Chapter 10: Accounting for Derivatives

1. Overview and ICAI Guidelines

The accounting treatment for financial derivative contracts—including equity index futures, stock futures, equity index options, and stock options—is governed by guidance notes issued by the Institute of Chartered Accountants of India (ICAI). Market participants are advised to regularly monitor standard updates on the ICAI website (www.icai.org).

In the curriculum of the NCFM Derivatives Market (Dealers) Module, Chapter 10 carries a weighting of 5%.

Scope of Accounting Rules

• Client / Investor Perspective: The core accounting guidance specifically addresses the books of account of clients (buyers and sellers of derivative contracts).
• Intermediary Perspective: For trading members (TMs), clearing members (CMs), brokers, and clearing corporations, derivative transactions follow standard equity trading accounting principles and do not present unique accounting complexities.

2. Accounting for Futures Contracts

2.1 Accounting at Inception of a Futures Contract

• No Contract Entry for Value: At the time of entering into a futures contract, no journal entry is passed to record the underlying contract value because no purchase or sale payment is made at inception.
• Initial Margin Accounting:
  • Every client must pay an initial margin specified by the clearing corporation to the trading/clearing member.
  • The initial margin paid or payable is debited to "Initial margin - Equity index futures account".
  • Any additional margins paid are debited to the same account.
• Balance Sheet Presentation:
  • On the balance sheet date, the debit balance in the "Initial margin - Equity index futures account" is shown separately under Current Assets.
  • Any excess amount paid beyond initial or additional margin requirements is disclosed separately as a deposit under Current Assets.
  • If initial margin is provided via bank guarantees or lodged securities instead of cash, a full disclosure must be made in the notes to the financial statements.

2.2 Accounting at Daily Settlement (Mark-to-Market)

• Daily Cash Settlements:
  • Daily cash payments made or received for Mark-to-Market (MTM) settlements are credited or debited to the bank account.
  • The corresponding debit or credit is made to an account titled "Mark-to-market margin - Equity index futures account".
• Lump Sum MTM Deposits:
  • If a client deposits a lump sum amount with the broker for MTM requirements instead of settling daily, the deposit is debited to "Deposit for mark-to-market margin account".
  • Actual daily MTM amounts received or paid are then credited or debited to "Mark-to-market margin - Equity index futures account" with the corresponding debit or credit to "Deposit for mark-to-market margin account".
  • At year-end, any remaining balance in the "Deposit for mark-to-market margin account" is reported as a deposit under Current Assets.

2.3 Accounting for Open Positions at Balance Sheet Date

Accounting for open futures positions at year-end is driven by the accounting principle of prudence:

• Anticipated Loss (Debit Balance):
  • A debit balance in the "Mark-to-market margin - Equity index futures account" indicates net payments made due to adverse price movements.
  • A provision for anticipated loss equal to this net payment must be created by debiting the Profit and Loss Account and crediting a provision account.
  • In the balance sheet, the debit balance is shown under Current Assets, Loans and Advances, and the created provision is shown as a deduction therefrom.
• Anticipated Profit (Credit Balance):
  • A credit balance in the "Mark-to-market margin - Equity index futures account" indicates net receipts due to favorable price movements.
  • Under the prudence convention, anticipated profits are ignored, and no credit is taken in the Profit and Loss Account.
  • The credit balance is shown as a current liability under Current Liabilities and Provisions in the balance sheet.

2.4 Accounting at Final Settlement and Squaring-Up

• Profit or Loss Calculation:
  • At expiration, the overall profit or loss on a futures series is calculated as the difference between the final settlement price and the respective contract prices.
  • When a contract is squared-up by entering into a reverse contract, the profit or loss is calculated similarly.
• Utilization of Provision:
  • The net profit or loss is recognized in the Profit and Loss Account by a corresponding credit or debit to "Mark-to-market margin - Equity index futures account".
  • If a provision for anticipated loss was previously created, any settlement loss is first charged against that provision account to the extent available, and any remaining loss is debited to the Profit and Loss Account.
• FIFO Method:
  • If multiple contracts in the same series are outstanding when squaring-up occurs, the contract price of the squared-up position is determined using the First-In, First-Out (FIFO) method.
• Release of Margin:
  • Upon final settlement, the initial margin is released, crediting "Initial margin - Equity index futures account" and debiting the Bank Account or Deposit Account.

2.5 Accounting Treatment in Case of Default

• If a client defaults on daily MTM payments, the broker closes out the contract.
• The unpaid MTM amount is adjusted against the client's initial margin by debiting "Mark-to-market margin - Equity index futures account" and crediting "Initial margin - Equity index futures account".
• Any remaining initial margin after covering the MTM default is released back to the client.
• If the daily settlement liability exceeds the initial margin, the excess constitutes an unfulfilled liability reported under Current Liabilities and Provisions if it persists on the balance sheet date.
• The resulting profit or loss on the closed-out position is recognized in the Profit and Loss Account.

2.6 Disclosure Requirements for Futures Contracts

Financial statements must disclose the following details for open futures positions at year-end:

1. Bank guarantees provided and the book value as well as market value of pledged securities lodged for initial margin.
2. Total number of contracts entered and gross number of units traded (separately for buy and sell) across each series.
3. Number of open contracts, corresponding units, and the daily settlement price as of the balance sheet date, categorized separately for long and short positions per series.

3. Accounting for Option Contracts

ICAI guidance covers both index options and stock options for buyers/holders and sellers/writers.

