Accounting for Derivative Instruments
Accounting for derivatives is a balance sheet item in which the derivatives held by a company are shown in the financial statement in a method approved either by GAAP or IAAB or both.
Under current international accounting standards and Ind AS 109, an entity is required to measure derivative instruments at fair value or mark to market. All fair value gains and losses are recognized in profit or loss except where the derivatives qualify as hedging instruments in cash flow hedges or net investment hedges.
Let us take an example to understand how to calculate profit or loss on derivative transactions.
Accounting for Profit & Loss in Call Option
In this example let us take Exercise price at $ 100, call option premium $ 10, Lot size 200 equity shares. Now we will find out pay off and profit/loss of the buyer and seller of option if the settlement price is $ 90, $ 105, $ 110 and $ 120
“Call” option on equity shares-Profit /loss calculation for both option seller and buyer
| Exercise price = $ 100 | Scenario-1 | Scenario-2 | Scenario-3 | Scenario-4 |
|---|---|---|---|---|
| Settlement price (under different scenarios) | 90 | 105 | 110 | 120 |
| Call option premium(option premium*lot size) ($ 10*200) | 2000 | 2000 | 2000 | 2000 |
| Payment to be made by call option buyer= (settlement price-exercise price)x lot size | 0 (since settlement price is less he will not exercise option) | 1000 =200*(105-100) | 2000 =200*(110-100) | 4000 =200*(120-100) |
| Profit or loss to a buyer( payment made minus premium paid) | -2000 | -1000 (1000-20000 | 0 (2000-2000) | 2000 (4000-2000) |
| Payoff for call seller= Max(settlement price-exercise price)x lot size | 0 | -1000 | -2000 | 4000 |
| Pay off of call seller = Pay off minus premium paid | 2000 | 1000 | 0 | -2000 |
I hope now you understand how the profit/loss is calculated in the case of derivatives.
Let us take one more example with dates and I will explain the accounting entriesAccounting EntriesAccounting Entry is a summary of all the business transactions in the accounting books, including the debit & credit entry. It has 3 major types, i.e., Transaction Entry, Adjusting Entry, & Closing Entry. read more in derivatives that will flow based on the scenario
Accounting for Profit & Loss in Put Options
“Put” option on equity shares-Profit /loss calculation for both option seller and buyer
| Exercise price = $ 100 | Scenario-1 | Scenario-2 | Scenario-3 | Scenario-4 |
|---|---|---|---|---|
| Settlement price (under different scenarios) | 80 | 90 | 100 | 110 |
| Call option premium ($ 7*200) | 1400 | 1400 | 1400 | 1400 |
| Payment to be made by put option buyer= (Exercise price-settlement price)x lot size | 4000 | 2000 | 0 | 0 |
| Profit or loss to put buyer( payment made minus premium paid) | 2600 | 600 | -1400 | -1400 |
| The payoff for put writer = Max(Exercise price-settlement price)x lot size | -4000 | -2000 | 0 | 0 |
| Pay off of call writer= Pay off minus premium paid | -2600 | -600 | 1400 | 1400 |
Let us take on examples to understand how to calculate accounting entries on derivative transactions in the Both books of “Writer and Buyer of Call and Put options (Next 4 examples are based on this- Writer call, Buyer call, Writer put, Buyer Put)
Accounting for Derivatives – Writing a call
Mr. A has written a call option (i.e Sold Call option) details are as follows with a lot size of 1000 shares of X Limited shares on 1st Feb 2016 with a premium of $ 5 per share. Exercise date is 31st Dec 2016 and Exercise price is $ 102 per share
Market price on 1st Feb 2016 =100 per share :
Market price on 31st Mar 2016 =104 per share :
Market price on 31st Dec 2016 =105 per share
Solution:
In this contract, “A” Agrees to Buy shares at $ 102 despite whatever is the price on 31st Dec 2016.
