Executive Summary
This manuscript provides a comprehensive, professional-level treatment of accounting for derivatives within treasury operations. It covers types of derivative instruments, regulatory and accounting frameworks (with emphasis on Ind AS/IFRS principles), detailed recognition and measurement guidance, hedge accounting rules, practical journal entries, numerical illustrations, risk management considerations, and corporate case studies. The write-up targets senior accountants, treasury professionals, and auditors operating in India and seeks to blend technical accounting precision with real-world treasury practices.
1. Introduction
Derivative instruments are contracts whose value is derived from one or more underlying variables such as interest rates, foreign exchange rates, commodity prices or equity indices. In treasury operations, derivatives are employed mainly for hedging economic exposures, achieving balance-sheet or cash-flow management objectives, and sometimes for limited, authorized market-making or arbitrage. An in-depth accounting understanding is essential because derivatives are inherently leveraged, require fair value measurement, and impact both profit or loss and other comprehensive income depending on accounting elections and hedge effectiveness.
2. Overview of Common Derivative Instruments in Treasury
Treasury desks typically use four broad categories of derivatives: forwards, futures, options and swaps. Forwards are tailored OTC agreements to buy or sell an asset at a predetermined price on a future date; futures are standardized exchange-traded contracts with daily marking-to-market; options confer the right but not the obligation to buy or sell; and swaps are agreements to exchange cash flows, commonly interest rate swaps (IRS) and cross-currency swaps (CCS). Each instrument carries different credit, liquidity, and accounting implications.
2.1 Forwards
Forwards are bilateral, over-the-counter instruments frequently used by corporates to hedge foreign currency receivables or payables. Because forwards are bespoke, they are recognized at fair value on the date the contract is entered into and subsequently marked to market. Accounting treatment depends on whether the derivative qualifies for hedge accounting (cash flow hedge of forecast transactions; fair value hedge of recognized items) or is held for trading.
2.2 Futures
Futures are exchange-traded and benefit from standardized terms and daily settlement through a clearinghouse. The daily marking-to-market reduces counterparty credit risk. Accounting mirrors that of other derivatives; however, margin requirements and daily variation margin calls should be reflected in accounting records (margin receivable/payable).
2.3 Options
Options provide asymmetrical payoff profiles. Purchasers pay a premium upfront which is recorded as an asset (option premium) and subsequently measured at fair value. Sellers (writers) record premium received as liability or income depending on designation and accounting policy. Options require valuation models that consider volatility, time value and underlying price dynamics.
2.4 Swaps
Swaps are commonly used to convert interest rate profiles (fixed-to-floating or vice versa) or to manage currency mismatches via cross-currency swaps. Interest rate swaps are foundational in managing interest rate risk for portfolios of loans or debt issuances. Accounting often involves recognition at fair value with subsequent periodic accrual of interest differential cash flows.
3. Regulatory and Accounting Framework (Ind AS/IFRS)
In India, the relevant accounting standards for derivatives are Ind AS 109 ‘Financial Instruments’ and Ind AS 32 ‘Financial Instruments: Presentation’. Ind AS 109 (aligned with IFRS 9) prescribes classification and measurement, impairment and hedge accounting. Key concepts include: initial recognition at fair value, subsequent measurement through profit or loss (FVTPL) or other comprehensive income (FVOCI) depending on instrument and business model, and strict criteria for hedge accounting which require formal designation and documentation, expected hedge effectiveness, and ongoing effectiveness assessment. ICAI guidance notes and RBI circulars govern bank treasury operations
and provide additional regulatory requirements for banks and financial institutions.
4. Recognition and Initial Measurement
Derivatives are recognized at the trade date at fair value. Transaction costs, in most cases for derivatives measured at fair value through profit or loss, are expensed immediately. Institutions must record any premiums paid or received and establish appropriate receivable/payable or asset/liability classification. For a forward contract to sell USD for INR, for example, the initial entry at inception records the forward at fair value (often zero if entered at par) and any upfront fees as expense.
5. Subsequent Measurement and Fair Value Accounting
Subsequent measurement of derivatives depends on classification. If the derivative is designated as FVTPL, all fair value changes are recognized in profit or loss. If designated in a hedging relationship and qualifying for hedge accounting, the accounting differs: i) Cash flow hedge — effective portion of gain/loss on derivative is recognised in OCI and reclassified to profit or loss when the hedged item affects profit or loss; ii) Fair value hedge — gain/loss on derivative and the hedged item attributable to the hedged risk are recognized in profit or loss, generally
offsetting each other; iii) Hedge of a net investment in a foreign operation — treated similarly to a cash flow hedge with OCI impact.
