• QA 226
    How should futures transactions be accounted for?
    How should forward purchases and sales on the futures exchange be entered into the accounting system? On the date and at the value the transactions are made or adjusted to the effective forward value?
    Asked by:
    Extension Adviser - Mexico

    Trading in futures contracts creates instant accounts entries. For the full answer please see below. See chapters 8 and 9 of the Coffee Guide for a full review of futures markets, the trading of futures contracts, hedging operations etc.

    A. Trading futures

    1. An Original Margin or deposit is required when a position is taken = a futures contract is bought or sold.  The current minimum is USD 2,000 per lot but more may be required depending on one's credentials. *

    2. A Variation Margin has to be paid within 24 hours if the market runs counter to a trader's position = he shows a loss. If on the other hand the position shows a profit or Equity then the margin account is credited and, if he so wishes, the trader can take those funds out.

    3. Open positions are 'marked to market' daily resulting in daily Variation Margin and Equity calls. It is up to the trader and his broker to arrange how these daily calls are dealt with in practice but the point is that the margin account always shows the profit or loss realised to date.

    4. Once purchase and sale match the position is closed out. At this point the margin account automatically reflects the final result, irrespective of how far in the future the underlying delivery month may be. Closing out establishes the final balance, including the original margin that was paid. If the end result is negative the trader has to honour a final variation margin call. If the balance is positive the trader can demand payment. And, accounting is complete.

    B. Accounting

    1. Accounting for 'open' futures positions (long or short) and margin fluctuations is a hugely complicated subject. This is so because open positions represent obligations that will have an unknown financial impact on a company's results. Legislation in terms of valuing such 'open' obligations at financial year-end differs from country to country, particularly in respect of income and corporation tax considerations. Such legislation also evolves over time, i.e. it is subject to change. And, individual companies have their own internal reporting practices as well. Consequently we can only provide a general example of how such positions might be accounted for, using the 'mark to market' principle.

    2. If futures positions are simply booked at the original price, the Cost Principle, then the monthly balance sheet or financial statement only indicates the historical value. But the current value may be very different.

    3. Using the 'Mark to Market' principle instead at least shows the current average value at the date the accounts statement is made. When adjusting the original value to the current market value an offsetting entry is made simultaneously in a special equity account that we shall call 'Unrealised Holding Gain (Loss) on Hedging/investments'. This will show 'holding gains' and 'holding losses'. In this way the 'mark to market' adjustment shows in the balance sheet but it does not impact on the net income for the accounting period in question. Usually, we would expect direct tax implications to arise only once the transaction or hedging operation is truly finalised but, individual tax regimes may view this differently…

    C. To answer the question…

    We suggest to enter futures trades as and when the obligation to the Exchange arises, at the value at which the trades are made. In the monthly balance sheet or financial statement all 'open' transactions should then be 'marked to market' and price adjustments booked as per the principle described above.

    However, whereas the foregoing briefly addresses the accounting aspects of 'open' positions the commercial truth is of course that the values provided by the monthly financial statement are already out of date after one trading day. In other words, these statements do not project any potential outcome nor do they quantify exposure to risk other than by way of a 'snapshot' on an arbitrary date (month-end for example).

    D. It is therefore appropriate to comment on the issue of 'open' positions also from a trade perspective.

    1. Responsible companies limit exposure to market movements by setting internal position limits that, when properly structured and applied, will avoid catastrophic loss.

    Chapter Ten of the Guide, section 10.02, deals with issues as position limits, stock control, price risk, currency risk, the potential implications of over-trading etc. The main recommendation is that exporters and traders should maintain a Daily Position Report that, amongst others, lists stocks and sales, and whether the type of stocks matches outstanding sales. If they do not match then there are 'open' positions: on the one hand (some) unsold stock and on the other (some) open sales against which there is no stock. Similarly the report should list all futures positions that remain 'open'.  Other sections would deal with exposure to currency risk, exposure to individual buyers etc. **

    2. Clearly all 'open' positions (so futures and physicals both) should be 'marked to market' on a daily basis if such an internal report is to have any value. In this way potential gains and losses, as well as overall risk exposure, will be obvious.

    The margin accounts show the accumulated status on futures positions by a given date because open positions are 'marked to market' every day by the Exchange. The internal Daily Position Report on the other hand will show the operation's total exposure including futures. ***

    * A position is created when a trader buys a lot (goes 'long') or sells a lot (goes 'short'). The position remains 'open' until such time as an offsetting transaction is made which 'closes' it.

    ** All this is covered in Chapter 10 (Risk and the relation to Trade Credit) because the Coffee Guide is aimed primarily at exporters.

    *** From a trade perspective therefore we believe the Internal Position Report should be an integral part of in-house financial reporting.

    Posted 22 July 2009

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