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17 - Accounting and Taxation

from Part–VI - Accounting, Taxation and Regulatory Framework

Published online by Cambridge University Press:  02 August 2019

T. V. Somanathan
Affiliation:
Government of India
V. Anantha Nageswaran
Affiliation:
Singapore Management University
Harsh Gupta
Affiliation:
Bain and Company
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Summary

This chapter deals with the accounting and tax treatment of derivatives transactions. These are specialised topics in themselves and this chapter can only serve as an introduction to the subject.

Accounting for derivatives

The increase in the range and complexity of derivative instruments, increased regulatory attention to accounting for derivatives after the global financial crisis, and differing accounting standards and rules in different countries, combine to make this subject exceptionally complicated. Indeed, derivatives accounting is probably the single most complicated topic in the field of accounting. This section presents a simplified summary intended to give the reader an exposure to the main concepts and issues.

Basic principles

The basic principles that govern accounting for derivatives can be summarised as follows:

  • a. Derivatives must be shown in the balance sheet at ‘fair value’ (see below), and all changes in fair value must normally be recognised in the profit and loss account (also referred to in this chapter simply as ‘P & L’). Thus, not only realised profits and losses, but also unrealised profits and losses must be recognised; not only must they be recognised but normally they should be recognised as part of current profits or losses. This is known as ‘fair value accounting’. This is in contrast to the normal accounting convention of prudence or conservatism which would imply not recognising unrealised gains.

  • b. The general principle in (a) above will not apply if the derivative is a hedge. To qualify as a hedge, a derivative transaction or position must meet certain criteria. The general principle for derivatives which are used as hedges is that their accounting treatment must correspond to the treatment of the asset or liability being hedged. This treatment is known as ‘hedge accounting’.

  • Fair value

    The term ‘fair value’ is important in relation to accounting for derivatives. Fair value is the price that would be received to sell an asset/paid to transfer a liability in an orderly transaction between market participants. It must be an ‘arm's length’ transaction where the parties are independent of each other, have no relationship to each other and where each is trying to protect his /its own interests. Where there is quoted market value established in a liquid and transparent market, fair value is the same as market value.

    Type
    Chapter
    Information
    Derivatives
    , pp. 257 - 281
    Publisher: Cambridge University Press
    Print publication year: 2017

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