Accounting for Derivatives

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.

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 entries in derivatives that will flow based on the scenario.

“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)

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

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

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

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

Solution:

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

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

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

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

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

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

The 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 the price was on 31^st 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 1^st Feb 2016(The date on which the contract was 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:

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

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

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

The 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 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 31^st 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 1^st Feb 2016(The date on which the contract was entered) Fair value of the option= was $ 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

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 a premium of $ 5 per share.  The exercise date is 31^st Dec 2016, and the Exercise price is $ 98 per share

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

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

The 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 the price was on 31^st Dec 2016. If the 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 the price of X ltd on 31^st 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 1^st Feb 2016(The date on which the contract was entered) Fair value of the option= was $ 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

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.

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.

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

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

The market price on 1^st Feb 2016:   $ 100

The market price on 31^st Mar 2016:   $ 110

The market price on 31^st Dec 2016: was $ 106

Solution: Fair value of forwarding 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

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

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