Derivatives Accounting

Bimaquest - Vol.
VI Issue I, January 2006 43

DERIVATIVES ACCOUNTING
A NEW OPTION FOR THE FUTURE

Rajas Parchure & S.Uma
*

This is the second part of this paper. The first part was published in July 2005 issue
of Bimaquest.

7. Options

The rights and obligations of the buyer and seller in an options contract are not
symmetrical, the buyer has the right, the seller has the obligation. By the very nature of
the contract the buyers liability is limited to the premium but the seller has in principle
an unlimited liability. Accordingly, the accounting treatment must differ for the buyer and
the seller so as to reflect this non-symmetry.

Obviously, the bought option is an acquired asset because it has a potential to earn. Since
options are usually short-term, the asset may be recognized as a current asset. In the case
of the seller who carries the obligation, the treatment needs to be reasoned out more
carefully. It is clear of course that the seller contracts an explicit liability at the strike
price; in the case of a call option he is obliged to deliver money to purchase the U/L at
this strike price and in case of a put option he is obliged to make a payment equal to the
strike price. Accordingly, he must show a liability equal to the strike price. Of course
since he is also entitled to receive value equivalents, money or the U/L, he must also
record an asset of equal value.

The difficult part is the treatment of the option premium. Now anybody who sells an
option expects the option premium he quotes to cover the losses in the event of exercise.
Then again there are option sellers who have positions in the U/L and are using these
positions to earn additional income. These day-to-day facts suggest that the motivation
for selling options is to earn revenue so that at the time of entry into the contract the
option premiums received should be shown as revenue. This may be codified in a
principle.

Professor & Faculty Associate, National Insurance Academy, Pune 45, India.
E-mail: rajasparchure@niapune.com , uma@niapune.com.
Derivaties Accounting A New Option for the Future

44 Bimaquest - Vol. VI Issue I, January 2006
Principle 1 : At the time of entry into an options contract the buyer will book the option
premium paid as current asset. But the seller will credit the premium received in the P &
L Account.

But there is a qualification. Time is always against the holder of options. Therefore, when
books are closed on the balance sheet date some portion of the option value would have
been irretrievably decayed against the buyer and in favour of the seller so that only the
unexpired portions of the contracted option premium can represent the residual values of
the assets and liabilities. In effect the buyer should debit and the seller should credit the
expired portion of the option premium to the P & L A/c. As for the unexpired portion the
buyer will show it as an asset. However for the seller the unexpired portion will be shown
only as a liability, the corresponding entry on the asset side being in the form of such
assets as represent the investments of premiums received.

The next problem is to find a robust method for estimating the expired and unexpired
portions of the option premium. Two methods suggest themselves. Allusion has been
made to the time value decay of options. This can serve as one method. Another less
elaborate method is the linear approximation method.

(i) Time Value Method

Under this method the expired portion is equal to the decline in the time value of the
option from the contract date to the accounting date. This is easy to find for exchange
traded options. But in case of OTC options only time value at the inception of the contract
is known. In principle it would be possible to obtain an OTC quote for the same option on
the accounting date and estimate the time value on that date as well. But, besides putting
a burden on the accountant, it may be open to question and/or it may give scope for
ambiguities. Therefore, for OTC options the time value decay may be estimated by a
linear approximation method, i.e. with reference to the lapsed maturity in relation to the
option maturity. For example a 3 month OTC option was transacted on 1
st
February, 2003
for a price of 30. Its time value was 20. When closing books on 31
st
March it may be
supposed that 2/3
rd
of the time value has decayed and 1/3
rd
remains unexpired. Then
13.33 will be debited or credited by the buyer or seller to the P&L A/c respectively and
6.67 will be shown as current asset and liability respectively for the buyer and seller. For
exchange traded options the expired value is simply the time value at contract date less
the time value on accounting date and the unexpired portion will be the contracted option
premium less the expired portion.

(ii) Linear Method

The other alternative is to use the linear approximation for the entire option premium. For
example a 6 month option contract transacted on 1
st
March may be said to have lost 1/6
th


Bimaquest - Vol. VI Issue I, January 2006 45
of its value on the balance sheet date of 31
st
March. If it was bought / sold for 25 then the
expired value would be 4.16 and the unexpired portion would be 20.84. The former
would be debited / credited to the P&L A/c and the latter would be shown current asset
and liability respectively for the buyer and seller.

The choice of method will be governed by two considerations the nature of business of
the entity and convenience of accounting. If the entitys business entails transacting a
large number of options contracts the linear method is recommended because of its
convenience. If transactions in options are few and far between the more elaborate and
accurate time value method is recommended.

In what follows we shall illustrate the application of the linear method which it may be
pointed out, gives almost the same results as the time value method when the entity
transacts a large number of in-the-money, at-the-money and out-of-the money contracts
which will result in a linearisation of the otherwise non-linear decay of time value over
the life of options.

Principle 2 : Expired option value must be calculated by the time value method or by the
linear method. Although the time value method is recommended, entities having
numerous options transactions may follow the linear method. In the case of OTC options
only the linear method is feasible.

Before proceeding to give illustrations we need to dispose two matters. First, the realized
gains and losses in respect of contracts that have been reversed / settled during the
accounting period. We follow the principle stated in futures accounting.

Principle 3 All realized capital gains or losses on delivery or reversal of transactions in
options will be shown in the profit and loss account.

