This note is a rough guide to possible accounting practices that could develop in India. The note covers only accounting of index futures and does not extend to other instruments like options and swaps. The Institute of Chartered Accountants of India (ICAI) has set up a committee to set up accounting practices in this area. There are currently no guidelines available for accounting of these transactions. In most cases in India, securities are valued at lower of cost or market value, applying the principles of conservatism. Further, in the interim period till the ICAI issues its guidelines, the following accounting practices could be considered:
All futures transactions, irrespective of whether they are hedging transactions or speculative transactions would be treated uniformly as under:
- Unrealised losses on derivative transactions should be recognised, while unrealised profits should not be accounted until realisation. This follows from the principle of conservatism.
- Realised profits and losses would be carried to the Profit & Loss Account.
Margins paid against Futures will be reflected as Assets. Mere payment of margins will not qualify as profits or losses, though in most cases, the amounts of such margins will be based on the price movements of the futures in the market.
There is a controversy currently on whether daily payment of margins and daily ‘settlement’ as proposed in India would amount to daily ‘realisation’ of profits or losses for the purposes of accounting. The ICAI view on the issue is awaited. If the daily ‘settlement’ is construed as daily ‘realisation’, then the question of ‘unrealised’ profits or losses will not arise.
a)Commonly followed international accounting practises
International practices vary from country to country and could apply differently to various types of derivatives transactions, for example, those that seek to use index futures as against those that attempt to protect cash flow regularity. What follows is a very general and rough guide to commonly followed practices, and should not be construed as rigid application of accounting regulations. It is important to first recognise whether the index future is a ‘hedge’ or not. If the transaction is not a ‘hedge’, it would be treated as a ‘trading’ transaction.
b) Hedge Accounting
Accounting for hedges differs significantly from regular accounting practices, as the recognition of profits and losses on the hedge is intricately connected with the fluctuations in the market values of the underlying securities. Hence, the profits or losses on hedge transactions are adjusted in the carrying amount of the underlying securities instead of being taken to the Profit & Loss Account.
For this purpose, the definition of what constitutes a ‘hedge’ is important. The British Bankers Association in their Statement of Recommended Practice on hedge accounting have laid down the following criteria, which should be satisfied so as to be able to apply hedge accounting to a situation:
- The derivative transaction must be intended to be a hedge, and must, in fact, provide a reasonable hedge.
- The derivative transaction must match or eliminate a substantial portion of the market risk inherent in the hedged position.
- Adequate evidence of such intention to hedge should be established at the outset of the transaction.
Hedge accounting can be applied only to specific hedges, that is, transactions where the hedge can be identified with a specific underlying asset or liability or commitment.
The application of hedge accounting principles will also depend on the method of valuation used for the underlying security. Where the underlying security is valued at cost, the hedge will also be valued at cost. Where the underlying security is marked to market, the hedge will also be marked to market. Where the underlying security is valued at lower of cost or market value, the hedge and the underlying security will be bundled together to ascertain the aggregate cost and market values respectively, and the lower of the two of the bundle will be considered for valuation.
c) Trading Transactions
Internationally, trading transactions are marked to market. Accordingly, both unrealised losses and profits are taken to the Profit & Loss Account. This is a significantly different practice, vis-à-vis the most common Indian conservative accounting practice of recognising only unrealised losses.
Trading transactions will include general hedges, i.e. those hedging transactions which are not specifically related to specific assets or liabilities or commitments. Further, trading transactions will also include those specific hedge transactions which do not meet all the defined criteria and hence cannot follow hedge accounting principles.
Some examples are provided below. These are intended to be suggestive rough guides and should not be construed as authoritative pronouncements on the subject.
Example – 1 First Year
Underlying securities purchased for Rs 200,000
Index futures sold for Rs 200,000 and margin of Rs 12,000 paid
Further margins of Rs 2,500 paid from time to time
Year end values of underlying securities Rs 1,93,000
Year end value of future Rs 205,000
Example – 2 Above transactions continued effects in the Second Year if the underlying securities are sold
underlying Securities are sold for Rs 2,15,000
Futures contract has not expired and closing price comes to Rs 202,000
Future Margin paid are Rs 7,000
Example – 3 Above transactions continued effects in the Second Year the Futures Transaction Expires
Margins Paid further Rs 7,000
Futures Contract expires at a closing value of Rs 2,10,000 – amount receivable is immediately received.
In the scheme of accounting entries outlined below, it is assumed that daily ‘settlement’ of futures is not treated as daily ‘realisation’ of profits and losses in the Indian context. As stated above, this issue needs the guidance of the ICAI.
An attempt is made to provide a simple scheme of entries so as to enable readers to understand the gist of accounting quickly. Various refinements are possible in practice. For example, when investments are acquired, it may be regular practice to credit the broker (to whom the amounts are due) rather than crediting the bank account from where payments are effected.
Example 1: First Year
Investments (Assets) Dr 200,000
To Bank 200,000
Margins (Assets) Dr 12,000 To Bank 12,000
Margins (Assets) Dr 2,500
To Bank 2,500
Dimunition in Investment (Expense) Dr 7000
To Investments (Assets) 7,000
Unrealised gains on Futures are not to be accounted
Balance Sheet Impact
Investments will be reflected at Rs 1,93,000
Profit & Loss Impact
Dimunition in Investments will reduce profits by Rs 7,000
Example 2: Second Year
Bank Dr 2,15,000
To Investments(Assets) 1,93,000
To Profit on sale of Investments (Gain) 22,000
No entry for Futures as no profits realised so far
Margins(Assets) Dr 7,000
To Bank 7,000
Example 3: Second Year
Margins Dr 7,000
To Bank 7,000
Bank Dr 31,500
To Profits on Futures 10,000
To Margins (released) 21,500
The realised Profit on Futures will be taken to the Profit & Loss Account in the absence of specific guidelines on Hedge accounting in India currently.