Accounting for Derivative Instruments

Session 1 and 2
Accounting for Derivative

Instruments
Edited by Taufik Hidayat
Agenda
1.
2.
3.
4.
5.
6.
7.
Financial Intruments and Derivative.

Forward Contracts.
Future Contracts.
Hedge using forward and future contracts.
Option.
Swap.
Hedge using option and swap.
Session 1
Session 2
Financial Instruments
Financial instrument is formally defined in PSAK 50 while PSAK 55
refers to the same definition as follows:
A financial instrument is any contract that gives rise to
a financial asset of one entity and
a financial liability or equity instrument of another entity.
Financial
instrument
Financial
asset
Financial
liability
of one entity
or
Equity
instrument
of another entity
Financial Instruments (2)

Financial
Financial asset is any asset that is:
asset
Cash
Financial
instrument
An equity instrument of another entity
A contractual right
i) to receive cash or another financial asset from another entity
ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity
A contract that will or may settled in the entitys own equity instruments and is
i) a non-derivative for which the entity is or may be obliged to receive a variable
number of the entitys own equity instruments; or
ii) a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entitys
own equity instruments. For this purpose the entitys own equity instruments
do not include certain instruments,
say specified puttable financial instruments, or instruments that are
contracts for the future receipt or delivery of the entitys own equity
instruments
Financial Instruments (3)

Financial liability is any liability that is
A contractual right
i) to deliver cash or another financial asset from another entity
ii) to exchange financial assets or financial liabilities with another
entity under conditions that are potentially unfavourable to the entity
A contract that will or may settled in the entitys own equity instruments and is
i) a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entitys own equity instruments; or
ii) a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entitys
own equity instruments. (For this purpose, certain other conditions are
required to observe)
Financial
instrument
Financial
liability
Definition of Derivative
Derivative
is a financial instrument or other contract within the

scope of PSAK 55 with all 3 of the following
characteristics:
Value change based

on an underlying
Little or no initial net

investment
Settled at
a future date
a) its value changes in response to the change in a

specified interest rate, financial instrument price,
commodity price, foreign exchange rate, index of prices
or rates, credit rating or credit index, or other variable
(sometimes called the underlying);
b) it requires no initial net investment or an initial net
investment that is smaller than would be required for
other types of contracts that would be expected to have a
similar response to changes in market factors; and
c) it is settled at a future date.
Derivative Instruments
Example
Melody Limited makes a five-year fixed rate loan to Tony Inc, while
Tony at the same time makes a five-year variable rate loan for the
same amount to Melody.
There are no transfers of principal at inception of the two loans, since
Melody and Tony have a netting agreement.
Is this a derivative under PSAK 55?
Yes.
This meets the definition of a derivative (that is to say, there is an
underlying variable, no initial net investment or an initial net investment
that is smaller than would be required for other types of contracts that
would be expected to have a similar response to changes in market
factors, and future settlement).
Derivative Instruments (2)

Example of derivative instruments and their underlying
Types of derivative
instruments
Underlying
Used by
Option contracts
(call and put)
Security price
Producers, trading firms,

financial institutions, and
speculators
Forward contracts
e.g. foreign exchange
forward contract
Foreign
exchange rate
Various companies
Future contracts
e.g. commodity futures
Commodity
prices
Producers and
consumers
Interest rate
Financial institutions
Swaps
Derivative Instruments (3)

Use of derivatives
1. Manage market risk
2. Reduce borrowing cost
3. Profit from trading or speculation
Types of derivatives
1. Forward type derivatives such as forward contracts,
future contracts and swaps
2. Option-type derivatives such as call and put options,
caps and collars and warrants
3. Free standing derivatives
4. Embedded derivatives
Compound Financial Instrument &

Embedded Derivative
There are certain financial instruments that have a
hybrid or combined nature.
For example, a convertible bond is a debt instrument
with an embedded option to convert the debt
instrument to equity shares.
From the perspective of the issuer, the debt instrument is a
financial liability while the embedded option may be an
equity instrument.
From the perspective of the holder of that convertible bond,
the debt instrument is a financial asset and the embedded
option is similar to a derivative.
Compound Financial Instrument &

Embedded Derivative
In PSAK 50, from the perspective of an issuer, these
kinds of financial instruments are termed as compound
financial instruments.
PSAK 50 requires an issuer of a compound
financial instrument to separately classify different
components of the instrument in accordance with the
definition of financial liability and equity instrument.
In PSAK 55, from the perspective of a holder, these kinds
of financial instruments are termed as hybrid (combined)
instruments.
PSAK 55 requires a holder of a hybrid instrument to
separately account for the embedded derivative of
the instrument if certain conditions are fulfilled.
Will be discussed in
session 3
Initial Recognition
Initial recognition requirements for financial
assets and financial liabilities in PSAK 55:
An entity is required to recognise a financial
asset or a financial liability on its balance
sheet when, and only when, the entity
becomes a party to the contractual
provisions of the instrument.
In other accounting standards, the
recognition criteria are
1) it is probable that future economic benefits
associated with the item will flow to (or flow out
from) the entity; and
2) the cost of the item can be measured reliably.
Imply trade date

accounting
Imply settlement
date accounting
Initial Recognition (2)

