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Introduction
In recent months, regulators and accounting
standard-setters have proposed or rolled out changes affecting how corporations
treat derivatives in treasury operations. These updates aim to tighten
transparency, reduce volatility in financial statements, and align with global
best practices. The shift matters especially for corporates, banks, and their
auditors, because it will directly influence earnings, risk disclosures, and
internal hedging strategies. This article examines the regulatory context, key
changes, implications, and how finance teams can stay compliant.
Background & Context
Derivatives — such as forwards, swaps, options
— are financial contracts whose values derive from underlying assets (e.g.
currencies, interest rates, commodities). They are widely used in treasury
operations to hedge exposures (e.g. foreign exchange risk, interest rate risk).
Accounting for derivatives has long been one
of the more complex areas in corporate finance, because these instruments
require fair value measurement, continuous revaluation, and strict rules for
hedge accounting. In India, the principal accounting standards governing
derivatives are Ind AS 32
(Financial Instruments: Presentation) and Ind AS 109 (Financial
Instruments) which is aligned with IFRS
9.
Over the years, regulators such as the Reserve
Bank of India (RBI), the Institute of Chartered Accountants of India (ICAI),
SEBI and sectoral norms have supplemented these standards with guidance
specific to financial institutions and corporate treasury operations.
However, challenges remain: volatility from
revaluations, complex effectiveness tests, documentation compliance, and
divergence in practice across companies. The recently proposed and
implementable changes are meant to plug gaps, reduce ambiguity, and better
align domestic practices with global norms.
Detailed Explanation of the New Developments
Below is a breakdown of the principal changes
and regulatory signals affecting accounting for derivatives in treasury
operations.
1. RBI’s Proposed Draft Guidelines on
Novation of OTC Contracts
In July 2025, the Reserve Bank of India
released draft directions
governing novation
of over-the-counter (OTC) derivative contracts. Novation involves transferring
the rights and obligations of a derivative contract from one counterparty to
another. The draft aims to:
·
Standardize procedures for novation transactions
in the OTC space
·
Enhance transparency in the change of
counterparties
·
Reduce counterparty
credit risk by making the process more formal and auditable
This proposal is notable because novation
plays a key role in liquidity, netting, and collateral management in derivative
markets.
2. Updated Regulatory Norms for Banks’
Investment & Derivative Portfolios
In October 2023, the RBI released revisions to
its classification, valuation, and disclosures regime for banks. Among other
things:
·
Banks must comply with ICAI’s Guidance Note on Accounting for
Derivative Contracts (2021) when dealing with derivative assets
and liabilities.
·
Derivative assets/liabilities are to be
presented as separate line items under “Other Assets / Other Liabilities.”
·
Disclosures on fair value hierarchies (Level 1 /
2 / 3), and constraints on dividend payouts from unrealised gains on Level 3
instruments are required.
Thus, banks and financial institutions now
face more robust disclosure obligations tied to derivative holdings.
3. Changes in Hedge Accounting Criteria &
Effectiveness Testing
Under Ind AS 109 / IFRS 9, a derivative may be
designated as a hedge (fair value hedge, cash flow hedge, or net investment
hedge) if certain criteria are met:
·
Formal
designation & documentation at inception
·
Demonstrable
economic relationship between hedged item and hedging
instrument
·
Effectiveness
testing, both prospective and retrospective
Recent guidance relaxes some of the strict
mechanical “80–125%” effectiveness corridor used earlier, allowing more
qualitative and prospective judgments — provided documentation supports the
economic linkage.
For example, when a company hedges forecasted
foreign currency revenue using forward contracts, the effective portion of gain
or loss can be parked in Other
Comprehensive Income (OCI) until the underlying impacts profit
or loss.
4. Practical Journal Entries & Accounting
Treatment
Here is a simplified illustration for a forward
hedge of a USD receivable:
|
Event |
Journal Entry |
Explanation |
|
At inception (forward at par) |
No initial fair value entry (or premium/fee expensed) |
Often initial fair value is zero |
|
Change in fair value (FVTPL classification) |
Dr / Cr Derivative Asset / Liability |
Gains/losses recognized immediately |
|
Designated as cash flow hedge |
(Effective portion) Dr / Cr Derivative Asset / Liability |
Deferred in OCI until reclassification |
|
Reclassification when forecasted sale occurs |
Dr / Cr OCI |
Aligns hedging result with underlying item |
Similar entries apply for swaps and options —
the premium paid becomes an asset initially, then revalued; the premium
received by option writers may be treated as income or liability based on
designation.
5. Compliance, Stamp Duty & Documentation
Formalities
Regulatory oversight also extends to documentation formality.
In India:
·
Derivative agreements are typically documented
using standard ISDA Master Agreements
and Credit Support Annex (CSA) for OTC deals.
·
Stamp duty and local witnessing requirements
apply; variation across states is common.
·
For payments to non-resident counterparties, withholding tax (section 195 of the
Income Tax Act) may apply unless exemption certificates are
obtained.
These procedural and legal steps are often
overlooked, but noncompliance can cause enforcement or tax risks.
Impact Analysis
Who Stands to Gain or Lose?
Beneficiaries
·
Well-prepared
corporates with robust treasury, accounting, and risk teams
will gain transparency, lower audit risk, and smoother adoption of hedge
accounting.
