THE VALUATION SCHOOL | PARTH VERMA

NISM VIII
EQUITY DERIVATIVES

NOTES
 Parth Verma / The Valuation School

NISM VIII
CHAPTER 9: ACCOUNTING AND TAXATION

Learning Objectives
Accounting treatment for derivatives contracts
Taxation of derivatives transaction in securities

9.1 ACCOUNTING

When the forward contract is for hedging:

Amortize premium or discount (spot vs. forward rate)

over the contract's life.
Recognize exchange differences (settlement/reporting
date vs. previous date) in the year's P&L.
Recognize profit/loss from forward contract
cancellation/renewal in the year's P&L.

When the forward contract is for trading/speculation:

No premium or discount is recognized.

Recognize gain or loss (difference between
contract/previous year-end forward rate and year-
end forward rate) in the P&L for the period.
Recognize profit/loss from forward contract
cancellation/renewal in the year's P&L.
Accounting of Equity index and Equity stock
futures in the books of the client:

The Institute of Chartered Accountants of India (ICAI)

has issued guidance notes on the accounting of index
futures contracts from the viewpoint of parties who
enter into such futures contracts as buyers or sellers.

For other parties like brokers, trading members, clearing

members, and clearing corporations, a trade-in equity
index futures is similar to a trade-in, say shares, and does
not pose any peculiar accounting problems.

IN THIS CHAPTER MAIN FOCUS ON THE BOOKS OF

CLIENTS ONLY

Accounting at the inception of the contract

(Accounting for Initial Margin)

Clients must pay initial margins as per Exchange

regulations when entering equity index/stock futures
contracts, debited to "Initial Margin - Equity Index/Equity
Stock Futures Account".
Additional margins are recorded in the same account.
No accounting entry for the contract itself at inception,
only for the initial margin.

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

At the balance sheet date, initial margin balances are

listed under 'Currency Assets'.
Any payment exceeding the required margins is shown as
a separate deposit under 'Current Assets'.
Non-cash margins (like bank guarantees or securities)
are disclosed in the financial statement notes without an
accounting entry.

THE ACCOUNTING ENTRIES

1. Deposit for Initial Margin Kept:

Deposit for Initial Margin A/c Dr.

To Bank A/c

2. Initial Margin Paid / Adjusted from Deposit

Initial Margin A/c Dr.
To Deposit for Initial Margin A/c

OR if paid directly from the bank:

Initial Margin A/c Dr.
To Bank A/c

3. Initial Margin Returned / Released

Bank A/c Dr.
To Initial Margin A/c
 OR If adjusted from margin account
Deposit for Initial Margin A/c Dr.
To Initial Margin A/c

EXAMPLE:
Mr. Y purchased a Futures Contract on April 10, 2023. The
initial margin required, calculated using SPAN, is ₹60,000.
The subsequent margin requirements are as follows:
April 11, 2023: ₹65,000
April 12, 2023: ₹55,000
April 13, 2023: ₹58,000

SOLUTION:
April 10, 2023:
Mr. Y deposits the initial margin of ₹60,000

Initial Margin – Equity Futures A/c Dr ₹60,000

To Bank A/c ₹60,000
(Being initial margin paid on Equity Futures Contracts)

April 11, 2023:

Initial Margin – Equity Futures A/c Dr ₹5,000
To Bank A/c ₹5,000
(Being additional margin paid to the Exchange)

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

April 12, 2023:

Bank A/c Dr ₹10,000
To Initial Margin – Equity Futures A/c ₹10,000
(Being margin refunded by the Exchange)

April 13, 2023:

Initial Margin – Equity Futures A/c Dr ₹3,000
To Bank A/c ₹3,000
(Being further margin paid to the Exchange)

ACCOUNTING AT THE TIME OF DAILY SETTLEMENT -

PAYMENT/RECEIPT OF MTM MARGIN

MTM Margin Payments/Receipts:

Daily adjustments based on market movement
for futures contracts.
Losses are debited, and gains are credited to the Mark-to-
Market Margin - Equity Index/Stock Futures Account.

Account Maintenance (Index/Stock-wise):

To track provisions for losses accurately, maintain separate
accounts for each stock or index, such as Nifty Futures or
specific stock futures.
 Settlement Methods:
Payments/receipts can be through:
Bank Account (direct payment).
Or from a Deposit for Mark-to-Market Margin
Account (kept with the clearing member or broker).

