ACCOUNTING OF INDEX FUTURES TRANSACTIONS

This Section deals with Accounting of Derivatives and attempts to cover the Indi
an scenario in some depth. The areas covered are Accounting for Foreign Exchange
Derivatives and Stock Index Futures. Stock Index Futures are provided more cove
rage as these have been introduced recently and would be of immediate benefit to
practitioners.
International perspective is also provided with a short discussion on fair value
accounting. The implications of Accounting practices in the US (FASB-133) are a
lso discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Not
e for Accounting of Index Futures in December 2000. The guidelines provided here
in this Section below are in accordance with the contents of this Guidance Note
.
INDIAN ACCOUNTING PRACTICES
Accounting for foreign exchange derivatives is guided by Accounting Standard 11.
Accounting for Stock Index futures is expected to be governed by a Guidance Not
e shortly expected to be issued by the Institute of Chartered Accountants of Ind
ia.
Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial i
nstrument that is in substance a forward exchange contract to establish the amou
nt of the reporting currency required or available at the settlement date of tra
nsaction. Accounting Standard 11 provides that the difference between the forwar
d rate and the exchange rate at the date of the transaction should be recognised
as income or expense over the life of the contract. Further the profit or loss
arising on cancellation or renewal of a forward exchange contract should be reco
gnised as income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan instal
lment and interest. As on 1st December 1999, it appears to the company that the
US $ may be dearer as compared to the exchange rate prevailing on that date, say
US $ 1 = Rs. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with
a banker for US $ 3,00,000. The forward rate may be higher or lower than the sp
ot rate prevailing on the date of the forward contract. Let us assume forward ra
te as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs. 43
.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ Ltd $ 3,
00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume th
at the Spot rate as on that date be US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward co
ntract.
Payment to be made as per forward contract
(US $ 3,00,000 * Rs. 44)
Rs 1,32,00,000
Amount payable had the forward contract not been in place
(US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000
Gain arising out of the forward exchange contract
Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the
transaction should be recognised as income or expense over the life of the cont
ract. In the above example, the difference between the spot rate and forward rat
e as on 1st December is Rs.0.50 per US $. In other words the total loss was Rs.
1,50,000 as on the date of forward contract.
Since the financial year of the company ends on 31st March every year, the loss
arising out of the forward contract should be apportioned on time basis. In the
given example, the time ratio would be 4 : 1; so a loss of Rs. 1,20,000 should b
e apportioned to the accounting year 1999-2000 and the balance Rs. 30,000 should
be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot
rate on the date of forward contract be accounted. As a result, the benefits or
losses accruing due to the forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward
exchange should recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March
2000 @ US $ 1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $
. The total loss on cancellation of forward contract would be Rs. 30,000. The St
andard requires recognition of this loss in the financial year 1999-2000.
Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock ind
ex future. Both the Bombay Stock Exchange and the National Stock Exchange have i
ntroduced index futures in June 2000 and permit trading on the Sensex Futures an
d the Nifty Futures respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this
will represent 50 units of the underlying Sensex Futures. Currently, both excha
nges have listed Futures upto 3 months expiry. For example, in the month of Sept
ember 2000, an investor can buy September Series, October Series and November Se
ries. The September Series will expire on the last Thursday of September. From t
he next day (i.e. Friday), the December Series will be quoted on the exchange.
Accounting of Index Futures
Internationally, fair value accounting plays an important role in accounting for i
nvestments and stock index futures. Fair value is the amount for which an asset
could be exchanged between a knowledgeable, willing buyer and a knowledgeable, w
illing seller in an arm s length transaction. Simply stated, fair value accounting
requires that underlying securities and associated derivative instruments be va
lued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provi
des that the current investments should be carried in the financial statements a
s lower of cost and fair value determined either on an individual investment bas
is or by category of investment. Current investment is an investment that is by