The settlement date is the
to or by an entity.
The trade date is the date
purchase or sell an asset.
The recognition criteria in
recognise financial asset
becomes a party to the
instruments.
date that an asset is delivered

that an entity commits itself to
PSAK 55 require an entity to
or financial liability when it
contractual provisions of the
These criteria imply an entity to recognise financial asset or

financial liability on a trade date basis.
Initial Recognition (3)

In consequence of the recognition criteria of PSAK 55, all
the financial assets and liabilities, including derivatives
(such as options and futures), become on-balance sheet
from the trade date.
In other words, an entity is also required to recognise all of its
contractual rights and obligations under derivatives in its balance
sheet as assets and liabilities.
PSAK 55 specifically states that a contract that requires or

permits net settlement of the change in the value of the
contract (such as derivative contract) is not a regular way
contract.
Such contract is accounted for as a derivative in the period
between the trade date and the settlement date.
Initial Measurement
When a financial asset or financial liability (except for it at
fair value through profit or loss) is recognised initially, an
entity is required to measure it at:
1. its fair value plus
2. its transactions costs that are directly attributable to
the acquisition or issue of the financial asset or
financial liability.
In the case of a financial asset or financial liability that
will be classified as financial asset or financial liability
at fair value through profit or loss (FVTPL),
1. an entity is only required to measure it at its fair value
only
2. its transaction costs should not be recognised.
Derivative FVTPL
Initial Measurement (2)

Fair value is the amount for which an asset could be
exchanged, or a liability settled, between knowledgeable,
willing parties in an arms length transaction.
New definition of Fair Value based on PSAK 68: Fair
Value is defined as the price that would be received to
sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the
measurement date.
Transaction costs are incremental costs that are directly
attributable to the acquisition, issue or disposal of a
financial asset or financial liability. An incremental cost is
one that would not have been incurred if the entity had
not acquired, issued or disposed of the financial
instrument.
Subsequent Measurement
Default accounting treatment for derivatives under PSAK 55:
Derivatives are classified under the Fair Value through Profit or Loss
category and changes in their fair values are taken to income
statement
Exception - when a derivative is designated as a hedge of an
identified risk and the hedge is effective. In this case, accounting for
the derivative follows hedge accounting rules.
Financial instrument at fair value through profit or loss

(including derivative) is initially recognised at fair value only.
After initial recognition, an entity is required to measure
financial instrument at fair value through profit or loss
(including derivative) at their fair values.
Derecognition of a Financial Asset

The general derecognition criteria in accordance with PSAK
55 require an entity to derecognise a financial asset when,
and only when:
1. the contractual rights to the cash flows from the financial asset
expire; or
2. the entity transfers the financial asset that meet the conditions set
out in PSAK 55 (i.e. asset transfer test) and
the transfer qualifies for derecognition in accordance with PSAK 55
(i.e. the risks and rewards test and the control test).
Derecognition of a Financial Liability

An entity is required to remove a financial liability (or a part
of a financial liability) from its balance sheet (i.e.
derecognise a financial liability) when, and only when, it is
extinguished.
PSAK 55 explains that a financial liability is extinguished when the
obligation specified in the contract is discharged or cancelled or
expires.
A financial liability or part of it is extinguished when the

debtor either:
1. discharges the liability or part of it by paying the creditor, normally
with cash, other financial assets, goods or services; or
2. is legally released from primary responsibility for the liability (or part
of it) either by process of law or by the creditor.
Forward Contracts
An agreement between two parties (counterparties) whereby one
party agrees to buy and the other party agrees to sell a specified
amount (notional amount) of an item at a fixed price (forward
rate) for delivery at a specified future date (forward date).
Can either be a forward purchase contract or a forward sales
contract, depending on the perspective of the counterparties.
A Company
Sells Forward
Contract
Forward sales contract
B Company
Forward purchase contract

10
Forward Contracts (2)

Not standardized contracts as they are not traded on an
exchange
They entail counterparty risks
They are can be tailored to specific needs of counterparties
They involve lower transaction costs
Fair value of forward contract:

Notional x (Current forward rate contracted forward rate)
t
(1+r)
amount
where
Contracted forward rate is forward rate
fixed at inception
r = discount rate
Current forward rate is forward rate for

remaining period to maturity
t = period to maturity
Forward Contracts: Journal Entries

At inception
No journal entry
as fair value is nil
During life of contract
Closing position or
at expiration*
Dr Forward Contract
(asset)
Cr Gain on forward
contract
Dr Cash
Cr Forward contract
or
Dr Loss on forward
contract
Cr Forward Contract
(liability)
Dr Forward contract
Adjust fair value and

record gain/loss
Close out and record

net settlement of
contract
Cr Cash
* Its also required the journals to adjust fair value and settlement of underlying at expiration.
11
Forward Contracts : illustration