Year-End Treatment of Deposits:

Any remaining balance in the Deposit for MTM Margin

Account at the year-end is treated as a Current Asset
in the balance sheet.

JOURNAL ENTRIES
1. Deposit for Mark-to-Market Margin Kept:
Deposit for M to M Margin A/c Dr.
To Bank A/c

2. Mark-to-Market Margin Paid/Adjusted from

Deposit:
M to M Margin A/c Dr.
To Bank A/c / Deposit for M to M Margin A/c

3. Mark-to-Market Margin Received:

Bank A/c / Deposit for M to M Margin A/c Dr.
To M to M Margin A/c

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

ACCOUNTING FOR OPEN INTERESTS

AS ON THE BALANCE SHEET DATE

1. Debit/Credit Balance in Mark-to-Market (MTM)

Margin Account:
The debit balance shows the net amount paid (loss), and
the credit balance shows the net amount received (profit)
due to price movements in index or stock futures.

2. Anticipated Loss Provision (Prudence Principle):

If there's a debit balance (loss), create a provision by
debiting the Profit & Loss account to reflect the potential
loss.
If there's a credit balance (profit), ignore it, meaning don't
record it as a profit in the P&L as it's just an anticipated
profit.

3. Presentation in the Balance Sheet:

The debit balance (amount paid to the broker) should be

listed under Current Assets, Loans and Advances. The
provision for the loss should be shown as a deduction
from this amount.
The credit balance (amount received from the broker)
should be listed under Current Liabilities and Provisions.
 4. Index/Stock-Wise Calculation:
The provision for loss should be calculated separately for
each stock or index, combining all series of the same stock.

PROVISION FOR LOSS ON EQUITY

STOCK/INDEX FUTURES

1. If Provision is Increased (Insufficient Provision):

Profit & Loss A/c Dr
To Provision for Loss on Equity Stock/Index Futures A/c

2. If Provision is Decreased (Excess Provision):

Provision for Loss on Equity Stock/Index Futures A/c Dr

To Profit & Loss A/c

Example:
Suppose Mr. B pays ₹3,000 as Mark-to-Market Margin
due to losses on an Equity Futures Contract:

Profit & Loss A/c Dr ₹3,000

To Provision for Loss on Equity Futures A/c ₹3,000
(Provision made for the loss paid due to price movement
in the futures contract)

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

ACCOUNTING AT THE TIME OF FINAL SETTLEMENT

OR SQUARING-UP OF THE CONTRACT

1. Profit/Loss Calculation at Expiry:

When the equity index futures expire, calculate the profit

or loss as the difference between the final settlement
price and the contract price.

2. Recording Profit/Loss:

The profit or loss calculated is recorded in the

Profit & Loss Account with a corresponding
entry in the Mark-to-Market Margin Account.

3. Squaring-up of Contracts:

When a contract is squared-up (closed by entering into

an opposite contract), the same accounting treatment is
applied.

4. Handling Multiple Contracts:

If multiple contracts are outstanding for the same series, use

the weighted average method to calculate the contract
price for determining the profit/loss when squaring up.
 5. Release of Initial Margin:
Once the contract is settled, the initial margin that was paid
is released. Credit the Initial Margin Account and debit the
Bank/Deposit Account.

JOURNAL ENTRIES
1. If Profit on Settlement / Squaring off:

Mark-to-Market Margin A/c Dr

To Profit & Loss A/c

2. If Loss on Settlement / Squaring off:

Profit & Loss A/c Dr

To Mark-to-Market Margin A/c

3. Entry for Release of Initial Margin:

Bank A/c / Deposit for Initial Margin A/c Dr

To Initial Margin A/c

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

ACCOUNTING IN CASE OF DEFAULT:

1. Client Default:

If a client defaults, the contract is closed out.

2. Margin Adjustment:
Unpaid amount is adjusted against the initial margin.
Excess margin is released.
Shortfall must be paid by the client.

3. Accounting:
Profit/loss is calculated and recorded in the Profit & Loss
Account as usual.

DISCLOSURE REQUIREMENTS:

1. Bank Guarantee & Securities:

Disclose bank guarantee, and book/market value of
securities lodged as margin.

2. Open Interest:

Disclose the number of open contracts, units, and

positions (long/short) for each index/stock futures.
ACCOUNTING FOR EQUITY INDEX OPTIONS IN CASE OF
CASH SETTLED OPTIONS

1. For Seller/Writer:

Initial Margin Paid:

Journal Entry:
Equity Index/Stock Option Margin A/c Dr
To Bank A/c
(Initial margin paid for entering the option contract)

The seller deposits a margin to enter the contract, which

is treated as a Current Asset in the balance sheet.