Second in respect of unrealized gains or losses. Here too as in the case of forwards and in
keeping with the principle of conservatism the net losses should be provided for and net
gains only disclosed. Now in case of the buyer the losses to be provided for will be equal
to the excess of the strike price over the closing stock price on the balance sheet date
subject to a maximum of the unexpired premium. In case of the seller the provision will
be equal to the excess of closing stock price over the strike price and has of course no
limit.

Principle 4 : Provision will be made for net losses with reference to U/L price but gains
will only be disclosed.

To illustrate consider an example of a naked 6 month call option contract at strike of 110
at a premium of 30. Suppose the balance sheet date falls after 1 month and both buyer and

seller have an open position on that date. Suppose also that price of the U/L on the
balance sheet date is 105 so that the call option is out of the money and the option is
quoted at 10. The P&L A/c and Balance sheet of the buyer will be as follows :

P&L Account - Buyer
Particulars Amount Particulars Amount
Call Option Premium
(Expired)
20 P & L Account Balance 25
Provision for Loss on call
Option
5
25 25

Balance Sheet Buyer
Liabilities Amount Assets Amount
Equity 30 Call Option Premium 30
Provision for Loss
on call option
bought
5 (-) Expired Premium 20 10
P&L Account 25
35 35

If we mark the above balance sheet to market there will be no difference in entries as
provision has been made for the losses.

In the case of the seller in order to bring out the provisioning method clearly, suppose that
the U/L price on the balance sheet date is 120 so that the call option is in the money and
the option price is 35. The sellers financial statements would be as follows;

P&L Account Seller
Unexpired Premium 10 Premium on option sold 30
Variation Margin (110
120)
10
P & L Account Balance 10
30 30


Balance Sheet Seller
Liability on Sold option 110 Call Option sold 110
Unexpired Premium 10 Bank / Investment 30
Variation Margin 10
P & L A/c Balance 10
140 140

Observe the difference between the balance sheets of the seller vis--vis the buyer. It
shows much greater leverage and risk because of the presence of the obligation under the
option contract.

Principle 5 : Mark to Market Reserve will be made for gains with reference to U/L price
and option price.

If the above balance sheet were to be marked to market, it will be as follows:
M-T-M Balance Sheet Seller
Liability on Sold option 110 Call Option sold 120
Unexpired Premium 10 Bank / Investment 30
MTM reserve on option
(120- 110)
10
Provision for loss on
option sold
10
P & L A/c Balance 10
150 150

8. Stock and Option

Consider now the case of an agent who owns the U/L and sells say a call option on it; to
illustrate, he owns a stock bought at 70 and sells a 6 month call at a strike of 110 at a
premium of 30. The principle of the net open position will now come into operation.

Principle 6 : The value of the net open position in the U/L must be shown on the face of
the balance sheet.

The agent in our example has a net open position of zero. For the sake of simplicity
suppose the call option is sold on the balance sheet date. Then the balance sheet would be


Equity 70 Investments 70
Unexpired premium 30 Bank (Premium) 30
Liability on call
Option sold
40 Call Option sold (Net Open
Position)
40
140 140

Observe that the value of the net open position (which is zero) is 40, it being the
difference between the price locked in for delivery and the purchase price. Observe that
the balance sheet shows no leverage.

A similar position will be observed in the case of an agent who owns the stock and buys a
6 month put option at a strike price of 70, equal to his holding price. Once again the net
open position is zero and so is its value.

Equity 100 Investments 70
Put Option premium 30
100 100

The above statements shown at historical cost do not fully reveal the dynamics of the
transaction though they do show absence of leverage and risk. The dynamics of price
changes are revealed if the U/L and the option are marked to market. Thus suppose the
covered call seller closes his books when the market price of the stock is 130 and the
option price is 50. The MTM balance sheet will be

Equity 100 Investment 130
MTM Reserve
Investment 60
Call Option 20
Loss on call option

80
20
Call options

P & L A/c Balance
50

20
Unexpired premium 30 Bank (premium received) 30
230 230

There is no diminution in net worth or increase in provision because the transaction is a
hedge the loss on the sold call is offset by gains on the U/L and in turn the increase in
the value of call option sold.

In the case of the protective put buyer suppose the closing price is 50 then the MTM
balance sheet will be :


Equity 70 Investment 70
Less : Provision for
diminution in value 20

50
Unexpired premium
Provision for loss on
option

30

20
Put Options Premium

P & L A/c
30

40
120 120

Of course we may also mark to market the option positions where secondary market
quotes are available. The effect will be identical.

9. Two Options

Having tested shallow waters let us venture further. Suppose an agent buys a 90 strike
call for 40 and sell a 110 strike call for 30 both of 3 months maturity. This is called
buying a bullish call spread in the language of the trader. Suppose for simplicity that the
spread is struck on the balance sheet date. The net open position is zero and its value is
10, the difference in the option premiums. His balance sheet would be

Equity 10 Spread premium 10
10 10

If he does the reverse viz. he sells the 90 strike call and buys the 110 strike call the
treatment is not so simple. He now has a bearish call spread for which he receives the
option price spread which he must keep in reserve and invest. But this will not suffice
because even though his net open position is zero he is exposed to risk equal to the
difference in strike prices viz. 20 which is not covered and must be recognized as a
liability; he has agreed to deliver the U/L at 90 and take delivery at a higher price of 110.
If the closing U/L price stands below 90 his balance sheet would be

Unexpired spread Premium 10 Bank 10
Liability on call Spread 20 Call Spread 20
30 30


If however the U/Ls price on the balance sheet date stands at 100 there is an unrealized
loss of 10 which must be provided for and which will reduce the net liability on the
spread to 10. The balance sheet will be

Unexpired spread Premium 10 Bank 10
Provision for Loss 10 P&L A/c 10
Liability on Spread 10 Call Spread 10
30 30

We may state this as a principle.
Principle 7 : Whenever there are sold calls at lower strikes than bought calls and/or there
are sold puts at higher strikes than bought puts the difference in strike prices must be
recognized as liability (and an equivalent asset) to the extent they are not provided for.

