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Total Number of Subscribers: 426 |
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Date: 19 May 2008 |
Compiled by Mr. M. Sathya Kumar |
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Accounting
treatment for derivatives The accounting of financial instruments is based on whether
those are used for hedging or not. Where they are not used for hedging they
could fall under any of the four categories:(i) Financial asset/liability at
fair value through profit and loss account (ii) Held-to-maturity investments
(iii) Loans and receivables and (iv) Available for sale. Financial asset/liability at fair value through profit and loss
account would generally cover trading items and those that management
voluntarily wishes to classify under this category. All the fair value
changes in the financial asset/liability are taken to the income statement
and consequently the income statement would become highly volatile. Derivatives would fall under this category, unless they are used
for hedging purposes in which case hedge accounting would apply. Held-to-maturity financial assets are those investments where
there is positive intention to hold those assets till the maturity period.
They do not include derivatives since they are included in the first
category. A financial asset that fulfills the definition of loans and
receivables are also not included. Besides an investment which is otherwise held-to-maturity may be
classified voluntarily by the management in the fair value category or available
for sale category. Held-to-maturity investments are accounted for through the
effective interest rate method and the consequent gains and losses are
recognised in the income statement. Getting Ready The markets for derivatives have been remarkable and continued
growth over the past decade. This reflects the increasing use of such
instruments by business, either for speculation or hedging purposes.
Accordingly, the accounting treatment for derivatives and hedging activities
has taken on a high degree of importance. Hedge accounting does not sit well with the standard setters’ desired goal for financial instrument accounting, i.e. a
full fair value model. Further, hedge accounting relies on management intent
to link for accounting purposes what the standard setters see as two or more
separate transactions. It also overrides accounting requirements that would
otherwise apply to those transactions when viewed separately. Standard setters believe that separate accounting is the best
way to “tell it as it is”, in other words, to apply the full
fair value model. However, the wider financial reporting community could not
be persuaded to accept the abolition of hedge accounting. Accounting Standard
AS-30 on Financial Instruments-Recognition and Measurement has been issued by
the institute as published in January 2008 journal. This Accounting Standard will become mandatory in respect of
accounting period commencing on or after April 1, 2011, for all commercial,
industrial and business entities except to a small and medium size entity. Correspondingly, a limited revision has also been made to AS-11
so as to withdraw the requirements concerning forward exchange contracts from
that Standard. ICAI is also in process of formulating a separate Accounting
Standard AS-32 on Financial Instruments-Disclosures. As such AS-30 deals with
Recognition and Measurement, and AS-32 deals with exclusively on Disclosure. Hedge Accounting As required by the standard, on the date of this standard
becoming mandatory, an entity should; measure all derivatives at fair value;
and eliminate all deferred losses and gains, if any, arising on derivatives
that under the previous accounting policy of the entity were reported as
assets or liabilities. Any resulting gain or loss (as adjusted by any related tax
expense/benefit) should be adjusted against opening balance of revenue
reserves and surplus. On the date of this standard becoming mandatory, an entity
should not reflect in its financial statements a hedging relationship of a
type that does not qualify for hedge accounting under this standard (for
example, hedging relationships where the hedging instrument is a cash
instrument or written option; where the hedged item is a net position; or
where the hedge covers interest risk in a held-to-maturity investment).