3.1 Accounting for Cash-Settled Options

Accounting at Inception

• Option Buyer / Holder:
  • Pays no initial margin.
  • Debits the option premium paid to "Equity Index Option Premium Account" or "Equity Stock Option Premium Account".
  • Shows this account under Current Assets on the balance sheet.
• Option Seller / Writer:
  • Must pay initial margin, which is debited to "Equity Index Option Margin Account" or "Equity Stock Option Margin Account" (shown under Current Assets).
  • Credits the option premium received to "Equity Index Option Premium Account" or "Equity Stock Option Premium Account".
  • Shows this premium account under Current Liabilities on the balance sheet.

Payment and Receipt of Margin

• Daily margin payments/receipts by the seller are debited/credited to the Bank Account and credited/debited to the Option Margin Account.
• If a lump-sum margin deposit is maintained, transactions pass through a "Deposit for Margin Account", reported as a deposit under Current Assets at year-end.

Accounting for Open Option Positions at Balance Sheet Date

• Buyer / Holder:
  • Compares premium paid against the prevailing market premium on the balance sheet date.
  • If premium paid exceeds prevailing premium, a provision for loss is created: debit Profit and Loss Account and credit "Provision for Loss on Equity Index/Stock Option Account".
  • The provision is shown as a direct deduction from the Option Premium Account under Current Assets.
• Seller / Writer:
  • Compares premium received against the prevailing market premium on the balance sheet date.
  • If prevailing market premium exceeds premium received, a provision for loss is created: debit Profit and Loss Account and credit "Provision for Loss on Equity Index/Stock Option Account".
  • Both Option Premium Account and Provision Account are presented under Current Liabilities and Provisions.
• Adjustment of Opening Provision: Any opening balance in the provision account is adjusted against the current year's required provision, with the net difference debited or credited to the Profit and Loss Account.

Accounting at Final Settlement (Cash-Settled)

• Buyer / Holder:
  • Recognizes the premium paid as an expense by debiting Profit and Loss Account and crediting Option Premium Account.
  • Receives the favorable cash difference (if strike price < final settlement price for call, or strike price > final settlement price for put), recognizing it as Income in the Profit and Loss Account.
• Seller / Writer:
  • Recognizes the premium received as Income by debiting Option Premium Account and crediting Profit and Loss Account.
  • Pays the adverse cash difference, recognizing it as a Loss in the Profit and Loss Account.
  • Upon exercise, the initial margin paid is released, crediting the Option Margin Account and debiting Bank.

Accounting at Squaring-Off

• When an option contract is squared-off prior to expiration, the net difference between premium paid and premium received is transferred directly to the Profit and Loss Account.

3.2 Accounting for Delivery-Settled Options

Entries at inception, margin payment/receipt, and year-end open position valuations match those of cash-settled options.

Final Settlement Accounting

• Unexercised Options: If options expire unexercised, entries are identical to cash-settled options.
• Exercised Options: Shares are physically transferred at the agreed strike price:

• Premium Transfer: In addition to the share transfer entry at the strike price, the original premium paid or received is transferred to the Profit and Loss Account.

4. Taxation of Derivative Transactions in Securities

4.1 Taxation of Profit / Loss on Derivative Transactions

Historical Context (Pre-FY 2005–06)

• Prior to FY 2005–06, Section 43(5) of the Income-tax Act defined a "speculative transaction" as any contract for purchase or sale of stocks/commodities settled otherwise than by actual delivery.
• Consequently, derivative transactions were treated as speculative transactions.
• Losses on speculative transactions could only be set off against other speculative income, causing higher tax burdens for market participants.

Reform via Finance Act 2005

• Finance Act 2005 amended Section 43(5) to exclude derivative transactions carried out on a recognized stock exchange from the definition of speculative transactions.
• Current Tax Status: Income or loss from exchange-traded derivatives is treated as normal business income / loss (non-speculative).

Set-Off and Carry Forward Rules

1. Set-Off: Loss on derivative transactions can be set off against any other income (speculative or non-speculative) during the same assessment year.
2. Carry Forward: Unadjusted derivative losses can be carried forward for up to 8 assessment years and set off against any non-speculative or business income in subsequent years.
3. STT Tax Deduction: Securities Transaction Tax (STT) paid on derivative transactions is eligible as an allowable business deduction under the Income-tax Act, 1961.

4.2 Securities Transaction Tax (STT) on Derivatives

Statutory authority for STT is provided under Chapter VII of the Finance (No. 2) Act, 2004. Rates applicable under the Finance Act 2008 (w.e.f. June 1, 2008) are summarized below:

Statutory STT Rate Schedule

• Sale of an option in securities: 0.017% (payable by the Seller)
• Sale of an option in securities, where option is exercised: 0.125% (payable by the Purchaser)
• Sale of a futures in securities: 0.017% (payable by the Seller)

Practical Numerical Example

• Transaction Details:
  • Trader: Mr. A
  • Action: Sells 1 futures contract of XYZ Ltd.
  • Lot Size: 1,000 shares
  • Sale Price: Rs. 300 per share
  • Spot Price: Rs. 290 per share
• Computations:
  • Total Futures Contract Value = Lot Size * Futures Price
  • Total Futures Contract Value = 1,000 * 300 = Rs. 3,00,000
  • STT Rate Payable by Seller = 0.017%
  • STT Payable = Total Contract Value * STT Rate
  • STT Payable = 3,00,000 * 0.017% = Rs. 51
• Key Operational Rule: No Securities Transaction Tax is payable by the buyer of a futures contract.

5. Summary of Primary Accounting Accounts