Consider next the treatment for straddles. A trader buys both a call and a put option at
strike of 100 at 10 and 30 each with expiry of 3 months. Assuming once again for
convenience that the position is taken on the balance sheet date, his balance sheet would
be :

Unexpired Option Premium 40 Bank 40
40 40

Note that the buyer of the straddle would never have to make a provision for unrealized
losses since he can only gain; the seller of the same straddle would of course recognize
two liabilities, to make delivery of the U/L at 100 and to take delivery at 100, i.e. a
liability of 200. Also he must make provisions, if the ruling price is greater than 100 there
is an unrealized loss on the sold call and if the ruling price is lesser than 100 there is an
unrealised loss on the sold put. The provision will of course be duly reduced from the
liability according to principle 7. Thus, suppose the U/Ls price stands at 80 and there is
an unrealized loss of 20 on the sold put. The balance sheet would be

Unexpired Premium 40 Bank 40
Provision for Loss on
Put option
20 P & L A/c 20
Liability on Straddle 80 Receivable from
Straddle
80
140 140


Observe that the balance sheet of the straddle seller shows high leverage, a debt : equity
ratio of 100 : 40 but the buyers book shows nil leverage. The same observation holds for
the seller of the spread in the earlier example in relation to the buyer of the spread.

10. Multiple Options

The foregoing discussion has prepared the ground for a generalization to a situation
where a trader has several open positions in calls and puts of various maturities at various
strikes. Calculations will now be more detailed for four reasons :

(i) The unexpired portions of the option premiums will have to be calculated by
linear interpolation from the contract date to the balance sheet date with
reference to the expiry date.
(ii) The average price of the bought or sold positions in the option contracts
corresponding to each strike and each expiry date will have to be calculated.
(iii) The liability due to selling calls at strikes lower than buying calls and vice
versa for put options would have to be recognized.
(iv) Provisions for unrealized loses on the net open position at the ruling price of
the U/L must be calculated.

Consider an example with multiple call options. Suppose that the net outstanding
positions (i.e. after netting bought and sold call options at each strike and each expiry date
and taking realized gains / losses to the revenue account) are as follows. Suppose also that
we are closing books on December 31, 2003.

Calls Options : Short (-), Long (+)
Strike Expiration Day
90 100 110

15/1/04 +5 (30) -6 (23) +8 (18) +7
15/ 2/04 -10 (40) +5 (32) -4 (25) - 9
15/3/04 -6 (50) +8 (45) -2 (36) 0
- 11 +7 +2 -2

Of course each of the 9 outstanding positions in the table will have its own history.
Suppose the J anuary 2004 90-strike calls have the following history.

No. Contracted Date Contracted Price
+2 1/12/03 30
+2 11/12/03 32
+1 21/12/03 26


Then the average price for the position +5, J anuary 2004, 90-strike calls will be :

30
5
1 * 26 92 * 32 2 * 30
=
+ +

This is the figure shown in brackets next to the position. A similar calculation should be
made for all the other positions. To keep things simple however let us suppose that all the
remaining positions were taken on the same day, 15 December 2003 at the average prices
shown in brackets.

The option premium on the net position of 2 sold calls (read directly from the extreme
southeast corner of the table above) is arrived at by adding across the 9 positions,

(30 x 5) +(8 x 8) +. (-2) (36) = -196
showing that a net premium of 196 is received. This must be split into the expired and
unexpired portions to be respectively considered in P&L A/c and shown as liability on the
balance sheet. To find this is the next step.

Each of the 9 positions in the table will have its own history. For the J anuary 15, 2004
90-strike call as on 31 December, 2003 this history will be as follows :

Contracted Date Expired Period
Till Balance Sheet
Date
Maturity Unexpired Value
1/12/03 30 45 15/45 x 30 =10
11/12/03 20 35 15/35 x 32 =13.71
21/12/03 10 25 15/25 x 26 =15.60

And since there are +2, +2 and +1 contract numbers the unexpired option value will be

(10 x 2) +(13.71 x 2) +(15.60 x 1) =63.02

The expired value will of course be 150 63.02 =86.98. The unexpired option premium
for all the positions will be as follows :

The sum of all these is the unexpired option premium for the net open position. It is
109.98 and the expired portion is 86.02. Thus 86.02 will be credited to revenue account
and 109.98 will be shown as unexpired option premium liability.


11. Liability on NOP

Now the difficult part the determination of liability in terms of delivery of the U/L
1
. The
principle that is a natural analog of that applied in the case of futures and principles of
prudence &consistency may be stated.

Principle 8 : The liability under a net open sold position in a series of option contracts of
one type, either call or put, on an U/L will be the sum of :

(i) Liability of the net sold position at the weighted average strikes at which
there are net sold contracts (See Note 3). In our example all the sold contracts
are at 90 strike so that liability to be shown on the balance sheet will be 90 x
2 =180. In general the formula is :

) ( ) ( ) ( NOP
N
N X
NOP X
i
i i
=
where N
i
denotes sold contracts at strike X
i
.

