Seminar on Issues in Accounting, WIRC ICAI

Transcription

1 Accounting Application & Issues in Currency Derivatives Seminar on Issues in Accounting, Auditing & Taxation of Derivatives WIRC ICAI Mumbai Anagha Thatte, M P Chitale & Co. July 16, 2011

2 Disclaimers Thesearemypersonalviewsandcannotbeconstrued tobetheviewsofm/s.m.p.chitale&co.,chartered Accountants. ICAI has no responsibility for its contents Theseviewsdonotandshallnotbeconsideredasa professional advice. This presentation should not be reproduced in part or inwhole,inanymannerorform,withoutmywritten permission. Anagha Thatte, M.P.Chitale & Co. 2

3 Coverage Definition Brief on Indian Derivative Markets Types of Currency Derivatives Transaction Life Cycle Accounting Issues Anagha Thatte, M.P.Chitale & Co. 3

4 Definition Currency In Economics, currency means a particular currency name which comprise the physical aspects of a nation s money supply. Eg.`, $,,, Derivatives as defined in AS 30 / Ind AS 39 A derivative is a financial instrument or other contract within the scope of the standard which will comply with all the following three characteristics : Its value changes in response to the change in the underlying asset It requires no initial net investment or very small initial investment It is settled at a future date Currency Derivative means a derivative contract where the underlying is Currency Products which can be classified under Currency Derivatives are : Currency Forwards Currency Futures Currency Swaps Currency Option A word of caution financial derivatives are powerful tools in the hands of careful and competent financial managers. They can also be very destructive devices when used recklessly. Anagha Thatte, M.P.Chitale & Co. 4

5 Coverage Definition Brief on Indian Derivative Markets Types of Currency Derivatives Transaction Life Cycle Accounting Issues Anagha Thatte, M.P.Chitale & Co. 5

6 Brief on Indian Currency Derivatives Market Derivative Markets are broadly divided into : Exchange Traded Over the Counter (OTC) The world s first financial underlying in respect of derivatives market was Currency May 16, 1972, the first currency futures transaction was traded on Chicago Mercantile Exchange A well functioning currency derivatives market is a must to demonstrate the ability of the economy to absorb exchange rate fluctuations. Recently, it was observed that the Currency Futures are more liquid than the Nifty Futures Basically, there are 3 types of traders / intentions Speculators, Hedgers, and Arbitrageurs Anagha Thatte, M.P.Chitale & Co. 6

7 Coverage Definition Brief on Indian Derivative Markets Types of Currency Derivatives Transaction Life Cycle Accounting Issues Anagha Thatte, M.P.Chitale & Co. 7

8 Currency Forward A forward contract is an agreement between a counterparty / customer and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future. Not traded on Exchange but need to approach Bankers / trading platforms Forward rates may also contain a premium or discount. If the forward rate exceeds the existing spot rate, it contains a premium. If the forward rate is less than the existing spot rate, it contains a discount. These contracts have counter-party risk and liquidity risk The Accounting Features involved are Trade date, Settlement Date, Notional amount, currency pairs, rate (Spot) and forward Eg: M/s A Corp. enters a contact with a bank to buy for 1 month forward. (Current Spot Rate is`46.86) Anagha Thatte, M.P.Chitale & Co. 8

9 Currency Futures Currency futures contracts specify a standard volume of a particular currency to be exchanged on a specific settlement date, Traded on Exchanges Standardized i.e. contract size is fixed (lot size), trading parameters & settlement parameters are fixed. No Counter party Risk since contracts are guaranteed by the exchange or CCIL (Margin Money) Eg: M/s. A entered into Buy 200 $-`Future on July 1, 2011 for September maturity (300911) at Accounting Features involved are Notional Booking, currency pair, MTM and daily settlement, margin maintenance Anagha Thatte, M.P.Chitale & Co. 9

10 Types of currency derivatives Features Forwards Futures Contract size Customized Standardized Delivery Date Customized Standardized Participants Banks, brokers, non- Banks, brokers, nonbanks, Corporates banks, corporates Security Deposits Credit Limits (NFL), or funded in terms of deposits Small security deposit Presence in India Established Recently started in 2008 Anagha Thatte, M.P.Chitale & Co. 10

11 Currency Swaps Contracts to Exchange cashflows on or before specified future date based on underlying value of currencies/exchange rates, interest rates Swaps can be Interest Rate Swap or Principal Only Swap or a combination of both Currency Swaps is an agreement between two parties to exchange principal and or interest payments of loan in one currency for equivalent of an equal in net present value loan in another currency. Motivated by Comparative Advantage i.e. ability of party to produce particular goods or services at a lower opportunity cost than another party. Traded in OTC markets. Anagha Thatte, M.P.Chitale & Co. 11