Example
On March 1, 20X5, Company A entered into a forward contract

with a foreign exchange dealer to buy 1 million foreign currency
(FC 1,000,000) for delivery on May 30, 20X5. Following
exchange rates are given:
Date
Spot rate
$/FC
May 30 forward rate

$/FC
March 1
$1.185
$1.20
March 31
1.19
1.21
April 30
1.20
1.205
May 30
1.215
1.215
Forward Contracts: illustration (2)

Example
Date
March 1
Account
Amount
No Entry
Fair value of forward contract is zero at inception
March 31 Dr Forward Contract (asset)

Cr
Gain on Forward Contract
April 30
May 30
10,000
10,000
To record change in fair value of forward contract
(1.21 - 1.2) x 1,000,000
Dr Loss on Forward Contract

Cr
Forward Contract (liability)
5,000
(1.21 - 1.205) x 1,000,000
Dr Forward Contract (asset)

Cr
10,000
(1.215 - 1.205) x 1,000,000
Dr Cash
Cr
Forward Contract
15,000
To close forward contract at maturity
(1.2 - 1.215) x 1,000,000
Dr Foreign Currency
Cr
Cash
1,215,000
To record settlement of underlying
5,000
10,000
15,000
1,215,000
1.215 x 1,000,000
When forward contracts fall due more than 12 months after the reporting period, they should be
discounted.
12
Forward Contracts: illustration (3)

Example
Alternative journal entries:
Date
March 1
Account
Amount
No Entry
Fair value of forward contract is zero at inception
March 31 Dr Forward Contract (asset)

Cr
April 30
May 30
10,000
10,000
(1.21 - 1.2) x 1,000,000
Dr Loss on Forward Contract

Cr
Forward Contract (liability)
5,000
(1.21 - 1.205) x 1,000,000
Dr Forward Contract (asset)

Cr
10,000
(1.215 - 1.205) x 1,000,000
Dr Foreign Currency
Cr
Cash
Cr
Forward Contract
1,215,000
*(1.2 - 1.215) x 1,000,000
5,000
10,000
1,200,000
15,000*
Futures Contracts
A future contract is similar to a forward contract except that
it is a standardized contract and is traded on an exchange.
Futures contracts are marked-to-market and settled on a
daily basis.
Futures contracts require payment of a margin deposit
which has to be maintained throughout the contract period.
Margin account is not part of initial investment but as
collateral for counterparty or clearinghouse.
Margin accounts are separate assets and accounted
separately.
Wide range of exchange-traded future contracts:
Commodity futures
Interest rate futures
Currency futures
13
Futures Contracts: Journal Entries

At inception
Dr Margin deposit
Cr Cash
Closing position or
at expiration*
Dr Futures Contract
Cr Gain on future
contract
Dr Cash
Dr Gain on future
contract
Cr Margin deposit
or
Dr Loss on future
contract
Cr Futures Contract
Record payment of
initial margin deposit
Record daily settlement of

future contracts
Dr Cash
Cr Loss on future
contract
Cr Margin deposit
Close out and and recover
margin deposit
Futures Contracts : illustration

Example
On March 1, 20X5, Company A speculates that the price of gold

will increase and purchases 10 gold futures contracts at a price of
$800/ounce. Each contract is for 100 ounces of gold and maturity
date is May 30. The futures exchange requires a payment of 10%
of notional amount as margin deposit. Following prices are given:
Date
Price/ounce
May 30 futures
price/ounce
March 1
$798
$800
March 31
797
799
April 30
799
801
May 30
802
802
14
Futures Contracts: illustration (2)

Date
March 1
Account
80,000
To record payment of margin deposit
10% x $800,000
March 31 Dr Loss on Futures Contract

Cr
Futures Contract
April 30
May 30
Amount
Dr Margin Deposit
Cr
Cash
80,000
1,000
1,000
To record settlement or change in fair value
(800 - 799) x 100 x 10
Dr Futures Contract
Cr
Gain on Futures Contract
2,000
(801 - 799) x 100 x 10
Dr Cash
Dr Futures Contract
Cr
Cr
Margin Deposit
80,000
1,000
To record change in fair value and return of margin
(802 - 801) x 100 x 10
Dr Gold
Cr
Cash
Cr
Futures Contract
802,000
To record settlement and close futures contract
**(802 - 800) x 100 x 10
2,000
1,000
80,000
800,000
2,000**
Futures Contracts: illustration (3)

Example
Alternative journal entries:
Date
March 1
Account
80,000
To record payment of margin deposit
10% x $800,000
March 31 Dr Loss on Futures Contract

Cr
Futures Contract
April 30
May 30
Amount
Dr Margin Deposit
Cr
Cash
80,000
1,000
1,000
(800 - 799) x 100 x 10
Dr Futures Contract
Cr
2,000
(801 - 799) x 100 x 10
Dr Futures Contract
Cr
1,000
(802 - 801) x 100 x 10
Dr Gold
Cr
Margin deposit
Cr
Cash
Cr
Futures Contract
802,000

