Ind AS 109 requires derivatives to be classified as ‘fair value through profit or loss’ (FVTPL). This means that all the derivatives should be valued at fair value at every reporting period and the fair value changes should be recognised in the profit and loss account. The fair value of the derivative itself should be recognised in the balance sheet. If the derivative has a positive fair value, then it should be shown as an asset and if it has a negative fair value, then the same should be shown as a liability.
Ind AS 32 recognises derivative when the standard defines a financial asset and a financial liability. A derivative which should be shown as an asset is specified in the accounting standard Ind AS 32 as a contractual right to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity. Similarly a derivative which should be shown as a liability is specified in the accounting standard Ind AS 32 as a contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.
Derivative financial instruments create rights and obligations that have the effect of transferring between the parties to the instrument one or more of the financial risks inherent in an underlying primary financial instrument.
On inception, derivative financial instruments give one party a contractual right to exchange financial assets or financial liabilities with another party under conditions that are potentially favourable, or a contractual obligation to exchange financial assets or financial liabilities with another party under conditions that are potentially unfavourable. However, they generally do not result in a transfer of the underlying primary financial instrument on inception of the contract, nor does such a transfer necessarily take place on maturity of the contract. Some instruments embody both a right and an obligation to make an exchange. Because the terms of the exchange are determined on inception of the derivative instrument, as prices in financial markets change those terms may become either favourable or unfavourable.
A put or call option to exchange financial assets or financial liabilities gives the holder a right to obtain potential future economic benefits associated with changes in the fair value of the financial instrument underlying the contract. Conversely, the writer of an option assumes an obligation to forgo potential future economic benefits or bear potential losses of economic benefits associated with changes in the fair value of the underlying financial instrument.
The contractual right of the holder and obligation of the writer meet the definition of a financial asset and a financial liability, respectively. The financial instrument underlying an option contract may be any financial asset, including shares in other entities and interest bearing instruments. An option may require the writer to issue a debt instrument, rather than transfer a financial asset, but the instrument underlying the option would constitute a financial asset of the holder if the option were exercised. The option-holder’s right to exchange the financial asset under potentially favourable conditions and the writer’s obligation to exchange the financial asset under potentially unfavourable conditions are distinct from the underlying financial asset to be exchanged upon exercise of the option. The nature of the holder’s right and of the writer’s obligation are not affected by the likelihood that the option will be exercised.
Further details on derivatives accounting will be covered in Derivatives Accounting – Part 2.