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.

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

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

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:

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.

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

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 sharesBuy SharesKnowing how to buy shares is crucial for a person who wants exposure to the equity market. Equity markets are volatile, and timing is very important. Shares trade in exchanges, but you just can’t go and buy a share from the exchange. There are several steps involved in purchasing a share.read more 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.

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

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

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.

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 contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more. 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 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. The fair value of forwarding is zero at initial recognition, so no accounting entry is required when a forward contract is entered. The fair valueFair 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 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 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: 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 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

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

Accounting for Derivatives Video

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

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