Derivatives explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
Under Ind AS 109 a derivative is measured at fair value, with changes in profit or loss, unless it is designated in a hedge. A derivative can also hide inside another contract, such as a supply agreement or a debenture. When it does, the standard sometimes requires the entity to pull it out and account for it separately.
A contract is a derivative when its value moves with an underlying variable, it needs little or no initial net investment, and it settles at a future date. A stand-alone derivative is FVTPL. In a hybrid contract with a host that is not a financial asset, the embedded derivative is separated only if it is not closely related to the host, a separate contract on the same terms would be a derivative, and the hybrid is not itself FVTPL. If the host is a financial asset, the whole contract is classified under the usual two tests.
Ind AS as on 1 April 2025 (ICAI Compendium of Ind AS 2025-26, the standards notified under the Companies (Indian Accounting Standards) Rules, 2015). Amendments notified after 1 April 2025 are not reflected in this article; check mca.gov.in before applying it to a later period.
What the paragraphs require
| Paragraph | Requirement | What it means in practice |
|---|---|---|
| Ind AS 109, Appendix A | Derivative: value changes with an underlying; no or small initial net investment; settled at a future date | Forwards, futures, swaps and options usually meet all three |
| 2.4 to 2.7 | Contracts to buy or sell non-financial items that can be net settled are within scope, unless held for own purchase, sale or usage | The own-use exception removes ordinary commodity supply contracts |
| BA.1 to BA.5 | Notional amount not essential; variable must not be specific to a party | A fixed payment tied to a market index can be a derivative |
| 4.3.1 | An embedded derivative changes some cash flows of a host contract; one that is transferable separately is not embedded | Check whether it can be detached |
| 4.3.2 | Host is a financial asset: classify the whole hybrid under 4.1.1 to 4.1.5 | No separation on the asset side |
| 4.3.3 | Separate only if not closely related, would be a derivative on its own, and hybrid is not FVTPL | Three conditions, all required |
| 4.3.5 to 4.3.7 | Option to designate the whole hybrid as FVTPL; required if the derivative cannot be measured separately | A fallback that avoids the separation work |
| B4.3.11 | Assess at inception; reassess only when the terms significantly change the cash flows | Not at every reporting date |
Step 1: is it a derivative at all?
Test all three characteristics in the Appendix A definition. The underlying can be an interest rate, a financial instrument price, a commodity price, an exchange rate, an index or a credit rating, and a non-financial variable counts only if it is not specific to a party (BA.5). A notional amount is not required (BA.1). An option qualifies because its premium is less than the cost of the underlying (BA.3). A regular way purchase or sale is technically a short fixed-price commitment but is not recognised as a derivative (BA.4).
Step 2: scope for commodity and similar contracts
Paragraph 2.4 pulls into the standard contracts to buy or sell non-financial items that can be settled net in cash or another financial instrument, except those entered into and held for the entity's expected purchase, sale or usage. Paragraph 2.6 lists the ways a contract can be net settled, including a practice of net settlement or of selling soon after taking delivery. Contracts caught by 2.6(b) or (c) are not own-use. An entity may designate an own-use contract as FVTPL at inception only to remove an accounting mismatch (paragraph 2.5).
Step 3: separate or not?
Measure a separated derivative at fair value on initial recognition and then through profit or loss, with the host measured under the applicable standard (B4.3.1, 4.3.4). Paragraph B4.3.5 lists terms that are not closely related, for example equity-indexed or commodity-indexed interest or principal on a debt host, and a put whose price varies with an equity or commodity index. Paragraph B4.3.8 lists terms that are closely related, including an interest rate cap or floor set at or beyond market when issued, and some foreign currency terms.
A host that is a debt contract with payments in a foreign currency is closely related under B4.3.8(c). For a host that is not a financial instrument, B4.3.8(d) accepts an embedded foreign currency term only if it is not leveraged, has no option feature, and requires payment in (i) the functional currency of any substantial party, (ii) the currency in which the good is routinely priced in commercial transactions around the world, or (iii) a currency commonly used in such contracts in the local economic environment.
If your team is mapping which contracts carry such terms, our virtual CFO services practice can help set up the review across supply, loan and lease contracts.
Worked example
The entity and all figures in this example are invented for illustration. Forward rates, spot rates and discount rates are assumed, for arithmetic only. Discounting uses simple interest for the remaining months, and amounts are rounded to the rupee.
Part A: a stand-alone forward. On 1 January 2026 Tapti Exports Limited sells USD 5,00,000 forward at ₹86.00 for settlement on 30 June 2026. It does not apply hedge accounting. The contract meets the definition: its value follows the dollar rate, it needs no investment and it settles in future. The contract rate equals the market forward rate on day one, so fair value is nil and there is no entry.
At 31 March 2026 the forward rate for 30 June is ₹85.20. The gain is (86.00 - 85.20) x 5,00,000 = ₹4,00,000 on settlement day; discounted for three months at 7 per cent a year (assumed), the factor is 1 ÷ (1 + 0.07 x 3/12) = 0.9828, so fair value is ₹3,93,120. On 30 June the spot rate is ₹84.70, so the contract settles for (86.00 - 84.70) x 5,00,000 = ₹6,50,000.
| Date | Fair value of forward (asset) | Gain recognised in profit or loss |
|---|---|---|
| 31 March 2026 | 3,93,120 | 3,93,120 |
| 30 June 2026 | 6,50,000 (settled) | 2,56,880 |
Check: 3,93,120 + 2,56,880 = 6,50,000, the cash received.
