The recently issued ‘Guidance Note on Accounting for Derivative Contracts’ (GN) under Indian GAAP amongst other things will apply to forward contracts or derivatives that hedge a highly probable forecasted transaction or firm commitment. It will also apply to derivatives entered into for hedging both foreign currency and interest rate risk such as a cross currency interest rate swap which are outside the scope of AS-11.
The GN however does not cover items that are within the scope of other standards, for example, investments which are in the scope of AS-13 and forward exchange contracts to hedge existing items in the balance sheet which are in the scope of AS-11.
The GN is not meant to be exhaustive, for example, it does not cover accounting of embedded derivatives.
The GN contains the following broad requirements:
i. All derivative contracts should be recognised on the balance sheet and measured at fair value.
ii. If any entity decides not to use hedge accounting as described in this GN, it should account for its derivatives at fair value with changes in fair value being recognised in the statement of profit and loss.
iii. If an entity decides to apply hedge accounting as described in this GN, it should be able to clearly identify its risk management objective, the risk that it is hedging, how it will measure the derivative instrument if its risk management objective is being met and document this adequately at the inception of the hedge relationship and on an ongoing basis.
iv. An entity may decide to use hedge accounting for certain derivative contracts and for derivatives not included as part of Hedge Accounting, it will apply the principles at (i) and (ii) above.
v. Adequate disclosures of accounting policies, risk management objectives and hedging activities should be made in its financial statements.
In case a derivative contract is not classified as a hedging instrument because it does not meet the required criteria or an entity decides against such designation, it will be measured at fair value and changes in fair value will be recognised immediately in the statement of profit and loss.
Transitional provisions in the GN
The transitional provisions in the GN requires any cumulative impact (net of taxes) to be recognised in reserves as a transition adjustment and disclosed separately. The GN becomes applicable for accounting periods beginning on or after 1st April, 2016; its earlier application is encouraged.
Query
In March 2008, the ICAI issued an announcement that in case of derivatives, if an entity does not follow AS 30, keeping in view the principle of prudence as enunciated in Accounting Standard (AS) 1, Disclosure of Accounting Policies, the entity is required to provide for losses in respect of all outstanding derivative contracts at the balance sheet date by marking them to market.
Accordingly, Company Aggrieved Ltd. (CAL), accounting policy is to recognise mark to market losses on derivative, and ignore mark to market gains. As per its accounting policy this exercise is carried out on an itemised basis (and not on a portfolio basis).
Assume CAL is a private company with a low net worth and therefore is not covered under Ind AS, nor does it want to apply it voluntarily. On 1st April, 2016, CAL expects a huge unrecognised mark to market gain, which under the GN it is required to be recognised in reserves. CAL falls in the normal income tax bracket, and is not covered under MAT. For certain reasons, CAL wants to recognise the unrecognised mark to market profits at 31st March, 2016 in the P&L. It feels aggrieved that it is not allowed to do so under the GN.
Can CAL recognise in the year ended 31st March 2016 P&L, the unrecognised mark to market gains?
Author’s Response
Yes. The transitional provisions in the GN are conflicting with the requirement of notified accounting standard AS 5 Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies. As per AS 5, any changes in accounting policies, other than those that are caused on account of a new accounting standard is recognised in the P&L. The changes in accounting policies caused as a result of a new accounting standard are recognised as per the requirement contained in that new accounting standard. The new accounting standard may require the change in accounting policy to be recognised in the reserves.
In the instant case, the change in accounting policy is not caused as a result of a new accounting standard but due to a new Guidance Note. The changes in accounting policy due to the GN should therefore be necessarily recognised in the P&L. This will be the technically right thing to do. However, given that the GN has been issued under the authority of the ICAI, it appears that entities will have an option of either following the principle of AS 5 or to follow the requirements of the GN. In other words, the unrecognised mark to market gains can either be recognised in the 31st March 2016 P&L or alternatively is adjusted in the reserve at 1st April 2016.
