Accounting for Derivatives

Last Updated :

21 Aug, 2024

Blog Author :

Wallstreetmojo Team

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya

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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

Let's take the Exercise price at $ 100, the call option premium at $ 10, and a Maximum of 200 equity shares. Now we will find out payoff and profit/loss of the buyer and seller of the 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 = $ 100Scenario-1Scenario-2Scenario-3Scenario-4
Settlement price (under different scenarios)90105110120
Call option premium(option premium*lot size) ($ 10*200)2000200020002000
Payment to be made by call option buyer= (settlement price-exercise price)x lot size0  
(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)
The payoff for call seller= Max(settlement price-exercise price)x lot size0-1000-20004000
Payoff of call seller = Pay off minus premium paid200010000-2000

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 entries in derivatives that will flow based on the scenario.

Accounting for Derivatives Video Explanation

 

Accounting for Profit & Loss in Put Options

“Put” option on equity shares-Profit /loss calculation for both option seller and buyer

Exercise price = $ 100Scenario-1Scenario-2Scenario-3Scenario-4
Settlement price (under different scenarios)8090100110
Call option premium ($ 7*200)1400140014001400
Payment to be made by put option buyer= (Exercise price-settlement price)x lot size4000200000
Profit or loss to put buyer( payment made minus premium paid)2600600-1400-1400
The payoff for put writer = Max(Exercise price-settlement price)x lot size-4000-200000
Payoff of call writer= Payoff minus premium paid-2600-60014001400

Let us take on examples to understand how to calculate accounting entries on derivative transactions in the books of "Writer and Buyer of Call and Put options (the Next four 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 X Limited shares on 1st Feb 2016 with a premium of $ 5 per share.  The exercise date is 31st Dec 2016, and the Exercise price is $ 102 per share.

The market price on 1st Feb 2016 =100 per share :

The market price on 31st Mar 2016 =104 per share :

The market price on 31st Dec 2016 =105 per share

Solution:

In this contract, "A" Agrees to Buy shares at $ 102 despite whatever the price is on 31st Dec 2016.

So fair value of an option, in this case, is as follows

On 1st Feb 2016(The date on which the contract was 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:

DateParticularsDrCr
1st Feb 2016Bank 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                      Dr2000 
Fair value gain account                                  Cr 2000
 (Increase in fair value of the option)($ 5000- $ 3000)  
31st Dec 2016
(Exercise date)
Call option obligation account                      Dr1000 
Fair value gain account                                  Cr 1000
 (Increase in fair value of option)($ 3000- $ 2000)  
31st Dec 2016
(Exercise date)
Call option obligation account                      Dr2000 
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                      Dr2000 
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 2016Bank account                                                   Dr5000 
 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                                                     Dr102000
Shares of X Limited Account                            Cr102000
 (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 X Limited shares on 1st Feb 2016 with a premium of $ 5 per share.  The exercise date is 31st Dec 2016, and the Exercise price is $ 102 per share.

The market price on 1st Feb 2016 =100 per share :

The market price on 31st Mar 2016 =104 per share :

The 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 the price was 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(The date on which the contract was 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:

DateParticularsDrCr
1st Feb 2016Call option Asset account                             Dr5000 
 Bank account                                                  Cr 5000
 (Option premium paid for buying call options)(Call premium of $ 5000)  
31st Mar 2016
(Reporting date)
Fair value loss Account                                  Dr2000 
Call option Asset Account                             Cr 2000
 (Decrease in fair value of the option)($ 5000- $ 3000)  
31st Dec 2016
(Exercise date)
Fair value loss Account                                  Dr1000 
Call option Asset Account                             Cr 1000
 (Decrease in fair value of option)($ 5000- $ 3000)  
31st Dec 2016
(Exercise date)
Bank Account                                                  Dr2000 
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                                         Dr2000 
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 2016Call option Asset account                             Dr5000 
 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                                                     Dr102000 
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 X Limited shares on 1st Feb 2016 with a premium of $ 5 per share.  The exercise date is 31st Dec 2016, and the Exercise price is $ 98 per share

The market price on 1st Feb 2016 =100 per share:

The market price on 31st Mar 2016 =97 per share:

The 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 the price was 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; 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(The date on which the contract was entered) Fair value of the option= was $ 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

DateParticularsDrCr
1st Feb 2016Bank account                                                   Dr5000
Put option obligation account                     Cr5000
(Option premium received for writing put options)(put a premium of $ 5000)
31st Mar 2016
(Reporting date)
Put option obligation account                      Dr1000
Fair value gain account                                  Cr1000
(Increase in fair value of put option)($ 5000- $ 4000)
31st Dec 2016
(Exercise date)
Put option obligation account                      Dr2000
Fair value gain account                                  Cr2000
(Increase in fair value of the option)($ 4000- $ 2000)
31st Dec 2016
(Exercise date)
Put option obligation account                      Dr2000
Bank account                                                   Cr2000
(Cash settlement on the exercise of the Put option)($ 5000-$ 1000-$ 2000)
Incase transaction is settled in shares
31st Dec 2016
(Exercise date)
Put option obligation account                      Dr2000
Shares of X Limited                                         Cr2000
(Cash settlement on the exercise of the Put option)($ 5000-$ 2000-$ 1000)
Cash for shares: i.e gross shares settlement
1st Feb 2016Bank account                                                   Dr5000
Call option obligation account                     Cr5000
(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                                                     Dr98000
Shares of X Limited Account                            Cr98000
(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.  The exercise date is 31st Dec 2016, and the Exercise price is $ 98 per share

