How are derivatives accounted in balance sheet

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

In this example let us take Exercise price at $ 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 = $ 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)

Payoff for call seller= Max(settlement price-exercise price)x lot size0-1000-20004000
Pay off 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 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
Pay off of call writer= Pay off minus premium paid-2600-60014001400

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 – 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 shares of X Limited shares on 1st Feb 2016 with a 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 an 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:

DateParticularsDrCr
1st Feb 2016Bank 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 the 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 the 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 the exercise of the call option)($ 5000-$ 2000-$ 1000)

2000

2000

                     Cash for shares: i.e gross shares settlement
1st Feb 2016Bank 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 the option is not recognized

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 – 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 a 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 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(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:

DateParticularsDrCr
1st Feb 2016Call 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 the 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 the 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 the exercise of the call option)($ 5000-$ 2000-$ 1000)

2000

2000

                     Cash for shares: i.e gross shares settlement
1st Feb 2016Call 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 an option is not recognized

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  – 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 shares of X Limited shares on 1st Feb 2016 with a 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 the price of X ltd is more than 98 the buyer of an option may not sell shares to A and 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(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

DateParticularsDrCr
1st Feb 2016Bank account                                                   Dr

Put option obligation account                     Cr

(Option premium received for writing put options)(put a 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 the option)($ 4000- $ 2000)

2000

2000

31st Dec 2016

(Exercise date)

Put option obligation account                      Dr

Bank account                                                   Cr

(Cash settlement on the 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 the exercise of the Put option)($ 5000-$ 2000-$ 1000)

2000

2000

                     Cash for shares: i.e gross shares settlement
1st Feb 2016Bank account                                                   Dr

Call option obligation account                     Cr

(Option premium received for writing put options)(put a premium of $ 5000)

5000

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                                                     Dr

Shares of X Limited Account                            Cr

(Settling the transaction in shares)($ 98*1000)

98000

98000

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.  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 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(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

DateParticularsDrCr
1st Feb 2016Put option Asset Account                            Dr

Bank Account                                                 Cr

(Option premium paid for buying put options)(put a 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 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

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 the exercise of the Put option)($ 5000-$ 2000-$ 1000)

2000

2000

                     Cash for shares: i.e gross shares settlement
1st Feb 2016Put option Asset Account                            Dr

Bank Account                                                 Cr

(Option premium paid for buying put options)(put a premium of $ 5000)

5000

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                           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 into 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 forwarding on initial recognition is considered as a financial asset or liability. The fair value of forwarding 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 derecognized on settlement receipt/payment of cash or any other financial asset.

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: On this, 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 own shares as per the 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

The market price on 31st Mar 2016:   $ 110

Market price on 31st Dec 2016:   $ 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                             Dr

Forward value gain Account                    Cr

(Decrease in fair value of forwarding 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

(Counterparty 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

(Counterparty settles the forward contract by delivering shares of X Ltd worth $ 2000)

2000

2000

        Cash for shares i.e gross shares settlement
1st Feb 2016Equity shares suspense account           Dr

Stock repurchase liability account        Cr

(Present value of shares purchase liability under forwarding 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

(Purchase of own equity shares on forwarding contract and adjustment of equity suspense)

100000

100000

31st Dec 2016

(Exercise date)

Bank account                                                 Dr

Stock repurchase liability account             Cr

(Settlement of forwarding liability)

104000

104000

Accounting for Derivatives Video

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

Filed Under: Accounting, Liabilities in Accounting