**(802 - 800) x 100 x 10
2,000
1,000
80,000
720,000
2,000**
15
Hedging
Propose is to neutralize an exposed risk
Loss on hedge item offset by gain on hedging instrument
Reduce volatility than preserve gains
Other ways of hedging through non-derivative

derivatives
Money market instruments (money market hedge)
Natural hedge (offsetting foreign currency assets and
liability in the same currency)
Special accounting rules called hedge accounting

applies when derivatives are used for hedging
purposes
Rationale of Hedge Accounting

Arises because of the mismatch of incomeoffsetting effect between hedged item and hedging
instrument
Situations requiring hedge accounting:
Hedge item and hedging instrument are measured using
different bases (One is at cost while the other is at fair
value)
Hedged item yet to be recognized in financial statement
Different treatment for changes in fair value (changes
taken to equity while the other is taken to income
statement)
16
Risks That Qualify for Hedge Accounting
Interest rate risk
Foreign exchange risk
Specific risks
that qualify for
hedge accounting
Risks must be specific risk,

not general business risks
Price risk
Credit risk
Possible for a derivative to

hedge more than one risk
Qualifying Hedging Instruments and

Hedged Items
Instruments that qualify as hedging instruments include:
Designated derivatives (except written options).
Embedded Derivatives.
Designated non-derivatives financial asset/ liability that hedge
foreign exchange risks only.
Instruments that qualify as hedged items include:

Financial assets and liabilities with exposure to changes in fair
value.
Non-financial assets exposed to foreign exchange or price risks.
Firm commitment.
Highly probable forecast transaction with exposures to future cash
flows.
Net investment in foreign entity.
17
Assessing Hedge Effectiveness

During the duration of hedge, hedge effectiveness is
assessed on dollar-offset method:
Hedge effectiveness ratio (HER):
Hedge effectiveness Changes in fair value or future cash flow of hedging instrument
=
(or delta ratio)
Changes in fair value or future cash flow of hedged item
0.8
1.25
Effective hedge
Classification of Hedging
Fair value
hedge
Cash flow
hedge
Hedge of a net
investment in a
foreign entity
Hedge of the exposure to changes in fair value of a

recognized asset or liability or an unrecognized firm
commitment, or an identified portion of such asset, liability
or firm commitment, which is attributable to a particular
risk and could affect profit or loss.
Hedge of the exposure to variability in cash flows that
(i) is attributable to a particular risk associated with a
recognized asset or liability (such as all or some future
interest payment on variable debt instrument )or a highly
probable future transaction, and
(ii) could affect profit or loss.
Hedge of the foreign currency risk associated with a
foreign operation whose financial statements are required
to be translated into the presentation currency of the
parent company.
18
Classification of Hedging (2)

The designation of a derivative as a fair value
hedge or a cash flow hedge is determined by the
hedged risk, that is, whether the entity has a fair
value exposure or a cash flow exposure.
An exception where a derivative can be designated
as either a fair value hedge or a cash flow hedge is
where the hedged risk is the foreign exchange risk
of a firm commitment.
Accounting for a Fair Value Hedge
Hedged Item (recognized asset

or liability or firm commitment)
Hedging Instruments
Change in fair value
Change in fair value
Income statement
Gain (loss) on hedging instrument
offset loss (gain) on hedged item
Balance sheet
Change in fair value adjusted
against carrying amount
Change in fair value adjusted

against carrying amount
19
Fair Value Hedge Forward Contract

Example
Ilustration:
31/10/20X3
Inventory of 10,000 ounces of gold
Carried at cost of $3,000,000 ($300 per ounce)
Price of gold was $352 per ounce
1/11/20X3
Sold forward contract on 10,000 ounce for forward price of
$350 ounce
Forward contract matures on 31/3/20X4
Spot Rate
March 31 Forward Rate
Nov 1, 20X3
Date
$352
$350
Dec 31, 20X3
342
340
March 31, 20X4
330
330
Fair Value Hedge Forward Contract (2)

Example
1/10/20X1
No entry or just a memorandum entry as the fair value of the forward
contract is nil
31/12/20X3
Dr
Forward contract .
Cr
Gain on forward contract ...
100,000
100,000
Gain on forward contract: 10,000 x ($340 -$350)

Taken to income statement
Dr
Loss on inventory
Cr
Inventory ..
100,000
100,000
Gain on forward contract: 10,000 x ($342 - $352)
20

Example
31/3/20X4
Inventory is sold to third-party at $330 per ounce (also maturity date of
forward contract
Dr
Forward contract .
Cr
Gain on forward contract ...
100,000
100,000
Gain on forward contract: 10,000 x ($330 -$340)
Dr
Loss on inventory
Cr
Inventory ..
120,000
120,000
Loss on forward contract: 10,000 x ($330 - $342)
Dr
Cash ..
Cr
Sales .
3,300,000
3,300,000
Sale of inventory: 10,000 x $330


Example
31/3/20X4
Dr
Cost of Good Sold
Cr
Inventory .........................
2,780,000
2,780,000
Cost of Good Sold: $3,000,000 - $100,000 - $120,000
Dr
Cash ..................
Cr
Forward Contract .....
200,000
200,000
Close forward contract and record net receipt on settlement:

10,000 x ($350 - $330)
21

Example
31/3/20X4
If inventory is NOT sold to third-party but SETTLED at maturity date
Dr
Inventory .
Cr
Gain on inventory ...
520,000
520,000
Gain on inventory at inception: 10,000 x ($352 -$300)
Dr
Cash ..................
Cr
Cr
Forward Contract .....

