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Accounting for derivatives

Subject : Derivatives
Month-Year : Sep 2001
Author/s : Dr. Amita S. Kantawala
Chartered Accountant
Topic : Accounting for derivatives
Article Details :

Derivatives are financial instruments that derive their value from changes in benchmark based on stock prices, interest rates, mortgage rates, currency rates, commodity prices or some other agreed upon base. Derivative Financial Instruments (DFIs) can be either on the balance sheet or off the balance sheet and include : options contract, interest rate swap, interest rate floors, interest rate collars, forward contract, futures, etc.

According to FASB 133 para 6, “derivative instrument is a financial instrument or other contract with all three of the following characteristics :

  1. It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and in some cases, whether or not a settlement is required.
  2. It requires no initial net investment or an initial net investment that is smaller than would be expected to have a similar response to changes in market factors.
  3. Its terms require or permit net settlement, it can readily be settled net by a means outside the contract or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.”

According to International Accounting Standard (IAS) 39 para 10, “a derivative is a financial instrument :

  1. whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or similar variable (sometimes called the underlying);
  2. that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and
  3. that is settled at a future date.”

From the above, it follows that the definition of derivative as per FASB 133 and IAS 39 is more or less same. Typical examples of derivatives are futures and forward, swap and option contracts. One of the defining conditions of a derivative is that it requires little initial net investment relative to other contracts that have a similar response to market conditions. An option contract meets that definition because the premium is significantly less than the investment that would be required to obtain the underlying financial instrument to which the option is linked.

If one takes Indian scenario, forward contracts are in operation for last number of years, mainly to control or to manage the foreign exchange rate risk. Since April 1996, cross currency options are allowed. Since August 1996, interest rate swaps, currency swaps, purchase of interest rate caps and collars and forward rate agreements are also allowed. Rupee-based derivatives are also allowed since August 1997 resulting into 5-year forward contract, which originally was available only for 6 months. In the equity market in India, stock index futures are available since June 2000.

There are varieties of issues attached with these developments of derivatives :

  1. effects on (a) capital market, (b) money market, (c) exchange rates and (d) interest rates.
  2. The burning issue will be taxation of derivatives and the accounting treatment.

The article published in ‘The Chartered Accountant’ October 2000 issue deals with accounting of forward rate agreements very briefly, and Stock Index Futures in detail. It is also interesting to note here that the Institute of Chartered Accountants of India has also come out with the Guidance Note on Accounting for Index Future.

In the light of the above developments, the present paper attempts to deal with the accounting treatment for Forward Contract, Interest Rate Swap, Currency Swap and Currency Options.

  1. Forward contract :
    A forward contract is basically a contractual arrangement in which one party buys and other party sells designated currency at a forward rate mutually agreed upon on the date of contract for delivery at designated future date. As mentioned in the pre-ceding para, forward contracts are allowed in India for long. Not only this but para 13 of Accounting Standard 11 ‘Ac-counting for Effects of Changes in Foreign Exchange Rates’ deals with accounting treatment of Forward Contract. Accordingly, ‘An enterprise may enter into a forward contract or other financial instrument that is in substance a forward exchange contract to establish the amount of reporting currency required or available at settlement date of a transaction. The difference between the forward rate and the exchange rate at the date of transaction should be recognised as income or expense over the life of the contract, except in respect of liabilities incurred for acquiring fixed assets, in which case, such difference should be adjusted in carrying amount of the respective fixed assets.’ The treatment of AS 11 for the trans-action gain or loss to profit and loss account for non-fixed asset items is in line with FASB 133 para 18(d). The gain or loss on a derivative instrument or non-derivative instrument designated and qualifying as a foreign currency-hedging instrument shall be accounted as follows :
    1. The gain or loss on the hedging derivative or non-derivative instrument in a hedge of a foreign currency dominated firm commitment and the offsetting loss or gain on the hedged firm commitment shall be recognised currently in earnings in the same accounting period, as provided in para 37.
    2. The gain or loss on the hedging derivative instrument in a hedge of an available for sale security and the offsetting loss or gain on the hedged available for sale security shall be recognised currently in earnings in the same accounting period, as provided in para 38.

    However, it is important to note that Accounting Standard 11 does not define whether the contract should be disclosed in the balance sheet or not. Ac-cording to para 27 of IAS 39, ‘An enterprise should recognise a financial asset or financial liability on its balance sheet when it becomes party to contractual provisions of instru-ment’. According to para 28(c) of IAS 39, ‘A forward contract — a commitment of purchase or sell specified financial instru-ment or commodity subject to this standard on a future date at a specified price is recognised as an asset or a liability on the commitment date . . . . .’

