For starters, derivatives are financial instruments whose value changes in response to the changes in underlying variables, as Wikipedia defines. The main types of derivatives it lists are futures, forwards, options, and swaps.

The use of derivatives can result in large losses due to the use of leverage, reads a cautionary paragraph that cites major financial disasters such as the Nick Leeson affair in 1994, the bankruptcy of Long-Term Capital Management in 2000, the losses suffered by Amaranth Advisors and Socit Gnrale.

Derivatives allow investors to earn large returns from small movements in the underlying assets price. However, investors could lose large amounts if the price of the underlying moves against them significantly, educates http://en.wikipedia.org.

Recently, ICAI asked auditors to adopt a new accounting norm that forces companies to disclose and/or provide for all losses on derivative contracts. In the eye of the storm is Accounting Standard 30 (AS 30) that was earlier was supposed to be mandatory from April 1, 2011.

The word on the street is that auditors who adopt the standard as per the ICAIs wishes may end up opening the Pandora s Box for Indian companies.

But, what if they do not adopt? Irrespective of whether or not the ICAIs announcement is binding on corporates, the members of the Institute have to certainly take into account the guidance when giving their opinion on the March 31, 2008 financial statements, said Mr Viren H Mehta, Director, Ernst and Young ,in an interaction with Business Line on Sunday afternoon.

The ICAI had originally issued AS 30, Financial Instruments: Recognition and Measurement, which contains accounting for derivatives, to be become recommendatory from 1.04.2009 and mandatory from 1.04.2011. Why this change now?

The ICAIs announcement encouraging early adoption of AS 30 on recognition and measurement is a welcome indication. This step of further integrating with international practices of accounting for financial instruments will promote greater transparency in current turbulent times. Nonetheless, this announcement will be followed by several days of discussions and clarifications as to the timing of this announcement and its enforceability.

So, what does this announcement say?

The announcement mandates that corporates not adopting AS30 need to measure and recognise unrealised losses on financial instruments using the principles of prudence explained in AS1.

As per this principle, known liabilities and losses are required to be provided for, even though the amount cannot be determined with certainty and represent only a best estimate in the light of available information.

What about positions where companies may gain?

Corporates with outstanding financial instruments and not adopting AS30 at March 31, 2008, will need to measure unrealised gains/losses on financial instruments and record only unrealised losses, while ignoring unrealised gains.

Is there a problem with enforceability of the Institutes pronouncement?

The ambiguity surrounding the enforceability emanates from the fact, that the announcement is not part of any accounting standard or interpretation that is adopted as law.

Currently, corporates prepare financial statements using accounting standards that are notified as law by the Companies (Accounting Standards) Rules 2006. They may need more clarity if they need to recognise unrealised losses on financial instruments, in case they do not early adopt AS30.