However, if an entity designated a net position as a hedged item under its
previous accounting policy, it may designate an individual item within that
net position as a hedged item under Accounting Standards, provided that it
does so on the date of this standard becoming mandatory. It, before the date of this standard becoming mandatory, an
entity had designated a transaction as a hedge but the hedge does not meet
the conditions for hedge accounting in this standard, the entity should apply
paragraphs 102 and 112 to discontinue hedge accounting. Transactions entered
into before the date of this standard becoming mandatory should not be
retrospectively designated as hedges. Embedded Derivatives As entity that applies this standard for the first time should
assess whether an embedded derivative is required to be separated from the
host contract and accounted for as a derivative on the basis of the
conditions that existed on the date it first became a party to the contract
or on the date on which a reassessment is required by appendix A paragraph
A56, whichever is the later date. Recent Announcement Notwithstanding the applicability of AS-30, it is very important
to understand the impact and effect of this announcement. The announcement on
accounting for derivatives issued by ICAI on March 29, 2008, clarifies the
best practice treatment to be followed for all derivatives is as follows: (i) All derivatives except forward contracts covered by AS 11,
can be accounted for on the basis of the requirements prescribed in AS 30,
Financial Instruments: Recognition and Measurement. (ii) In case an entity does not follow AS 30, keeping in view
the principle of prudence as enunciated in AS 1, ‘Disclosure of Accounting Policies’, the entity is required to provide for losses
in respect of all outstanding derivative contracts at the balance sheet date
by marking them to market. The effect of the above announcement is as
follows: (i) In case an entity does not follow AS 30, the losses in
respective of derivative contracts at the balance sheet date have to be
provided for and disclosed. (ii) In case an entity follows AS 30, then the effect will be
broadly as follows: In case the derivatives do not meet the hedge accounting
criteria as laid down in AS 30, the gains or losses in respect thereof will
have to be recognised in the statement of profit and loss. The derivatives
will have to be shown as financial assets or financial liabilities on the balance
sheet, as the case may be, as per the requirements of the accounting
standard. In case the hedge accounting criteria, e.g., hedge
effectiveness, qualifying hedges, documentation etc, as laid down in AS 30
are met, the entity will have to consider, keeping in view the requirements
of AS 30, whether the hedge is a fair value hedge or cash flow hedge. ‘Fair value hedge’ and ‘cash flow hedge’ have been explained in AS 30 as follows: (a) Fair value hedge: A hedge of the exposure to changes in fair
value of a recognised asset or liability or an unrecognised firm commitment,
or an identified portion of such an asset, liability or firm commitment, that
is attributable to a particular risk and could affect profit or loss. (b) Cash flow hedge: A hedge of the exposure to variability in
cash flows that (i) is attributable to a particular risk associated with a
recognised asset or liability (such as all or some future interest payments
on variable rate debt) or a highly probable forecast transaction and (ii)
could affect profit or loss. As per the standard, a hedge of the foreign currency risk of a
firm commitment may be accounted for as a fair value hedge or a cash flow
hedge. Fair value hedges are accounted for as
follows: The gain or loss for re-measuring the derivative hedge
instruments at fair value should be recognised in the statement of profit and
loss, and The gain or loss on the hedged items (the underlying) should
adjust the carrying amount of the said items and be recognised in the
statement of profit and loss. Cash flow hedges are accounted for as follows: (i) In case of effective cash flow hedges, the gain or loss on
the hedging derivative is recognised directly in an appropriate equity
account, say, hedge reserve account (the ineffective hedge portion is
recognised in the statement of profit and loss account). (ii) If a hedge of a forecast transaction subsequently results
in the recognition of a financial asset or a financial liability, the
associated gains or losses that were recognised directly in the appropriate
equity account in accordance should be reclassified into, i.e., recognised in
the statement of profit and loss in the same period or periods during which
the asset acquired or liability assumed affects profit or loss (such as in
the periods that interest income or interest expense is recognised). (iii) If a hedge of a forecast transaction, subsequently results
in the recognition of a non-financial asset or a non-financial liability, or
a forecast transaction for a non-financial asset or non-financial liability
becomes a firm commitment for which fair value hedge accounting is applied,
then the entity should adopt (a) or (b) below: (a) It reclassifies, i.e., recognises, the associated gains and
losses that were recognised directly in the appropriate equity account into
the statement of profit and loss in the same period or periods during which
the asset acquired or liability assumed affects profit or loss (such as in
the periods that depreciation expense or cost of sales is recognised). (b) It removes the associated gains and losses that were
recognised directly in the equity account, and includes them in the initial
cost or other carrying amount of the asset or liability. An entity should adopt either (a) or (b) as its accounting
policy and should apply it consistently to all hedges to which (iii) above
relates. (iv) For cash flow hedges, other than those covered by
paragraphs (ii) and (iii) above, amounts that had been recognised directly in
the equity account should be reclassified into, i.e., recognised in the
statement of profit and loss in the same period or periods during which the
hedged forecast transaction affects profit or loss (for example, when a
forecast sale occurs). The above is only a summary. For the detailed application,
Accounting Standard (AS) 30 should be referred to. Source : The Business Line |
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