·
Auditors
and CAs who specialize in derivatives will find renewed demand
for advisory services.
·
Investors
and analysts, because tighter disclosure reduces surprises from
revaluation swings.
Those
at risk
·
Corporates with weak documentation, fragmented
offices, or inconsistent derivatives practices may struggle to meet new
standards.
·
Smaller firms or those without dedicated
treasury units might find compliance burdensome.
Practical Implications
For Businesses
·
Need to revise
internal policies: hedge designation memos, risk limits,
effectiveness test protocols.
·
Likely to upgrade
systems (treasury & accounting), especially for continuous
mark-to-market, data capture, and audit trails.
·
May reassess
hedging strategies: if cost of compliance or volatility
outweighs benefit, some firms might scale back derivatives usage.
For Taxpayers / Corporate Finance Teams
·
Must be vigilant on withholding tax,
especially for cross-border derivative payments to non-residents.
·
Earnings volatility from derivatives (if
classified FVTPL) could affect tax planning, provisioning, and dividends.
·
Greater emphasis on alignment between tax
accounting and financial accounting treatment.
For Auditors / Chartered Accountants
·
Increased scrutiny on adequacy of documentation,
fair value models, and effectiveness testing.
·
Responsibility to challenge assumptions (e.g.,
discount rates, volatility inputs) and ensure audit evidence is robust.
·
Possible specialization in derivatives advisory,
valuation review, and internal training.
In sum, the changes raise the bar for
technical capability, systems maturity, and governance discipline in treasury
and accounting operations.
Common Misunderstandings
·
“All
derivatives must go through P&L immediately.”
Not true — if a derivative qualifies for hedge accounting, some gains/losses
may be deferred in OCI.
·
“Effectiveness
must always be measured 80–125% by formula.”
That rigid corridor has been softened; qualitative and prospective assessments
may now be used if documented.
·
“Stamp
duty is negligible for derivative contracts.”
Stamp duty can vary by state and instrument; oversight can void enforceability.
·
“Non-resident
counterparties are exempt from withholding tax always.”
Only when an explicit exemption certificate is obtained under section 195 of
the Income Tax Act.
·
“Novation
is just administrative; no accounting impact.”
Novation can change counterparties, credit support, and valuation dynamics —
affecting accounting and risk exposure.
Expert Commentary
From my vantage point after two decades
covering finance, these reforms signal a maturity in India’s derivative
accounting regime. The push toward clarity in novation, stricter disclosures,
and international accounting alignment is overdue. But the real value lies not
merely in compliance, but in discipline: finance teams that treat derivative
risk as an integrated process (from front office to accounting to audit) will
thrive. Weak links — such as inadequate documentation or model assumptions —
will no longer fly under the radar.
Conclusion & Action Steps
The evolving regulatory and accounting
landscape for derivatives in treasury operations is reshaping the expectations
for corporations, banks, and auditors alike. With greater emphasis on transparency, integrity, and risk
alignment, firms must realign their internal policies, systems,
and expertise.
Key
next steps:
1.
Audit
your current derivatives practice — documentation, valuation
models, hedge accounting designations.
2.
Upgrade
your technology stack to support real-time fair value and audit
trails.
3.
Train
your teams (finance, treasury, audit) to internalize the new
norms.
4.
Engage
external advisors early to validate model assumptions and
compliance readiness.
As regulators fine-tune these rules,
companies that stay ahead will gain a competitive edge in credibility, capital
access, and investor confidence.
FAQs
Q1:
What is the difference between FVTPL and hedge accounting?
Under FVTPL (Fair Value
Through Profit or Loss) classification, all changes in fair
value of derivatives are reflected immediately in the income statement. In
contrast, hedge accounting
allows qualified derivatives to defer the “effective” portion of gains/losses
into OCI (Other
Comprehensive Income) or offset changes in the hedged item —
thereby reducing volatility in profits.
Q2:
Can a forward contract always be designated as a cash-flow hedge?
Not always. The forward must meet criteria such as a documented hedging
relationship, evidence of an economic relationship with the hedged item, and
prospective effectiveness. If these are absent, it may need to be treated as
FVTPL.
Q3:
How often must effectiveness testing be performed?
Effectiveness must be tested both
at inception (prospective) and on an ongoing basis
(retrospective). The frequency depends on the risk profile and accounting
policy, but it is often done quarterly or at each reporting date.
Q4:
How do the proposed novation rules affect derivative accounting?
When a derivative is novated (i.e. old counterparty replaced by new), the
accounting must reassess valuation, credit risk, and re-document the hedging
relationship. The proposed guidelines bring more structure to this process,
making it auditable and less opaque.
Q5:
Will the new rules apply to all companies?
The changes are especially relevant to corporates with active treasury
operations and financial institutions. However, even smaller firms using
hedging derivatives must evaluate compliance — failure to do so may trigger
audit adjustments or regulatory scrutiny.
References & Source Links
·
“Accounting for Derivatives in Treasury
Operations,” TaxGuru
·
“Derivatives Laws and Regulations India 2025,”
ICLG
·
RBI’s Master Directions & revised investment
classification guidelines
·
ISDA / charting India OTC derivatives practices
·
RBI’s draft novation guidelines (via media)