Accounting and Taxation — the books and the tax return

Two separate subjects in one chapter

The first half is accounting — what entries go into the books. The second half is taxation — what the Income Tax Act does with your profit. They are examined separately, so learn them separately.

This chapter carries 5% of the paper.

Forward contracts under AS-11

The treatment splits by purpose, which is the whole point.

When the forward contract is for hedging:

• The premium or discount — the difference between the value at spot rate and forward rate — should be amortised over the life of the contract
• The exchange difference — between the value at settlement or reporting date and the value at the previous reporting date or inception — is recognised in the Profit and Loss statement of the year
• Profit or loss on cancellation or renewal is recognised in the P&L of the year

When the forward contract is for trading or speculation:

• No premium or discount is recognised
• A gain or loss — the difference between the contract or previous year-end valuation rate and the forward rate available at year end for the remaining maturity — is recognised in the P&L of the period
• Profit or loss on cancellation or renewal is recognised in the P&L of the year

The distinction to carry: hedging amortises the premium; speculation does not recognise it at all.

Futures in the client's books

The Institute of Chartered Accountants of India (ICAI) issued the guidance notes. Note who they are aimed at: parties who enter into futures contracts as buyers or sellers. For brokers, trading members, clearing members and clearing corporations, a trade in equity index futures is similar to a trade in shares and poses no peculiar accounting problems.

At inception — initial margin only

Every client pays initial margin determined by the Clearing Corporation. This is debited to "Initial Margin — Equity Index/Equity Stock Futures Account", and additional margins are accounted for the same way.

Here is the point most candidates miss:

A futures contract costs nothing to enter. There is no asset to record — only the margin deposited.

At the balance sheet date the balance in that account is shown separately. Anything paid in excess of initial or additional margin is disclosed separately as a deposit under Current Assets. Where the client lodges bank guarantees or securities instead of cash, a disclosure is made in the notes to the financial statements — this requires no accounting entry.

Daily settlement — the MTM account

Payments made or received on daily settlement are debited or credited to "Mark-to-Market Margin — Equity Index/Equity Stock Futures Account". It may be maintained index-wise or stock-wise so as to facilitate calculation of provision for loss.

At the balance sheet date — prudence in action

This is the highest-yield idea in the accounting half:

Losses you have not yet crystallised are provided for. Profits you have not yet crystallised are not counted. That asymmetry is the prudence principle.

Presentation follows from it: the debit balance goes under "Current Assets, Loans and Advances" with the provision shown as a deduction from it; the credit balance goes under "Current Liabilities and Provisions".

Provision is calculated index-wise or stock-wise, meaning all series of a stock are combined.

At final settlement or squaring up

Profit or loss is the difference between the final settlement price and the contract prices of all contracts in the series, recognised in the P&L by a corresponding debit or credit to the Mark-to-Market Margin Account. The same treatment applies when a contract is squared up by entering into a reverse contract.

Where more than one contract in the series is outstanding at the time of squaring up, the contract price of the squared-up contract is determined using the weighted average method.

On settlement, the initial margin is released — credit Initial Margin Account, debit bank or deposit.

On default

When a client defaults on daily settlement, the contract is closed out. The unpaid amount is adjusted against the initial margin; excess margin is released and any shortfall is payable by the client.

Options in the client's books

The two sides record different things at inception:

Provisions on open options — prudence again, mirrored

In the books of the buyer/holder: provide for the amount by which the premium PAID exceeds the premium prevailing on the balance sheet date — because the buyer can reduce his loss to the extent of the premium prevailing in the market, by squaring off. The excess of market premium over premium paid is NOT recognised, on the consideration of prudence.

In the books of the seller/writer: provide for the amount by which the premium prevailing on the balance sheet date exceeds the premium received. Again, the excess of premium received over the premium prevailing is not recognised.

Both directions provide for the adverse movement and ignore the favourable one.

With multiple open options, provision is made stock-wise or index-wise, taking together all open options of any strike price and any expiry date under that stock or index. Profit and loss on bought and sold positions of each stock are adjusted; if the net result is a loss, provide; if a gain, ignore it.

At final settlement

Buyer/holder: recognises the premium as an expense; on exercise, receives the favourable difference between final settlement price and strike price, recognised as income.

Seller/writer: recognises the premium as income; on exercise, pays the adverse difference, recognised as a loss. As soon as an option is exercised, the margin paid is released by the exchange.

Delivery-settled stock options

Entries at inception, margin and balance sheet date are the same as for cash-settled options. If the option expires unexercised, the treatment is also the same. If exercised, shares move against cash at the strike price:

And in addition, the premium paid or received is transferred to the profit and loss account, exactly as for cash-settled options.

Equity stock options settled in cash are accounted for exactly as equity index options, because in both cases settlement is done otherwise than by delivery of the underlying.

Taxation — the 2005 change that mattered

Gains or losses from derivatives transactions on exchanges are taxable under the head "Profits and Gains from Business or Profession".

Business income is either speculative or non-speculative, and loss from a speculative business can only be set off against gains from a speculative business.

Before Financial Year 2005–06, derivatives were treated as speculative. Section 43(5) defined a speculative transaction as one periodically or ultimately settled otherwise than by actual delivery — which describes almost every derivatives trade. The consequence was harsh: loss on derivatives could be set off only against other speculative income, which meant higher taxes.

So today:

• Derivatives income or loss on a recognised exchange is not speculative
• Loss can be set off against any other income during the year — except salary income
• Unabsorbed loss can be carried forward for 8 assessment years, and then set off only against non-speculative business income of the subsequent year
• The right to carry forward and set off exists only if the return of income was filed on or before the due date
• Securities transaction tax paid on such transactions is eligible as a deduction under the Income Tax Act, 1961

That filing-deadline condition is worth telling clients. A late return forfeits years of accumulated loss relief.

FPIs are treated differently

For Foreign Portfolio Investors, gains or losses from derivatives on a recognised stock exchange are taxable under the head "Capital Gains". And since most exchange-traded derivatives contracts have a maturity up to 3 months, those gains are generally short-term capital gains.

Same trade, same exchange, different head of income depending on who you are.

Presumptive taxation and tax audit

Income from F&O can be offered either under the normal scheme or under the presumptive scheme of Section 44AD, if total turnover does not exceed ₹2 crore. Under the presumptive scheme, gains are assessed at 6% of turnover, without allowing any deduction for expenses.

Securities Transaction Tax on derivatives

STT is levied on every purchase and sale of securities listed on Indian exchanges, covering equity, derivatives and equity oriented mutual funds. For derivatives, the exchange collects the STT and remits it to the Government.

Rates effective from 1 April 2026:

Note the switch on the second row: on exercise, it is the purchaser who pays.

What the tax is charged on:

• Sale of an option → the option premium
• Sale of an option where exercised → the settlement price

Physical settlement is different. Where a derivative contract is settled by physical delivery of shares, the transaction resembles a delivery-based equity trade, so the delivery-based equity STT rate applies — 0.1%, payable by BOTH the seller and the purchaser.

How exchanges apply it:

• STT is applicable on all sell transactions for both futures and option contracts
• Each futures trade is valued at the actual traded price; each option trade at premium
• On voluntary or final exercise, STT is levied on the settlement price on the day of exercise — if the option contract is in the money
• STT payable by the clearing member is the sum total of STT payable by all trading members clearing under him, and a trading member's liability is the aggregate liability of clients trading through him