Premium Received:
Journal Entry:
Bank A/c Dr
To Equity Index/Stock Option Premium A/c
(Premium received from buyer for selling the option)

The seller receives the premium as income for selling

the option.

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

2. For Buyer/Holder:

Premium Paid:
Journal Entry:
Equity Index/Stock Option Premium A/c Dr
To Bank A/c
(Premium paid for purchasing the option)

The buyer pays the premium, which is treated as an

expense in their books.

ACCOUNTING AT THE TIME OF

PAYMENT/ RECEIPT OF MARGIN

1. For Seller/Writer - Payment/Receipt of Margin:

Payment of Margin:
Journal Entry:

Equity Index/Stock Option Margin A/c Dr

To Bank A/c
(Being margin payment made by seller for the
option contract)

The margin is paid and debited to the Margin Account,

reducing the bank balance.
Receipt of Margin:
Journal Entry:

Bank A/c Dr
To Equity Index/Stock Option Margin A/c
(Being margin received by seller for the option contract)

When the margin is refunded or received back, it is

credited to the Margin Account and bank balance is
increased.

2. Lump Sum Deposit with Clearing Member:

Payment of Margin from Lump Sum Deposit:

Journal Entry:

Equity Index/Stock Option Margin A/c Dr

To Deposit for Margin A/c
(Being margin paid from deposit held with clearing
member)

Receipt of Margin into Lump Sum Deposit:

Journal Entry:

Deposit for Margin A/c Dr

To Equity Index/Stock Option Margin A/c
(Being margin received and added to deposit with
clearing member)

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

If a lump sum deposit is used for margin, the Deposit for

Margin A/c is adjusted accordingly. At year-end, any balance
in the deposit account is shown under Current Assets.

ACCOUNTING FOR OPEN OPTIONS AS ON THE BALANCE

SHEET DATE

Premium Account:
Buyer's Premium: Shown under Current Assets.
Seller's Premium: Shown under Current Liabilities.

For Multiple Options:

Combine all premiums in one account but maintain stock-
wise/index-wise entries for provisions.

FOR BUYER/HOLDER:

Loss Provision:

If premium paid > market premium, create a provision for

the difference:
Profit & Loss A/c Dr
To Provision for Loss on Options A/c

This reduces the value in Current Assets.

FOR SELLER/WRITER:

Loss Provision:

If market premium > premium received, create

a provision for the difference:

Profit & Loss A/c Dr

To Provision for Loss on Options A/c

This adds a liability under Current Liabilities.

Final Adjustments:

Losses are accounted for; profits are ignored (as a

precaution).
Adjust old provisions from previous years against the new
year's calculations.

ACCOUNTING AT THE TIME OF FINAL SETTLEMENT

For the Buyer/Holder:

1. Premium Expense:
The buyer records the premium paid as
an expense in the Profit & Loss Account.

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

2. Income on Exercise:
If the option is exercised, the buyer receives the
difference between the final settlement price and
the strike price, recorded as income.

For the Seller/Writer:

1. Premium Income:
The seller records the premium received
as income in the Profit & Loss Account.

2. Loss on Exercise:
If the option is exercised, the seller pays the
difference between the final settlement price and
the strike price, recorded as a loss.

3. Release of Margin:
Once the option is exercised, the margin is released
by the exchange, credited to the Margin Account,
and debited to the Bank Account.

ACCOUNTING FOR SQUARING OFF AN OPTION CONTRACT

1. Premium Difference:
The difference between the premium paid and
premium received when squaring off the option is
recorded as a profit or loss in the Profit & Loss
Account.
2. Release of Margin:
When the option is squared off, any margin held is
released, just like in final settlement. The margin is
transferred back to the Bank Account.

3. Handling Multiple Options:

If there are multiple options with the same stock/index,
strike price, and expiry date, use the weighted
average method to calculate the profit or loss.

ACCOUNTING FOR DELIVERY-SETTLED OPTIONS

For Buyer/Holder:
1. Call Option (Buyer Receives Shares):
The buyer exercises the call option and
receives equity shares by paying cash.

Equity Shares A/c Dr

To Bank/Cash A/c
(Being equity shares received at the strike price on
exercise of call option)

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

2. Put Option (Buyer Delivers Shares):

The buyer exercises the put option and delivers
equity shares, receiving cash.

