Accounting for Derivatives Comprehensive Guide (With Examples)

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

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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 1^st October 2016 for purchase of 10,000 Tata steel shares at $ 440 on 1^st January 2017. In this case irrespective of the price on 1^st 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 1^st 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 belong 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 1^st 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 1^st 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

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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

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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

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“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  

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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 1^st Feb 2016 with premium of $ 5 per share.  Exercise date is 31^st Dec 2016 and Exercise price is $ 102 per share

Market price on 1^st Feb 2016 =100 per share :

Market price on 31^st Mar 2016 =104 per share :

Market price on 31^st Dec 2016 =105 per share

Solution:

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

So fair value of option in this case is as follows

On 1^st Feb 2016(Date on which contract entered) Fair value of option= $ 5000

On 31^st March 2016(Reporting date) = 5000-(104-102)*100= $ 3000

On 31^st 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 

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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 1^st Feb 2016 with premium of $ 5 per share.  Exercise date is 31^st Dec 2016 and Exercise price is $ 102 per share

Market price on 1^st Feb 2016 =100 per share :

Market price on 31^st Mar 2016 =104 per share :

Market price on 31^st 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 31^st 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 1^st Feb 2016(Date on which contract entered) Fair value of option= $ 5000

On 31^st March 2016(Reporting date) = 5000-(104-102)*100= $ 3000

On 31^st 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 

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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 1^st Feb 2016 with premium of $ 5 per share.  Exercise date is 31^st Dec 2016 and Exercise price is $ 98 per share

Market price on 1^st Feb 2016 =100 per share:

Market price on 31^st Mar 2016 =97 per share:

Market price on 31^st 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 31^st 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 31^st 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 1^st Feb 2016(Date on which contract entered) Fair value of option= $ 5000($ 5*1000 shares)

On 31^st March 2016(Reporting date) = 5000-(98-97)*100= $ 4000

On 31^st 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 

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Mr A Bought a Put option details are as follows with a lot size of 1000 shares of X Limited shares on 1^st Feb 2016 with premium of $ 5 per share.  Exercise date is 31^st Dec 2016 and Exercise price is $ 98 per share

Market price on 1^st Feb 2016 =100 per share:

Market price on 31^st Mar 2016 =97 per share:

Market price on 31^st 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 31^st Dec 2016. If price of X ltd is more than 98 on 31^st Dec 2016, then he will buy the shares of X ltd at $ 98 otherwise if price of X ltd on 31^st 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 1^st Feb 2016(Date on which contract entered) Fair value of option= $ 5000($ 5*1000 shares)

On 31^st March 2016(Reporting date) = 5000-(98-97)*100= $ 4000

On 31^st 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:

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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

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X ltd entered into a forward contract to buy its own shares as per following details.

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

Market price on 1^st Feb 2016:   $ 100

Market price on 31^st Mar 2016:   $ 110

Market price on 31^st Dec 2016:   $ 106

Solution: Fair value of forward on 1^st Feb 2016    $ 0

Fair value of forward on 31^st March 2016      $ 6,000 (1000*(110-104))

Fair value of forward on 31^st 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: 

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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

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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.