(ii) Liability due to the difference between the strike prices of sold options and
the strike prices of bought options in the cases in which the latter exceeds the
former.
In our example there are two such cases. Firstly there are 7 sold options at
strike of 90 corresponding to 7 bought at 100 and secondly there are another
2 sold at 90 corresponding to 2 bought at 110. The liability due to them will
be

(100 90) x 7 +(110 90) x 2 =110

This figure will be added to 180 which is liability due to 2 sold calls to give
290. Note that step (ii) will apply even when the net open position is long.

The last step concerns provisioning for unrealized losses. Suppose the stock
price stands at 105 on the balance sheet date. The 11 short positions at 90-
strike will each shown an unrealized loss of 15 giving a total of 165. But the
7 long positions at 100-strike will show unrealized gain of 5 each, i.e. 35.
Now since the prices of a series of call options on a U/L move in the same
direction it is the net unealised loss that must be considered, i.e., 130.
Accordingly, 130 will be provided for in the P&L A/c and the provision
shown in the balance sheet. The effect of this would however be to recognize
a net liability of 290-130 =160 in the U/L.


An identical procedure applies to transactions in a series of put options on an
U/L excepting for one difference, viz. that the liability on the net open
position in put options will be topped up in all cases where the strikes of sold
puts are greater than the strikes of bought puts.

12. Calls and Puts

When there are net open positions in calls as well as puts these too must be combined to
find the net open position in the U/L. Four possibilities can arise which are shown below :

Calls Puts
(1) - +
Net Open (2) + -
Position (3) + +
(4) - -

The option premium on the overall position would of course be the sum total of the
option premiums paid and received at the average option price at each strike and each
expiry date,

i.e.,
ipt it ict it
N P N C +

N
i
> 0 for bought
N
i
< 0 for sold

And
it
C and
it
P are the average call and put option prices. The split of this into the
expired portion and the unexpired portions will be made in the same manner as has been
illustrated above with reference to a series of call options.

To recognize the liability in the U/L the net open positions will be combined depending
upon the pattern of signs shown above. For example, if both NOPs show bought
positions, say +2 and +5 then there is no liability on the U/L. If both positions show sold
positions, say 5 and 3, then the liability on the U/L will be
p c
X X 3 5 + where
c
X
and
p
X are the weighted average strike prices of sold calls and sold puts respectively.

If the NOPs in calls and puts are of opposite sign, e.g. 5 and +3, then 3 sold calls are
matched to 3 bought puts and 2 sold calls remain. The matched position will be
considered as 3 short futures (the obligations of selling calls get combined with the rights

of bought puts on the same U/L) at the average of the weighted average strikes of calls
and puts, ( ) 2 /
p c
X X + which gives a liability of

( )
2
3
p c
X X +

To this must be added the liability due to 2 sold calls at
c
X to give

( )
c
p c
X
X X
L 2
2
3
+
+
=

As before the net liability recognized will depend on the stock price ruling on the balance
sheet date and the provisions for net losses that it leads to.

13. Options and Futures

In practice yet another round of matching and netting will be required if there is a net
open position in the futures on the U/L as well. For example suppose the net open
positions are 5, -3 and +4 in calls, puts and futures on the same U/L. The matching of 5
and 3 gives 3 short futures at a price ( ) 2 /
p c
X X + . This offsets 3 out of the 4 long
futures at average price F with the shortfall if any of the price of bought futures below
the price of shorted futures bearing provided, viz.

( )
2
3 F X X
p c
+

otherwise a disclosure for unrealized gains. There remain 2 short calls and 1 long futures.
Clearly 1 position can be offset and liability recognized only if there is a shortfall of the
average futures price below the average strike of the sold call,

) 1 )( ( F X
c

otherwise zero. Finally there remains 1 short call at average strike
c
X whose implied
liability is
c
X . The sum of provisions and liability will be,


F
X X
F X X
p c
c c
+
+ +
2
3 , 0 max( ) , 0 max(

This net open position in derivatives taken as a whole must finally be combined with
position in the spot to evaluate the grand net position in the U/L.

14. Compound Derivatives

The accounting method proposed for derivatives on an U/L generalizes very comfortably
to derivatives on derivatives as well , i.e., contracts such as options on futures and options
on options. It will suffice to give only one example.

Consider the case of options on futures. The buyer will show the unexpired portion of the
option premium as asset, making the necessary provisions and booking all realized profits
and losses during the accounting period. The seller will do all of the above and in addition
recognize the liability on the U/L, which is now a futures contract at the relevant striking
price. There will be only one difference - if the contract goes to delivery the buyer will
expense the option premium, the seller will take credit for the revenue and both will have
an open position, bought and sold respectively, in the futures contract which will be
shown as liability by the seller and asset by the buyer after making provisions for
unrealized losses depending upon the market price of the futures contract that rules on the
accounting date.

Of course when calculating the values of the net open position account must be taken of
the position in the U/L as well as the U/L of the U/L.

15. Index Derivatives

Positions in index derivatives, whether futures or options, pose some special problems.
Index derivatives like all other derivatives may be used to speculate, hedge or arbitrage
but unlike other derivatives considered so far their U/L is a generalised index, not a
specific asset. Thus in a situation where an index fund manager uses index derivatives
there is no problem whatsoever for accounting, everything said so far applies exactly and
without modification.

There is no problem in the other kind of situation as well i.e. where the agent has no
position, short or long, in any of the stocks that constitute the index. The problem lies in
the intermediate case where the agent has a position in some of the stocks constituting the
index and others which do not constitute the index. But even here there is no problem in

those cases in which there are no short positions in stocks and there is a long position in
the index futures or index calls. So the problem really arises in 2 cases.