12 Currency Swaps IRS Overnight Indexed Swap Bank A to pay Bank B Notional Amount: INR 1,000,000,000 Trade Date: May 31, 2010 Effective Date: June 01, 2010 Termination Date: June 01, 2011 Close out value June 02, 2011 Fixed Leg Fixed Rate Payer: A Fixed Rate: % p.a. Floating Leg Floating Rate Payer: B Floating Rate Benchmark: INR NSE Mibor Rate Designated Maturity: Overnight Interest Rate count 365 days for both. Anagha Thatte, M.P.Chitale & Co. 12

13 Currency Swaps Plain Vanilla IRS (Principal + Interest) Bank A with Bank B for $ 50 million Spot Rate $1.25 per euro, 1 year swap with bullet repayment feature, interest settlement on quarterly basis Dollar Interest Rate 3.25% Euro Interest Rate 2.50% Principal Exchange Bank A Principal $ 50 million Bank B Bank B Principal 40 million Bank A Interest Bank A Int. 40 mio * 2.50 Bank B Bank B Int. 50 mio * 3.25 Bank A End of Swap Bank A Principal 40 mio Bank B Bank B Principal $50 mio Bank A Anagha Thatte, M.P.Chitale & Co. 13

14 Currency Swaps In India, for Interbank Market Swap product is traded as a simultaneous buying and selling of a currency unit Eg: Bank A enters into an agreement with Bank B for a month Buy- Sell $ swap against This means Bank A will Buy $ value spot and sell the same $ after 1 month at a forward rate Anagha Thatte, M.P.Chitale & Co. 14

15 Forward Rate Agreement Forward Rate Agreement (FRA) is a forward contract on interest rate in which one party, the long, agrees to pay a fixed interest payment at a future date and receives an interest payment at a rate to be determined at expiration To hedge the interest rate risk Traded in OTC market FRAs are for shorter duration Accounting Features involved are Trade date, Fixing date, Notional amount, Marking to market, cash flow exchange 15 Anagha Thatte, M.P.Chitale & Co.

16 Forward Rate Agreement Trade Date Dec 30, 2010 Fixing / Start Date June 30, 2011 End Date Dec 30, 2011 Notional Principal Fixed Leg Fixed Leg Payer: Fixed Rate: Floating Leg Floating rate payer Floating Rate Benchmark USD 100 Mio A % p.a. B 6 month USD LIBOR Such a FRA is denoted as a 6x12 FRA, and the difference between the two numbers 12-6 represents the duration of the FRA which is 6 months. Net Settlement upfront on fixing date PV of the amount, discounted at the floating rate. Anagha Thatte, M.P.Chitale & Co. 16

17 Currency Option A foreign currency option is a contract giving the purchaser of the option the right to buy or sell a given amount of currency at a fixed price per unit for a specified time period The most important part of clause is the right, but not the obligation to take an action Two basic types of options, calls and puts Call buyer has right to purchase currency Put buyer has right to sell currency The buyer of the option is the holder and the seller of the option is termed the writer Anagha Thatte, M.P.Chitale & Co. 17

18 Currency Option Every option has three different price elements The strike or exercise price is the exchange rate at which the foreign currency can be purchased or sold The premium, the cost, price or value of the option itself paid at time option is purchased The underlying or actual spot rate in the market There are two types of option maturities American options may be exercised at any time during the life of the option European options may not be exercised until the specified maturity date Anagha Thatte, M.P.Chitale & Co. 18

19 Currency Option Options may also be classified as per their payouts ( moneyness of Option) At-the-money (ATM) options have an exercise price equal to the spot rate of the underlying currency In-the-money (ITM) options may be profitable, excluding premium costs, if exercised immediately Out-of-the-money (OTM) options would not be profitable, excluding the premium costs, if exercised Anagha Thatte, M.P.Chitale & Co. 19

20 Currency Option Trade Date July 1, 2011 Expiry Date September 28, 2011 Delivery Date September USD/INR Exposure USD Receivables of $ 10,000,000 A buys USD Put/ INR in USD 10,000,000 A sells USD Call/ INR in USD 10,000,000 Anagha Thatte, M.P.Chitale & Co. 20

21 Coverage Definition Brief on Indian Derivative Markets Types of Currency Derivatives Transaction Life Cycle Accounting Issues Anagha Thatte, M.P.Chitale & Co. 21