its nature readily realisable and is intended to be held for not more than one y
ear from the date of investment. Any reduction in the carrying amount and any re
versals of such reductions should be charged or credited to the profit and loss
account.
On the disposal of an investment, the difference between the carrying amount and
net disposal proceeds should be charged or credited to the profit and loss stat
ement.
In countries where local accounting practices require valuation of underlying at
fair value, size=2 index futures (and other derivative instruments) are also va
lued at fair value. In countries where local accounting practices for the underl
ying are largely dependent on cost (or lower of cost or fair value), accounting
for derivatives follows a similar principle. In view of Indian accounting practi
ces currently not recognising fair value, it is widely expected that stock index
futures will also be accounted based on prudent accounting conventions. The Ins
titute is finalising a Guidance Note on this area, which is expected to be short
ly released.
The accounting suggestions provided in the Indian context in the following parag
raphs should be read in this perspective. The suggestions contained are based on
the author s personal views on the subject.
Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupt
a Committee and the Prof J R Verma Committee. Both the Bombay Stock Exchange and
the National Stock Exchange have set up independent derivatives segments, where
select broker-members have been permitted to operate. These broker-members are
required to satisfy net worth and other criteria as specified by the SEBI Commit
tees.
Each client who buys or sells stock index futures is first required to deposit a
n Initial Margin. This margin is generally a percentage of the amount of exposur
e that the client takes up and varies from time to time based on the volatility
levels in the market. At the point of buying or selling index futures, the payme
nt made by the client towards Initial Margin would be reflected as an Asset in t
he Balance Sheet.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the
closing price would be compared with the closing price of the previous evening
and profit or loss computed by the exchange. The exchange would collect or pay t
he difference to the member-brokers on a daily basis. The broker could further p
ay the difference to his clients on a daily basis. Alternatively, the broker cou
ld settle with the client on a weekly basis (as daily fund movements could be di
fficult especially at the retail level).
Example
Mr. X purchases following two lots of Sensex Futures Contracts on 4th Sept. 2000
:
October 2000 Series 1 Contract @ Rs. 4,500
November 2000 Series 1 Contract @ Rs. 4,850
Mr X will be required to pay an Initial Margin before entering into these transa
ctions. Suppose the Initial Margin is 6%, the amount of Margin will come to Rs 2
8,050 (50 Units per Contract on the Bombay Stock Exchange).
The accounting entry will be :
Initial Margin Account Dr 28,050
To Bank 28,050
If the daily settlement prices of the above Sensex Futures were as follows:
Date
04/09/00
05/09/00
06/09/00
07/09/00
08/09/00 Oct. Series
4520
4510
4480
4500
4490
Nov. Series
4850
4800
--
--
--
Let us assume that Mr X he sold the November Series contract at Rs 4,810.
The amount of Mark-to-Market Margin Money Sensex receivable/payable due to increas
e/decrease in daily settlement prices is as below. Please note that one Contract
on the Bombay Stock Exchange implies 50 underlying Units of the Sensex.
Date October Series October Series November Series November Series
Receive(RS) Pay(RS) Receive(RS) Pay(RS)
4th September 2000 1,000 - - -
5th September 2000 - 500 - 2,500
6th September 2000 - 1,500 - -
7th September 2000 1,000 - - -
8th September 2000 - 500 - -
The amount of Mark-to-Market Margin Money received/paid will be credited/debited t
o Mark-to-Market Margin Account on a day to day basis. For example, on the 4th of
September the following entry will be passed:
Bank A/c Dr. 1,000
To Mark-to-market Margin A/c 1,000
TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the Novemb
er Series Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810.
He therefore suffered a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contrac
t. This loss will be accounted on 6th Sept. Further, the Initial Margin paid on
the November Series will be refunded back on squaring up of the transaction. Thi
s receipt will be accounted by crediting the Initial Margin Account so that this
Account is reduced to zero. The Mark to Margin Account will contain transaction
s pertaining to this Futures Series. This component will also be reversed on 6th
Sept 2000.
Bank Account Dr 15,050
Loss on November Series Dr 2,000
Initial Margin 14,550
Mark to Market Margin 2,500
Margins maintained with Brokers
Brokers are expected to ensure that clients pay adequate margins on time. Broker
s are not permitted to pay up shortfalls from their pocket. Brokers may therefor
e insist that the clients should pay them slightly higher margins than that dema
nded by the exchange and use this extra collection to pay up daily margins as an
d when required.
