Guidance Note on Accounting for Derivative Contracts

Table of Contents:

1. Introduction
2. Applicability and Scope
3. Accounting of Derivatives
4. Recognition of Derivative Contracts
5. Hedge Accounting and its Types
6. Temporary Exceptions to Hedge Accounting prescribed under Guidance Note
7. Presentation in Financial Statements
8. Disclosures

1. Introduction:

A Derivative is a financial instrument or other contract carrying all of the following three characteristics:-

• • Its value changes in response to the change in the underlying asset;
  • It requires no initial net investment or a small initial investment; and
  • It is settled at some future date.

Currently, the relevant regulation that provides guidance on accounting for foreign currency transactions and foreign exchange forward contract is Accounting Standard 11 Effects of Changes in Foreign Exchange Rates. However, the standard outlines from scope the forward contracts which are used to hedge the highly probable forecast transactions and firm commitments. Thus, in order to build a uniform accounting practice for derivatives, the Accounting Standard Board of the ICAI has issued Guidance Note on Accounting for Derivatives in year 2015. Looking towards the recent developments regarding Interbank Offered Rates (IBOR) and to avoid an undue impact on financial statements, a need was felt to revise the existing Guidance Note.

Accordingly, relevant revisions have been made in the Guidance Note, 2021 to provide necessary exceptions relating to hedge accounting. Thus, this Guidance Note is formulated to provide complete guide on accounting for derivatives until Accounting Standards on the subject matter are formulated and/ or enforced.

2. Applicability and Scope:

The Guidance Note, 2021 is applicable for Non- Ind AS entities and enterprises – mainly Banks and other companies that are currently not required to apply Ind AS. This Guidance Note applies to following Derivative Contracts whether or not used as hedge instruments:-

• • Foreign Exchange Forward Contract that hedges the highly probable forecast transactions and commitments;
  • Foreign currency derivative contracts such as cross currency interest rate swaps, foreign currency futures to the extent not covered under AS 11;
  • Commodity derivative contracts;
  • Other derivative contracts such as traded equity index futures, traded index future options, traded stock futures and option contracts.

3. Accounting of Derivatives:

The accounting for derivatives as per this Guide is based on the following key principles:-

• • All derivative contract should be recognized on the balance sheet date and measured at fair value;
  • If principles stated in the guidance note are not applied then it should account for derivatives at fair value and changes being recognized in the statement of profit and loss;
  • If an entity applies hedge accounting as per this guidance note, it should clearly identify the (a) risk management objective, (b) the risk that is being hedged, (c) how it will measure the derivative instrument if risk management objective is being met.
  • If an entity decides to use the hedge accounting for certain derivative contracts and for derivatives not included as part of hedge accounting, it will apply principles stated at (i) and (ii) above;
  • Adequate disclosures relating to accounting policies, risk management objectives and for hedge accounting should be made in its financial statements.

4. Recognition of Derivative Contracts:

Since derivative contracts represents a contractual right or an obligation, it should be recognized on the balance sheet date as at fair value. Fair value in context of derivative contracts means the ‘exit price’, the price that would be paid to transfer a liability or the price that would be received transferring an asset to a counterparty.

5. Hedge Accounting and its Types:

As per guidance note, the designation of derivative as hedge instrument is optional. However, in case a derivative id not designated as hedging instrument, it should be measured at fair value and changes in fair value should be recognized immediately in the statement of profit and loss.

The guidance note recognizes three types of hedge accounting –

• • Fair Value Hedge Accounting Model – While applying this model of hedge accounting, the hedging instrument is measured at fair value with changes being recognized in the statement of profit and loss. The fair value changes of the hedged item and the hedging instrument will offset and result in no impact in the statement of profit and loss except for the impact of ineffectiveness. For example, hedging of a fixed rate bond with an interest rate swap.
  • Cash Flow Hedge Accounting Model – While applying this model of hedge accounting, the hedging instrument is measured at fair value, but any gain or loss is determined to be recognized in equity e.g. cash flow hedge reserve. This is intended to avoid volatility in the statement of profit and loss in a period in which the gain/ loss on the hedged item is not recognized therein.
  • Hedge of Net Investment in Non- Integral Foreign Operation – The gain/ loss on foreign currency derivative used as hedge instruments are recognized directly in equity to the extent the hedge is considered to be effective. The ineffective portion of gain/ losses on hedge instruments in the statement of profit and loss immediately.

This guidance note does not override the principles stated in AS 11.

6. Temporary Exceptions to Hedge Accounting prescribed under Guidance Note:

With recent global developments impacting the financial statements due to IBOR Reforms, the issues arising from these changes need to be addressed and hence the financial reporting has been identified globally. This guide covers the IBOR reforms (i) Phase I Pre-replacement issues, providing temporary exceptions from hedge accounting requirements, effective for accounting periods beginning on or after 1 April 2020; (ii) Phase II Replacement issues, providing temporary exceptions for modifications in financial contracts arising due to Interest Rate Benchmark Reform, effective for accounting periods beginning on or after 1 April 2021.

The guidance note provide exceptions only to the requirements stated in paragraph 4-11 of the Appendix III attached to the guidance note.

7. Presentation in Financial Statements:

The presentation of derivative assets and liabilities recognized as on the balance sheet depends on the following considerations:-

• • Derivatives that are intended for trading or speculative purposes should be reflected as current assets and liabilities.
  • Derivative that are hedges of recognized assets or liabilities should be classified as current or non-current based on the classification of hedged item.
  • Derivatives that are hedges of forecasted transactions and firm commitments should be classified as current or non-current based on settlement date/ maturity date of derivative contracts.
  • Derivative that have periodic or multiple settlements such as interest rate swaps should be classified into current or non-current based on when a predominant portion of their cash flows are due for settlement as per their contractual terms.

8. Disclosures:

In case an entity applies the exceptions relating set out in the guidance note, an entity shall disclose the following:-

• • How the entity is managing the process to transition to alternative benchmark rates;
  • The significant interest rate benchmarks to which the entity’s hedging relationship is exposed;
  • The extent of risk exposure that entity is managing which is directly affected by the interest rate benchmark reforms;
  • A description of significant assumptions or judgements that entity made in applying the temporary exceptions.

An entity shall apply the temporary exceptions for annual period (s) beginning on or after 1 April 2020.