Accounting for Derivatives – In the regular course of business operations, organizations are exposed to following risks market risks such as Interest rate risk, Foreign exchange risk, Commodity price risk etc. These risks give rise to income volatility. As a result, organizations often will take some action to mitigate or economically hedge against such exposures using derivative financial instruments (Forwards, Futures, Options, Swaps). In addition, some organizations may enter into derivative contracts for speculative or trading purposes.
In this article, we are going to see how we account for derivative transactions in books of accounts.
- Understanding Derivatives
- Accounting for derivative instruments
- Call Options – Profit & Loss Calculation Example
- Put Options – Profit & Loss Calculation Example
- Accounting for Derivatives Example – Writing a call
- Accounting for Derivatives Example – Buying a Call
- Accounting for Derivatives Example – Writing a Put
- Accounting for Derivatives Example – Buying a Put
- Forwards or futures contract to buy or sell entity own equity
- Accounting for Derivatives Example – Forward contract to buy own shares
- Treasury shares
- Transaction Costs
Understanding Derivatives
Forward contract:
A forward contract is simply a contract between two parties to buy or to sell an asset at a specified future time at a price agreed today.
For example: Company “A” enters into contract with a stock broker “B” on 1st October 2016 for purchase of 10,000 Tata steel shares at $ 440 on 1st January 2017. In this case irrespective of the price on 1st January 2017 Stock Broker “B” has to sell 10,000 shares of Tata steel at $ 440 to company “A”. In this case, if the price of the share is more than $ 440 on 1st January 2017 then Company “A” will be at profit other wise Stock broker “B” will be at profit.
Futures contract:
On a simple sense futures and forwards are essentially same except that Futures contract happens on Futures exchanges, which act as a market place between buyers and sellers. Contracts are negotiated at futures exchanges, which act as a marketplace between buyers and sellers. The buyer of a contract is said to be long position holder, and the selling party is said to be short position holder. As both parties risk their counter-party walking away if the price goes against them, the contract may involve both parties lodging a margin of the value of the contract with a mutually trusted third party.
For Example: Continuing the above example, if the contract to purchase the shares of Tata steel is entered on a futures exchange (I.e clearing house) and both parties has to deposit some amount of money for honoring the contract, and then the contract is futures. Futures are nothing but a forward contract except that a third party is there in between to avoid the risk of denying honoring the contract.
So in case of futures- Even if the price of Tata steel on 1st January 2017 went up to $ 600, then also Stock broker “B” has to sell 10,000 shares to company “A” at $ 440 and risk of denying by “B” is eliminated as a clearing house/futures exchange is there in between and margin amount is deposited.
Options contract:
An option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on a specified date, depending on the form of the option.
For example: Continuing the same example, In case of options Company “A” purchased an option to “buy” (Call option) Tata steel shares at $ 440 per share from Stock broker “B” at an option amount of $ 20 per share. In this case denial by “B” is not possible as Company “A” bought right but not obligation to buy the shares. On 1st January 2017, if Tata steel shares are operating at $ 300 then company “A” is not obliged to buy the shares from “B” at $ 440.
So in this case Maximum loss for company “A” is $ 20/ share and Maximum profit for stock broker “B” is $ 20/share. Profit of company “A” is unlimited and loss of stock broker “B” is unlimited.
The option prices are calculated using various option pricing models. Example: Black-Scholes model.
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Accounting for derivative instruments
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.
What is fair value as per accounting standards?
It is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable and willing parties in an arm’s length transaction. Fair value does not take into consideration transaction costs incurred at initial acquisition or expected to be incurred on transfer or disposal of a financial instrument
Let us take an example to understand how to calculate profit or loss on derivative transactions.
Call Options – Profit & Loss Calculation Example
In this example let us take Exercise price as $ 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 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 case of derivatives.