If a client is called upon to pay further daily margins or receives a refund of
daily margins from his broker, the client would again account for this payment o
r refund in the Balance Sheet. The margins paid would get reflected as Assets in
the Balance Sheet and refunds would reduce these Assets.
The client could square up any of his transactions any time. If transactions are
not squared up, the exchange would automatically square up all transactions on
the day of expiry of the futures series. For example, an October 2000 future wou
ld expire on the last Thursday, i.e. 26th October 2000. On this day, all futures
transactions remaining outstanding on the system would be compulsorily squared
up.
Recognition of Profit or Loss
A basic issue which arises in the context of daily settlement is whether profits
and losses accrue from day to day or do they accrue only at the point of squari
ng up. It is widely believed that daily settlement does not mean daily squaring
up. The daily settlement system is an administrative mechanism whereby the stock
exchanges maintain a healthy system of controls. From an accounting perspective
, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or l
oss would be recognised in the Profit & Loss Account of the period in which the
squaring up takes place.
If a series of transactions were to take place and the client is unable to ident
ify which particular transaction was squared up, the client could follow the Fir
st In First Out method of accounting. For example, if the October series of SENS
EX futures was purchased on 11th October and again on 12th October and sold on 1
6th October, it will be understood that the 11th October purchases are sold firs
t. The FIFO would be applied independently for each series for each stock index
future. For example, if November series of NIFTY are also purchased and sold, th
ese would be tracked separately and not mixed up with the October series of SENS
EX.
Accounting at Financial Year End
In view of the underlying securities being valued at lower of cost or market val
ue, a similar principle would be applied to index futures also. Thus, losses if
any would be recognised at the year end, while unrealised profits would not be r
ecognised.
A global system could be adopted whereby the client lists down all his stock ind
ex futures contracts and compares the cost with the market values as at the fina
ncial year end. A total of such profits and losses is struck. If the total is a
profit, it is taken as a Current Liability. If the total is a loss, a relevant p
rovision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring
up of the transaction. This would be accounted net of the provision towards loss
es (if any) already effected in the previous year at the time of closing of the
accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty future
s for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these
 futures are Rs 2,20,000 and Rs 2,35,000 respectively. He has not squared up the
se transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an un
realised loss of Rs 15,000 on the Nifty futures. As the net result is a profit,
he will not account for any profit or loss in this accounting period.
Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty future
s for Rs 2,50,000 on 7th March. On the 31st of March, the market values of these
futures are Rs 2,20,000 and Rs 2,15,000 respectively. He has not squared up the
se transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an un
realised loss of Rs 35,000 on the Nifty futures. As the net result is a loss of
Rs 15,000, he will record a provision towards losses in his Profit or Loss Accou
nt in this accounting period.
In the next year, the Nifty future is actually sold for Rs 2,10,000.
At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 ha
s already been accounted in the earlier financial year. The balance of Rs 25,000
will be accounted in the next financial year.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accou
nting Standard Board, US defines the criteria /attributes which an instrument sh
ould have to be called as derivative and also provides guidance for accounting o
f derivatives. The Standard is facing tough opposition and controversies from th
e US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characterist
ics:
A derivative s cash flows or fair value must fluctuate or vary based on the change
s in an underlying variable.
The contract must be based on a notional amount of quantity. The notional amount
is the fixed amount or quantity that determines the size of change caused by th
e movement of the underlying.
The contract can be readily settled by net cash payment
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the
Balance Sheet as assets or liability at fair value and changes in fair value sh
ould be recognised in the year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivat
ives contracts. It is important to understand the purpose of the enterprise whil
e entering into the transaction relating to the derivative instrument. The deriv
ative instrument could be used as a tool for hedging or could be a trading trans
action unrelated to hedging. If it is not used as an hedging instrument, the gai