Inventory .......................
3,500,000
200,000
3,300,000
Close forward contract and record net receipt on settlement:

10,000 x ($350 - $330)
Accounting for a Cash Flow Hedge
Effective Cash Flow Hedge
Effective portion
of gain/ loss
Ineffective portion
of gain/ loss
Recognized directly
in equity through
statement of
changes in equity
Recognized in profit
or loss
22
Assessing Effective Portion of Cash Flow

Hedge
Example
Lesser of
Effective
two
portion
cumulative credited/
amount in
(debited)
absolute to equity in
terms
current
(c)
period*
Ineffective
portion
credited/
(debited)
to income
statement
in current
period**
Period
ending
Cumulative
in FV of
future
contracts
(a)
Cumulative
in PV of
expected
cash flow
(b)
31/1/20x1
$100
$(105)
$100
$100
28/2/20x1
190
(185)
185
85
31/3/20x1
293
(290)
290
105
(2)
30/4/20x1
255
(245)
245
(45)
$0
* (c) - previous balance

**(a) - (c) - previous balance
Accounting for a Cash Flow Hedge (2)
Cash flow hedges are applicable to the following:

Forecasted
transactions
involving financial
and non-financial
assets/liabilities
which will result in
cash inflow/ outflow
Interest rate swaps
Other transactions
which affect future
cash flows
23
Cash Flow Hedge Futures Contract

Example
Ilustration:
1/10/20X1
Inventory of 5,000,000 ounces of silver.
Carried at cost of $15,000,000 ($3 per ounce).
Price of silver was $3.3 per ounce
Sold futures contract on 5,000,000 ounce for $3.21 /ounce.
Futures contract matures on 31/3/20X2.
Required margin deposit was $0.03 per ounce.
Date
Oct 1, 20X1
Spot Price/ounce
March 31 Futures Price
$3.30
$3.21
Dec 31, 20X1
3.265
3.17
Feb 28, 20X2
3.15
3.05
March 31, 20X2
3.10
3.00
Cash Flow Hedge Futures Contract (2)

Example
Calculation of expected cash flows & fair value of futures contract
24

Example
Period-to-period & cumulative hedge effectiveness assessment

Example
Determination of effective and ineffective portions of a cash flow hedge
Period
ending
Cumulative Cumulative
in FV of
in PV of
future
expected
contracts
cash flow
(a)
(b)
Lesser of
two
cumulative
amount in
absolute
terms
(c)
Effective
portion
credited/
(debited) to
equity in
current
period*
Ineffective
portion
credited/
(debited)
to income
statement
in current
period**
31/12/X1
200,000
(175,000)
175,000
175,000
25,000
28/2/X2
800,000
(750,000)
750,000
575,000
25,000
31/3/X2
1,050,000
(1,000,000)
1,000,000
250,000
* (c) - previous balance

**(a) - (c) - previous balance
25

Example
1/10/20X1
Dr
Margin deposit
Cr
Cash .................................
150,000
150,000
Margin deposit: $0.03 x 5,000,000 ounce
31/12/20X1
Dr Futures contract ..
200,000
Cr
OCI Hedge reserve .......
175,000
Cr
Gain on futures contract ...
25,000
Record fair value adjustment of futures contract
28/2/20X2
600,000
Cr
575,000
Cr
Gain on futures contract ...
25,000


Example
31/3/20X2
Cr
250,000
250,000
Dr
Cash ..
Cr
Sales .
15,500,000
15,500,000
Sale of inventory: 5,000,000 x $3.1
Dr
Cost of Good Sold
Cr
Inventory .........................
15,000,000
15,000,000
Cost of Good Sold at carried cost
Dr
Cr
Sales/ Cost of Good Sold ..
1,000,000
1,000,000
To recycle hedging reserve against Profit & Loss

26

Example
31/3/20X2
Dr
Cash ..................
Cr
Margin deposit ................
150,000
Cr
Futures Contract ......
1,050,000
1,200,000
Close the futures contract and record receipt of margin
Option Contracts
Contract that gives holder the right but not the
obligation to buy or sell a specified item at a
specified price.
2 type of option contracts:
Call option right, but not obligation to buy.
Put option right, but not obligation to sell.
Can be American option (exercisable anytime to

expiration) or European option (exercisable only on
maturity date).
Can also be customized (not traded) or standard
contract quoted on exchange (listed options).
27
Option Contracts (2)

