Accounting for Investments – Volume 1

Accounting for Investments  Volume 1 attempts to give an exhaustive treatment of various accounting entries that should be recorded by any entity holding any financial instrument. Over the past two decades there have been several innovative financial instruments from the ‘Street’ that calls for special treatment from the accounting, legal and regulatory perspective. The accounting requirements are constantly being monitored and enhanced by the regulators and standard setters to provide more transparency in recording and reporting of these financial products. The book is written from the practical angle and is meant to cater to the needs of those accountants as a handbook. The first volume covers equity, futures, options, ADRs. It also covers the hedge accounting treatment for written options.

This book assumes that the reader already has basic accounting knowledge. Those who are entirely new to the field of accounting should refer to some basic accounting book before attempting to use this book. However Appendix A gives an overview of the basic accounting principles and concepts.

The entire trade life cycle of each financial instrument is covered in detail with the accounting entries that should be recorded. For each illustration, the journal entries, general ledger accounts, trail balance, income statement and balance sheet is presented to give a complete understanding of the accounting treatment. Also for all calculated numbers the details of such calculations are given.

With the spurt in the investment banking institutions, hedge funds and several other financial institutions, the need for automating the entire trading process assumes great importance. This becomes absolutely essential as the front office before the beginning of a trading day should have the positions of the various financial instruments held by the entity with the flexibility to have detailed break up of cost etc. Technology has enabled all this possible today at the touch of a button and the technology experts are much sought after to do the needful for these financial institutions. However the technology experts in spite of having the domain knowledge in financial products some times feel the necessity to have an in depth understanding of the entire trade life cycle with the accounting treatment that goes with it. This book proposes to fill that knowledge gap of these aspiring technology wizards.

An overview of the trade life cycle for each financial instrument is given. However the readers are advised to refer other resources for a detailed treatment on the trade life cycle from the front office and middle office perspective. The trade life cycle in so far as it relates to the back office viz., the accounting aspects are covered in detail with appropriate reference to the GAAP requirements. For each financial instrument, the relevant accounting standards that are applicable are given and a comparative chart showing the similarities and differences between the US GAAP and IFRS is given. The first volume covers broadly the equity, equity option and equity futures. Subsequent volumes would cover the other financial instruments.

Chapter arrangement

Chapter 1 Accounting for Trading

Equity Accounting for Trading – This chapter covers the accounting for equity shares held for trading purposes. After defining equity investment as per the accounting standards, the different types of investments viz., – passive investments and investments commanding significant influence as well as controlling interest is discussed. The broad classification of trading and available-for-sale is given. The brief distinction between exchange traded securities and over the counter securities is analyzed giving an overview of the functions of a stock exchange and the functioning of a stock exchange. The trade life cycle for equity shares held as trading securities is given with the accounting entries to be passed at the various stages.

The differences between trade date accounting and settlement date accounting is explained giving the behavior of held for trading and available for sale securities on trade date, reporting date and settlement date for various parameters like the financial asset, the liability as well as the changes in the fair value to the financial asset.

Worked out illustration covers equity shares in the functional currency of USD that are held for trading purposes.

Distinction between FX revaluation and FX translation is given in great detail along with the explanation of functional currency, presentation currency, trade currency and the requirements of accounting standards in this regard. Another worked out illustration covers equity shares in trade currency of JPY with the functional currency of USD explaining the FX revaluation and FX translation processes.

The two major accounting standards viz., – US GAAP and IFRS is discussed giving the hierarchy of both and the measures taken towards the convergence of both the standards.

Chapter 2 Accounting for AFS

Equity Accounting for AFS – This chapter covers the accounting for equity shares that are held as available for sale. The trade life cycle for equity shares classified as available for sale securities is given with the accounting entries to be passed at the various stages. Worked out illustration covers equity shares in the functional currency of USD held as available for sale. One more illustration is given on trade currency with FX translation into the functional currency of USD.

Chapter 3 – Accounting disclosures

Equity Accounting Disclosures – This chapter covers the transfers between trading securities to available for sale securities and vice versa. Also the presentation in Income statement when there is an impairment of securities as well as realized and unrealized gains or losses is treated. When a category change happens it also impacts the deferred tax on unrealized gain/loss and this is explained with an illustration.

The similarities and differences between US GAAP and IFRS in so far as it relates to equity investments is given in tabular form under various topics like definition, recognition, valuation, impairment, reclassification and so on. The disclosure requirements of both the accounting standards are given at the end of the chapter.

Chapter 4 – Equity Futures Theory

Equity Futures Theory – This chapter covers the distinction between a forward contract and a futures contract is explained discussing the essential components of a future contract. The subtle differences between hedging, speculation and arbitrage are discussed. The limitations of forward market and the advantages of futures contract are discussed.

Open interest in derivatives contract, the method computing the same and the implications of a change in open interest is elaborately discussed. Pricing of a futures contract and the cost of carry is analyzed.