n or loss on the derivative instrument is required to be recognised as profit or
loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or
liability, are called Fair Value Hedges. The gain or loss on such derivative ins
truments as well as the off setting loss or gain on the hedged item shall be rec
ognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may d
ecide to hedge this portfolio using the Sensex Futures Contract. The gain or los
s on the index futures contract would compensate the loss or gain on the portfol
io. Both the gains and losses will be recognised in the Profit and Loss Statemen
t. If the hedge is perfect, gains and losses will offset each other and hence wi
ll not have any impact on the current earnings. However, if the hedge is not a p
erfect hedge, there would be a difference between the gain and the compensating
loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recogni
sed asset and liability, it is called Cash Flow hedge. The gain or loss on such
derivative instruments will be transferred to current earnings of the same perio
d or the periods during which the forecasted transaction affects the earnings. T
he remaining gain or loss on the derivative instrument if any shall be recognise
d currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of f
oreign currency transactions or investments overseas or in subsidiaries, it is c
alled Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order t
o qualify as a hedge transaction, the company should at the inception of the tra
nsaction:
Designate the hedge relationship
Document such relationship
Identifying hedge item, hedge instrument and risks being hedged
Expect hedge to be highly effective
Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be r
eported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB rec
ognised that not all hedging transactions can be perfect. There can be a degree
of ineffectiveness which should be recognized. The Statement requires that the a
ssessment of effectiveness must be consistent with risk management strategies do
cumented for that particular hedge relationship. Further the assessment of effec
tiveness is required whenever financial statements or earnings are reported.
Conclusion
The Indian accounting guidelines in this area need to be carefully reviewed. The
international trend is moving towards marking the underlying securities as well
as associated derivative instruments to market. Such a practice would bring int
o the accounts a clear picture of the impact of derivatives related operations.
Indian accounting is based on traditional prudence where profits are not recogni
sed till realisation. This practice, though sound in general, appears to be inco
nsistent with reality in a highly liquid and vibrant area like derivatives.
TAXATION OF DERIVATIVE TRANSACTIONS IN INDEX FUTURES
This Note seeks to provide information on the taxation aspects of index futures
transactions. The contents of this Note should not be treated as advice or guida
nce or authoritative pronouncements. Readers are advised to consult their tax ad
visors before taking any action relating to their tax computations or planning.
This Note is not intended for any such purpose.
In the absence of special provisions, the current provisions, which are inadequa
te to handle the complexities involved are reviewed in this Note. It is expected
that the Central Board of Direct Taxes (CBDT) will shortly provide guidelines f
or taxation aspects of Derivative transactions.
Speculation Losses Cannot be set off
Losses from Speculation business can be set off only against profits of another
speculation business. If speculation profits are insufficient, such losses can b
e carried forward for eight years, and will be set off against speculation profi
ts in these future years. (Section 73)
Definition of Speculative Transactions
Section 43(5) defines speculative transactions as those which are periodically o
r ultimately settled otherwise than by actual delivery or transfer. By this defi
nition all index futures transactions will qualify prima facie as speculative tr
ansactions, as delivery of such futures is not possible.
Exceptions are provided to this definition to cover cases where contracts are en
tered into in respect of stocks and shares by a dealer or investor to guard agai
nst loss in holdings of stocks and shares through price fluctuations. Another ex
ception is provide for contracts entered into by a member of a forward market or
a stock exchange in the course of any transaction in the nature of jobbing or a
rbitrage to guard against loss which may arise in the ordinary course of his bus
iness as such member.
The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The
important provisions of this Circular are summarised below:
Hedging sales can be taken to be genuine only to the extent the total of such tr
ansactions does not exceed the ready stock, the loss arising from excess transac
tions should be treated as total stocks of raw material or merchandise in hand.
If forward sales exceed speculative losses.
Hedging transactions in connected, though not the same, commodities should not b
e treated as speculative transactions.
It cannot be accepted that a dealer or investor in stocks or shares can enter in
