Accounting of Derivaties

This is the text taken from the BCA REFRENCER 05-06




ACCOUNTING
Accounting of Equity Futures and Options is based on the Guidance Note issued by the Institute. These guidelines are summarized below:

Accounting treatment of future contracts

At the time of inception of contract
Every person is required to pay initial margin determined by the Clearing Corporation/House before entering into the contract of either Stock Future or Index Future. Such initial margin payment shall be debited to the "Initial Margin – Index/S he head "Current Assets". If the initial margin is paid by way of collaterals like TDS, securities, Bank Guarantees etc. entries would be passed in memorandum Banks.


At the time of Daily Settlement
All future contracts are Marked to Market (MTM) on daily basis. This involves payment or receipts of difference in price fluctuation on daily basis. The amount of Marked to Market margin received/paid into/from such accounts should be debited or credited to "Marked to Market Margin Index/Stock Future Account" and will appear as a separate item as "Current Asset" or "Current Liabilities" as the case may be.


Open interest as on Balance Sheet date
At the year end appropriate provision shall be created by a debit to Profit and Loss account for anticipated Loss equivalent to debit balance in "Marked to Market Margin Index/Stock Futures Account." Net amount received which is anticipated profit represented by credit balance in MTM Margin account shall be ignored and no credit shall be taken to Profit and Loss account considering principle of "prudence". For this purpose the net amount paid or received on account of MTM on Open contracts should be determined index wise or scrip wise. Provision so created should be shown as deduction from MTM Margin Index/Stock Future under the head "Current Assets". Proper disclosure is required to be made for the open interest as on the Balance Sheet date in respect of different series of contract.


At the time of Final Settlement
As on date, all future contracts whether Index Future or Stock Future are cash settled on the settlement date. The difference between contract price and the settlement price shall be calculated and recognised in the Profit and Loss account after adjusting provisions created for anticipated loss, if any. Any loss arising out of settlement shall be first charged to such provision account and balance of loss if any shall be charged to Profit and Loss account. If more than one contract in respect of relevant series of equity index future/equity stock future contract to which the square up contract pertains is outstanding, the contract price of the contract so squared up should be determined using Weighted Average Method for calculating Profit or Loss on squaring up.


ACCOUNTING TREATMENT OF OPTION CONTRACT

At the inception of the Contract
In the Books of Buyer
The buyer of the option whether call or put is required to pay premium. In the books of buyer, such premium should be debited to "Index Option Premium Account" or "Stock Option Premium Account" as the case may be.

In the Books of Seller
On receiving the premium the "Index/Stock Option Premium Account" will be credited. However, the seller is also required to pay initial margin to the clearing corporation for entering into contract as in case of futures contracts. Such initial margin is debited to "Index / Stock Option Margin Account".

"Index/Stock Option Premium Account" or "Index/Stock Option Margin Account" shall be shown separately under the head "Current Assets" or "Current Liabilities" as the case may be.


At the time of continuance of Contract
In the books of buyer no entries are required to be passed. In the books of seller/writer, entries will be passed for payment or receipt of marked to market (MTM) margin difference in a similar manner as in case of future contracts.

However, if the contracts are live (open) as on the balance sheet date, appropriate provision has to be made in the books of account by giving effect into Profit and Loss Account.


Open Contracts as on Balance Sheet date
In the Books of Buyer
The maximum loss in Option Contract to the buyer is limited to the premium account. At the time of balance sheet date if the premium prevailing in the market for a contract of similar nature is lower than the premium so paid, then the provision is to be made for the difference. The provision so created shall be credited to "Provision for Loss on Index/Stock Option Account" and shall be reduced from "Index/Stock Option Premium Account" appearing under the head Current Assets.

In the Books of Seller

If the premium received is lower than what is prevailing in the market for a contract of a similar nature, then appropriate provision for loss will be made by debiting profit and loss account and crediting "Provision for Loss Index/Stock Option Account". This account shall appear under the head "Current Liabilities".

In case, if the premium prevailing in the market as compared to premium paid/received renders expected profits, the same shall be ignored considering the principle of prudence.

In case of multiple open options at the year end, the index wise /stock scrip wise provision should be made considering all open options of any strike price and any expiry date pertaining to that index/scrip taken together.


At the time of final settlement
In the Books of Buyer
As on now, the Index Options and the Stock Options both are settled in cash and the accounting entries will also be similar. On exercising the option either at the time of final settlement or at the time of squaring up, the premium will be recognised as expense, net of amount lying in provision account, if any.

In addition to this, the buyer is also entitled for a favourable difference (if any) of settlement price and strike price, and the same shall be recognised as income.

In the Books of Seller

Similar the seller will recognise the premium as income after adjusting provision made in this regards, if any. Payment of actual difference by seller at the time of squaring up will be debited to profit and loss as a loss.

For working out Profit & Loss in case of outstanding multiple options of the same scrip/index with the same strike price at the same expiry date, weighted average method should be followed on final settlement.

Accounting for forward foreign exchange contracts is covered by AS 11.


TAXATION
The Finance Act, 2005 has clarified that equity derivative transactions will not amount to speculation. Section 43 (5) defines a speculative transaction and its provisos provide exceptions to this definition. A new proviso (d) is now added to this sub section and provides that : an eligible transaction in respect of trading in derivatives referred to in Section 2 (aa) of the Securities Contract Regulation Act, 1956 carried out in a recognized stock exchange will not be treated as a ‘speculative transaction’. The transaction is required to be carried out on electronic trading systems through a recognized broker or sub broker and supported by a time stamped contract note which should contain the PAN No and the Unique Identification Number of the assessee.

The amendment as drafted in the Finance Bill does not seek to cover commodity derivatives.

The taxability of persons who are not in the business of securities but have carried out derivative transactions is not covered clearly by the Income-tax Act. It is widely believed by experts that these could be treated as Capital Gains or as Income from Other Sources.