Accounting for Derivatives


A Brief Look at the Complexities of Accounting for Derivatives

The basic premise of accounting is the accurate disclosure of information to allow the market to make informed judgments about firm value. This coincides with the third pillar of Basel II for banks; increased transparency allows the market to make more informed judgments about the value of the Bank. Regulators then use the share price of the bank as an additional indicator of the health of the bank.

The Statement of Financial Accounting Standards (SFAS) 133 and its close cousin, International Accounting Standards (IAS) 39[1] conclude that all derivatives meet the definition of assets or liabilities and must be recognized in financial statements. The two basic ways to record the value of a financial instrument are book value and fair value.

Book value bases the current value on the historical value with adjustments for age of the instrument. However, historical cost makes no sense for derivatives as many have an initial value of $0.

Fair value is an accounting approach to a market oriented value. A current market value is determined to set the value for accounting purposes.

Derivatives positions are generalized into two groups, speculative transactions and hedge transactions. The major difference between the two has to do with the impact on reported earnings.

Gains and losses from speculative trades are immediately recognized in the income statement, thus these trades have an immediate impact on reported earnings.

Gains and losses from hedge trades are reported, in accordance with the type of hedge either, in Other Comprehensive Income (OCI) or ordinary income.

OCI is not reported in the income statement, but accumulated in the equity account on the balance sheet. As such there is no impact on earnings. At some future date, items in OCI are re-categorized and impact earnings at a later date. Companies prefer to match up the gains or losses in the hedged position with the offsetting losses or gains from the hedge transaction. The goal is to have the impact from both positions go to ordinary income at the same time. A mismatch in timing could result in a negative impact on income in one reporting period, only to be offset by a similar positive impact in a different reporting period. This results in earnings volatility, which can impact share price.

Simplified Accounting for Speculative Transactions

Speculative trades are less complex to record for accounting purposes. Generally, a fair value is determined each day and unrealized gains or losses are recorded in ordinary income. For example, let’s look at the purchase of a call option on the SGX Nikkei 225 Index futures in a transaction classified as a speculative transaction. Assume on November 28 the following:

Nikkei 225 index is at 15,630

Nikkei 225 futures with a January maturity are trading at 15,650

The same maturity SGX Nikkei 225 call option with a strike price of 15,750 is trading at 420.

The underlying for the call option is one Nikkei 225 futures contract. The notional value is 500 Yen times the Nikkei 225 Index. In the current situation, the notional value of the futures is 7,825,000 Yen (500*15,650). For the call, if the index is above 15,750 at expiration the option will have value, but if not, the option will expire worthless.

The following accounting entries could be used by the firm to record the purchase of the above call option on the purchase date.

Debit Call Option 210,000 (420*500)

Credit Cash210,000

Each day, the fair value of the position will be determined and gains and losses will be recorded. Accounting recognizes that option prices have both time value and intrinsic value.

Intrinsic value = Market price of the underlying – Strike price

On Nov 28, the intrinsic value is zero because the market price is less than the strike price of the option, thus it is an out of the money option. Time value is the option price minus intrinsic value.

As time passes the value of the position will change. For example, assume that on December 11, the January Nikkei futures contract has moved from 15,650 to 15,800. The option is now in the money (15,800>15,760) and it has both intrinsic and time value. The option has an intrinsic value of (15,800-15,750)*500=25,000; the rest is time value. The intrinsic value was zero at inception since the option was not in the money, thus the time value was (420*500)=210,000. If the option is now priced at 440, the new time value is (440*500)-25,000=195,000.

The following entries will be made:

Debit Unrealized Holding Loss – Income Statement Entry; 15,000 (210,000-195,000)

Credit Call Option – Balance Sheet Entry 15,000

Debit Call Option – Balance Sheet Entry 25,000

Credit Unrealized Holding Gain or Loss—Income Statement Entry 25,000

Determining fair value for exchange traded derivatives is quite simple as the exchange provides a daily settlement price to market. This price is the fair value. For OTC derivatives, finding fair value can be more complicated. In some instances a pricing model, for example Black-Scholes for option pricing, could be used to determine an approximate fair value. Other methods are used as well such discounted cash flow models.[1] The accounting profession employs many acronyms. For a complete list see www.wikipedia.org

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