to hedging transactions outside his holdings. By this interpretation, transactio
ns in index futures will not be covered under the definition of hedging .
Speculation loss, if any carried forward from earlier years, could first be adju
sted against speculation profits of the particular year before allowing any othe
r loss to be adjusted against those profits.
Deemed Speculation
As per Explanation to Section 73, where any part of the business of a company co
nsists in the purchase and sale of shares of other companies, such company shall
, for the purposes of this Section, be deemed to be carrying on a speculation bu
siness to the extent to which the business consists of purchase and sale of such
shares.
The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The
important provisions of this Circular are summarised below:
Company whose Gross Total Income consists mainly of Income chargeable under the
heads Interest on Securities, Income from House Property, Capital Gains and Inco
me from Other Sources
Company whose principal business is Banking
Company whose principal business is granting of loans and advances
Most brokers and dealers are currently caught within the mischief of this Explan
ation, especially after the wave of corporatisation of brokers businesses.
The Explanation however does not cover index futures.
Possibility of Speculation treatment
In view of the above provisions, it appears that the possibility of the Income T
ax department treating index futures transactions to be speculative and taxed ac
cordingly, is high as far as assessees carrying on business are concerned, unles
s a clarification is issued by the Central Board of Direct Taxes.
Another possible view (as far as non-business assessees are concerned) could be
that gains and losses from index futures be treated as short term capital gains.
This view can gain support from the fact that such assessees are not covered wi
thin the ambit of Sections 43 and 73 referred to above.
Possible Arguments :
It is possible to argue that index futures transactions are not speculative tran
sactions. Some lines of argument are explored below.
Section 43(5) speaks of purchase and sale of any commodity , including shares and s
tocks. Index futures are not commodities . Further, index futures are also not stock
s and shares . Hence, section 43(5) does not apply to futures transactions. The qu
estion of examining the provisos (exceptions) does not arise.
Exceptions to speculative transactions as provided in Section 43(5) also include h
edging transactions undertaken in respect of stocks and shares. Proviso (b) to S
ection 43(5) sates a contract in respect of stocks and shares entered into by a d
ealer or investor therein to guard against loss in his holdings of stocks and sh
ares through price fluctuations . It however remains to be seen whether index futu
res can be covered under stocks and shares .
To our mind, it appears that if index futures are considered to be part of stock
s and shares as per the wording of Section 43(5), then the proviso will also bec
ome applicable and hence hedging contracts through the mechanism of index future
s will not be considered speculative. On the other hand, if index futures are no
t part of stocks and shares, then neither Section 43(5) nor the proviso apply an
d hence the entire gamut of index futures transactions will remain out of the pu
rview of speculative transactions.
Explanation to Section 73 speaks of purchase and sale of shares of other compani
es. Index futures are not shares . Hence, this Explanation does not apply to future
s transactions.
It is believed and understood that foreign exchange forward transactions are cur
rently not being caught within the mischief of Sections 43 and 73. This lends mo
re comfort to the possibility of index futures also being left out of this net,
though only experience will indicate the stand the Income tax department will ta
ke.
Other Possible Controversies:
The Income tax department may take a stand that profits and losses accrue on a d
ay to day basis, in view of the daily settlement procedure. This could be contra
ry to the accounting guidelines, which (as it currently appears) may advocate pr
ofit (loss) recognition at the expiry of the contract.
It appears currently that accounting guidelines will require recognition of unre
alised losses at financial year end, but not unrealised profits. The Income tax
department may not agree with this conservative treatment
APPENDICES
Section 43(5)
Section 73
Section 28 - Explanation
Circular No 23 dated 12th September 1960
APPENDIX 1
INCOME TAX ACT, 1961
Section 43 (5)1
Speculative transaction means a transaction in which a contract for the purchase o
r sale of any commodity, including stocks and shares, is periodically or ultimat
ely settled otherwise than by the actual delivery or transfer of the commodity o
r scrips:
Provided that for the purpose of this clause:
a contract in respect of raw materials or merchandise entered into by a person i
n the course of his manufacturing or merchanting business to guard loss against
loss through future price fluctuations in respect of his contracts for actual de
livery of goods manufactured by him or merchandise sold by him; or

