Financial derivatives are complex instruments; their accounting and communication to investors and tax authorities are even tougher. Financial derivatives have been used by large companies in India for many years (available since early 1990s). The evolution of accounting rules (ICAI, SEBI, RBI) with respect to financial instruments broadly has been slow-paced. Though in the initial days fewer companies used risk management tools employing derivates, the use of such tools today is wide. Infosys, on 31st March 2015, reported outstanding forward exchange and options contracts worth Rs.5,800 crores. TCS at the same time reported outstanding derivative contracts worth about Rs.20,000 crores.
The existing set of accounting standards (for shareholder reporting) that covers financial instruments are rudimentary and does not address issues of complex derivatives. AS-13 which deals with Investments for instance covers only plain-vanilla equities and debt. AS-11 which deals with foreign exchange transactions provides rules on translating foreign currency items to local currency. A part of the standard also deals with currency forwards. It prescribes amortization of premium or discount (the difference between forward and spot rates) over the life of the contract. However, this depreciation-like method rarely reveals the true value of such contracts at any point in time. The accounting standard which addresses these concerns and that which also deals with a broad range of financial products – AS 30 to 32 on financial instruments – has been kept in abeyance for several years now. If implemented, the measurement, presentation/disclosure of various derivatives would be in line with international standards. Voluntary disclosure is however encouraged by regulatory institutions. This is as far as shareholder reporting is concerned.
As far as tax laws go, there is confusion over clarity. In early part of year 2015, the tax department issued its own set of rules, namely, ICDS (Income Computation and Disclosure Standards) which companies are required to follow for the financial year 2015-16 and later. Some of these standards mirror the ones issued by ICAI, but there are significant differences in others. The ICDS is subsidiary to the Indian Income Tax Act. Companies using derivatives will be impacted by the tax impact of ICDS beginning financial year 2015-16.
The Indian income tax law accords favourable treatment to most exchange-traded products, treating them on par with regular business activities. Non-exchange traded products, if it has characteristics of a true derivative (that is netting-off based on price change rather than actual delivery at a price), will be sub-par with regular business activities. The net effect of such ‘subpar’ activities will be carried under a separate heading called speculative business. The impact is, if there is a net loss on such contracts, the losses cannot be adjusted against regular business income. In contrast, if the contract is settled through delivery, then it acquires characteristics of a regular business activity.
The ICDS on foreign exchange transaction (ICDS-VI) is a narrower counterpart of AS-11. The premium/discount amortization is allowed only for contracts which are taken out for hedging items that are already recorded on the balance sheet. Other derivative contracts are not accounted until settlement. Therefore this is a mix of cash and accrual accounting. In effect, contracts taken by companies to hedge forecasted sales (viz.. 6 months out) or purchase commitments (both of which are not yet recorded on the balance sheet) cannot be recorded at its market value on the balance sheet at the close of financial year. This treatment is unfair on the tax position of companies and creates friction between tax outgo and true taxable income.
Derivative accounting by companies goes through three stages – inception recording, financial year-end reporting, and settlement recording. At inception, the contract fair value is nil, and the only transaction needed to be recorded is that of margin money transfer. At financial year-end the true value of such contracts can be known only by marking to market such items. At settlement, the contract closes out with remaining MTM impact (from previous MTM to settlement date). This is the path, taken by international standards such as IFRS, for accounting derivative transactions. Indian tax laws seem to push the impact (for most contracts) until settlement.
There is lack of clarity about treatment of various other derivatives – such as currency swaps, interest rate swaps, currency options – both for shareholder reporting and tax purposes. Shareholder reporting, in the absence of common rules, will differ from company to company making comparisons tedious. Taxation, in the absence of rules, will create uncertainty and litigation. India could take a leaf out of UK tax legislation which has a comprehensive code for taxation of derivative financial instruments covering interest rate contracts, interest rate options, currency contracts, currency options, debt contracts and debt options. To begin with, Indian tax authorities could look at permitting mark to market accounting for exchange-traded products in addition to treating them on par with regular business activities.
ICAI: Institute of Chartered Accountants of India; SEBI: Securities and Exchange Board of India; RBI: Reserve Bank of India; AS: Accounting Standards