(i) Where some of the stocks constituting the index are held and index futures
and index calls are shorted or index puts purchased.
(ii) Where there are some short and long positions, partly in stocks constituting
the index and partly not, and there are long or short positions in index
derivatives.

What if any is the net open position in these circumstances and how is it to be valued? To
begin with it is generally true that stocks tend to move up and down together, those in the
indexes and those outside. More generally indexes tend to move up and down together
and worldwide experience shows that it to be so. It is for this reason that fund managers
hedge their positions in individual stocks or portfolios by opposite positions on index
derivatives when they are trading on the specific risks of those stocks. In fact in these
cases they do not want to short individual stock futures for example because that would
be self defeating. That being so there is no harm in regarding long stocks and short index
futures (or short index calls or long index puts) as reducing the net open position of the
fund manager. Thus the value of the net open position will in this case be simply the
value of stocks held minus the value of index futures / calls shorted or index puts
purchased. There would not of course be any meaning to the net physical open position.
To be sure there is bound to be a basis risk viz. the risk that all stocks would not move
exactly with the index but this would show itself in the net capital gains and losses on the
positions. And these capital gains and losses must necessarily be considered to be short-
term unless the positions have been held for period longer than one year.

When there are some short and long positions in stocks and long or short positions in the
index derivatives however the positions will have to be matched in the following way to
calculate the value of the net open position;
1. Long positions in stocks (+) with short index futures plus short index calls
plus long index puts (-).
2. Short positions in stocks with long index futures plus long index calls plus
short index puts (-).
3. The sum of the two above, given the sign conventions +for bought and for
sold, which will be the effective net positions when signs differ and the sum
when signs are the same.

This of course raises the question about the treatment to be accorded to the presence of
individual stock options as well. But thats no problem provided we consider only the net
long and short positions in individual stocks in steps (1) and (2).


16. Swaps

Swaps, eg. fixed rate for floating rate or vice versa involve exchanges of interest coupons
on an U/L notional amount. Implied in every swap deal is a deal in derivatives as is
revealed by the equation of value for swaps,

Fixed Rate A/L =Floating Rate A/L +Long Interest Rate Put Short Interest Rate Call

i.e. a holder of a fixed rate asset / liability buys an interest rate put option (quoted for the
sake of exposition in interest rate terms instead of the usual asset price terms) and sells an
interest rate call at a striking interest rate equal to the fixed rate. In other words he shorts
an interest rate futures contract implicitly.

Thus an agent who swaps a fixed rate liability for a floating rate liability without owning
a floating rate asset is buying (back) an interest rate futures contract. Now in a swap
typically the exchange of interest coupons is made with interest calculated on the notional
amount. The value of the net open position will not however be the notional amount,
which only serves as the base for the calculation, but the present value of the difference
between the interest coupons that are swapped. And this is equal to,

t
n
t
Rate Fixed
Amount Notional te FloatingRa FixedRate
) 1 (
) ( (
1
+
=

where n is the maturity of the swap arrangements and t denotes the time periods at which
the interest rate on the floating rate instruments is reset and | | denotes absolute value.
(Needless to say that in the above calculation the fixed rate floating rate pertains to the
reset period). Obviously the value of the swap which, because it contains a position in the
interest rate futures, must be shown both as a liability and an asset on the balance sheet. If
the maturity of the swap arrangements exceeds the accounting period this value must of
course be periodically amortised.

Consider an example. Suppose there is a manufacturing corporate that has Rs.1000 worth
of real assets supported by Rs.1000 worth of fixed rate loans at 9% p.a. It can swap this
for a floating rate liability at B +2% where B is the benchmark rate which is currently
6%. Suppose net return on fixed assets is 15%. Also suppose the reset period for the
floating rate loan is 1 year and the corporate considers a 2 year swap. The value of the
swap will be :

2
) 09 . 1 ( ) 100 (
) 1000 ( %) 8 % 9 (
) 09 . 1 ( ) 100 (
) 1000 ( %) 8 % 9 (
59 . 17
=


The balance sheet will at the start of the year when the swap also is assumed to
commence will be

(Floating) Loan 1000 Assets 1000
Swap Liability 17.59 Value of Net Open Position 17.59
1017.59 1017.59

For the simplicity suppose that B does not change over the two years then the P&L A/c
extract for year 1 will be

Interest 80 Net Income 150
Amortisation of Swap 8.42 8.42
Profit 70
158.42 158.42

The amortisation charge of 8.42 is arrived at by subtracting from the annuity represented
by difference in rates of interest the first years interest on the present value of the swap.
Note that this implies the use of the annuity method of depreciation. In subsequent years
the depreciation / amortisation charge will simply rise by a factor of 1.09 for each year.

The balance sheet at year 2 will be.

(Floating) Loan 1000 Assets 1000
Liability on Swap 17.59
(-) Amortisation 8.42

9.17
Value of Swap
Position 17.59
(-) Amortisation 8.42

9.17
1009.17 1009.17

The P&L A/c of the second year will be the same as above except that the amortisation
will now be 9.17 giving once again a profit of 70 and the balance sheet at the end of the
second year will simply show (fixed rate) loans and asset worth 1000 since the swap has
expired. Of course in reality the profit figure will depend on how the benchmark rate B
moves, being greater for declines in B and lower for increases in B. If B doesnt move
then the corporate saves 1% in interest cost and raises it income by 10 every year which is
what is shown. (At the fixed rate net profit would be 150 90 =60).