a contract in respect of stocks and shares entered into by a dealer or investor

therein to guard against loss in his holdings of stocks and shares through price
fluctuations; or

a contract entered into by a member of a forward market or a stock exchange in t

he course of any transaction in the nature of jobbing or arbitrage to guard agai
nst loss which may arise in the ordinary course of his business as such member
APPENDIX 2
INCOME TAX ACT, 1961
SECTION 73 Losses in speculation business
Any loss, computed in respect of a speculation business carried on by the assess
ee, shall not be set off except against profits and gains, if any, of another sp
eculation business.
Where for any assessment year any loss computed in respect of a speculation busi
ness has not been wholly set off under sub-section (1), so much of the loss as i
s not so set off or the whole loss where the assessee had no income from any oth
er speculation business, shall, subject to the other provisions of this chapter,
be carried forward to the following assessment year,and:

it shall be set off against the profit and gains, if any, of any speculation bus
iness carried forward to the following assessment year; and
if the loss cannot be wholly set off, the amount of the loss not so set off shal
l be carried forward to the following assessment year and so on.
In respect of allowance on account of depreciation or capital expenditure on sci
entific research, the provisions of sub-section (2) of section 72 shall apply in
relation to speculation business as they apply in relation to any other busines
s.
No loss shall be carried forward under this section for more than eight assessme
nt years immediately succeeding the assessment year for which the loss was first
 computed.
Explanation. Where any part of the business of a company (other than a company w
hose gross total income consists mainly of income which is chargeable under the
heads Interest on securities , Income from house property , Capital gains and Income f
other sources or a company the principal business of which is the business of ba
nking or the granting of loans and advances) consists in the purchase and sale o
f shares of other companies, such company shall, for the purposes of this sectio
n, be deemed to be carrying on a speculation business to the extent to which the
business consists of the purchase and sale of such shares.
APPENDIX 3
Section 28
Explanation 2 Where speculative transactions carried on by an assessee are of su
ch a nature as to constitute a business, the business (hereinafter referred to a
s speculation business ) shall be deemed to be distinct and separate from any other
business.
APPENDIX 4
Central Board of Revenue
Circular No. 23(XXXIX) of 1960
Dated 12th September 1960
A number of representations and suggestions have been received by the Board from
associations and chambers of commerce regarding the manner in which the provisi
ons of section 24 of the Income-tax Act, particularly those of explanation 2 to
sub-section (1) thereof, are being interpreted and applied by the Income-tax off
icers. The Direct Taxes Administration Enquiry Committee have also made a few su
ggestions on this subject in chapter III of their Report. The board have careful
ly considered the points involved. Those points and their decisions thereon are
given below :
Point (i) Under clause (a) of the proviso to Explanation 2 to section 24(1) of t
he Income-tax Act 1922, the Income-tax Officers exclude from the category of spe
culative transactions only a hedging purchase transaction entered into with refere
nce to specific contracts for sale of goods but do not exclude a hedging sale tran
saction made against stocks in hand or against contracts for purchase of ready g
oods. The latter type of transactions are also genuine hedging transactions and
should be excluded from the category of speculative transactions so that any los
ses sustained therein will be allowed to be set off against other income.
Board s decision The intention has always been that where bonafide forward sales a
re entered into with a view to guarding against the risk of raw materials or mer
chandise in stock falling in value, the losses arising as a result of such forwa
rd sales should not be treated as speculation losses. Accordingly, Income-tax Of
ficers should not treat such transactions as speculative transactions within the
meaning of Explanation 2 to Section 24(1). It is to be noted in this connection
that hedging sales can be taken to be genuine only to the extent the total of s
uch transactions does not exceed the total stocks of raw materials or merchandis
e in hand. If the forward sales exceed the ready stock, the loss arising from th
e excess transactions should be treated as loss arising from speculative transac
tions and not from genuine hedging transactions.
Point (ii) Hedging transactions in connected, though not the same, commodities s
hould not be treated as speculative transactions
Board s decision The Board accepted this point. Attention is invited to Board s lett
er No. 13(102) IT/53 dated September 8, 1954, in which it was stated that as reg
ards hedging in raw materials, the Income-tax Officers should not be particular
about the quantities and timing so long as the transactions constitute genuine h
edging. Similarly, Income-tax officers should not treat genuine transactions in
connected commodities as speculative transactions though the transactions may no
t be in identically the same commodity. Thus, hedging transactions in one type o
f cotton against another type of cotton, one variety of oil seed against another
, one type of grain against another, should not be treated as speculative transa
ctions provided the other conditions of Explanation 2 to section 24 are satisfie
d. The conditions mentioned in last two sentences of the decision on point (i) a
bove will apply here also.
Point (iii) Where a transaction contemplating actual delivery is ultimately sett
led (wholly or partially) by paying differences and without actual delivery due
to any reasons and where there was no intention to speculate, the transaction sh
ould be excluded from the purview of speculative transactions
Board s decision The Board are unable to accept this suggestion as a general rule.
It is already provided that if on the facts of any case it can be demonstrated
that the forward transaction has been entered into only for safeguarding against
loss through future price fluctuations, such a transaction should not be treate
d as a speculative transaction but as a case of hedging. However, the case of a
bonafide ready delivery contract being settled by delivery to a substantial exte
nt and by payment of difference paid need be treated as a loss arising in a spec
ulative transaction.
Point (iv) Bonafide hedging transactions by a dealer or investors on shares shou
ld be allowed provided that the hedging transactions are up to the amount of his
holdings even though these transactions may extend to other types of shares not
held by him.
Board s decision The Board are unable to accept this suggestion. It cannot be acce
pted that a dealer or investor in stocks or shares can enter into hedging transa
ctions in scrips outside his holding. The materials words in clause (b) of the p
roviso to Explanation 2 to section 24(1) are to guard against loss in his holding
s of stocks and shares through price fluctuations Therefore, hedging transactions
having reasonable relations to the value and volume of the dealer s or the invest
or s holdings are expected from the ambit of speculative transactions; but transac
tions in scrips outside his holding are not.
Point (v) Speculation loss, if any carried forward from the earlier years or the
speculation loss, if any in a year should first be adjusted against speculation
profits of the particular year before allowing any other loss to be adjusted ag
ainst those profits.
Board s decision The suggestion is accepted. For the purpose of set-off under sect
ion 10 and section 24(1) (of the 1922 Act) the speculation loss of any year shou
ld be first set-off against the speculation profits of that year and the remaini
ng amount of speculation profits, if any, should then be utilised for setting of
f of any loss of that year from other sources. For the purpose of section 24(2)
(of the 1922 Act) the Income-tax Officer may allow the assessee:

