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As the Indian economy globalises and its companies grow rapidly, there is greater exposure to risks. Derivatives, an essential tool in managing risks, are evolving to suit complex business needs — and, accounting for these is now an important area of focus for stakeholders.
Under the International Financial Reporting Standards, the guidance for accounting of derivatives is well established. All derivatives are marked-to-market at each reporting date, and the gain or loss is recognised in the income statement. Exceptions apply when entities choose hedge accounting on a case-to-case basis, which involves stringent testing and documentation.
This accounting reflects the underlying economic substance of the transaction. For example, certain types of hedge accounting (say, for a highly probable forecast transaction such as future foreign currency sale), the mark-to-market of the hedging derivative is kept in reserve and transferred to the profit-and-loss account when the actual transaction occurs. However, under Generally Accepted Accounting Principles in India (Indian GAAP), guidance for accounting of derivatives lacks proper organisation.
The Institute of Chartered Accountants of India issued AS-30, which is based on IFRS and contains comprehensive guidance on accounting for derivatives. However, AS-30 is recommendatory, and not applied by many companies. Furthermore, AS-30 cannot override a mandatory standard such as AS-13 Investments and AS-11 Foreign Exchange. Thus, the lack of unified guidance has resulted in the use of different standards across companies.
For forward exchange contracts, companies apply AS-11, which contains specific guidance for them. Under AS-11, a forward exchange contract is accounted based on the purpose for which the company obtains it — namely, trading, speculation, or other reasons. Forward exchange contracts for trading or speculation are marked-to-market at each reporting date, and the gain or loss is recognised in the income statement.
For forward exchange contracts not intended for trading or speculation, the premium or discount arising at inception is amortised as expense or income over the life of the contract. Furthermore, the exchange differences are recognised in the profit-and-loss account for the reporting period.
For all other derivatives, there is no other specific literature, and many companies follow ICAI guidance. Whilst some companies analogise the principles of AS-30 and recognise the mark-to-market differences (gain or loss) in the income statement, others not following AS-30 are required to recognise only mark-to-market losses based on the principles of prudence (AS-1).
For entities in certain sectors, the regulatory authorities concerned have prescribed guidelines that override the accounting standards. For example, the Reserve Bank of India guidelines for banks include accounting for derivatives such as interest rate swaps. The RBI accounting guidelines state that while transactions for market making should be marked-to-market, those for hedging could be accounted on accrual basis.
These diversified accounting practices are relevant for most derivatives. This limits the quality of financial information and, hence, the usefulness of the financial statement for various stakeholders.
Even for Indian companies that want to apply AS-30, it is not fully clear whether they can only apply specific principles (such as recognition and measurement), or if they have to adopt the full suite of financial instruments guidance comprising AS-30, AS-31 and AS-32. The latter prescribes extensive disclosure requirements, which can be onerous. The fact that these accounting standards have not yet been notified by the Ministry of Corporate Affairs also adds to the uncertainty and confusion.
Nevertheless, with the announcement of AS-30, Indian GAAP has laid the foundation for accounting of derivatives in line with IFRS. However, as international standards are evolving fast and Indian accounting standards are not mandatorily applied yet, hopefully it is not a case of ‘too little, too late’.
The author is Director, Assurance, Grant Thornton India LLP
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