Make now a variation. Suppose the corporate is one whose assets of 100 consist of
floating rate instruments yielding B+3%. Now a swap of the liability at 9% for a liability
at B +2% will amount to a net open position in floating rate instruments equal to zero and
since the notional amount is also equal to value of assets, no liability will be recognized
on the balance sheet. If, however, the swap is for 500 notional amount then there is
residual mismatch whose value will be,

t
t
B
) 09 . 0 1 (
) 500 )%]( 2 ( % 9 [
2
1
+
+
=

and will be shown on the balance sheet. The application of the principle of net open
position once again demonstrates leverage in the balance sheet of one who has such a
position as compared to one who hasnt. Only, for swaps, the net open position must be
reckoned with reference to assets for liability swaps and with reference to liabilities for
asset swaps.

The method for swap accounting suggested above is almost identical with that
recommended by FASB in SFAS 133 with two exceptions. Firstly, the present value of
the swap payoff is not reflected in the balance sheet of FASB. Secondly, the present value
is recalculated each year depending upon the floating rate in the market, it is not
amortised over the life of the swap. On the first point, our treatment is consistent with our
stand that transactions in derivatives must be reflected on the face of the balance sheet so
that leverage in the structure of liabilities can be identified. On the second point, the
treatment is consistent with expensing over a period of time the asset value implicit in
derivatives contracts.
17. Taxation
The Income Tax Act does not have any specific provision regarding taxability of gains or
losses from derivatives. The only provisions which have an indirect bearing on derivative
transactions are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed
in respect of a speculative business carried on by the assessee, shall not be set off except
against profits and gains, if any, of speculative business. Section 43(5) of the Act defines
a speculative transaction as a transaction in which a contract for purchase or sale of any
commodity, including stocks and shares, is periodically or ultimately settled otherwise
than by actual delivery or transfer of the commodity or scrips. It excludes the following
types of transactions from the ambit of speculative transactions:
1. A contract in respect of stocks and shares entered into by a dealer or investor
therein to guard against loss in his holding of stocks and shares through price
fluctuations;

2. A contract entered into by a member of a forward market or a stock exchange in
the course of any transaction in the nature of jobbing or arbitrage to guard against
loss which may arise in ordinary course of business as such member.
These provisions of Income Tax Act give rise to two issues;
1. How to distinguish a speculative transaction with that of non-speculative one?
2. What should be the tax treatment of gains / losses on a derivative transaction
which are generally for a short term but used to offset the gains / losses on an
underlying held for long term?
1. As per Act provisions, a transaction is speculative, if
1. it is in commodities, shares, stock or scrips
2. it is settled otherwise than by actual delivery
3. the participant has no underlying position
4. it is not for jobbing/arbitrage

But again, one has to prove that the transaction was a non-speculative one to set off the
losses against any business income. The accounting method suggested in the paper
automatically takes care of these requirements. Suppose there is an underlying position
against which derivative transactions are entered, only the net open position is accounted
for. If both underlying and derivatives are liquidated simultaneously, the gain or loss on
one position will offset loss or gain on the other position, in case of a perfect, complete
hedge. If the hedge is not perfect, for example, when underlying is hedged by index
derivative, there will be a basis risk whose effect on income will in any case be captured
by the usual accounting rules. In fact, the proposed accounting system itself simplifies the
procedure for segregating the speculative and hedging transactions for the income tax
authorities!

If all the positions in NOP, say U/L and derivatives, are not liquidated simultaneously,
there will be a question as to how this may be taxed? One may say that realized gains or
losses shown in the revenue account may be taxed as speculative gains / losses. This will
be too stringent for the trader who entered the transaction for managing price risk.
There will be two situations of this nature: 1) when the U/L (derivative) position will be
making a loss and the derivative (U/L) is sold to book profits. 2) when the U/L
(derivative) position will be in profit and the derivative (U/L) is sold to book losses.

Under (1) above, the accounting procedure illustrated in the paper calls for
making provision for unrealized losses and showing realized gains or losses in
the revenue account. Under the present taxation rules, though it is not
permissible, the taxable income, may be defined to adjust provision for
unrealized gains against the realized losses.
Under (2) above, both the positions may be marked to market and the realized
losses to be set off against marked to market reserve, before arriving at the
taxable income
All the realized losses may be allowed to be carried forward.
4. The second issue relating to long term and short term transactions can also be
easily settled by taking into account the nature of capital gains / losses of the
underlying. Long term gains / losses of the underlying may be set off against the
short-term gains / losses on derivatives. If it is a perfect hedge, there will not be
any tax liability. If not, the tax treatment on derivatives would be similar to the
treatment of gains / losses on underlying.

18. Appraisal

It may be appropriate in concluding this paper to make an unforgivably brief comparison
of the accounting system proposed in this paper vis--vis those of ICAI (2003), FASB
(1998) and IASC (2000) on 2 key issues viz.,
1. Recognition of assets and liabilities
2. Recognition of income and expense

To begin at home, the ICAI system appears to be a transaction based system which
recognises the option premium alone as asset and liability in the books of both buyers and
sellers. These are marked to market and continue in the books until they are closed out by
cash settlement / delivery or expire. Realised gains are recognised in the P&L A/c. In case
of futures contracts only the margin accounts with the exchange which are marked to
market are reflected in the balance sheet. This is done for both buyers and sellers.
Surprisingly the ICAI guidance note is silent on the margin accounts of sellers of options
which are marked to market. The ICAI system does, however, conform to the principle of
conservatism in recognising and making provisions for unrealised losses. Overall the
ICAI philosophy seems to be to consider derivatives as being transactions only with the
Exchange and in which only the money flows to and from the Exchange are material.
Derivative contracts are accounted at face value, margin accounts in case of futures and
premiums in case of options but the underlying positions are not considered at all. Also
the ICAI system is silent on OTC derivatives contracts.