(i) either to first set off the speculation losses carried forward from an e
arlier year against the speculation profits of the current year and then set off
the current year s losses from other sources against the remaining part, if any,
of the current year s speculation profits,
or to first set off the current year s losses from non-specculation business and o
ther sources against the current year s speculation profit and then to set off the
carried forward speculation losses of the earlier year against the remaining pa
rt, if any of the current year s speculation profit, whichever is advantageous to
the assessee.

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Certain issues have been raised with regard to the foreign currency derivative e
xposures of various corporates that are not being fully accounted for. These exp
osures may translate into heavy losses due to fluctuations in the foreign exchan
ge rates. The matter was considered by the Council of the ICAI at its meeting he
ld on March 27-29, 2008. The Council decided to clarify the best practice treatm
ent to be followed for all derivatives, which is contained in the following para
graphs.

It may be noted that although the ICAI has issued AS 30, Financial Instruments:
Recognition and Measurement, which contains accounting for derivatives, it becom
es recommendatory from 1.04.2009 and mandatory from 1.04.2011. In this scenario,
the Council expressed the view that since the aforesaid Standard contains appro
priate accounting for derivatives, the same can be followed by the entities, as
the earlier adoption of a standard is always encouraged.

In case an entity does not follow AS 30, the entity should mark-to-market all th
e outstanding derivative contracts on the balance sheet date. The resulting mark
-to-market losses should be provided for keeping in view the principle of pruden
ce as enunciated in AS 1, Disclosure of Accounting Policies.

The entity needs to disclose the policy followed with regard to accounting for d
erivatives in its financial statements.
In case AS 30 is followed by the entity, a disclosure of the amounts recognised
in the financial statements should be made.
In case AS 30 is not followed, the losses provided for as suggested in paragraph
3 above should be separately disclosed by the entity.

The auditors should consider making appropriate disclosures in their reports if

the aforesaid accounting treatment and disclosures are not made.

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