| Particulars | Debit (₹) | Credit (₹) |
|---|---|---|
| 31 March 2026: Derivative asset | 3,93,120 | |
| To Gain on derivative (profit or loss) | 3,93,120 | |
| 30 June 2026: Derivative asset | 2,56,880 | |
| To Gain on derivative (profit or loss) | 2,56,880 | |
| 30 June 2026: Bank | 6,50,000 | |
| To Derivative asset | 6,50,000 |
Part B: a supply contract priced in a third currency. On 1 July 2026 Bhima Alloys Limited, whose functional currency is the rupee, agrees to buy 1,000 tonnes of steel coil from a seller whose functional currency is the Korean won. The price is JPY 90,000 a tonne, JPY 9,00,00,000 in all, payable at delivery on 31 December 2026. The contract is for the entity's own use, so the host is an executory purchase and not a financial instrument. The embedded term is the yen price. For the example it is assumed that the yen is not routinely used worldwide for this good and not commonly used in Indian contracts for steel.
| Condition in B4.3.8(d) | Assessment |
|---|---|
| (i) Functional currency of a substantial party | Rupee and won; the yen is neither |
| (ii) Routinely used worldwide for this good | Assumed no |
| (iii) Commonly used locally for such contracts | Assumed no |
| Result | Not closely related (4.3.3(a)); a yen forward on the same terms would be a derivative (4.3.3(b)); the hybrid is not FVTPL (4.3.3(c)). Separate it. |
Had the price been in won, the seller's functional currency, the term would pass (d)(i) and stay inside the host, provided there was no leverage and no option.
Under B4.3.3 a separated forward starts at a fair value of nil, which fixes the host at the yen amount converted at the 1 July forward rate of ₹0.5800 a yen: JPY 9,00,00,000 x 0.5800 = ₹5,22,00,000. At 30 September the forward rate for 31 December is ₹0.5950 (assumed). Since Bhima must pay yen, a stronger yen is a loss: (0.5950 - 0.5800) x 9,00,00,000 = ₹13,50,000 at settlement; at 8 per cent a year for three months (assumed), the factor is 1 ÷ (1 + 0.08 x 3/12) = 0.9804, giving ₹13,23,529. At delivery on 31 December the spot rate is ₹0.6020, so Bhima actually pays 9,00,00,000 x 0.6020 = ₹5,41,80,000, a rise of ₹19,80,000 over the host.
| Date | Embedded derivative (liability) | Loss in profit or loss |
|---|---|---|
| 30 September 2026 | 13,23,529 | 13,23,529 |
| 31 December 2026 | 19,80,000 (settled with the payment) | 6,56,471 |
Check: 13,23,529 + 6,56,471 = 19,80,000; and host ₹5,22,00,000 + 19,80,000 = ₹5,41,80,000, the amount paid.
| Particulars | Debit (₹) | Credit (₹) |
|---|---|---|
| 30 September 2026: Loss on embedded derivative (profit or loss) | 13,23,529 | |
| To Embedded derivative liability | 13,23,529 | |
| 31 December 2026: Loss on embedded derivative (profit or loss) | 6,56,471 | |
| To Embedded derivative liability | 6,56,471 | |
| 31 December 2026: Inventory (host) | 5,22,00,000 | |
| Embedded derivative liability | 19,80,000 | |
| To Bank | 5,41,80,000 |
The inventory carries the host price. The foreign exchange effect passes through profit or loss as the derivative moves.
Presentation and disclosure
A separated derivative is presented as a derivative asset or liability; Ind AS 109 does not itself decide whether it is shown separately in the balance sheet (paragraph 4.3.4). Gains and losses go to profit or loss unless hedge accounting applies, which is covered in our hedge accounting guide. Disclosure sits in Ind AS 107 and fair value inputs in Ind AS 113. For the standard-level summary see the Ind AS 109 post, and for the Division III view of derivatives see derivative disclosure for NBFCs.
Entities that follow Accounting Standards rather than Ind AS use a different framework for derivatives, in the ICAI guidance note on derivative contracts.
Common mistakes
- Testing the underlying but not the second and third characteristics of the definition (Appendix A).
- Treating a commodity contract as own-use despite a practice of net settlement (paragraph 2.6(b), (c)).
- Separating a derivative from a financial asset host instead of testing the whole asset (paragraph 4.3.2).
- Assuming any foreign currency price is closely related; B4.3.8(d) names three currency routes.
- Reassessing each year when no change to the cash flows occurred (B4.3.11).
Need help with derivatives and embedded derivatives?
Contracts with currency, commodity or index-linked pricing are usually found late, at audit. Our virtual CFO services team can review your contract register, document the own-use and closely-related conclusions and build the fair value workings with you.
Key takeaways
- Three characteristics define a derivative; all three must be met.
- Stand-alone derivatives are FVTPL unless hedge accounting applies.
- Own-use commodity contracts sit outside the standard unless net settled in practice.
- Separation needs three conditions; a financial asset host is never separated.
- For a non-financial host, a foreign currency term is closely related only through the three routes in B4.3.8(d).
- Assess at inception; reassess only on a significant change in cash flows.
Read next
- Hedge accounting under Ind AS 109: fair value and cash flow hedges
- Classification and measurement of financial assets under Ind AS 109
- ICAI guidance note on accounting for derivative contracts for entities following Accounting Standards
- Derivative disclosure for NBFCs: the two-part structure
Disclaimer: Based on the Indian Accounting Standards as on 1 April 2025 (ICAI Compendium of Ind AS 2025-26, the standards notified under the Companies (Indian Accounting Standards) Rules, 2015) and, where named, the ITFG clarification bulletins of ICAI, as consulted on 4 October 2026. The worked example uses invented figures. Amendments notified after 1 April 2025 should be checked on mca.gov.in. This article is general information, not legal advice; check the official text before acting.