So fair value of an option, in this case, is as follows
On 1st Feb 2016(Date on which contract entered) Fair value of option= $ 5000
On 31st March 2016(Reporting date) = 5000-(104-102)*100= $ 3000
On 31st Dec 2016(Expiry date) = 5000-(105-102)*100=$ 2000
Accounting entries:
| Date | Particulars | Dr | Cr |
|---|---|---|---|
| 1st Feb 2016 | Bank account Dr | 5000 | |
| Call option obligation account Cr | 5000 | ||
| (Option premium received for writing call options)(Call premium of $ 5000) | |||
| 31st Mar 2016 (Reporting date) | Call option obligation account Dr | 2000 | |
| Fair value gain account Cr | 2000 | ||
| (Increase in fair value of the option)($ 5000- $ 3000) | |||
| 31st Dec 2016 (Exercise date) | Call option obligation account Dr | 1000 | |
| Fair value gain account Cr | 1000 | ||
| (Increase in fair value of option)($ 3000- $ 2000) | |||
| 31st Dec 2016 (Exercise date) | Call option obligation account Dr | 2000 | |
| Bank account Cr | 2000 | ||
| (Cash settlement on the exercise of the call option)($ 5000-$ 2000-$ 1000) | |||
| Incase transaction is settled in shares | |||
| 31st Dec 2016 (Exercise date) | Call option obligation account Dr | 2000 | |
| Shares of X Limited Cr | 2000 | ||
| (Cash settlement on the exercise of the call option)($ 5000-$ 2000-$ 1000) | |||
| Cash for shares: i.e gross shares settlement | |||
| 1st Feb 2016 | Bank account Dr | 5000 | |
| Call option obligation account Cr | 5000 | ||
| (Option premium received for writing call options)(Call premium of $ 5000) | |||
| 31st Mar 2016 (Reporting date) | No entry required | – | |
| This is an equity settlement, Change in fair value of the option is not recognized | – | ||
| 31st Dec 2016 (Exercise date) | Bank Account Dr | 102000 | |
| Shares of X Limited Account Cr | 102000 | ||
| (Settling the transaction in shares)($ 102*1000) |
Accounting for Derivatives – Buying a Call
Mr. A purchased a call option (I.e Bought call option) details are as follows with a lot size of 1000 shares of X Limited shares on 1st Feb 2016 with a premium of $ 5 per share. Exercise date is 31st Dec 2016 and Exercise price is $ 102 per share
Market price on 1st Feb 2016 =100 per share :
Market price on 31st Mar 2016 =104 per share :
Market price on 31st Dec 2016 =105 per share
Solution: In this contract, “A” purchased a call option to buy shares of X Ltd at $ 102 per share despite whatever is the price on 31st Dec 2016. If the price of X ltd is more than 102 A will buy shares at $ 102 otherwise if the shares are operating below $ 102 he can deny buying shares at $ 102.
So fair value of the option, in this case, is as follows
On 1st Feb 2016(Date on which contract entered) Fair value of option= $ 5000
On 31st March 2016(Reporting date) = 5000-(104-102)*100= $ 3000
On 31st Dec 2016(Expiry date) = 5000-(105-102)*100=$ 2000
Accounting entries:
| Date | Particulars | Dr | Cr |
|---|---|---|---|
| 1st Feb 2016 | Call option Asset account Dr | 5000 | |
| Bank account Cr | 5000 | ||
| (Option premium paid for buying call options)(Call premium of $ 5000) | |||
| 31st Mar 2016 (Reporting date) | Fair value loss Account Dr | 2000 | |
| Call option Asset Account Cr | 2000 | ||
| (Decrease in fair value of the option)($ 5000- $ 3000) | |||
| 31st Dec 2016 (Exercise date) | Fair value loss Account Dr | 1000 | |
| Call option Asset Account Cr | 1000 | ||
| (Decrease in fair value of option)($ 5000- $ 3000) | |||
| 31st Dec 2016 (Exercise date) | Bank Account Dr | 2000 | |
| Call option Asset Account Cr | 2000 | ||
| (Cash settlement on the exercise of the call option)($ 5000-$ 2000-$ 1000) | |||
| Incase transaction is settled in shares of X Limited | |||
| 31st Dec 2016 (Exercise date) | Shares of X Limited Dr | 2000 | |
| Call option Asset Account Cr | 2000 | ||
| (Shares settlement on the exercise of the call option)($ 5000-$ 2000-$ 1000) | |||
| Cash for shares: i.e gross shares settlement | |||
| 1st Feb 2016 | Call option Asset account Dr | 5000 | |
| Bank account Cr | 5000 | ||
| (Option premium paid for buying call options)(Call premium of $ 5000) | |||
