ACCOUNTING AND TAXATION

ACCOUNTING AND TAXATION

Key Concept 1: Accounting Treatment

• Definition: Accounting treatment refers to the way in which financial transactions are recorded and reported in an entity's financial statements.
• Details: The accounting treatment for derivative contracts is based on the following key principles:
  • All derivative contracts should be recognized on the balance sheet and measured at fair value.
  • If an entity decides not to use hedge accounting, it should account for its derivatives at fair value with changes in fair value being recognized in the statement of profit and loss.
  • If an entity decides to apply hedge accounting, it should be able to clearly identify its risk management objective, the risk that it is hedging, and how it will measure the derivative instrument.

Key Concept 2: Disclosure Requirements

• Definition: Disclosure requirements refer to the information that an entity must provide in its financial statements about its derivative contracts and hedging activities.
• Details: The disclosure requirements include:
  • Describing the entity's overall financial risk management objectives and approach towards managing financial risks.
  • Explaining what the financial risks are and how the entity manages them.
  • Disclosing the methodology used to arrive at the fair value of derivative contracts and the extent of fair value gains/losses recognized in the statement of profit and loss and in equity.
  • Disclosing the entity's risk management policies and outstanding hedge accounting relationships.

Key Concept 3: Hedge Accounting

• Definition: Hedge accounting refers to the accounting treatment for derivative contracts that are designated as hedges.
• Details: There are three types of hedge accounting:
  • Fair value hedge accounting model: applied when hedging the risk of changes in the fair value of assets and liabilities.
  • Cash flow hedge accounting model: applied when hedging the risk of changes in highly probable future cash flows.
  • Hedge of a net investment in a foreign operation: applied when hedging the risk of changes in the carrying amount of a net investment in a foreign operation.

Key Concept 4: Hedge Effectiveness

• Definition: Hedge effectiveness refers to the degree to which changes in the fair value or cash flows of the hedged item are offset by changes in the fair value or cash flows of the hedging instrument.
• Details: Hedge effectiveness is measured by comparing the changes in the fair value or cash flows of the hedged item to the changes in the fair value or cash flows of the hedging instrument. The entity should disclose its methodology for assessing hedge effectiveness and the results of the assessment.

Key Concept 1: Accounting for Derivatives

• Definition: A derivative is a financial instrument or other contract with three characteristics: its value changes in response to a specified variable, it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts, and it is settled at a future date.
• Details: Accounting Standard (AS) 30 defined derivatives, but it was withdrawn and replaced by Ind AS 109, which governs the accounting for derivatives for companies following the Ind AS framework.

Key Concept 2: Indian Accounting Standard (Ind AS) 109

• Scope: Ind AS 109 covers the classification and measurement of financial instruments, including derivatives, impairment of financial assets, hedge accounting, and derecognition of financial assets and liabilities.
• Key Principles:
  • Recognition and Initial Measurement: Derivatives are recognized on the balance sheet at fair value when the entity enters the contract.
  • Default Measurement: Derivatives are measured at Fair Value Through Profit or Loss (FVTPL) unless in a hedging relationship.
  • Hedge Accounting: Ind AS 109 provides criteria for hedge accounting, which aligns gain and loss recognition on hedging instruments and hedged items.
  • Types of Hedge Accounting: Fair Value Hedge, Cash Flow Hedge, and Net Investment Hedge.
  • Embedded Derivatives: Derivative components embedded in non-derivative contracts are separated and accounted for as standalone derivatives if they are not "closely related" to the host contract.

Key Concept 3: Taxation of Exchange Traded Currency Derivatives

• Taxation: Gains or losses from trading in Exchange traded derivatives are taxable under the head 'Profits and Gains from Business or Profession' (PGBP).
• Speculative Transactions: Transactions are deemed speculative if they are periodically or ultimately settled otherwise than through actual delivery or transfer, but certain derivative transactions are excluded from this definition.
• Normal Business Income: Income or loss from dealing in exchange traded currency derivatives is deemed as normal business income, allowing losses to be set off against any normal business income.

Key Concept 4: Computation of Turnover and Taxation Scheme

• Computation of Turnover: The total of favourable and unfavourable differences is taken as turnover, including premium received on sale of options and differences on reverse trades.
• Taxation Scheme: Income from Exchange traded derivatives trading can be offered to tax under the normal scheme of taxation or the presumptive scheme of taxation under Section 44AD, with the option to declare profits at a prescribed rate.
• Set-off and Carry Forward of Losses: Losses from trading in Exchange traded derivatives can be set off against income from other heads, and unabsorbed losses can be carried forward up to 8 assessment years.