Updated October 3, 2023
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 made at the end of the year to record the change in the value of the underlying asset.
Explanation
Changes in the currency’s value increase the risk for the dealers, or rapid changes in the stock market price increase the risk of investment. Hence, the derivative contract develops 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, the value fluctuates daily; Dealer A will enter into a forward contract with the Bank for payment 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 in the dollar’s market price and the agreed price between the bank and the dealer, the bank will record a gain or loss in accounts at the end of the financial year or the end of the contract period, whichever is earlier.
Rules for Accounting Derivatives
Accounting of derivatives is based upon the purpose for which it is used. We can use it for speculation, i.e., to earn profit from derivatives transactions, and hedging, i.e., to control the risk of future contracts. Suppose we want to recognize the speculation loss immediately in the accounts. Some of the rules for Accounting derivatives are as under:
- Initially, derivatives are 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 determines at the time of entering to decide whether it is speculation or hedging.
- Any transaction cost for entering into derivatives will immediately charged to the profit and loss account.
- If the derivative is of speculation, the loss or profit is immediately recognized in the profit and loss account.
- The loss or gain will transfer to a comprehensive income account if the derivative is non-speculative.
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 a loss. | |||
| Fair Value Loss A/c Dr. | XXX | ||
| To Forward Asset A/c | XXX | ||
| (Being Decrease in value of asset resulted in a loss in a 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 speculative in nature, the profit and loss are transferred to the profit and loss account at the end of the financial year instead of transferring 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 the value of forward asset results in a gain, and being nature of the gain being speculative transferred to a profit and loss account) |
Advantages
The advantages of Accounting for derivatives are provided below.
- The gain or loss on the derivative transaction records per the matching principle and the revenue recognition concept.
- We can avoid speculation or the chance of fraud by accounting for derivatives.
- Profits and losses can adjust against each other in the case of derivatives transactions.
- We can recognize speculative loss immediately to discourage unauthorized speculations.
- On acquisition, derivatives need to be recognized immediately as assets or liabilities, reflecting the accounts’ true and fair view.
- Temporary changes in the derivative’s fair value in the case of non-speculative transactions recorded in the comprehensive income account.
Disadvantages
The 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.
Conclusion
A derivative is a type of contract entered to manage the risk of earning a profit from speculations. They are usually traded at National Security Exchanges, which the US Security Exchange Commission regulates. Another derivative is over-the-counter derivatives that reflect individually negotiated agreements. Investment in derivatives involves 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 involved 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 shown as comprehensive income in reserves and surplus; if the transaction is speculative, 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 to account for the gain or loss on the derivative transaction.
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