Over time, the use of derivatives (forward, option and swap contracts) by Indian companies has increased significantly. Currently, accounting standard AS-11 — The Effects of Changes in Foreign Exchange Rates deals only with accounting for forward exchange contracts used to hedge the currency risks of a recognised asset/ liability, and contracts used for trading/ speculation. There is no notified standard for other derivative contracts. AS-30 — Financial Instruments: Recognition and Measurement deals with derivatives and hedge accounting in a comprehensive manner. However, it is not notified under Companies Act and is not mandatory.

As an interim measure, the Institute of Chartered Accountants of India issued an announcement on “Accounting for Derivatives”, which encourages companies to follow AS-30. A company not applying AS-30 should mark-to-market all outstanding derivative contracts on the reporting date and provide for the resulting loss. This is based on the principle of prudence in AS-1.

The absence of a notified standard results in differing practices on derivative accounting. For example, some companies follow AS-30 and recognise both gains and losses on derivatives. Many others follow the ICAI announcement and recognise only the losses on derivative contracts. There are significant variations in the calculation of loss. A few companies calculate derivative loss on contract-by-contract basis and provide for gross loss for all loss-making contracts. Others compute the net loss on a portfolio basis — that is, the net loss is determined for each category of derivatives, such as option or swap contracts.

Some companies calculate the net loss on a global basis — that is, net loss on all outstanding derivatives taken together. Due to the offsetting impact, the second and third approach will typically result in recognition of significantly lower loss.

Most Indian companies take derivative contracts to hedge one or more risks. There are significant differences in how companies treat the hedging effect. Some apply the detailed principles enunciated in AS-30, including the strict documentation and effectiveness requirement, for hedge accounting. Many companies appear to have followed the overall principles of hedge accounting without complying with the strict documentation and effectiveness requirement. Among companies that have not used AS-30, some recognise loss on a derivative contract using one of the above methods, without considering the underlying hedge impact. Other companies feel that the accounting should reflect the underlying economic substance for which a derivative is undertaken. Hence, they account for only net loss on derivative contracts, after considering the gains on the underlying hedged items.

The Ministry of Corporate Affairs has inserted paragraph 46/ 46A in AS-11 to allow capitalisation/ deferment of the exchange differences arising on long-term foreign currency monetary items. Additional complexity arises if a company has used this option and also decides to hedge the foreign currency loan. It is not clear how hedge accounting will work here. Can a company also capitalise gain/ loss arising on a derivative to achieve an offset impact? Or, should it capitalise only the net exchange gain/ loss after considering the hedge impact?

Under AS-30, derivative accounting should be applied to standalone derivative contracts as well as derivatives embedded in other host instruments, if certain criteria are met. It appears that only a few companies have indentified and accounted for such embedded derivatives separately.

The absence of a notified accounting standard is leading to significant variations in accounting for derivative contracts. The regulator should notify AS-30 on a priority basis.

The author is Senior Professional in a member firm of EY Global.

Published on July 21, 2013