Accounting Treatment for Derivatives: Issues and Challenges

Abstract

For a common man, 'derivatives' are financial instruments whose value changes in response to the changes in underlying variables. The main types of derivatives are Financial and Commodity Derivatives. Further Financial Derivatives are reclassified into: futures, forwards, options, and swaps. "The use of derivatives can result in large losses due to the use ofleverage," reads a cautionary paragraph that cites major financial disasters such as the Nick Leeson affair in 1994, the bankruptcy of Long-Term Capital Management in 2000, the losses suffered by Amaranth Advisors and Societe Generale. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. The markets for derivatives have been remarkable and have witnessed continued growth over the past decade. This reflects the increasing use of such instruments by business, either for speculation or for hedging purposes. Accordingly, the accounting treatment for derivatives and hedging activities has taken on a high degree of importance. Hedge accounting does not sit well with the standard setters' desired goal for financial instrument accounting, i.e. a full fair value model. Further, hedge accounting relies on management intent to link for accounting purposes what the standard setters see as two or more separate transactions. It also overrides accounting requirements that would otherwise apply to those transactions when viewed separately. The accounting of financial instruments is not based on their use, whether those are used for hedging or not. In case they are not used for hedging, they could fall under any of the four categories: (i) Financial asset/liability at fair value through profit and loss account (ii) Held-to-maturity investments (iii) Loans and receivables and (iv) Available for sale. How do you measure something that is yet to be realised? Difficult, but that's what the Institute of Chartered Accountants oflndia (ICAI), the body that seeks to regulate the profession of accountancy in India, has apparently asked its members, with regard to derivatives.