In contrast, the FAS 133 is motive-based in which the distinction between hedging
transactions and speculative transactions is given the centre-stage. Quite clearly and
entirely justifiably the chief concern seems to be to ensure that hedge transactions are
recognised for what they are and receive favourable tax treatment as compared to
speculative transactions. However, the apparatus that reveals the distinction of hedging
and speculation to the accountant is both complex and ambiguous : its chief requirement
is the designation of a transaction to qualify for hedge accounting. Though the standard
does not specify an appropriate method of assessing the effectiveness of the hedge, it
requires that the method used for assessing the effectiveness of hedge to be specified at
the time of designation and continued usage of the same method throughout the hedge
period. Usually used tools are betas / correlation coefficients / volatilities. Although they
are very useful statistical concepts, their use in this context give rise to a whole host of
questions; how long should be the time-series, of what frequency, whether P-beta or R-
beta is relevant, whether covariance or semi covariance is the right idea, what to do if
betas change over time, etc. etc. etc. These issues not only confound the job of the
accountant but may also lead to suspicions and allegations of creativity. However, this
standard of FASB does emphasize the need to recognize derivative instruments as assets
and liabilities and the necessity to show all derivatives transactions on the balance sheet
at fair value.

The IASB (IAS 39) follows fair value accounting and on balance sheet recognition of
derivatives. Fair value means in the first place the market value but failing that it should
be approximated by some scientific model eg. in case of options by the Black-Scholes
model etc.

Both FASB and IASB recommend the method of hedge accounting and there is a feeling
that hedge accounting is one of the main reasons for the complex nature of IAS 39 and
FAS 133. European countries try to evolve a method of accounting sans hedge
accounting.

The accounting system proposed here combines the advantages of the transaction based
and motive based approaches. The former is clearly accommodated in showing option
premiums as assets and liabilities, making appropriate provisions for prudence and
booking premium to revenue / expense both for exchange traded and OTC derivatives.
The latter too finds an explicit place because the net open position in derivatives is shown
on the face of the balance sheet to reveal the liability in terms of the U/L. Both IASB and
FASB say that derivatives are assets and liabilities but show entries only for net rights or
obligations under derivative contracts on the basis of change in fair values. We, on the
other hand explicitly recognize the assets and liabilities and also show the effect of their
recognition on the leverage in the balance sheet. Apart from this, there are strong
similarities between the FASB procedure for hedge accounting and the proposed method.

These are 1) the treatment of expired portion of option premium in terms of time value
and 2) the principles of marked to market balance sheet
2
.

Note, however, that we have been under no necessity to pre-designate transactions as
hedge, speculation or otherwise. Our position is that motives should not be written into
the accounts by its author, motives should be revealed by the accounts to its reader.
Accordingly, the principles and rules that are devised to calculate the net open position
and its value automatically bring out whether transactions in derivatives have on the
whole been for hedging or for speculation. All of the statistical paraphernalia of FASB is
completely avoided.

Apart from the synthesis that is sought to be achieved, we have sought to clarify in detail
the procedures and rules to be applied in case of multiple, numerous and complex
positions in derivatives. Such an exposition is woefully absent in the accounting literature
on this subject, whether academic or official, which makes it difficult to understand
derivatives accounting in a comprehensive way. This is the gap we have tried to fill.
Incidentally these procedures and rules fit an interesting acronym NOMAD meaning
Netting, Offsetting, Matching, Averaging and Differencing, but which, we hope, will give
settled and stable accounting results.


APPENDIX II
OPTIONS
Buyer Seller
I. At the time of Entry I. At the time of Entry
1. Call / Put Option
Premium A/c Dr
To Bank A/c
(Being recognition of
asset & liability on option
bought)
1. Bank A/c Dr
To Call / Put Option premium A/c
(For receipt of premium)
2. Call / put option sold A/c Dr
To Liability on call/put option sold
(Being recognition of asset & liability on
option sold)
*3. Variable Margin A/c Dr
To Bank A/c
(For the payment of margin to Exchange)
II. Squaring up / Settlement II. Squaring Up / Settlement
i). Squaring up i). Squaring up
a) Bank A/c Dr
To Call/Put Option
Premium A/c
(Being reversal of the
bought position on
options)
a) Call / Put Option
Premium A/c Dr
To Bank
(Being reversal of the sold options
position)
b) Liability on call/put option Dr
Call / Put option sold A/c
(Being the reversal of recognition entry)
b)

Profit on options A/c
To Profit & Loss A/c
(Being profit on bought
futures squared up)
(premium on sold
bought options)

Profit & Loss A/c Dr
To Loss on call/put
options A/c
(Being Loss on options
transaction reversed)
c)

Profit on options A/c Dr
To P & L A/c
(Being Profit on reversal of options
contract sold)
(premium on bought sold)

P & L A/c Dr
To Loss on options A/c
(Being Loss on reversal of options
contract)



*d)
Bank A/c Dr
To Variable Margin A/c
(Being the receipt of margins deposited)
(ii) Cash Settlement (ii) Cash Settlement
a) Bank A/c Dr
To Profit on Options
Loss on Options A/c Dr
To Bank A/c
(Being reversal of the
bought position on
options)
a) Liability on call/put option Dr
(Being reversal of recognition entry)
b) Profit on options A/c
To Profit & Loss A/c
(Being profit on bought
futures squared up)
(premium on sold
bought options)