| 31st Mar 2016 (Reporting date) | No entry required | – | |
| This is an equity settlement, Change in fair value of an option is not recognized | – | ||
| 31st Dec 2016 (Exercise date) | Bank Account Dr | 102000 | |
| Shares of X Limited Account Cr | 102000 | ||
| (Settling the transaction in shares)($ 102*1000) |
Accounting for Derivatives – Writing a Put
Mr. A has written a Put option (I.e sold Put option) details are as follows with a lot size of 1000 shares of X Limited shares on 1st Feb 2016 with a premium of $ 5 per share. Exercise date is 31st Dec 2016 and Exercise price is $ 98 per share
Market price on 1st Feb 2016 =100 per share:
Market price on 31st Mar 2016 =97 per share:
Market price on 31st Dec 2016 =95 per share
Solution: In this contract, “A” sold a put option to buy shares of X Ltd at $ 98 per share despite whatever is the price on 31st Dec 2016. If the price of X ltd is more than 98 the buyer of an option may not sell shares to A and otherwise, if the price of X ltd on 31st Dec 2016 is less than $ 98 then “A” has to buy shares at $ 98.
So fair value of an option, in this case, is as follows
On 1st Feb 2016(Date on which contract entered) Fair value of option= $ 5000($ 5*1000 shares)
On 31st March 2016(Reporting date) = 5000-(98-97)*100= $ 4000
On 31st Dec 2016(Expiry date) = 5000-(98-95)*100=$ 2000
| Date | Particulars | Dr | Cr |
|---|---|---|---|
| 1st Feb 2016 | Bank account Dr | 5000 | |
| Put option obligation account Cr | 5000 | ||
| (Option premium received for writing put optionsWriting Put OptionsWriting put options refer to the opportunity availed by an investor to own and sell an underlying asset at an exceptional pre-determined price on a future date. The owner has the right but not the obligation to sell off the underlying asset.read more)(put a premium of $ 5000) | |||
| 31st Mar 2016 (Reporting date) | Put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more obligation account Dr | 1000 | |
| Fair value gain account Cr | 1000 | ||
| (Increase in fair value of put option)($ 5000- $ 4000) | |||
| 31st Dec 2016 (Exercise date) | Put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more obligation account Dr | 2000 | |
| Fair value gain account Cr | 2000 | ||
| (Increase in fair value of the option)($ 4000- $ 2000) | |||
| 31st Dec 2016 (Exercise date) | Put option obligation account Dr | 2000 | |
| Bank account Cr | 2000 | ||
| (Cash settlement on the exercise of the Put option)($ 5000-$ 1000-$ 2000) | |||
| Incase transaction is settled in shares | |||
| 31st Dec 2016 (Exercise date) | Put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more obligation account Dr | 2000 | |
| Shares of X Limited Cr | 2000 | ||
| (Cash settlement on the exercise of the Put option)($ 5000-$ 2000-$ 1000) | |||
| Cash for shares: i.e gross shares settlement | |||
| 1st Feb 2016 | Bank account Dr | 5000 | |
| Call option obligation account Cr | 5000 | ||
| (Option premium received for writing put options)(put a premium of $ 5000) | |||
| 31st Mar 2016 (Reporting date) | No entry required | – | |
| This is an equity settlement, Change in fair value of an option is not recognized | – | ||
| 31st Dec 2016 (Exercise date) | Bank Account Dr | 98000 | |
| Shares of X Limited Account Cr | 98000 | ||
| (Settling the transaction in shares)($ 98*1000) |
Accounting for Derivatives – Buying a Put
Mr. A Bought a Put option details are as follows with a lot size of 1000 shares of X Limited shares on 1st Feb 2016 with a premium of $ 5 per share. Exercise date is 31st Dec 2016 and Exercise price is $ 98 per share
Market price on 1st Feb 2016 =100 per share:
Market price on 31st Mar 2016 =97 per share:
Market price on 31st Dec 2016 =95 per share
Solution: In this contract, “A” Bought a put option to buy shares of X Ltd at $ 98 per share despite whatever is the price on 31st Dec 2016. If the price of X ltd is more than 98 on 31st Dec 2016, then he will buy the shares of X ltd at $ 98 otherwise if the price of X ltd on 31st Dec 2016 is less than $ 98 then “A” can deny purchase at $ 98 and buy-in outside market.