Chapter 5 – Equity Index Futures

Equity Index Futures – This chapter covers the accounting requirements for equity index futures contracts. The salient features of a stock index and index futures are discussed with special reference to systematic and unsystematic risks. The trade life cycle for equity index futures is given with the accounting entries to be passed at the various stages.

Worked out illustration covers exhaustively equity index futures – both in trade currency other than USD and in the functional currency of USD.

Chapter 6 – Equity Stock Futures

Equity Stock Futures – This chapter covers the accounting requirements for equity stock futures contracts. The trade life cycle for equity stock futures is given with the accounting entries to be passed at the various stages.

Worked out illustration covers exhaustively equity stock futures – both in trade currency other than USD and in the functional currency of USD.

Chapter 7 – Equity Options Theory

Equity Options Theory – This chapter covers the theory behind the equity options. Derivative contract and options contracts are defined and the essential components of an equity options contract are analyzed. Strike price, expiration date, expiration cycle and the status of the option regarding the moneyness is discussed.

The main factors affecting the pricing of an option viz., – price of the underlying, strike price, time to expiry, rate of interest and volatility – are discussed elaborately. In volatility, the distinction between the historical and implied volatility along with the factors that influence the implied volatility is discussed.

The ‘Greeks’ in option pricing is discussed in great detail. The Black-Scholes model of option pricing as well as the binomial pricing model, its advantages and limitations are discussed.

Chapter 8 – Equity Call Options

Equity Call Options – This chapter covers the accounting requirements for exchange traded equity call options. The trade life cycle for equity long call options is given with the accounting entries to be passed at the various stages. This chapter covers only if the call option is held as a speculative position and not as a hedge against the underlying shares. Worked out illustration covers exhaustively equity long call options – both in trade currency other than USD and in the functional currency of USD.

The trade life cycle for equity short call options is also covered in this chapter with the accounting entries to be passed at the various stages. The worked out illustration covers exhaustively the treatment of equity short call options in USD.

Chapter 9 – Equity Put Options

Equity Put Options – This chapter covers the accounting requirements for exchange traded equity put options. The trade life cycle for equity long put options is given with the accounting entries to be passed at the various stages. This chapter covers only if the put option is held as a speculative position and not as a hedge against the underlying shares. Worked out illustration covers exhaustively equity long put options – both in trade currency other than USD and in the functional currency of USD.

The trade life cycle for equity short put options is also covered in this chapter with the accounting entries to be passed at the various stages. The worked out illustration covers exhaustively the treatment of equity short put options in USD.

Chapter 10 – Options HedgeAccounting

Equity Options – hedge accounting – This chapter covers the accounting for equity options that are held as a hedge against an underlying share. The definition of derivative, financial asset and financial liability as per the accounting standards is discussed. The similarities and differences between the US GAAP and IFRS in so far as it relates to derivatives and hedge accounting is discussed elaborately under the various topics like definition, initial measurement, subsequent measurement, changes in the fair value of derivative instrument, and hedge accounting criteria. The salient features of FAS 133 is covered in great detail as also the specific features of the standard in so far as it relates to options is covered. A table illustrates as to when hedge accounting is permissible as far as options are concerned.

The trade life cycle for long equity options is covered in this chapter with the accounting entries to be passed at the various stages. The worked out illustration covers exhaustively the treatment of equity put options in USD that are purchased as a hedging instrument against an underlying share.

Chapter 11 – Contract for Difference

Contract For Difference – This chapter covers the accounting requirements for contract for difference contracts. Definition and product features of CFD are covered including the concepts of margin, funding cost, interest on clear margin and so on. The advantages and disadvantages of CFD as an investment instrument is analyzed. The method of terminating CFD and its effects are also discussed.

The trade life cycle for CFD contracts is given with the accounting entries to be passed at the various stages. Worked out illustration covers exhaustively equity stock futures – both in trade currency other than USD and in the functional currency of USD.

Chapter 12 – Equity Short Selling

Accounting for Equity – Short selling and stock lending – This chapter covers the accounting requirements for short selling including the requirements for a box position where both the long and short positions are maintained by the investor. Typically this practice is resorted to by the hedge funds. Since there are some regulatory issues on short selling, the investor will do well to comply with the laws of the land whenever short positions are taken. The custodian also ensures to keep the long and short positions separately for the investor to facilitate position reconciliation and accounting. The stock lending which is intertwined with the short position trading is also dealt with in this chapter especially the requirements and accounting treatment of cash collateral deposited with the broker as well as the stock lending fee payments and the interest receipts relating to the cash collaterals with the broker.

Chapter 13 – Accounting for ADR/GDR

Accountings for ADR/GDR – International Depositary Receipts are becoming increasingly popular and this chapter covers the accounting treatment of ADRs. The investor usually holds position of the same stock in both the local exchange as well as in ADRs. The stock is sold at a convenient time in the local stock exchange and to that extent the ADRs are converted into the local equity shares incurring conversion charges. This chapter illustrates how the cost of such conversion is arrived at and how the profit on liquidation is computed and accounted.