6. Hedge Accounting: Types and Eligibility
Hedge accounting is optional and is applied to align the accounting for hedging instruments with the hedged item. The three primary types of hedges are cash flow hedges, fair value hedges and hedges of net investments. Eligibility requires formal documentation at hedge inception specifying the hedging relationship, the entity’s risk management objective, the hedged item and the method for assessing hedge effectiveness. Ind AS 109 relaxes the 80–125% mechanical effectiveness corridor of earlier guidance and allows more qualitative and prospective assessments, though an entity must still demonstrate an economic relationship between
the hedge and the hedged item and that the hedge ratio is consistent with the entity’s risk management strategy.
7. Practical Journal Entries and Worked Examples
This section provides practical journal entries for common treasury derivative transactions: a) forward contract hedging a USD receivable; b) purchased option to hedge currency exposure; c) interest rate swap used to convert floating-rate borrowing to fixed-rate exposure. For simplicity, entries assume a corporate (non-bank) accounting framework under Ind AS.
Example A — Forward Contract Hedging USD Receivable (Journal Entries)
Background: ABC Ltd. (reporting currency INR) expects to receive USD 1,000,000 on 30 June 20X2. To hedge the foreign currency risk, ABC enters into a 6-month forward to sell USD 1,000,000 at a forward rate of INR 74.00/USD on 31 December 20X1. The spot rate on 31 December 20X1 is INR 73.50/USD. Assume the forward contract is designated as a cash flow hedge of a forecasted transaction and qualifies for hedge accounting. At inception (31 December 20X1) the forward has zero fair value (entered at par). ABC documents the hedge relationship
and expected that the hedge is highly effective. Journal entries (narrative): At inception on 31-Dec-20X1, the forward is entered at par and documented as a cash flow hedge; initial recognition commonly requires no P&L impact. 31-Dec-20X1 — Hedge inception (no initial fair value) No journal entry required for forward at par (common practice: disclose contract in notes) 30-Jun-20X2 — Settlement (USD received and INR received under forward) Bank (INR) 74,000,000 — Dr Accounts Receivable (USD) [converted at spot] 73,500,000 — Cr Gain on cash flow hedge transferred from OCI 500,000 —Cr
Example B — Purchased Option to Hedge Currency Risk
ABC purchases a 6-month USD put option (to sell USD) with strike INR 74 costing an upfront premium of INR 1,500,000 to hedge an expected USD receipt of USD 1,000,000. The premium is recognised as an asset initially (Option Premium) and subsequently measured at fair value. If designated as a cash flow hedge of a forecasted transaction, the effective portion of changes in fair value goes to OCI. At expiry, if exercised, the option settlement and reclassification from OCI occur.
Example C — Interest Rate Swap (IRS) for Floating Borrowing
ABC has a floating-rate loan (3M LIBOR + 200 bps) and enters into a receive-floating-pay-fixed interest rate swap to convert cash flows to fixed. The swap is designated as a cash flow hedge of future interest payments. The swap is recorded at fair value at inception and subsequently measured with effective portion in OCI. Periodic net settlement amounts (difference between floating and fixed legs) are accrued as interest expense/income and adjustments through OCI are made accordingly.
8. Numerical Illustrations (Detailed)
Numerical Illustration 1 — Forward Contract MTM and OCI movements: Assumptions: • USD 1,000,000 receivable on 30-Jun-20X2 • Forward rate at hedge inception (31-Dec-20X1): INR 74.00/USD • Spot at inception: INR 73.50/USD • Spot at 31-Mar-20X2 (quarter end) for MTM: INR 75.00/USD Calculation: The fair value of the forward at 31-Mar-20X2 will reflect the change in forward points and spot; for simplicity assume the forward fair value implies that the contract has an unrealised gain of INR 1,500,000 (i.e., the present value of moving the locked-in rate relative to the current
forward curve). If designated as a cash flow hedge, the effective portion (assume fully effective) INR 1,500,000 is recognised in OCI and presented in equity as ‘cash flow hedge reserve’. Journal entry at 31-Mar-20X2: Dr Derivative (Asset) 1,500,000 Cr Other Comprehensive Income — Cash Flow Hedge Reserve 1,500,000 If at settlement the derivative produces INR 500,000 net benefit relative to spot conversion, the amount released from OCI to P&L equals the realised benefit recognised when the hedged item affects P&L.