Main features:
Purchaser (holder) pays premium to seller (writer of option).
Holder has the right, but not obligation to perform; while write has
obligation to perform.
Asymmetrical pay-off profile:
Holder has limited loss (due to premium) and unlimited gain.
Writer has limited gain and unlimited loss.
Strike price>
Underlying
(spot price)
Strike price=
Underlying
(spot price)
Strike price>
Underlying
(spot price)
Holder of call
option
Out-of-the-money
At-the-money
In-the-money
Holder of put
option
In-the-money
At-the-money
Out-of-the-money
Option Contracts (3)

Fair value of option contract
Fair value of an option = Intrinsic value +
Listed options = quoted price

Not traded options = Valuation
model ( Black-Scholes model)
Time value
Diminishes over time

Zero at expiration
Call option = Max [0, Notional amount x (Spot price Strike Price)
Put option = Max [0, Notional amount x (Strike price Spot Price)
28
Purchased Option Contracts: Journal Entries
At inception

Dr Option Contract
Cr Gain on future
contract
Dr Option contract
(asset)
Cr Cash
Closing position or
at expiration
Dr Cash*
Cr Gain on option
contract
Cr Option Contract
or
Dr Loss on futures
contract
Cr Option Contract
Dr Cash*
Dr Loss on option
contract
Cr Option Contract
(* assume expires in-the-money. If out-ofthe money, no cash entry is needed)
Record payment of
Adjust for fair value

and record gain/loss

net settlement of
contract
Written Option Contracts: Journal Entries
At inception

Dr Option Contract
Cr Gain on future
contract
Dr Cash
Cr Option contract
(liability)
Closing position or
at expiration
Dr Option contract
Cr Gain on Option
Contract
(Expires out-of-the-money)
or
Dr Loss on futures
contract
Cr Option Contract
Dr Option contract
Dr Loss on option
Cr Cash
(Expires in-the-money)
Record payment of
Adjust for fair value

and record gain/loss

net settlement of
contract
29
Call Option Contracts : illustration

Example
On March 1, 20X5, Company A purchased 100,000 unit of call

option of Company B with strike price of $35 and premium $4.5.
On that date, current market price of Company B stock was
$38/share. Company A settle the option on Aprill 30, 20X5 to
third party. Following prices are given:
Stock Price
Option Price
March 1
Date
$38
$4.50
March 31
41
6.80
April 30
43
8.25
Option Price
Intrinsic Value
Time Value
March 1
Date
$4.50
$3
$1.50
March 31
6.80
0.80
April 30
8.25
0.25
Call Option Contracts: Buyer

Date
March 1
Account
450,000
To record payment of premium
$4.5 x 100,000
450,000
March 31 Dr Call Option

Cr
Gain on Option Contract
To record change in intrinsic value
March 31 Dr Loss on Option Contract

Cr
Call Option
April 30
April 30
Amount
Dr Call Option
Cr
Cash
300,000
300,000
(6 3) x 100,000
70,000
70,000
To change in time value
(0.8 1.5) x 100,000
Dr Call Option
Cr
200,000
(8 6) x 100,000
Dr Loss on Option Contract

Cr
Call Option
To record change in time value
200,000
55,000
55,000
(0.25 0.8) x 100,000
Alternative: record the net amount

30

Date
April 30
Account
Dr Cash
Cr
Call option
Amount
825,000
825,000
To record settlement of option
If company A exercise the option on Aprill 30, 20X5 :

Date
Account
Dr AFS
Dr Loss on Exercise of Option
Cr
Call Option
Cr
Cash
Amount
4,300,000
25,000
825,000
3,500,000
To record the exercise and close option contract
Call Option Contracts: Writer

Date
March 1
Account
450,000
$4.5 x 100,000

Cr
Call Option
March 31 Dr Call Option

Cr
April 30
April 30
Amount
Dr Cash
Cr
Call Option
450,000
300,000
300,000
(6 3) x 100,000
70,000
70,000
(0.8 1.5) x 100,000

Cr
Call Option
200,000
To change in intrinsic value
(8 6) x 100,000
Dr Call Option
Cr
200,000
55,000
55,000
(0.25 0.8) x 100,000
31

If company A exercise the option on Aprill 30, 20X5. Following
prices are given:
Date
Account
Amount
Dr Cash
Dr Call Option
Cr
AFS
Cr
Gain on Exercise of Option
3,500,000
825,000
4,300,000
25,000
Put Option Contracts : illustration

Example
On March 1, 20X5, Company A purchased 100,000 unit of put

option of Company C with strike price of $35 and premium $2.5.
On that date, current market price of Company C stock was
$34/share. Company A settle the option on Aprill 30, 20X5 to
third party. Following prices are given:
Stock Price
Option Price
March 1
Date
$34
$2.50
March 31
32
4.00
April 30
31
4.80
Option Price
Intrinsic Value
Time Value
March 1
Date
$2.50
$1
$1.50
March 31
4.00
1.00
April 30
4.80
0.80
32

Date
March 1
Account
250,000
$2.5 x 100,000
250,000
March 31 Dr Put Option

Cr

Cr
Put Option
April 30
April 30
Amount
Dr Put Option
Cr
Cash
200,000
200,000
(3 1) x 100,000
50,000
50,000
(1.0 1.5) x 100,000
Dr Put Option
Cr
100,000
(4 3) x 100,000

