Derivative Contracts

Derivative Contracts – New Reporting Values Derived

Posted on Posted in Accounting and Finances

The given Guidance Note “GN” highlights on recognition, measurement, presentation and disclosure for derivative contracts so as to bring uniformity in their accounting and presentation in the financial statements.

This GN covers all derivative contracts that are not covered by an existing notified Accounting Standard; hence, it does not apply to the following:

  1. Foreign exchange forward contracts (or other financial instruments which in substance are forward contracts covered) by AS 11.
  2. Derivatives that are covered by regulations specific to a sector or specified set of entities.

Key Accounting Principles

If any entity decides not to use Hedge Accounting, then it should account for its derivatives at fair value with changes in fair value being recognized in the P&L.

If an entity decides to apply hedge accounting it should be able to clearify the following:-

  1. identify its risk management objective,
  2. explain how the derivative contract will measure the derivative instrument if its risk management objective is being met.
  3. demonstration of hedging a future cash flow that the cash flows are highly probable of occurring.
  4. conclude that the risk that is being hedged could impact P&L.

Note: Hedging is a risk reduction technique whereby an entity uses a derivative instrument to offset future changes in the fair value or cash flows of an asset or liability.

Recognition of Derivatives on the Balance Sheet Date

The said GN requires that all derivatives are recognized on the balance sheet and measured at fair value since a derivative contract represents a contractual right or an obligation.

Note: Fair value represents the ‘exit price’ i.e. the price that would be paid to transfer a liability or the price that would be received when transferring an asset to a knowledgeable, willing counterparty.

Presentation in the Financial Statement

Derivative assets and liabilities recognized on the balance sheet at fair value should be presented as current and non-current based on the following considerations:

  1. Derivatives intended for trading/speculative purposes : current assets and liabilities.
  2. Derivatives that hedge recognised assets or liabilities are classified based on the hedged item.
  3. Derivatives being hedges of forecasted transactions/ firm commitments are classified based on the settlement / maturity dates of the derivative contracts.
  4. (d) Periodic or multiple settlements Derivatives such as interest rate swaps should not be bi-furcated into current and non-current elements. Their classification should be based on when a predominant portion of their cashflows are due for settlement as per their contractual terms.

Categories of Hedge Accounting to Hedge the Exposures

FAIR VALUE HEDGE ACCOUNTING CASH FLOW HEDGE ACCOUNTING NET INVESTMENT IN FOREIGN OPERATIONS
Changes in fair value of
· Recognised asset or liability
· unrecognised firm commitment,
· identified portion of asset/ liability/ commitment,
Variability in cashflows associated to a component of
· recognized asset or liability
· highly probable forecast transaction
Net investment in foreign Branch, as the investor in a non-integral foreign operation is exposed to changes in the carrying amount of the net assets of the foreign operation arising from the translation of those assets into the reporting currency of the investor.
Attributable to a particular risk and could affect P&L.
Example : Hedging of a fixed rate bond with an interest rate swap,

changing the interest rate from fixed to floating

 

Example : Hedging of future highly probable sales in a foreign currency using a forward exchange contract.

 

Illustration for Cash Flow Hedge

July 2016: received order for export to USA in the month of January 2017 & realise USD 100,000 in April 2017.

Entered futures in the month of April @ Rs. 65 (Spot Rate:.64.50 Rs/USD).

January 2017: 61 Rs/USD, and forward rate 61.20 Rs./USD.

March 2016: the 60.50 Rs/USD and forward rate 60.60 Rs./USD.

Realization 60 Rs/USS

Date Transaction
January 2017 Recognises the revenue @ Spot Rate
Debtors 61,00,000To Sales 61,00,000Account the MTM effect [(65 – 61.20)*10000]:

Forward entered @ 65 & similar Forward trading @ 61.20.

Forward contract Receivable 3,80,000

To Cash Flow Hedge Reserve 3,80,000

Cash Flow Hedge Reserve 3,80,000

To Profit and loss. 3,80,000 (Recognition of hedging gain as the revenue is booked)

March

2017

Forward rate 60.60 Rs/USD, Spot rate Rs. 60.50 Rs/USD

Restatement of Debtors (60.50 – 61)

Forex Loss (P&L)…………50,000

To Debtors 50,000

MTM Effect of Forward Cover (60.60 – 61.20)

Forward Contract Receivable 60,000

To Forex Gain (P&L) 60,000

April 2017 Spot rate : 60.00 Rs/USD

Realisation of Debtors

Bank 60,00,000

Forex Gain/Loss (P&L) 50,000

To Debtors 60,50,000

Maturity of Forward Contract

Bank 5,00,000

To Forward Contract Receivable 4,40,000

To Forex Gain/Loss (P&L) 60,000

 

Leave a Reply

Your email address will not be published. Required fields are marked *

five × three =