9. Corporate Case Studies and Lessons Learned
Case Study 1 — Currency Hedging by a Large IT Exporter: Background: A major Indian IT services company (generic description to preserve confidentiality) enters into a disciplined hedging program to mitigate USD/INR volatility for forecast revenue. The treasury uses a combination of forwards and option collars. Accounting practice: designation of cash flow hedges for forecast contracts; strict documentation; monthly effectiveness assessment; detailed disclosures in notes to accounts describing notional amounts, maturity profile and location of gains/losses (OCI vs P&L). Lessons: Best practice involves centralized hedge policy, segregation of duties, and robust
documentation. Case Study 2 — Commodity Price Hedging by a Large Refinery: Background: An energy conglomerate hedges crude oil price exposure using swaps and futures. Accounting complexity arises when hedges are of forecast purchases and when inventory valuation interacts with hedge accounting. Effective integration between procurement, treasury and accounting teams is essential to ensure correct hedge designation (cash flow hedge of forecast purchase) and timely accounting for OCI recycling into cost of goods sold as inventory is sold. Case Study 3 — Bank Treasury Use of Interest Rate Swaps: Background: A
public sector bank uses IRS to manage interest rate exposure on large loan portfolios. Accounting considerations include recognition of derivatives at fair value, treatment of accrued net settlement, and regulatory capital implications. Banks also follow RBI circulars which require additional disclosures.
10. Risk Management, Controls and Governance
Derivatives require strong governance. Key elements include: an approved treasury policy (covering permitted instruments, hedge ratios, documentation standards), limits and authorisation matrices, independent risk control and middle office functions, daily mark-to-market procedures, counterparty credit assessment, and back-testing of hedging strategies. Internal audit and board oversight are critical. For banks, supervisory authorities impose additional controls and reporting requirements.
11. Disclosure Requirements and Reporting
Ind AS 107 (Financial Instruments: Disclosures) along with Ind AS 109 and Ind AS 32 requires entities to provide qualitative and quantitative disclosures about exposure to risks, objectives and strategies for risk management, and detailed tables showing notional amounts, fair values, maturity analysis and the effect of hedging instruments on financial statements. Entities must also disclose accounting policies adopted for derivatives and hedge accounting, including methods for testing effectiveness, and the amounts reclassified from OCI to profit or loss.
12. Common Pitfalls and Practical Guidance
Common pitfalls include inadequate documentation at hedge inception, failure to perform ongoing effectiveness assessment, mismatch between hedge designation and actual risk management activity, incorrect accounting for option premiums and embedded derivatives, and omission of necessary disclosures. Practical guidance: maintain contemporaneous hedge documentation; use systems that capture MTM movements and link hedges to underlying items; involve tax, legal and audit teams when creating complex hedging structures.
13. Conclusion and Recommendations
Accounting for derivatives in treasury operations combines technical accounting rules with practical treasury processes. Entities should adopt clear policies, maintain strong controls, ensure appropriate segregation between trading and hedging activities, and apply Ind AS requirements faithfully. Where hedge accounting is applied, rigorous documentation and effectiveness assessment are essential. Regular training for treasury and accounting staff, coupled with enhanced systems and audit oversight, will mitigate operational and accounting risks.
Annexures
A. Sample Journal Entry Templates
1. Recognition of forward at inception (entered at par): No entry required; disclose contract and terms. 2. Recognition of option premium paid: Dr Option Premium (Asset) — Cr Bank 3. MTM gain on derivative (FVTPL): Dr Derivative Asset — Cr Gain on Derivative (P&L) 4. MTM gain on derivative (cash flow hedge — effective): Dr Derivative Asset — Cr OCI — Cash Flow Hedge Reserve 5. Reclassification from OCI to P&L when hedged forecast affects P&L: Dr OCI — Cash Flow Hedge Reserve — Cr Revenue or Cost of Goods Sold
(depending on hedged item) 6. Settlement of forward contract: Dr Bank (INR) — Cr Receivable (FX translated) — Cr/Dr difference to P&L or OCI as appropriate.
B. Sample Hedge Policy (Key clauses)
Objective: Define permitted instruments and risk management objectives. • Approval: Board approval required for hedge policy and any material deviation. • Documentation: Formal hedge documentation at inception, including risk being hedged, hedging instrument, hedge ratio and effectiveness testing methodology. • Limits: Notional and counterparty exposure limits. • Controls: Middle office valuation, independent verification, daily MTM and monthly reporting to ALCO/Board.
C. Glossary
OCI — Other Comprehensive Income FVTPL — Fair Value Through Profit or Loss FVOCI — Fair Value Through Other Comprehensive Income IRS — Interest Rate Swap CCS — Cross-Currency Swap MTM — Mark-to- Market
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