Profit & Loss A/c Dr
To Loss on call/put
options A/c
(Being Loss on options
transaction reversed)
b) Bank A/c Dr
To Profit on Options
Loss on Options A/c Dr
To Bank A/c
c) P & L A/c Dr
To Call / Put Options
Premium A/c
(Being the unexpired
portions of premiums in
options contract settled)
c) Profit on options A/c Dr
To P & L A/c
(Being Profit on reversal of options
contract sold)
(premium on bought sold)

P & L A/c Dr
To Loss on options A/c
(Being Loss on reversal of options
contract)
(iii) Physical Settlement (iii) Physical Settlement
a) Stock / Investment A/c
Dr
To Bank A/c
(Being the receipt of U/L
on Options Contract)
a) Bank A/c Dr
To Stock / Investment A/c
(Being the delivery of U/L on Options
Contract)
b) P & L A/c Dr
To Call / Put Options
Premium A/c
b) Liability on call/put option Dr
(Being the reversal of recognition entry)

(Being the unexpired
portions of premiums in
options contract settled)
*c) Bank A/c Dr
Margin A/c
(Being the receipt of margins deposited)
III. Open Positions III. Open Positions
a) P&L A/c Dr
Expired option
Premium A/c
(Being the entry for
expensing the expired
portion of option
premium)
a) P&L A/c Dr
To provision for Unexpired Premium
A/c
(Being the provision for unexpired option
premium)
b) Profit & Loss A/c Dr
To Provision for
losses on
Options A/c
(Being the losses on
options contract)
b) Profit & Loss A/c Dr
To Variation Margin A/c
(Being the losses on options contract)

Appendix III

Disclosures

1. Total Transactions Bought and sold separately
2. Realised Profit / loss on transactions settled / closed out.
3. Schedule of Net Open Position giving details on Number of U/L and derivatives
4. (Unrealised) Losses on Derivative Contracts

The above details be furnished separately for Options, Futures, Forwards and Swaps
for each U/L i.e., Commodities, Interest Rates (Long term and short term separately),
Stocks, Indexes, Foreign exchange.

5. Initial margin paid other than by cash.



References

01 Alternative Approaches to Testing Hedge Effectiveness under SFAS 133,
J .D.Finnerty & D.Grant, Accounting Horizons, J une, 2002.
02 Derivatives Core Module Workbook, National Stock Exchange of India Ltd, 2001.
03 Financial Infrastructure and Public Policy - A Functional Perspective Merton
R.C. & Z. Bodie, in Crane D.B. et. Al (eds) . The Global Financial System : A
Functional Perspective, Harvard Business School Press, Boston, 1995.
04 GAAP, 2001, P.R.Delaney, R.Nach, B.J .Epstein, S.W.Budak, J ohn Wiley & Sons,
Inc, 2001.
05 Guidance Note on Accounting for Futures and Options, Institute of Chartered
Accountants of India, 2003.
06 International Accounting Standards, 2001, Taxman Publications (P) Ltd., New
Delhi, 2001.
07 Using and Accounting for Derivatives: An International Concern, L.E.Crawford,
A.C. Wilson & B.J .Bryan, Journal of International accounting, Auditing and
Taxation, J anuary, 1997.

1
It is perfectly legitimate to take an average of strikes for bought positions and an
average of strikes of sold positions. But bought and sold positions cannot be averaged.
Several methods suggest themselves. First is to simply value the whole position but that
will not do as shown by the following example.

Strike (Call)
90 110 NOP
No. -11 +9 - 2
Value - 990 +990 0

There is a liability due to 2 net sold contracts but the value of the whole position does not
show it. Another method is to value the net sold position of 2 at 90 to 180. This is correct
for this example but runs into difficulty as shown below :

Strike (Call)
90 100 110 NOP
No. -10 +8 - 2 - 4
Value - 900 +800 -220


How do we value the NOP ? At 90 or 110 ? This leads to the best approximation viz.
valuation at the weighted average strike, viz.

33 . 93
12
) 2 110 ( ) 10 90 (
=
+ x x

with a liability of 93.33 x 4 =373.33. This is the method used in the text. Of course the
liability will be topped up for the strike price difference of bought over sold calls for 8
contracts, i.e. 10 x 8 =80.

2
Suppose, an agent has bought 100 shares of XYZ Ltd for Rs.15 on 1
st
J uly, 2003. On
30
th
September, the value has risen to Rs.25. In order to protect the appreciation on
shares, the agent buys an equal amount of put option on XYZ shares. The premium paid
for acquiring 6 months at-the-money option was Rs.350. On 31
st
December, the share
price was Rs.22 and put option value was Rs.515. Let us now compare the balance sheets
of the agent prepared under FAS standard and our accounting method.

Balance sheet Extract under FAS 133


Equity / overdraft 1850 Shares of XYZ Ltd 1200
Other Comprehensive Valuation Allowance 1000
Income 1000 (exercise price cost)
(exercise price cost) Put option
Time value expired 135
(515 300 intrinsic value)

------- -------
2850 2850



Balance sheet Extract under our system (Under MTM accounting)

Equity / overdraft 1500 Shares of XYZ Ltd 2200
MTM reserve Put option 515
(2200-1500) 700 P&L A/C bal
Liability on Option 350 (expired premium) 135
MTM reserve 300
(intrinsic value)
------- -------
2850 2850

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VI Issue I, January 2006 43

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