Accounting for Futures Contracts

Accounting for Futures Contracts

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Accounting for Futures Contracts

 

 

AuthorAccounting for Futures Contracts

 CA. Rahul Lodaya

 

 


 

 

Attraction is what has brought a large number of retail investors to the market. And why wouldn’t they? The easiest way to make quick money right? Not as easy as it sounds. And so is the way books of account are kept for transactions executed at the F&O market. In this write-up, I have tried to simplify the accounting that can be done from a derivative trading perspective.
EXPLANATORY NOTES –
If there is anything that is the simplest in the derivative market, it has to be the futures. Yet, they bring their own set of complications. A futures transaction is based upon margins.
The types of margins include two broad categories
  1. Initial Margin
  2. Mark to Market Margin (M2M)
Initial margin is the margin paid at the inception of entering into a futures contract, whether buy or sell. Initial Margin comprises of SPAN margin & Exposure Margin.
SPAN Margin is also called VaR Margin based on the concept of Value at Risk. That is the reason it is a rule the “Lower the volatility, Lower the SPAN & vice versa”
 (SPAN – Standard Portfolio analysis of Risk)
Exposure Margin is like the cushion margin that has been availed over & above the SPAN margin, as a protection against broker’s liability. For index futures, the exposure margin is 3%. For others, it is 5% or 1.5 times the standard deviation, whichever is higher.
Mark to Market Margin is the margin payable till the futures position is open. The broker calls for a marking to the position and asks the client to bring in an extra amount of margin based on the movement of the price that has occurred due to the profit/loss that he has incurred.
SYSTEMS SETUP –
Ledgers to be created in the Books
Account Name
Head of Account
Broker’s Account
Current Asset
Bank Account
Current Asset
Brokerage & Other Charges
Direct Expenses
Futures Turnover Account
Sales Account
Margin Account
Current Asset
ACCOUNTING FOR FUTURES CONTRACTS –
Considering an example of two trades taken on Futures
Trade No 1 – Reliance Futures – Long at 2484.70 & Exit at 2504.70 – Lot Size 250 units per contract. This contract has fetched a gross gain of Rs 5000. The accounting treatment for this transaction along with the necessary journal entries are given below
Journal entries
Debit Account
 
Credit Account
Reason
Amount
Broker A/c
Bank A/c
Deposit funds
2,00,000
Margin A/c
Broker A/c
Trade entry
1,39,189
Margin A/c
Futures Turnover A/c
Book Gain on exit
5,000
Broker A/c
Margin A/c
Trade Exit
1,44,189
Brokerage A/c
Broker A/c
Charges
100
Assumption – Bank has an overdraft currently operating at a balance of Rs.0.
Effects
Broker Account – 2,00,000 – 1,39,189 +1,44,189 – 100 = Rs 2,04, 900
Bank Account – Rs 2,00,000 withdrawn
Margin Account – Closed on trade square off
Futures Turnover – Rs 5,000
Brokerage – Rs 100
Gross Profit – Rs 4,900
Structure of Balance Sheet after first trade (extract only)
Liabilities
Rs
Assets
Rs
Profit & Loss
4,900
Bank
(2,00,000)
Broker
2,04,900
Margin
NIL
Total
4,900
Total
4,900
Trade No 2 – Indian Oil Corporation Limited Futures – Short at 120.70. Lot size – 6500 units per contract. Trade position – Open as on 31-3-22, future trading at 124.70. This trade has an unrealized loss of Rs 26,000 & the broker has triggered an M2M margin for the same amount.
The accounting for the same would be
Journal Entries
Debit Account
 
Credit Account
Reason
Amount
Margin A/c
Broker A/c
Trade entry
1,69,144
Futures Turnover A/c
Margin A/c
Book Loss on exit
26,000
Margin A/c
Broker A/c
M2M Margin
26,000
Effects after Trade 1 & 2
Broker Account –2,04, 900 – 1,69,144 – 26,000  = Rs 9,756
Bank Account – Rs 2,00,000 withdrawn
Margin Account – 1,69,144 – 26,000 + 26,000 = Rs 1,69,144
Futures Turnover – 5,000 – 26,000 = (Rs 21,000)
Gross Profit – 4,900 – 26,000 = (Rs 21,100)
Structure of Balance Sheet after first & second trade (extract only)
Liabilities
Rs
Assets
Rs
Profit & Loss
(21,100)
Bank
(2,00,000)
Broker
9,756
Margin
1,69,144
Total
(21,100)
Total
(21,100)
Imagine that as on 03-04-2022, the price of futures fell to Rs 118.70 & the trade was squared off. The profit of the transaction was now booked at 13000.
The accounting for the same would be as under
Journal Entries
Debit Account
 
Credit Account
Reason
Amount
Margin A/c
Futures Turnover A/c
Book Gain on exit
39,000
Broker A/c
Margin A/c
Trade Exit
2,08,144
Brokerage A/c
Broker A/c
Charges
100
Effects after Trade 1 & 2
Broker Account – 9,756 + 1,69,144 + 39000 – 100 = Rs 2,17,800
Bank Account – Rs 2,00,000 withdrawn
Margin Account – closed on trade square off
Futures Turnover – – 21,000 + 39,000 = Rs 18,000
Brokerage – Rs 100
Gross Profit – 4,900 + 12,900 = Rs 17, 800
Structure of Balance Sheet after first & second trade (extract only)
Liabilities
Rs
Assets
Rs
Profit & Loss
17,800
Bank
(2,00,000)
Broker
2,17,800
Margin
Total
(21,100)
Total
(21,100)
EASE OF COMPLIANCE –
How to arrive at the futures turnover for Income Tax purposes?
The guidance note on tax audit quotes that the turnover shall be the sum of absolute profits & absolute losses.
However, in the calculation of turnover, one has to be quite skeptical of the open positions that can be visible from transactions occurring between January to March as open positions are ignored for the purpose of calculation of turnover.
Turnover would be found in the futures turnover account as a sum of the debits & credits appearing in that account. However, the reconciliation would be as under as the above illustration shall be taken into consideration for calculating turnover as on 31-03-2022.
Particulars
Amount
Sum of Absolute Debits in Futures Turnover Account
26,000
Sum of Absolute Credits in Futures Turnover Account
5,000
Open Positions – Both Debit & Credit
(26,000)
Turnover from Income Tax Perspective
5,000
The profit would also be reconciled as the Income Tax clearly points that unrealized gains/losses shall not be considered from a taxation point of view. The profit would also stand at Rs 4,900 for 31-03-2022 as the balance is a notional loss.
Why I chose this system of Accounting?
  1. Easily reconstruct trades taken
  2. Keep track of compliances from tax purposes
  3. Can be easily accounted for with broker’s note & need not wait for broker’s reports
  4. Keep track between free funds & funds kept as margin
  5. Also factors in the positions open at a given point of time.
Thank you for patiently going through this article.
I am always open for questions & valuable suggestions.
Article on Accounting for Options, soon to follow!!!

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