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Derivative Instruments: Accounting & Financial Reporting

Accounting for the various types of derivatives is important because of the frequent use of derivative contracts in
the normal course of business for many companies. This lesson goes over these contracts, the di erent types,
and the associated accounting entries.

Derivatives
What is a derivative contract? How do they impact the bottom line?

A derivative is a contract between two or more parties whose value is based on an underlying
nancial asset like a security. They've been around as investment instruments for decades and are
basically a buy or sell option on a security. An investor doesn't own the security but is just betting
on the direction that the price of the security will move.

For example, Harry is an investor who owns a derivative and he's betting that the price of a security
will increase. Penny is another investor who owns the opposite derivative, as she's betting that the
price will decrease. Directives can greatly increase leverage - the change in the derivative's value
with slight movements of the price of the underlying security makes them much more of a risky
investment.

Investors typically use derivatives for three reasons:

to hedge a position

to leverage the return on an asset, or

to speculate on an asset's price movement

Derivatives are not only instruments for investment by investors. Types of derivatives are used by
operating companies to hedge or protect themselves from risks associated with contracts taking
future delivery of raw materials or product.

The price of a derivative may feature a strike price, which is the price that the derivative may be
exercised. There may also be a call price with xed income derivatives, which is a price that the
issuer can convert or call a security.

Types of Derivatives
There are three basic types of contracts: options, swaps and futures/forward contracts.

an option is a contract that gives the right but not the obligation to buy or sell an asset.

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swaps are derivatives where counter parties exchange cash ows or other variables associated with
di erent investments.

in forward and future contracts parties agree to buy or sell an asset in the future for a speci ed price.

There are two classes of derivative products - lock and option. Lock products, like swaps, futures or
forwards, bind the respective parties from the outset to the agreed-upon terms for the life of the
contract. Option products o er the buyer the right but not the obligation to become a party to the
contract.

Say Supreme Oil wants to lock in its future crude oil price. It buys a forward contract for delivery of
100,000 barrels of crude oil at $60 a barrel for six months in the future. The seller of the forward
contract takes the risk because if the price is below $60 in six months, she can buy the oil for the
lower price and sell it to Supreme. If the oil price is higher, then the seller will have to take a loss to
ful ll the contract.

Accounting for Derivatives

Under current international accounting standards, investors and companies are required to
measure derivative instruments at fair market value or mark to market. All fair market gains and
losses are recognized in pro t or loss statements. The only exception is when the derivatives
qualify as hedging instruments in cash ow hedges or net investment hedges.

Say Sam buys a call option for 1000 shares of Limited stock on February 1st with a premium of $5 a
share. The exercise date is December 31st with an exercise price of $102 per share. What are the
accounting transactions for this call option? Say the price on 2/1 is $100, $104 on 6/30 and $105 on
12/31.

on 2/1, the call option is valued at: $5 * 1000 shares = $5,000

on 6/30, the fair value is: $5,000 - ($104 - $102)1000 = $3,000

on 12/31/exercise date, the fair value is: $5,000 - ($105 - 102)1000 = $2,000

The accounting entries for this call option would be:

Account Debit Credit

Feb. 1st

Call Option 5000

Cash 5000

June 30

Fair Value Loss 2000

Call Option 2000

Dec. 31st

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Fair Value Loss 2000

Call Option 2000

Settlement Debit Credit

Cash 2000

Call Option 2000

Or

Settlement Debit Credit

Stock 2000

Call Option 2000

A put option transaction would be just the opposite. The computation of fair value depends on the
premium paid for the contract and the strike price at the end and the di erence based on the value
of the underlying security at the date of the nancial statement.

Importance for Financial Reporting

Although a derivative is a hedge without really owning the asset, it is still a contract that has
nancial consequences. Accounting for any changes in fair value of the derivative must be
calculated at the closing date for any investor or company buying or selling the derivative
instrument.

Since a derivative instrument is leveraged, there is a greater impact on pro ts and losses with
changes in value of the underlying security. A company with signi cant hedging or derivative
activity could show signi cant uctuations in earnings and losses due to market changes.

Lesson Summary
Derivatives are contracts to buy or sell an underlying security/asset without actually owning the
asset. It is basically betting on the movement in price or value of the underlying asset with
signi cant pro t or loss depending on the movement of price.

There are three basic types of contracts:

options - contracts that gives the right but not the obligation to buy or sell an asset.

swaps - counter parties exchange cash ows or other variables associated with di erent investments.

forward and future contracts - parties agree to buy or sell an asset in the future for a speci ed price.

The value of the derivative is determined at purchase by the premium paid. The value of the
derivative must be determined for subsequent accounting periods by comparing the current value
of the derivative versus the premium paid for it.

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At the expiration of the derivative contract, the exercise or strike price compared to current value
will determine the ultimate value of the derivative and what further pro t or loss must be taken to
settle the contract.

Derivatives are a form of speculative investment that are highly leveraged, as their value will
uctuate signi cantly to minor changes in the value of the underlying investment. The accounting
entries required by the changes in fair market value of derivatives can have a signi cant nancial
impact on the returns to investors and companies trading in derivatives.

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