Bank/Cash A/c Dr
To Equity Shares A/c
(Being equity shares delivered at the strike price on
exercise of put option)

For Seller/Writer:

1. Call Option (Seller Delivers Shares):

The seller exercises the call option and delivers
equity shares to the buyer, receiving cash.

Bank/Cash A/c Dr
To Equity Shares A/c
(Being equity shares delivered on exercise of call
option by the buyer)

2. Put Option (Seller Receives Shares):

The seller exercises the put option and receives
equity shares by paying cash.

Equity Shares A/c Dr

To Bank/Cash A/c
(Being equity shares received on exercise of put
option by the buyer)
PREMIUM ENTRIES:
For both buyer and seller, the premium paid/received is
transferred to the Profit & Loss Account.

For Buyer:
Profit & Loss A/c Dr
To Equity Index/Stock Option Premium A/c
(Being premium paid transferred to P&L)

For Seller:
Equity Index/Stock Option Premium A/c Dr
To Profit & Loss A/c
(Being premium received transferred to P&L)

DISCLOSURE REQUIREMENTS:
1. Disclose accounting Policies for equity index/stock
options.
2. Details of Margins such as bank guarantees or securities
lodged.
3. Details of Outstanding Option Contracts at the year-end
for both buyer and seller.

This version includes all necessary journal entries and

summarizes the disclosure requirements as well.

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

ACCOUNTING FOR EQUITY STOCK OPTIONS

Cash-Settled Equity Stock Options:

Same accounting as Equity Index Options.

Settlement is done without delivery of the underlying
stock; only cash difference is exchanged.

Delivery-Settled Equity Stock Options:

At Inception, Daily Margin, and Open Options:

Same as cash-settled options (record premium,
margin payments, and adjust balances).

Final Settlement (if Exercised):

Shares are physically delivered (actual transfer of stock

and cash between buyer and seller)
9.2 TAXATION OF DERIVATIVE
TRANSACTION IN SECURITIES

Taxation of Profit/Loss:

Gains or losses from derivatives trading on recognized

stock exchanges (like futures and options) are taxed as
business income under the head ‘Profits and Gains from
Business or Profession’.

This income is treated as non-speculative (ordinary

business income), meaning losses can be set off against
any business income, except salary income.

Changes in Tax Law (Before & After 2005):

Before FY 2005-06, derivative transactions were
considered speculative (like gambling), and losses could
only be set off against speculative gains.

After 2005, the law was changed, and derivative

transactions on recognized exchanges are no longer
treated as speculative. Now, losses can be set off against
other business income or carried forward for up to 8 years.

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

Conditions for Carry Forward Losses:

To carry forward derivative losses, the income tax return
must be filed on or before the due date.

Securities Transaction Tax (STT):

The Securities Transaction Tax (STT) paid on these
derivative trades can be deducted under the Income
Tax Act.

Taxation for Foreign Portfolio Investors (FPIs):

For FPIs, gains/losses from derivative trading are taxed

as capital gains, mostly as short-term capital gains
since derivative contracts generally have short durations
(up to 3 months).

Presumptive Taxation:
Small traders (with turnover under ₹2 crores) can opt for
presumptive taxation under Section 44AD, where they
are taxed on 6% of their turnover without needing to
maintain detailed records or get their accounts audited.
SECURITIES TRANSACTION TAX (STT)

What is STT:
Securities Transaction Tax (STT) is a tax on the
purchase and sale of securities listed on Indian stock
exchanges.
Applies to equity, derivatives, and equity-oriented
mutual funds.

Who Collects STT:

The stock exchange collects STT on derivative
transactions and pays it to the Government.

STT Rates for Derivatives:

Sale of Options: 0.0625% (paid by seller).
Exercised Options: 0.125% (paid by buyer on
settlement price).
Sale of Futures: 0.0125% (paid by seller).

These are the older rates

→ Got revised in Budget 2024

Parth Verma / The Valuation School

 Parth Verma / The Valuation School

Valuation for STT:

For Options:
On sale: STT is applied on the option premium.
When exercised: STT is applied on the settlement
price.
Physical Settlement: STT for delivery-based transactions
is 0.1% (applies to both buyer and seller).

STT Procedure:

Futures: STT is applied on the actual trade price.

Options: STT is applied on the premium.
Exercised Options: STT is applied on the settlement price.

Clearing Member's Role:

STT liability is collected at each trading level:

Clearing members pay the total STT for all trading
members under them.
Trading members pay STT for all their clients.