    From the above, it follows that once the organisation enters into a forward contract, it should disclose the worth of the contract in the balance sheet in case where the contract is not settled on the balance sheet date. This can better be explained with the help of an illustration :

    On 1st February 2000, an Indian company sold goods to a company in the USA for an invoice price of US $ 10000 when the spot market rate was Rs.42.70 per US $. Payment is to be received in three months on 1-5-2000. To avoid the risk of loss from decline in the exchange rates on the date of receipt, the Indian exporter acquired a forward contract to sell US $ 10000 @ Rs.42.20 per US $, on May 1, 2000. The company’s accounting year ends on 31-3-2000 and the spot rate on this date was Rs.41.70 per US $. The spot rate on 1-5-2000, the date of receipt of money by Indian exporter, was Rs.41.20. The accounting entries will be as shown in Table 1.

    As per Accounting Standard 11, in case of fixed assets, effect is to be given to the fixed assets concerned and not to the profit and loss account. Hence, the deferred discount/premium will be debited or credited to the respective asset account rather than expense or income account.

    The accounting entries proposed in Table 1 take care of all three viz. FASB 133, AS 11 as well as IAS 39.

  2. Interest rate swap :
    As discussed in the beginning, Interest Rate Swap is allowed in India. Swap is basically a financial contract. This involves exchange of one set of payment (which is the obligation of one party ‘A’) by other set of pay-ment (which is the obligation of other party ‘B’). The interest Rate Swap involves the exchange of one interest rate payment with other interest rate payment where the principal amount is denominated in the same currency.
      “The IRS can be defined as a contract between two parties (called counter parties) to exchange on a particular date in the future, one series of cash flows (fixed interest) for other series of cash flows (variable or floating interest) in the same currency on the same principal (an agreed amount — called notional principal) for an agreed period of time.” (Singh Rajivkumar, "The Mechanism of Derivatives', The Chartered Accountant, December 1999, p 12)

    Coming to the accounting treatment, the flow of trans-actions will be like this :
    Consider XYZ Ltd., a manufacturing firm, which wants to borrow 5-year fixed rate rupee funding to finance an expansion project. Its credit rating is not very high. It is BBB. It finds that it will have to pay interest @11% if it borrows at fixed interest rate. In the floating rate market, it can issue floating rate note at margin of 0.75% over the prime rate, which is 10%. On the other hand, ABC Inc., a large Unit is looking for floating rate note but finds that it will have to pay prime rate, while in the fixed rate market it can raise 5-year funds at 9.5% due to AAA rating. Thus, spread demanded by market for AAA rating and BBB rating is 150bp in fixed rate segment and 75bp in floating rate segment. This differential is known as Quality Spread differential. The requirements and access of the two parties are summarised below :

      XYZ Ltd.
    (BBB)
    ABC Ltd.
    (AAA)
    Requirements Fixed rate Floating rate
    Cost of fixed loan 11% 9.5%
    Cost of floating rate Prime rate +0.75% Prime rate 10%)

    TABLE 1

    February 1, 2000 :
    Sundry debtors 4,27,000  
    --------------------------------------------------------------------------------------------------------------------
        To Sales   4,27,000
    --------------------------------------------------------------------------------------------------------------------

    The entry is to be passed to record agreement to exchange in 3 months US $ 10000 for Rs.422000. Moreover, to represent the exporter’s obligation to exchange US $ 10000 for Rs.422000 on May 1, 2000 also, the following entry is required to be passed. There is certainty about receivable of Rs.422000. Obligation to pay US $10000 is accounted at the spot rate like any other receivable or payable. This is considered as obligation because, in case where the US importer does not pay this amount on due date, the exporter will have to buy US $ 10000 at the spot rate prevailing on this date and meet the obligation.

        Forward (Rs.) contract receivable 4,22,000  
        Deferred discount 5000  
          To Forward ($) contract payable   4,27,000
    31st March 2000
    To indicate the translation loss between date of transaction and date of closing (31-3-2000), following entry is required to be passed :
        Exchange loss 10000  
          To Sundry debtors   10,000
    --------------------------------------------------------------------------------------------------------------------
    The reduction in the rate of exchange on the year-end also results in less rupees payable to exchange dealer at spot rate on 31-3-2000. For this, following entry is to be passed :
        Forward ($) contract payable 10000  
          To Exchange gain   10,000
    --------------------------------------------------------------------------------------------------------------------
        Discount expenses 3334  
          To Deferred discount   3334
    This indicates only proportionate discount.