Appendix A – Basics of Accounting Theory

Basics of Accounting Theory – This appendix gives an overview of the basics of accounting theory covering the basic assumptions underlying the accounting frame work. This also discusses the basic accounting concepts and the basic principles of accounting. The accounting model and the elements of basic reporting is also discussed with reference to the concept statement No. 6 of US GAAP.

Key Features & approach

This book proposes to cover the domain knowledge as well as the accounting treatment for the various financial products.  This should be a good addition to the literature of books that deal exclusively with the treatment for all financial products handled by financial institutions, banks, hedge funds etc., covering the domain knowledge about the respective financial products and the accounting treatment of the same with special reference to the regulatory requirements.  The one point source of information has been the requirement of the financial services industry for a long time.  This book proposes to serve that requirement. The series of books is aimed at providing a one point reference for this.

Throughout the book the approach has been to give illustrations and show detailed workings of the same. Wherever there is a computed number, the details of such calculations are given even at the cost of being somewhat elaborate for some advanced readers.

Intended Audience

This book is intended for all those who are directly involved in the financial sector in different capacities and roles, which today is one of the largest emerging sectors.  Since this book deals with the domain knowledge of many of the exotic products that have evolved over the last two decades it will be of interest to the accountants and the non-accountants alike to know about the trade life cycle of these products.

For an advanced user, the book is expected to provide the depth while for a novice this book starts from the fundamentals.  This book is expected to cater to the needs of an expert and a novice.  This series of books starts from the basics for any financial product, defining the product, the way it is structured, the advantages and disadvantages, the different events in the trade cycle and then discusses accounting journal entries that are passed for the same.  Also this book shows how the entries get reflected in the general ledger accounts, so as a give a macro level picture for the reader to understand the basics of the effect of such accounting.  Last but not the least in importance is the presentation of the results in the final accounts viz., the income statement and balance sheet is also well covered in this book. Thus this series of books is expected to be extremely useful to an expert as well as a novice, not to mention the ever increasing tech consultants who are in great need of such a book.

Foreword Sri T N Manoharan

Sri. CA T. N. Manoharan, Past President,

Institute of Chartered Accountants of India

Accounting for Financial Instruments is a complex exercise in view of the varied kind of instruments that are emerging in the market in the recent past. The flow of funds across the borders in the form of financial instruments is ever increasing in the global scenario. Equity, Futures and Options have trade life cycle and accounting treatment on such life cycle from the front office and back office perspectives call for detailed elucidation. Hardly there is any book that provides guidance on these matters. This book is a commendable effort to fill the knowledge gap that exists in the accounting of financial instruments.

International Financial Reporting Standards (IFRS) encompassing IAS 32, IAS 39 and IFRS 7 deals with the principles involved in recognition, measurement, disclosures and presentation of financial instruments. The Institute of Chartered Accountants of India (ICAI) has come out with corresponding Accounting Standards (AS) which are in different stages as on date. AS 30 on ‘Financial Instruments – recognition and measurement’ has been pronounced and is made recommendatory from 01.04.2009 and mandatory from 01.04.2011. Exposure draft has been issued for AS 31 on ‘Financial Instruments – Presentation’ which was published in September 2005 issue of the Chartered Accountant Journal for which re-exposure draft has been published in the January 2007 issue. On ‘Financial instruments – disclosures’, AS 32 Exposure draft is published in December 2007 issue of the Journal. In sum and substance, the Indian Accounting Standards are the same as the IFRS. This book deals with the principles laid down in the IFRS and in relevant places deals with similarities and differences between US GAAP and IFRS. In that sense, one can say without fear of contradiction, that this book is a comprehensive treatise of the title.

Mr.R.Venkata Subramani is a learned person, having immense knowledge and expertise on the matters dealt with in this book. The benefit of his hands on experience and in depth practical exposure is reflected in the illustrations given in the various chapters of this book. With the tremendous growth witnessed in the Investment Banking Institutions, Hedge funds and several other financial institutions, this book will become handy for understanding and capturing the entire trading process of the financial instruments. The author, Mr.R.Venkata Subramani, is also known as a ‘Technology wizard’. Consequently, the lucid exposition that he has adopted would help automating the system of proper accounting of the entire trade cycle of each of the financial instruments.

Investment bankers, financial institutions, dealers, brokers, professionals and other investors would find this book immensely useful in the day-to-day operations, as various concepts unique to the financial instruments are explained in this book besides laying down the accounting treatment in a detailed manner. This book will be a useful addition to any library, which serves as a source of knowledge and information with reference to various financial products dealt with in the market. Mr.R.Venkata Subramani has done a splendid job in authoring this book in order to share wealth of information and knowledge on the subject.

Place: Chennai

Date: 29^th March, 2008                                                T.N. MANOHARAN