Let us take one more example with dates and I will explain the accounting entries that will flow based on the scenario
Put Options – Profit & Loss Calculation Example
| “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 |
| 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 Example – Writing a call
Mr A 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 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 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
Call option obligation account Cr (Option premium received for writing call options)(Call premium of $ 5000) |
5000 |
5000 |
| 31st Mar 2016
(Reporting date) |
Call option obligation account Dr
Fair value gain account Cr (Increase in fair value of option)($ 5000- $ 3000) |
2000 |
2000 |
| 31st Dec 2016
(Exercise date) |
Call option obligation account Dr
Fair value gain account Cr (Increase in fair value of option)($ 3000- $ 2000) |
1000 | 1000 |
| 31st Dec 2016
(Exercise date) |
Call option obligation account Dr
Bank account Cr (Cash settlement on exercise of the call option)($ 5000-$ 2000-$ 1000) |
2000 |
2000 |
| Incase transaction is settled in shares | |||
| 31st Dec 2016
(Exercise date) |
Call option obligation account Dr
Shares of X Limited Cr (Cash settlement on exercise of the call option)($ 5000-$ 2000-$ 1000) |
2000 |
2000 |
| Cash for shares: i.e gross shares settlement | |||
| 1st Feb 2016 | Bank account Dr
Call option obligation account Cr (Option premium received for writing call options)(Call premium of $ 5000) |
5000 |
5000 |
| 31st Mar 2016
(Reporting date) |
No entry required
This is an equity settlement, Change in fair value of option is not recognised |
– |
– |
| 31st Dec 2016
(Exercise date) |
Bank Account Dr
Shares of X Limited Account Cr (Settling the transaction in shares)($ 102*1000) |
102000 |
102000 |
Accounting for Derivatives Example – 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 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 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 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
Bank account Cr (Option premium paid for buying call options)(Call premium of $ 5000) |
5000 |
5000 |
| 31st Mar 2016
(Reporting date) |
Fair value loss Account Dr
Call option Asset Account Cr (Decrease in fair value of option)($ 5000- $ 3000) |
2000 |
2000 |
| 31st Dec 2016
(Exercise date) |
Fair value loss Account Dr
Call option Asset Account Cr (Decrease in fair value of option)($ 5000- $ 3000) |
1000 |
1000 |
| 31st Dec 2016
(Exercise date) |
Bank Account Dr
Call option Asset Account Cr (Cash settlement on exercise of the call option)($ 5000-$ 2000-$ 1000) |
2000 |
2000 |
| Incase transaction is settled in shares of X Limited | |||
| 31st Dec 2016
(Exercise date) |
Shares of X Limited Dr
Call option Asset Account Cr (Shares settlement on exercise of the call option)($ 5000-$ 2000-$ 1000) |
2000 |
2000 |
| Cash for shares: i.e gross shares settlement | |||
| 1st Feb 2016 | Call option Asset account Dr
Bank account Cr (Option premium paid for buying call options)(Call premium of $ 5000) |
5000 |
5000 |
| 31st Mar 2016
(Reporting date) |
No entry required
This is an equity settlement, Change in fair value of option is not recognised |
– |
– |
| 31st Dec 2016
(Exercise date) |
Bank Account Dr
Shares of X Limited Account Cr (Settling the transaction in shares)($ 102*1000) |
102000 |
102000 |
Accounting for Derivatives Example – Writing a Put
Mr A 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 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 price of X ltd is more than 98 the buyer of option may not sell shares to A and otherwise if price of X ltd on 31st Dec 2016 is less than $ 98 then “A” has to buy shares at $ 98.
So fair value of 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
Put option obligation account Cr (Option premium received for writing put options)(put premium of $ 5000) |
5000 |
5000 |
| 31st Mar 2016
(Reporting date) |
Put option obligation account Dr
Fair value gain account Cr (Increase in fair value of put option)($ 5000- $ 4000) |
1000 |
1000 |
| 31st Dec 2016
(Exercise date) |
Put option obligation account Dr
Fair value gain account Cr (Increase in fair value of option)($ 4000- $ 2000) |
2000 |
2000 |
| 31st Dec 2016
(Exercise date) |
Put option obligation account Dr
Bank account Cr (Cash settlement on exercise of the Put option)($ 5000-$ 1000-$ 2000) |
2000 |
2000 |
| Incase transaction is settled in shares | |||
| 31st Dec 2016
(Exercise date) |
Put option obligation account Dr
Shares of X Limited Cr (Cash settlement on exercise of the Put option)($ 5000-$ 2000-$ 1000) |
2000 |
2000 |
| Cash for shares: i.e gross shares settlement | |||
| 1st Feb 2016 | Bank account Dr
Call option obligation account Cr (Option premium received for writing put options)(put premium of $ 5000) |
5000 |
5000 |
| 31st Mar 2016
(Reporting date) |
No entry required
This is an equity settlement, Change in fair value of option is not recognised |
– |
– |
| 31st Dec 2016
(Exercise date) |
Bank Account Dr
Shares of X Limited Account Cr (Settling the transaction in shares)($ 98*1000) |
98000 |
98000 |
Accounting for Derivatives Example – 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 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 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 price of X ltd on 31st Dec 2016 is less than $ 98 then “A” can deny purchase at $ 98 and buy in out sidemarket.