The market price on 1st Feb 2016 =100 per share:

The market price on 31st Mar 2016 =97 per share:

The 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 the price was 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(The date on which the contract was entered) Fair value of the option= was $ 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

DateParticularsDrCr
1st Feb 2016Put option Asset Account                            Dr5000
Bank Account                                                 Cr5000
(Option premium paid for buying put options)(put a premium of $ 5000)
31st Mar 2016
(Reporting date)
Fair value loss Account                                  Dr1000
Put option Asset Account                              Cr1000
(Decrease in fair value of put option)($ 5000- $ 4000)
31st Dec 2016
(Exercise date)
Fair value loss Account                                  Dr2000
Put option Asset Account                              Cr2000
(Decrease in fair value of put option)($ 4000- $ 2000)
31st Dec 2016
(Exercise date)
Bank Account                                                  Dr2000
Put option Asset Account                             Cr2000
(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                                         Dr2000
Put option Asset Account                              Cr2000
(Cash settlement on the exercise of the Put option)($ 5000-$ 2000-$ 1000)
Cash for shares: i.e gross shares settlement
1st Feb 2016Put option Asset Account                            Dr5000
Bank Account                                                 Cr5000
(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                           Dr98000
Bank Account                                                     Cr98000
(Settling the transaction in shares)($ 98*1000)

I hope you understand how to calculate profit or loss on call and put options under different scenarios and accounting treatments. Now let us go into forwards/futures of the company's equity.

Forwards or futures contract to buy or sell entity own equity:

A delivery-based forwards or futures contract on an entity's equity shares is an equity transaction. Because it is a contract to sell or buy the company's equity at a future date at a fixed amount.

If the contract is settled in cash for a different amount of shares settled for a different amount, they are treated as a derivative contract.

Cash settled: It is treated as a derivative contract. The forward is accounted for at fair value at each reporting date, and the resultant forward asset/liability is derecognized on settlement receipt/payment of cash or any other financial asset. The fair value of forwarding is zero at initial recognition, so no accounting entry is required when a forward contract is entered. The fair value of forwarding on initial recognition is considered a financial asset or liability.

Shares settlement: Under this, shares are issued/ repurchased for the net settlement amount at the spot price of the settlement date. Only the settlement transaction involves equity.

Settlement by delivery: 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 shares per the following details.

Contract date: 1st Feb 2016: Maturity date: 31st Dec 2016. Exercise price $ 104 and No of shares 1000

The market price on 1st Feb 2016:   $ 100

The market price on 31st Mar 2016:   $ 110

The market price on 31st Dec 2016: was $ 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

DateParticularsDrCr
1st Feb 2016No entry required
31st Mar 2016
(Reporting date)
Forward Asset Account                             Dr6000  
Forward value gain Account                    Cr6000
(Decrease in fair value of forwarding resulting in gain)(1000*(110-104))
31st Dec 2016
(Exercise date)
Fair value loss Account                             Dr4000
Forward Asset Account                            Cr4000
(Decrease in fair value of forward asset) (106-104)*1000
31st Dec 2016
(Exercise date)
Bank Account                                             Dr2000
Forward Asset Account                            Cr2000
(Counterparty settles the forward contract by paying $ 2000)
 Shares for shares i.e Net share settlement  
31st Dec 2016
(Exercise date)
Treasury stock account                           Dr2000
Forward asset account                            Cr2000
(Counterparty settles the forward contract by delivering shares of X Ltd worth $ 2000)
         Cash for shares i.e gross shares settlement  
1st Feb 2016Equity shares suspense account Dr100000
Stock repurchase liability account        Cr100000
(Present value of shares purchase liability under forwarding contract)
31st Mar 2016
(Reporting date)
Interest account                                       Dr3667
Stock repurchase liability account        Cr3667
(104-100)*1000*11/12
31st Dec 2016
(Exercise date)
Interest account                                          Dr333
Shares repurchase liability account         Cr333
(4000*1/12)
31st Dec 2016
(Exercise date)
Treasury stock account Dr100000
Equity suspense account                            Cr100000
(Purchase of own equity shares on forwarding contract and adjustment of equity suspense)
31st Dec 2016
(Exercise date)
Bank account                                                 Dr104000
Stock repurchase liability account             Cr104000
(Settlement of forwarding liability)

I hope you guys got a reasonable understanding of accounting treatment for derivative contracts.