    Next Financial Year
    May 1, 2000
        Cash 412000  
        Exchange loss 5000  
          To Sundry debtors   417000
    --------------------------------------------------------------------------------------------------------------------
    To account for delivery of US $ 10000 against forward contract at spot rate on 1-5-2000, following entry is to be passed :
        Forward ($) contract payable 417000  
          To Exchange gains   5000
          To Cash   412,000
        Cash 422000  
          To Forward (Rs.) contract receivable   422,000
    --------------------------------------------------------------------------------------------------------------------
        Discount expense 1666  
          To Deferred discount   1666

    Thus, for XYZ Ltd., even though interested in fixed rate loan, it is advisable to go for floating rate which will be 0.25% lower than fixed rate. Similarly for ABC Ltd., even though it is interested in floating rate loan, it is advisable for it to go for fixed rate as it is 0.5% lower than the floating rate. Under the circumstances, they may raise a loan the way it is cheaper and then they may enter into swap through an intermediary, a swap bank. Let us assume that the swap bank may pay fixed interest to ABC Ltd. @ 9.5% which ABC Ltd. will pass on to a lender and ABC Ltd. will effectively pay a floating rate of prime rate -.25% (9.75%) to swap bank. Hence, their effective cost will be 9.75%. Simultaneously, swap bank will pay prime rate -0.25% to XYZ Ltd., which they will pass on to floating rate lender by adding 1% (as the cost is prime rate +0.75%) and they will charge a fixed rate of 9.75%. Thus, the effective cost to XYZ Ltd. will be 10.75%, which is again 0.25% lower than the fixed rate loan raised from the market and simultaneously, the swap bank will also have net gain of 0.25%. For the purpose of accounting, let us assume that the amount borrowed from the financial institution is Rs.100,00,000. The transaction-wise accounting entries are easy to understand in the books of ABC Ltd. The accounting entries in the books of ABC Ltd. will be :

    At the time of borrowing :
    Cash
        To Loan
    10000000
    10000000

    Interest liability for six months will be :
    Interest 4750000  
        To FI   4750000
    FI 4750000  
        To Cash   4750000
    Interest 4875000  
        To Swap Bank   4875000
    Swap Bank 4875000  
        To Cash   4875000
    Swap Bank 4750000  
        To Interest   4750000
    Cash 4750000  
        To Swap Bank   4750000

    FASB 133 deals with fair value hedge. Accordingly, interest rate swap is the fair value hedge. According to para 22, gains and losses on qualifying fair value, hedged value shall be accounted as follows :

    1. the gain or loss on the hedging instrument shall be re-cognised currently in earnings.
    2. the gain or loss (the change in the fair value) on the hedged item, attributable to the hedged risk, shall adjust the carrying amount of the hedged item and be currently recognised in earnings.

    Thus, in the above case, it is required to find out what is the fair value of swap at the year end. This is considered to be an asset till the time period is over and the gain will be credited to profit and loss account. Thus, if the fair value of the swap is, say, ‘X’, then the entry will be
    Swap X  
        To Gain on swap   X

    Moreover, on account of swap, the market value of debt is also likely to change. Out of the total value, part may be attributable to change in the interest rate say X*. If the market value goes up it is to be considered as an obligation to pay premium. The proposed entry can be :
    Loss on debt X*  
        To premium on note payable   X*

    IAS 32, which deals with ‘Financial instrument : Dis-closure and Presentation’ also explains, vide its para 43, that transaction in financial instru-ments may result in an enterprise’s assuming or transferring to another party one or more of the financial risks viz., price risk, credit risk, liquidity risk and cash flow risk. The price risk also covers within its purview the interest rate risk, which is defined as the ‘risk that the value of financial instrument will fluctuate due to changes in market interest rates’. Para 49 of the IAS 32 states that when financial instrument held or issued by an enterprise, either individually or as class, creates a potentially significant exposure to the risks described in para 43 (mentioned above). Terms and conditions that may warrant disclosure include :

    The principal stated face value or similar amount, which for some derivative instrument, such as, interest rate swap may be the amount on which future payments are based. Para 51 of IAS 32 also states “similarly, it is important to disclose relation-ship between components of ‘synthetic instruments’, such as, fixed rate debt created by borrowing at a floating rate and entering into a floating to fixed interest rate swap”. In each case, the enterprise presents the individual financial assets and financial liabilities in its balance-sheet according to their nature, either separately or in the class of financial asset or financial liability to which they belong. The extent to which risk expo-sure is altered by relationship among the assets and liabilities may be apparent to financial statement users from infor-mation of the type described in para 49, but, in some circum-stances further disclosure is necessary.