Cr
Put Option
100,000
20,000
20,000
(0.8 1.0) x 100,000

Date
April 30
Account
Dr Cash
Cr
Put option
Amount
480,000
480,000
To record settlement of option
If company A already had Company C stock (assume: no hedge

relationship), and exercise the put option on Aprill 30, 20X5 :
Date
Account
Dr Cash
Dr Loss on Exercise of Option
Cr
Put Option
Cr
AFS
Amount
3,500,000
80,000
480,000
3,100,000
33

Date
March 1
Account
250,000
$2.5 x 100,000

Cr
Put Option

Cr
April 30
April 30
Amount
Dr Cash
Cr
Put Option
250,000
200,000
200,000
(3 1) x 100,000
50,000
50,000
(1.0 1.5) x 100,000

Cr
Put Option
100,000
(4 3) x 100,000
Dr Put Option
Cr
100,000
20,000
20,000
(0.8 1.0) x 100,000

If company A exercise the option on Aprill 30, 20X5. Following
prices are given:
Date
Account
Dr AFS
Dr Put Option
Cr
Cash
Cr
Gain on Exercise of Option
Amount
3,100,000
480,000
3,500,000
80,000
34
Fair Value Hedge Option Contract

Example
On March 1, 20X5, Company A purchased 100,000 of Company

D shares at $34/share.
To ptotect itself against a loss in value of the investment,
Company A purchased 100,000 unit of put option of Company D
with strike price of $35 and premium $2.5 on the same date.
Company A settle the option on Aprill 30, 20X5 (maturity date).
Following prices are given:
Stock Price
Option Price
March 1
Date
$34
$2.50
March 31
32
3.80
April 30
31
4.00
Fair Value Hedge Option Contract (2)

Stock Price
Option Price
March 1
Date
$34
$2.50
March 31
32
3.80
April 30
31
4.00
Option Price
Intrinsic Value
Time Value
March 1
Date
$2.50
$1
$1.50
March 31
3.80
0.80
April 30
4.00
0.00
35

Date
March 1
March 1
Account
Amount
Dr AFS
Cr
Cash
3,400,000
$34 x 100,000
Dr Put Option
Cr
Cash
250,000
$2.5 x 100,000
3,400,000
250,000

Cr
200,000
(3 1) x 100,000

Cr
Put Option
70,000
70,000
(0.8 1.5) x 100,000
March 31 Dr Loss on Investment

Cr
AFS
200,000
P/L
To record change in fair value of AFS
200,000
200,000
(32 34) x 100,000

Date
April 30
April 30
April 30
April 30
Account
Amount
Dr Loss on Investment
Cr
AFS
100,000
To record change in fair value of AFS
(31 32) x 100,000

Cr
Put Option
100,000
80,000
80,000
(0 0.8) x 100,000
Dr Put Option
Cr
100,000
(4 3) x 100,000
Dr Cash
Cr
Put Option
Cr
AFS
3,500,000
100,000
400,000
3,100,000
36
Swap
In a swap, two counterparties agree to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
2 type of basic swap:
Single Currency Interest rate swap
Plain vanilla fixed-for-floating swaps in one currency.
Cross Currency Interest Rate Swap (Currency swap)
Fixed for fixed rate debt service in two (or more)
currencies.
Swap (2)
Interest Rate Swap:
Used by companies and banks that require either fixed
or floating-rate debt.
Interest rate swaps allow the companies (or banks) and
the swap bank to benefit by swapping fixed-for-floating
interest payments.
Since principal is in the same currency and the same
amount, only interest payments are exchanged (net).
Hedge using interest rate swap:

Cash flow hedge changes in FV of swap are taken to
equity.
Fair value hedge changes in FV of swap are taken to
P/L.
37
Swap (3)
Interest Rate Swap:
Pay floating
Company A
Receive
prefers floating fixed
Swap
Bank
Pay fixed
Receive
Floating
Company B
prefers fixed
Issue floating
Issue fixed
Cash Flow Hedge - Swap

Cash flow hedge : Swap from floating to fixed rate.
To protect future cash flow (interest) payments.
Changes in fair value of swap are taken to equity.

Interest payments are taken to P/L.
38
Cash Flow Hedge Swap : Ilustration

Example
Company A had $10 million loan with interest at LIBOR + 50

basis points.
To ptotect itself against an increase in interest rate, Company A
entered into swap contract with Company B on June 30, 20X5.
Under this contract, Company A paid interest at fixed rate of
7.75% on notional amount $10 million to Company B over 1 year
for the receipt of floating rate of LIBOR + 50 basis point. Interest
settlement were made at the end of each quarter. The rates are
as follows:
Date
LIBOR
LIBOR + 50 bp
June, 30
7.25%
7.75%
Sept, 30
6.25%
6.75%
Dec, 31
7.45%
7.95%
March, 31
7.50%
8.00%
Cash Flow Hedge Swap : Ilustration (2)

