ACCOUNTING FOR DERIVATIVES

Who decides accounting regulations for derivatives?

Accounting is regulated in India by the Institute of Chartered Accountants of India (ICAI) which issues Accounting Standards and Guidance Notes from time to time on various areas. The ICAI has issued Guidance Notes for the Accounting of Index Futures and Options. The Options accounting Guidance Note covers both Index Options and Stock Options. No Guidance is available for the accounting of Stock Futures at the moment.

Readers should appreciate that accounting guidelines do not relate to tax issues which are decided by the Ministry of Finance along with the Central Board of Direct Taxes. This article covers only Accounting of Derivatives. Tax issues will be discussed in a later Article.

How do we account for initiation of an Index Futures contract?

When you buy (or sell) an Index Futures contract, you pay an Initial Margin amount to your broker. This amount paid is treated as a Current Asset and shown in your Balance Sheet.

The notional value of the contract will be far higher than the amount of margin paid. The Notional Value of the contract is not accounted in the books because you are not paying this value, nor are you liable to pay this value in the future.

What happens to daily settlement mark to market margins?

At the close of each trading day, the broker is required to debit you for mark to market losses and credit you for mark to market profits. The ICAI has taken a stand that these profits and losses are not in the nature of accounting accruals. Hence, they will not be taken to the profit and loss account on a daily basis. These amounts, whether paid or received, will be reflected under Current Assets in the Balance Sheet along with the Initial Margin amount earlier reflected. 

What happens when I square up my contract?

When you square up your contract, the entire profit or loss on the contract (which is the sum of all the daily mark to market profits and losses from the date of initiation to the date of squaring up) will be taken to the profit and loss account representing realized profits on square up.

The brokers account will be appropriately debited or credited for the second impact of the transaction. The broker will pay (or receive) the margin which will be appropriately accounted.

Thus, realized profits/losses are taken to Profit & Loss Account while unrealized profits/losses are retained in the Balance Sheet as far as day to day accounting is concerned.

What if Margins are paid in non cash forms?

Initial Margins can be paid in the form of cash, cash equivalents (treasury bills, Government securities, debt securities, bank guarantees, fixed deposits) or equities. In the case of payment by cash, the above accounting practice will be followed. If margins are paid in non cash forms, no accounting entry will be required. In the Notes to the Accounts, the fact that such margins have been paid will be disclosed.

How is accounting for the year end effected?

As discussed above, unrealized profits are not recognized for the purposes of daily accounting. However, at the year end the enterprise is required to work out the unrealized profits or losses on all the index futures contract open on the last day. If the net impact of all such index futures contracts is a profit, no further accounting is required as unrealized profits are not accounting as per regular conservative principles.

However, if the net impact of all such contracts is a loss, the enterprise is required to provide for such losses. Thus, the enterprise will on the hand debit the Profit & Loss Account and on the other hand create a liability towards this unrealized loss.

How are Options accounted at Initiation?

If you are a buyer of a Call (or a Put), you will pay a premium on the day of initiation of the contract (or soon thereafter). This premium amount is reflected as a Current Assets in your Balance Sheet.

If you are a seller of the Call (or the Put), you will receive this premium on the day of initiation or soon thereafter. This amount of premium received is reflected as a Current Liability in your Balance Sheet.

How are Margins accounted?

In the Options market, buyers are not required to pay any margins and hence the question of accounting will not arise. Sellers are required to pay margins which will be accounted as Current Assets in their Balance Sheets if paid in cash. If paid as cash equivalents or equity, there is no accounting entry required, but a disclosure in the Notes will be necessitated.

Such margins will be similarly accounted whether paid on the day of initiation or paid sometime later during the life of the Option Contract.

What happens when the Option is squared up?

Options can be squared up in the following ways:

• Sale of a purchased Option

• Purchase of a sold Option

• Exercise by the Buyer (resulting in square up for the exercising Buyer and a seller chosen by a computer algorithm)

• Expiry

On square up by way of purchase or sale, you will realize a profit or a loss. For example if you had bought an Option for Rs 23 and you have now sold it for Rs 34, you have made a profit of Rs 11. This profit will be taken to the Profit & Loss Account.

In the case of exercise, the buyer will receive intrinsic value (difference between the strike price of the option and the closing price of the underlying) and the seller will pay this intrinsic value. This intrinsic value will be treated as the transaction price and accordingly, profit or loss will be determined. The accounting implications will remain the same as above.

In the case of expiry, the option may or may not close in the money. If it closes in the money, the buyer will receive intrinsic value and the seller will pay the same amount. The accounting will remain the same as above. If the option closes at or out of the money, the buyer will receive nothing. The entire option price paid by him (and reflected as a Current Asset in the Balance Sheet) will not be written off to the Profit & Loss Account as an expense.

The seller will not pay any amount to the buyer on expiry in this situation. The entire Option Premium collected by the Seller (and taken to Current Liabilities in the Balance Sheet) will now be transferred to Income into the Profit & Loss Account.

What happens at the year end?

At the year end, you should value the Options which are open as on the last day. This valuation should be compared with your cost (if you are a buyer) and your collections (if you are a seller). Unrealized profits or losses should accordingly be computed.

If you have unrealized profits, no further accounting is required. If you have unrealized losses, you need to provide for these losses in your Profit & Loss Account.

The ICAI has taken a stand that if you have a number of transactions in various underlying securities, you cannot set off losses on one underlying vis-à-vis profits on another for the purpose of determination of the provision towards unrealized losses. For example, you have an unrealized profit of Rs 8,000 on Satyam Options and an unrealized loss of Rs 3,200 on Infosys Options, you need to provide for the entire Rs 3,200 of unrealized loss. You cannot argue that the net amount is a profit if you consider Satyam and Infosys on a combined basis.

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