So fair value of an option, in this case, is as follows
On 1st Feb 2016(Date on which contract entered) Fair value of option= $ 5000($ 5*1000 shares)
On 31st March 2016(Reporting date) = 5000-(98-97)*100= $ 4000
On 31st Dec 2016(Expiry date) = 5000-(98-95)*100=$ 2000
| Date | Particulars | Dr | Cr |
|---|---|---|---|
| 1st Feb 2016 | Put option Asset Account Dr | 5000 | |
| Bank Account Cr | 5000 | ||
| (Option premium paid for buying put options)(put a premium of $ 5000) | |||
| 31st Mar 2016 (Reporting date) | Fair value loss Account Dr | 1000 | |
| Put option Asset Account Cr | 1000 | ||
| (Decrease in fair value of put option)($ 5000- $ 4000) | |||
| 31st Dec 2016 (Exercise date) | Fair value loss Account Dr | 2000 | |
| Put option Asset Account Cr | 2000 | ||
| (Decrease in fair value of put option)($ 4000- $ 2000) | |||
| 31st Dec 2016 (Exercise date) | Bank Account Dr | 2000 | |
| Put option Asset Account Cr | 2000 | ||
| (Cash settlement on the exercise of the Put option)($ 5000-$ 1000-$ 2000)( In this case, Mr. A may deny purchase at $ 98 and Buy in the market at $ 95) For entry purpose, I am assuming he bought at $ 98 from writer | |||
| Incase transaction is settled in shares | |||
| 31st Dec 2016 (Exercise date) | Shares of X Limited Dr | 2000 | |
| Put option Asset Account Cr | 2000 | ||
| (Cash settlement on the exercise of the Put option)($ 5000-$ 2000-$ 1000) | |||
| Cash for shares: i.e gross shares settlement | |||
| 1st Feb 2016 | Put option Asset Account Dr | 5000 | |
| Bank Account Cr | 5000 | ||
| (Option premium paid for buying put options)(put a premium of $ 5000) | |||
| 31st Mar 2016 (Reporting date) | No entry required | – | |
| This is an equity settlement, Change in fair value of an option is not recognized | – | ||
| 31st Dec 2016 (Exercise date) | Shares of X Limited Account Dr | 98000 | |
| Bank Account Cr | 98000 | ||
| (Settling the transaction in shares)($ 98*1000) |
I hope now you understand how to calculate profit or loss on call and put options under different scenarios and accounting treatment. Now let us go into forwards/futures of the company’s own equity.
Forwards or futures contract to buy or sell entity own equity:
A delivery based forwards or futures contract on entity own equity shares is an equity transaction. Because it is a contract to sell or buy the company’s own equity at a future date at a fixed amount.
In case the contract is settled in cash for a differential amount, or shares settled for difference amount, then they are treated as a derivative contract.
Cash settled: It is treated as a derivative contract. The fair value of forwarding on initial recognition is considered as a financial assetFinancial AssetFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more or liability. The fair value of forwarding is zero at initial recognition, so no accounting entry is required when a forward contract is entered into. The forward is accounted at fair valueAccounted At Fair ValueFair value accounting is the process of maintaining items in financial statements at their fair value and current valuation. Mark to market mechanism is applied at specified periods to change the value of items and show them as per their fair value in the market.read more at each reporting date and resultant forward asset/liability is derecognized on settlement receipt/payment of cash or any other financial asset.
