Accounting of Derivative is a very peculiar thing and many people including the professionals find it a bit difficult to make accounting entries for the same in books of accounts.
Now, ICAI has issued guidance note on accounting of such derivative contracts to help the fellow members of the Institute.
Before going to the guidance note let’s understand the definition of Derivative which is as under:
Derivative: A derivative is a financial instrument or other contract with all three of the following characteristics:
(i) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the “underlying”);
(ii) it requires no initial net investment or an initial investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors;
and
(iii) it is settled at a future date.
Now let’s understand the objective and scope of this guidance note:
Objective
The objective of this Guidance Note is to provide guidance on recognition, measurement, presentation and disclosure for derivative contracts so as to bring uniformity in their accounting and presentation in the financial statements. This Guidance Note also provides accounting treatment for such derivatives where the hedged item is covered under notified Accounting Standards, e.g., a commodity, an investment, etc., because except AS 11, no other notified Accounting Standard prescribes any accounting treatment for derivative accounting. This Guidance Note, however, does not cover foreign exchange forward contracts which are within the scope of AS 11. This Guidance Note is an interim measure to provide recommendatory guidance on accounting for derivative contracts and hedging activities considering the lack of mandatory guidance in this regard with a view to bring about uniformity of practice in accounting for derivative contracts by various entities.
Scope
This Guidance Note covers all derivative contracts that are not covered by an existing notified Accounting Standard. Hence, it does not apply to the following:
(i) Foreign exchange forward contracts (or other financial instruments which in substance are forward contracts covered) by AS 11.
(ii) Derivatives that are covered by regulations specific to a sector or specified set of entities.
Entities such as banking, non-banking finance companies (‘NBFCs’), housing finance companies and insurance entities are required to follow the accounting treatment for derivative contracts, if any, prescribed by the concerned regulators such as the Reserve Bank of India (RBI) in case of banking entities and the NBFCs, National Housing Bank (NHB) in case of housing finance companies and Insurance Regulatory and Development Authority (IRDA) in case of insurance entities. In case the concerned regulator has not prescribed any accounting treatment for derivative contracts, the recommendations contained herein should be followed.
This Guidance Note also provides guidance on accounting of assets covered by Accounting Standard (AS) 2, Valuation of Inventories, Accounting Standard (AS) 10, Accounting for Fixed Assets, Accounting Standard (AS)
13, Accounting for Investments, etc., which are designated as hedged items, since such notified Accounting Standards are silent on hedge accounting using derivative instruments for items covered by these Standards. In contrast, AS 11 provides guidance specific to foreign currency forward contracts. Accordingly, guidance for accounting for derivatives and hedging relationships which pertain to hedged items covered under such notified Accounting Standards, e.g., commodities stock, fixed assets, investments etc., is provided in this Guidance Note. However, this Guidance Note does not provide guidance on accounting for items and transactions covered in AS 11, which is a notified Standard. Similarly, accounting for embedded derivative contracts is not part of the scope of this Guidance Note since there are potential conflicts with the requirements of certain other notified Accounting Standards such as AS 2, AS 13 etc. Further, this Guidance Note does not deal with macro-hedging and accounting for non-derivative financial assets/liabilities which are designated as hedging instruments since its objective is to provide guidance on accounting for derivative contracts only and not hedge accounting in its entirety.
This Guidance Note, thus, applies to following derivative contracts whether or not used as hedging instruments:
(i) Foreign exchange forward contracts (or other financial instruments that are in substance forward contracts) that are hedges of highly probable forecast transactions and firm commitments (therefore outside the scope of AS 11);
(ii) 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;
(iii) Other derivative contracts such as traded equity index futures, traded equity index options, traded stock futures and option contracts; and
(iv) Commodity derivative contracts;
This list is meant to be illustrative only and is not exhaustive.
Examples of contracts covered within the scope of AS 11 and thus not covered within the scope of this Guidance Note include:
Foreign currency forward or future contract entered into to hedge the payment of a monetary asset or a monetary liability recognised on balance sheet, e.g., a debtor, creditor, loan, borrowing etc.
A currency swap contract (principal only; no interest rate element) that hedges the repayment of the principal of a foreign currency loan.
This list is meant to be illustrative only and is not exhaustive.
To read full guidance note CLICK HERE.
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