Example
Assumption:
Fair value of swap at inception is zero.
Current floating rate continues to prevail till the end of
the swap tenure.
FV swaps are discounted with LIBOR + 50 bp.
Company A
prefers fixed
Pay
7.75%
Receive
7.75%
Receive
LIBOR +
50 bp
Pay
LIBOR
+ 50 bp
Issue LIBOR +
50 bp
Company B
prefers floating
Issue fixed
39

Example
Date
Current
LIBOR
+ 50 bp
Receipt of
previous
LIBOR + 50
bp
(a)
Payment
of 7.75%
(b)
Current
net
receipt
(paid)
(c)
FV of
Swap
asset
(liability)
(d)
Change
in FV
(e)
June, 30
7.75%
Sept, 30
6.75%
193,750
193,750
Dec, 31
7.95%
168,750
193,750 (25,000)
9,710
82,248
March, 31
8.00%
198,750
193,750
5,000
6,127
(3,583)
200,000
193,750
6,250
(6,127)
June, 30
0
0
(72,538) (72,538)
(a) (previous LIBOR + 50 bp) x notional amount.

(b) 7.75% x notional amount.
(c) (a) (b)
(d) PV of [ next period of (c) x number of next payments]
(e) Previous (e) + (d)

Example
Date
Sept 30
Account
Dr Interest Expense
Cr
Cash
Amount
193,750
193,750
To record payment of interest at floating rate
Sept 30
Dr FV adjustment (equity)
Cr
Interest rate swap asset/liability
72,538
72,538
To record fv adjustment
Dec 31
Dr Interest Expense
Cr
Cash
168,750
168,750
Dec 31
Dr Interest Expense
Cr
Cash
25,000
25,000
To record settlement of swap differential
Dec 31
Dr Interest rate swap asset/liability

Cr
FV adjustment (equity)
82,248
82,248
40

Date
Account
March 31 Dr Interest Expense

Cr
Cash
Amount
198,750
198,750
March 31 Dr Cash
Cr
Interest Expense
5,000
5,000
March 31 Dr FV adjustment (equity)

Cr
3,583
3,583
June 30
Dr Interest Expense
Cr
Cash
200,000
200,000
June 30
Dr Cash
Cr
Interest Expense
6,250
6,250
June 30
Dr FV adjustment (equity)
Cr
6,127
6,127
Fair Value Hedge - Swap

Fair value hedge : Swap from fixed to floating rate:
To protect from increase of value of debt.
If market rate decreases, the value of fixed rate debt
increases.
Changes in fair value of swap are taken to P/L.

Even though the debt is carried at amortised cost
under PSAK 55, the carrying amount should be
adjusted by its fair value P/L.
Changes in fair value of debt represent
discount/premium but not amortised as long as the
hedge is in place.
41
Sources:
Tan & Lee Advanced Financial Accounting.
Lam & Lau Intermediate Financial
Reporting 2nd Ed.
Baker, Christensen, Cottrell Advanced
Financial Accounting 10th Ed.
@Taufik_FEUI
42

Accounting for Derivative Instruments

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Session 1 and 2

Accounting for Derivative

Edited by Taufik Hidayat

Financial Intruments and Derivative.

Edited by Taufik Hidayat

Edited by Taufik Hidayat

Financial Instruments (2)

Financial Instruments (3)

is a financial instrument or other contract within the

Value change based

Little or no initial net

a) its value changes in response to the change in a

Edited by Taufik Hidayat

Edited by Taufik Hidayat

Derivative Instruments (2)

Producers, trading firms,

Edited by Taufik Hidayat

Derivative Instruments (3)

Compound Financial Instrument &

Edited by Taufik Hidayat

Compound Financial Instrument &

Imply trade date

Edited by Taufik Hidayat

Initial Recognition (2)

date that an asset is delivered

These criteria imply an entity to recognise financial asset or

Edited by Taufik Hidayat

Initial Recognition (3)

PSAK 55 specifically states that a contract that requires or

Initial Measurement (2)

Edited by Taufik Hidayat

Financial instrument at fair value through profit or loss

Derecognition of a Financial Asset

Edited by Taufik Hidayat

Derecognition of a Financial Liability

A financial liability or part of it is extinguished when the

Forward sales contract

Forward purchase contract

Forward Contracts (2)

Fair value of forward contract:

Current forward rate is forward rate for

Edited by Taufik Hidayat

Forward Contracts: Journal Entries

During life of contract

Adjust fair value and

Close out and record

Forward Contracts : illustration

On March 1, 20X5, Company A entered into a forward contract

May 30 forward rate

Edited by Taufik Hidayat

Forward Contracts: illustration (2)

March 31 Dr Forward Contract (asset)

To record change in fair value of forward contract

(1.21 - 1.2) x 1,000,000

Dr Loss on Forward Contract

To record change in fair value of forward contract

(1.21 - 1.205) x 1,000,000

Dr Forward Contract (asset)

To record change in fair value of forward contract

(1.215 - 1.205) x 1,000,000

To close forward contract at maturity

(1.2 - 1.215) x 1,000,000

To record settlement of underlying