So fair value of 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
Bank Account Cr (Option premium paid for buying put options)(put premium of $ 5000) |
5000 |
5000 |
| 31st Mar 2016
(Reporting date) |
Fair value loss Account Dr
Put option Asset Account Cr (Decrease in fair value of put option)($ 5000- $ 4000) |
1000 |
1000 |
| 31st Dec 2016
(Exercise date) |
Fair value loss Account Dr
Put option Asset Account Cr (Decrease in fair value of put option)($ 4000- $ 2000) |
2000 |
2000 |
| 31st Dec 2016
(Exercise date) |
Bank Account Dr
Put option Asset Account Cr (Cash settlement on exercise of the Put option)($ 5000-$ 1000-$ 2000)( In this case Mr A may deny purchase at $ 98 and Buy in market at $ 95) For entry purpose I am assuming he bought at $ 98 from writer |
2000 |
2000 |
| Incase transaction is settled in shares | |||
| 31st Dec 2016
(Exercise date) |
Shares of X Limited Dr
Put option Asset Account Cr (Cash settlement on exercise of the Put option)($ 5000-$ 2000-$ 1000) |
2000 |
2000 |
| Cash for shares: i.e gross shares settlement | |||
| 1st Feb 2016 | Put option Asset Account Dr
Bank Account Cr (Option premium paid for buying put options)(put premium of $ 5000) |
5000 |
5000 |
| 31st Mar 2016
(Reporting date) |
No entry required
This is an equity settlement, Change in fair value of option is not recognised |
– |
– |
| 31st Dec 2016
(Exercise date) |
Shares of X Limited Account Dr
Bank Account Cr (Settling the transaction in shares)($ 98*1000) |
98000 |
98000 |
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 in to forwards/futures of company 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 company 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 forward on initial recognition is considered as a financial asset or liability. The fair value of forward is zero at initial recognition, so no accounting entry is required when a forward contract is entered into. The forward is accounted at fair value at each reporting date and resultant forward asset/liability is derecognised on settlement receipt/payment of cash or any other financial asset.
Shares settlement: Under this, shares are issued/ repurchased for net settlement amount at spot price of settlement date. Only settlement transaction involves equity.
Settlement by delivery: On this as discussed above, 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 following details.
Contract date: 1st Feb 2016: Maturity date: 31st Dec 2016. Exercise price $ 104 and No of shares 1000
Market price on 1st Feb 2016: $ 100
Market price on 31st Mar 2016: $ 110
Market price on 31st Dec 2016: $ 106
Solution: Fair value of forward 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
Forward value gain Account Cr (Decrease in fair value of forward resulting in gain) (1000*(110-104)) |
6000 |
6000 |
| 31st Dec 2016
(Exercise date) |
Fair value loss Account Dr
Forward Asset Account Cr (Decrease in fair value of forward asset) (106-104)*1000 |
4000 |
4000 |
| 31st Dec 2016
(Exercise date) |
Bank Account Dr
Forward Asset Account Cr (Counter party settles the forward contract by paying $ 2000) |
2000 |
2000 |
| Shares for shares i.e Net share settlement | |||
| 31st Dec 2016
(Exercise date) |
Treasury stock account Dr
Forward asset account Cr (Counter party settles the forward contract by delivering shares of X Ltd worth $ 2000) |
2000 |
2000 |
| Cash for shares i.e gross shares settlement | |||
| 1st Feb 2016 | Equity shares suspense account Dr
Stock repurchase liability account Cr (Present value of shares purchase liability under forward contract) |
100000 |
100000 |
| 31st Mar 2016
(Reporting date) |
Interest account Dr
Stock repurchase liability account Cr (104-100)*1000*11/12 |
3667 |
3667 |
| 31st Dec 2016
(Exercise date) |
Interest account Dr
Shares repurchase liability account Cr (4000*1/12) |
333 |
333 |
| 31st Dec 2016
(Exercise date) |
Treasury stock account Dr
Equity suspense account Cr (Purhase of own equity shares on forward contract and adjustment of equity suspense) |
100000 |
100000 |
| 31st Dec 2016
(Exercise date) |
Bank account Dr
Stock repurchase liability account Cr (Settlement of forward liability) |
104000 |
104000 |
Treasury shares:
Treasury shares (Own equity shares) is deducted from equity . They are no recognised as financial asset regardless of reason for which they are acquired.
In addition no gain or loss is recognised in P&L on purchase or sale, issue or cancellation of entity own equity shares. Consideration paid or received is recognised directly in equity.
If an entity holds equity share on behalf of others, there is an agency relationship and as a result those holdings are not included in the entity’s statement of financial position.
Transaction Costs
The transaction costs of an equity transaction is accounted for as a deduction from equity, net of any tax benefit. Transaction costs include Registration, regulatory legal, printing costs and stamp duties.
Transaction costs relating to compound financial instruments are allocated to liability and equity in proportion of allocation of proceeds. For example: If a transaction cost of issuing a convertible debentures is $ 20,000 and proceeds are allocated in 80:20 ratio between debt and equity , there fore cost of issuing debt is $ 16,000(20000*80/100) and equity if $ 4,000(20000*20/100).
Cost of issuing debt is included in computing effective rate of interest and amortised cost and equity is deducted from conversion option.
I hope you guys got a reasonable understanding of accounting treatment for derivative contracts.
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