    According to para 57 of IAS 32, “An enterprise provides infor-mation concerning its exposure to the effects of future changes in the prevailing level of interest rates”. Changes in market interest rates have direct effect on the contractually determined cash flows associated with some financial assets and financial liabilities (cash flow risk) and on the fair value of others (price risk).

    According to para 60, “An enterprise indicates which of its financial assets and financial liabilities are :

    1. exposed to interest rate price risk, such as monetary financial assets and financial liabilities with fixed interest rate;
    2. exposed to interest rate cash flow risk, such as monetary financial assets and financial liabilities with a floating interest rate that is reset as market rate changes;
    3. not exposed to interest rate risk such as some investment in equity securities”.

    Thus, IAS 32 included numerous provisions regarding presentation and disclosure of interest rate swap. Moreover, IAS 39, which deals with ‘Financial instruments : Recognition and measurement’ — also deals with fair value hedges. According to para 153 of the same “If fair value hedge meets the conditions in para 142 during the financial reporting period, it should be accounted as follows :

    1. the gain or loss from remeasuring the hedging instrument at fair value should be recognised immediately in net profit or loss; and
    2. the gain or loss on the hedged item attributable to the hedged risk should adjust the carrying amount of the hedged item and be recognised immediately in net profit or loss”.

    Both these are taken care of in the accounting entries proposed above.

  3. Currency swap :
    In a currency swap, the two payment streams being exchanged are denominated in two different currencies. Usually, an exchange of principal amount at the begin-ning and re-exchange at termi-nation are features of currency swap. The principal amounts are equal at the current market rate. A typical currency swap situation is explained in the fol-lowing illustration :
      Corp. AUST Corp. FREN
    Requirements funding FRF funding AUD funding
    Cost of AUD funding 15% 16%
    Cost of FRF Funding 11% 10%

    In their home currencies each company has a 1% borrowing advantage. Corp. AUST for example can borrow AUD @ 15% or 1% below Corp. FREN. Similarly Corp. FREN can borrow FRF @ 10%, which is 1% below the cost to Corp. AUST. It is this relative advantage that allows currency swap to materialise. The currency swap process is as follows :

    1. Corp. FREN borrows FRF @ 10% and Corp. AUST borrows AUD @ 15%.
    2. The two companies then exchange the debt with each other so that Corp. AUST has FRF debt @ 10% and Corp.FREN has Aud debt @ 15%.

    Each party reduces its borrowing cost by 1%. However, it is difficult for most corporations and government borrowers to locate others that want to do an off-setting transaction at the same time and for the same amount. They also face credit risk with others. Under the circumstances, swap deals will be entered into through a bank. In exchange of services to be rendered, bank will take part of the savings involved in the swap. Consequently, the net savings of the swap for Corp. AUST and Corp. FREN will be less than 1%.

    Let us assume that spot FRF/AUD exchange rate is 5 FRF per 1 AUD. A deal based on 100 million AUD is executed. In order for swap to work, it is essential that the amount be of the same value. In the above case, 500 million FRF issue is needed to work the swap. Let us further assume that both corporations are raising funds in their own currencies. Corp. FREN, after raising the FRF loan, enters into a swap with bank, which in turn, will allow Corp. AUST to use FRF loan @ 10.20%. Simultaneously, the bank will allow Corp. FREN to use AUD debt @ 15.20%. Thus, effectively both of them will be saving 0.80%. The transactions can be summarised as follows :


    In terms of FRF :
    Time Transaction Corp. FREN Bank Corp. AUST
    0 Original Loan 500 million - -
      FREN to Bank (500) million 500 million -
      Bank to AUST - (500) million 500 million
    1 Interest payments :      
      Aust to Bank - 51 million (51) million
      Bank to FREN 50 million (50) million -
      FREN to investor (50) million - -

