedge can be reliably measured.

Hedging relationship itself is divided into three categories —
a) Fair Value Hedge, b) Cash Flow Hedge and c) Hedge of a net investment in a foreign operation. Fair value hedge is when the entity seeks to protect the changes in the values at which assets or liabilities are carried. Cash flow hedge is when the entity seeks to hedge the changes in the values of cash flows due to changing prices. When the entity seeks to hedge the net investment in a foreign operation it falls under the third category.

It is important to understand that in the framework of the standard a risk is perceived only when a value change in the assets or liability or the cash flow is likely to impact the profit and loss account. Naturally fair value hedge is possible only when the reported valued of the asset or liability is to be changed due to marked to market accounting and such change impacts the income statement. Technically then the changes in the fair value of available for sale investments would not be eligible for fair value hedge. In such cases the standard carves out an exception and mandates that changes in the fair value of such investments, if hedged and designated, are to be accounted in the income statement to offset the impact from the hedged derivative.

Accounting for Fair value hedge and non hedging derivatives is similar. In simple terms, it requires entities to mark to market the derivative and any changes in the fair value arising there from be accounted in the income statement. If the corresponding asset or liability similarly impacts the income statement then the two will offset each other. The only difference would be a resulting ineffectiveness in the hedge.

Entities must therefore understand that designating or not designating a fair value hedge would not make any difference in the accounting and the net result, while saving them from resultant record keeping. However if the underlying asset is like an available for sale investment and it is hedged then non designation would not be eligible for hedge accounting. Consequently the changes in the fair value of the derivative would be accounted in the income statement while the changes in the underlying investment would be accounted for in the balance sheet. In such cases the designation would be crucial. Fair value hedge is possible only for recognised assets or liabilities or for firm commitments. It cannot be used for forecasted transactions.

Cash flow hedge is possible for recognised asset or liability or highly probable forecasted transaction. The method of accounting is structured to ensure that matching principle, so necessary for the accounting environment, is preserved. It is easy to perceive that a cash flow hedge by its very nature is hedging future cash flows. The derivative being a contract entered into in the present would undergo fair value changes. Hence it is mandated that the changes in the fair value of the derivatives is to be kept in a reserve account till the corresponding impact from the cash flow hits the income statement. For instance, if the hedge is towards the future payments in foreign currency towards machinery purchase, the impact on the income statement would be when depreciation is charged. Proportionate amount would be released from the reserve account. If the hedge is towards payment for an item of inventory, then the impact is when the inventory is consumed and charged to income statement. It is at that point that the amount will be released. For example if a company hedges the purchase cost of copper for 100 tons and the total fair changes till the payment is made comes to Rs. 2 lakhs. If 40 tons is consumed in the next quarter then an amount of 80,000 (being 40% of the reserve created for the fair value change) will be released to the income statement. It is also appropriate that only the effective portion of the hedge be carried out and not the ineffective portion of the hedge. Hence the standard mandates that the changes in fair value of the derivative which is not effective (more or less than the change in the underlying) be charged to Income statement.

Hedge of a net investment in a foreign operation will be accounted similar to a cash flow hedge. This is because the translation of the net investment into the books of the parent company is captured in a separate reserve account and does not impact the income statement until the foreign operation is either discontinued or sold. The rule would apply even when monetary items in a foreign operation are hedged as part of the net investment in a foreign operation. The other aspect of this hedge is that the hedging instrument need not be a derivative. For example if a company like Telco decides to hedge its net investment in Korean subsidiary with a loan in Koran Won, then the loan can be designated as hedging the net investment. In such a case the changes in the fair value of the loan would also be carried in balance sheet and not charged to income statement.

All hedge relationship would have to be terminated under given circumstances. Hedge relationship must be effective both at the inception of the hedge and on a continuous basis. The standard also deals with how embedded derivatives are to be accounted for and which of them are to be segregated and accounted as such. This is not being dealt with in this issue, but the reader is advised to refer the standard for details.