22 Product Life Cycle & Accounting Trade Booking Exchange of Interest / Principal, if any Settlement of Margin and its accounting for exchange traded products On reporting date, MTM Analysis Cancellation / Unwinding Settlement Anagha Thatte, M.P.Chitale & Co. 22

23 Product Accounting Uptill, March 29, 2008, there was no AS specific on Derivatives Accounting AS 11 was applicable for Effect of changes in foreign exchange rates, this covers the accounting treatment of Forward Exchange Contract Few Guidance Notes issued by ICAI on Equity Futures AS 30 issued by ICAI is applicable for the accounting period starting from April 2009, and recommendatory till 2011 Ind As 39 was issued by ICAI in Feb 2011 as part of the IFRS Convergence Process Current status This standard is not yet announced by NACAS It may undergo a change considering the recent developments in IFRS at IASB forum and release of IFRS 9 in India Anagha Thatte, M.P.Chitale & Co. 23

24 Coverage Definition Brief on Indian Derivative Markets Types of Currency Derivatives Transaction Life Cycle Accounting Issues Anagha Thatte, M.P.Chitale & Co. 24

25 AS 30 AS 30 read with IAS 1, allows the preparation of financial statements into Functional currency, where Functional Currency is other than Reporting Currency Functional Currency is the currency of the primary economic environment in which the entity operates AS 30 covers following basis of accounting Accounting on Trade Date Basis Accounting on Settlement Date Basis As per AS 30, all Derivative contracts should measure at Fair Value So what if I have entered into a transaction for Hedging??? Anagha Thatte, M.P.Chitale & Co. 25

26 Components of a hedge relationship Hedging relationship components Hedged items Hedgeable risks Hedging instruments Anagha Thatte, M.P.Chitale & Co. 26

27 Criteria for hedge accounting 1. Hedge relationship must be documented at inception Risk management objective and strategy for the hedge Identification of the hedging instrument The related hedged item or transaction The nature of the risk being hedged How hedging instrument s effectiveness will be assessed 2(a) Hedge relationship must be expected to be highly effective at inception and subsequent periods 2(b) Hedge effectiveness can be reliably measured 2(c) Actual hedge effectiveness must be measured 3. In the case of hedging future cash flows, there must be a high probability of that cash flow occurring Anagha Thatte, M.P.Chitale & Co. 27

28 Qualifying hedging instruments General rules Few restrictions on use of derivatives as hedging instruments Important exception: net written options Natural hedges of FX risk permitted in limited circumstances All of the derivative must be used in the hedge relationship Derivative cannot hedge another derivative More than one derivative can be used in a hedging relationship Permitted strategies include: partial term 5 year swap used to hedge part of 10 year debt as part of cash flow hedge proportional hedging Profit related hedges not permitted Anagha Thatte, M.P.Chitale & Co. 28

29 Types of hedges Main types of hedging relationships Fair value hedge Cash flow hedge Net investment hedge Anagha Thatte, M.P.Chitale & Co. 29

30 Fair value hedge accounting model Measurement of derivative instrument Changes in FV Fair value Measurement of hedged item P&L Fair value with respect to risk being hedged (1) (1) This applies even if a hedged item is otherwise measured at FV with FV changes recognised in equity or if hedged item is measured at cost Anagha Thatte, M.P.Chitale & Co. 30

31 Cash flow hedge accounting model Measurement of derivative instrument Changes in FV Fair value Effective Equity (1) P&L (1) Based on timing of earnings impact of hedged item (cost of sales, depreciation, interest) Anagha Thatte, M.P.Chitale & Co. 31

32 Hedge effectiveness Hedge relationship must be expected to be highly effective at inception and in subsequent periods General principles Hedge effectiveness criteria highly effective at inception satisfy % effectiveness back test 125% 100% 80% No hedge accounting Hedge accounting; ineffectiveness in P&L Hedge accounting; ineffectiveness in P&L No hedge accounting any ineffectiveness must be recognized in P&L even if hedge relationship is effective Anagha Thatte, M.P.Chitale & Co. 32

33 When a hedge no longer is effective If the ongoing highly effective criterion fails, hedge accounting is discontinued Hedge activity recorded prior to loss of effectiveness is not affected. The hedge does not qualify for special accounting prospectively from the last time it was proven effective. There is therefore a trade off between performing effectiveness testing frequently to ensure effectiveness and the administration effort into doing this frequently What if the Standard itself is moving and hence not effective There is an Exposure Draft issued by IASB in December 2010 on Hedge Accounting, yet to issue a final standard Anagha Thatte, M.P.Chitale & Co. 33

34 Thank you Co-ordinates:- : :