Shares settlement: Under this, shares are issued/ repurchased
for the net settlement amount at the spot price of the settlement dateSettlement DateThe settlement date is the date on which the cash and assets that have been exchanged or traded are settled by netting out a process that happened a few days ago. Commonly for shares, it is two business days after the trade.read more. Only the settlement transaction involves equity.
Settlement by delivery: On this, as discussed above, the requisite number of shares are issued/Repurchased. This is an equity transaction.
Accounting for Derivatives Example – Forward contract to buy own shares
X ltd entered into a forward contract to buy its own shares as per the following details.
Contract date: 1st Feb 2016: Maturity date: 31st Dec 2016. Exercise priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more $ 104 and No of shares 1000
Market price on 1st Feb 2016: $ 100
The market price on 31st Mar 2016: $ 110
Market price on 31st Dec 2016: $ 106
Solution: Fair value of forwarding on 1st Feb 2016 $ 0
Fair value of forward on 31st March 2016 $ 6,000 (1000*(110-104))
Fair value of forward on 31st Dec 2016 $ 2,000 (1000*(106-104))
Accounting entries
| Date | Particulars | Dr | Cr |
|---|---|---|---|
| 1st Feb 2016 | No entry required | ||
| 31st Mar 2016 (Reporting date) | Forward Asset Account Dr | 6000 | |
| Forward value gain Account Cr | 6000 | ||
| (Decrease in fair value of forwarding resulting in gain)(1000*(110-104)) | |||
| 31st Dec 2016 (Exercise date) | Fair value loss Account Dr | 4000 | |
| Forward Asset Account Cr | 4000 | ||
| (Decrease in fair value of forward asset) (106-104)*1000 | |||
| 31st Dec 2016 (Exercise date) | Bank Account Dr | 2000 | |
| Forward Asset Account Cr | 2000 | ||
| (Counterparty settles the forward contract by paying $ 2000) | |||
| Shares for shares i.e Net share settlement | |||
| 31st Dec 2016 (Exercise date) | Treasury stock account Dr | 2000 | |
| Forward asset account Cr | 2000 | ||
| (Counterparty settles the forward contract by delivering shares of X Ltd worth $ 2000) | |||
| Cash for shares i.e gross shares settlement | |||
| 1st Feb 2016 | Equity shares suspense accountSuspense AccountSuspense Account is a general ledger account that holds records of temporary transactions that which do not have sufficient evidence for double entry or appropriate vouchers. This account is settled within the accounting period and does not appear anywhere in the financial statements.read more Dr | 100000 | |
| Stock repurchase liability account Cr | 100000 | ||
| (Present value of shares purchase liability under forwarding contract) | |||
| 31st Mar 2016 (Reporting date) | Interest account Dr | 3667 | |
| Stock repurchase liability account Cr | 3667 | ||
| (104-100)*1000*11/12 | |||
| 31st Dec 2016 (Exercise date) | Interest account Dr | 333 | |
| Shares repurchase liability account Cr | 333 | ||
| (4000*1/12) | |||
| 31st Dec 2016 (Exercise date) | Treasury stock accountTreasury Stock AccountTreasury Stock is a stock repurchased by the issuance Company from its current shareholders that remains non-retired. Moreover, it is not considered while calculating the Company’s Earnings Per Share or dividends. read more Dr | 100000 | |
| Equity suspense account Cr | 100000 | ||
| (Purchase of own equity shares on forwarding contract and adjustment of equity suspense) | |||
| 31st Dec 2016 (Exercise date) | Bank account Dr | 104000 | |
| Stock repurchase liability account Cr | 104000 | ||
| (Settlement of forwarding liability) |
Accounting for Derivatives Video
I hope you guys got a reasonable understanding of accounting treatment for derivative contracts.
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