    In terms of AUD :
    Time Transaction Corp. FREN Bank Corp. AUST
    0 Original Loan - - 100 million
    0 AUST to Bank - 100 million (100) million
    0 Bank to FREN 100 million (100) million -
    1 Interest payments :      
      Fren to Bank (15.2) million 15.2 million -
      Bank to AUST - (15) million 15 million
      AUST to investor/lender - - (15) million

    The proposed entries for the Corp. FREN will be :
    Initial borrowing :
    Cash 500 ml.  
        To FRF Loan   500 ml.
    FRF Loan 500 ml.  
        To Cash
    (For FRF Loan passed to intermediary/Swap Bank)
      500 ml.
    Cash 500 ml.  
        To AUD Loan
    (For AUD Loan received from intermediary/Swap Bank)
      500 ml.
    Interest on AUD Loan 76 ml.  
    To Cash
    (interest payments of 15.2 ml. AUD @ 5 FRF
      76 ml.
    Cash
    To Interest on FRF Loan (int. receipt from Swap Bank)
    50 ml.
    50 ml.
    Interest on FRF Loan 50 ml.  
        To Cash
    (Int. payment to investor)
      50 ml.

    In addition to the above entries entered for the purpose of transaction, the fair value of the loan is also likely to change. Therefore, to the extent that the fair value of the loan will be affected on account of currency swap, entries should also be passed, which will be on similar lines as for the interest rate swap. Moreover, at the end of the term of the debt re-exchange of the debt with the swap bank will also be required and this should also be recorded as per the normal principles of accounting.

  4. Currency options :
    Currency options provide the corporate treasurer another tool for hedging foreign exchange risks arising out of the firm’s operations. Unlike forward contract options allowing the hedger to gain from favourable exchange rate movements, Currency options are frequently suggested as an appropriate hedging tool because one can remove downside risk without limiting the upside potential. Options can be put option or a call option. A put option is a contract that specifies the currency that the holder has the right to sell. A call option is a contract that specifies the currency that the holder has the right to sell. This can better be explained with the help of an illustration.

    In late February, an American Importer anticipates a Yen payment of JPY 100 million to a Japanese supplier sometime in late May. The current USD/JPY spot rate is 0.007739 (which implies that JPY/USD rate of 129.22). A June Yen call option on the Philadelphia Exchange with the strike price of $0.0078 per yen is available for a premium of 0.0108 cents per yen or $ 0.000108 per yen. A contract is for JPY 6.25 million. Premium per contract is therefore : $ 0.000108 * 6250000 = $ 675. The firm decides to purchase 16 calls for a total premium of $ 10800. In addition, there is a brokerage fee of $ 20 per contract. Thus, total expenses in buying the options is $ 11120. The firm has, in effect, ensured that its buying rate for yen will not exceed - $0.0078 + $ (11120/100000000) = $ 0.0079112 per yen. The yen depreciates to $ 0.0075 per yen in late May when the payment becomes due. The firm will not exercise the option. It can sell 16 calls in the market, provided the resale value exceeds the brokerage commis-sion it will have to pay. Therefore, price per yen is $ 0.075 + 0.000112 $. If Yen appreciates, then the firm will exercise option. Under the above mentioned circumstances, following entries are suggested.

    For purchases irrespective of contract :
    Purchases
        To creditor

    Or
    Fixed asset
        To Supplier

    When option contract is entered into :
    Option premium
        To Cash

    year end, the amount of the premium is to be debited to profit and loss account or to fixed asset, as the case may be.

    P & L Fixed assets
        To Option To Option
        premium premium

    However, according to FASB 133, the financial option is to be shown as an asset or liability. According to para 28(c) “If written option is designated as hedging the variability in cash flows for a recognised asset or liability, the combination of the hedged item and the written option provides at least as much potential for favourable cash flows as exposure to un-favourable cash flows. That test is met if all possible percentage favourable changes in the underlying (from zero percent to 100 percent) would provide at least as much favourable cash flows as the unfavourable cash flow that would be incurred from an unfavourable change in the underlying of the same percentage. Therefore, depend-ing on the value, it will be accounted as asset or liability. Even IAS 39 clearly states in para 29(d) that ‘Financial Options are recognised as assets or liabilities when holder or writer becomes a party to contract.” Thus, options are to be recognised as asset or liability.

    The proposed accounting entry is :
    Options
        To Unrealised gain
        To Gain

    Above are the proposed entries for the accounting of forward contract, interest rate swap, currency swap and currency options. It is high time that the Institute of Chartered Accountants of India comes out with the standard for accounting for derivatives.


     

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