Definition of Accounting for Derivatives
A derivative is generally a contract between two or more parties to hedge or to control the risk of the underlying asset whose value depends upon the future market price of the underlying asset, which includes the instruments like future, options, forward contracts, swaps etc. and accounting for derivatives is done at the end of the year to record the change in the value of the underlying asset.
Changes in the value of the currency increase the risk for the dealers, or rapid changes in the stock market price increases the risk of investment. Hence the derivative contract is developed to control the risk of the underlying asset. For example dealer, A of India has to pay $ 50,000 after 3 months to dealer B of the USA for goods purchased. As there are rapid changes in the market due to which the value fluctuates every day, Dealer A will enter into forward contract with the Bank for payment to pay at the rate decided irrespective of the dollar’s market price. A forward contract is a type of derivative. So, if there is a change with the dollar’s market price and agreed price between bank and dealer, the bank will record gain or loss in accounts as at the end of the financial year or end of the period of the contract, whichever is earlier.
Rules for Accounting Derivatives
Accounting of derivatives is based upon the purpose for which it is used as it can be used for speculation, i.e. to earn profit from derivatives transactions and hedging, i.e. to control the risk of future contracts. Suppose there is speculation loss that is to be recognized immediately in the accounts. Some of the rules for Accounting of derivatives are as under:
- Initially, derivatives are to be recorded at fair value.
- Re-measurement of fair value is to be done at the end of the financial year or at the end of the contract period, whichever falls earlier.
- The purpose of the derivative is to be determined at the time of entering so as to decide whether it is speculation or hedging.
- Any transaction cost for entering into derivatives is to be charged to the profit and loss account immediately.
- If the derivative is of speculation in nature, the loss or profit is to be immediately recognized in the profit and loss account.
- If the derivative is non-speculative, the loss or gain is to be transferred to a comprehensive income account.
Accounting for Derivatives Journal Entries
Journal entries of accounting for derivatives are:
|Date||Particulars||Debit ($)||Credit ($)|
|On entering into a transaction for an underlying derivative asset:|
|Forward Asset A/c Dr.||XXX|
|To Bank/ Creditor A/c||XXX|
|(Being underlying asset purchased by entering into a derivative contract)|
|Increase in fair value of forward asset resulting in a gain|
|Forward Asset A/c Dr.||XXX|
|To Forward value gain A/c||XXX|
|(Being increase in the value of forward asset results in gain)|
|Decrease in fair value of asset resulting in loss|
|Fair Value Loss A/c Dr.||XXX|
|To Forward Asset A/c||XXX|
|(Being Decrease in value of asset resulted loss in forward contract)|
|Settlement of Forward contract|
|Creditor/ Bank A/c Dr.||XXX|
|To Forward Asset A/c||XX|
|To Profit and Loss A/c||XX|
|(Being Forward contract settled and net gain or loss is transferred to profit and loss A/c)|
If the transaction is of speculative in nature, the profit and loss are to be transferred to profit and loss account at the end of the financial year instead of transferring it to the comprehensive income account and similarly on the settlement of a forward contract, the gain or loss on the transaction is to be recorded in profit and loss account as speculation gain or speculation loss.
So, the Journal entry will be as under:
Increase in fair value of forward asset resulting in a gain
|Forward Asset A/c Dr.||XXX|
|To Profit and Loss A/c||XXX|
|(Being increase in value of forward asset results in a gain and being nature of gain being speculative transferred to profit and loss account)|
Advantages of Accounting for derivatives are defined and provided as under-
- The gain or loss on the derivative transaction is recorded as per the matching principle and as per the revenue recognition concept.
- Speculation or chance of fraud can be avoided with accounting for derivatives.
- Profits and loss can be adjusted against each other in the case of derivatives transactions.
- Speculative loss is recognized immediately to discourage unauthorized speculations.
- On acquisition, derivatives are to be immediately recognized as asset or liabilities, which reflects the true and fair view of in the accounts.
- Temporary changes in the derivative’s fair value in the case of non-speculative transactions are to be recorded in the comprehensive income account.
Downsides of Accounting for derivatives are explained as under-
- As derivatives are volatile in nature hence the risk is high.
- As the gain or losses on the speculative transactions are to be recorded immediately, it may result in an initial loss at the balance sheet date and subsequent gain at the end of the contract period or vice versa, which creates complexity in the accounts.
- There are chances of fraud in the case of over-the-counter transactions.
A derivative is the type of contract entered for managing the risk of earning the profit from speculations. They are usually traded at National Security Exchanges, which the US’s security exchange commission regulates. Other derivative is a type of over the counter derivatives which reflect individually negotiated agreements. Investment in derivatives involves the high risk. The value of a derivative is determined by the value of the underlying asset, which includes forward contracts, futures, options, swaps, etc. there are three parts involves in the accounting of derivatives first is initial recognition; initially, it is recognized at fair value as an asset or liabilities.
Subsequently, they are recognized at fair value on the balance sheet date, and changes in value are to be shown as comprehensive income in reserves and surplus; if the transaction is speculative in nature, the profit or loss is to be recognized immediately in the accounts. And lastly, at the end of the contract, the profit or loss on the transaction is to be transferred to the profit and loss account so as to account for the gain or loss on the derivative transaction.
This is a guide to Accounting for Derivatives. Here we also discuss the definition and rules for accounting derivatives along with advantages and disadvantages. You may also have a look at the following articles to learn more –