The turnaround in the Indian economy has paved way for new & sophisticated Financial instruments to mark their arrival on the scene, thereby broadening the “Investors’ Basket”. In the year 2000, the Indian capital markets welcomed one of such instruments called the ‘Derivatives’. The Derivatives are powerful weapons which the investors can use to kill the risk arising from the volatility of the Capital Markets.            There is a plethora of derivatives available in the market, some of the 'Top-Notch' derivatives are: Forwards, Futures, Options, Swaps, Leaps, baskets.

Lets now wipe our lenses & shift our focus to Option contracts & understand the       various terms associated with them & the accounting treatment arising thereon. Before actually tickling the various technicalities involved, a small example to throw light on the subject would be Prudent & for that the Indian mythology comes in handy.

“King Dashratha’s wife, queen Kaikai saves his life & his honour on the battlefield. He grants her a boon-‘ask for anything & it shall be yours’. An unconditional option! She refuses to exercise it then but does so years later, when she thinks its ‘In-the-Money’. Rama is banished into exile & the rest is mythical history”.

 Consider a situation wherein an investor wants to invest in a particular stock, now, every upward rise in the stock price will make his purse heavier & every drop will render his purse lighter. But as investor he will want to keep off the loss, which is just like saying ‘Heads I win, Tails you lose’. The question is, is it possible & the answer is in the affirmative. Enter into an options contract & flip the coin.

“An Option Contract gives the buyer of the option a right & not an obligation to buy/sell the underlying asset at a specified price on or before a specified date”. From the definition it is clear that the buyer of the option is under no obligation to buy/sell the underlying asset, meanwhile the seller of the option is under an obligation to buy/sell the underlying asset in case the buyer decides to exercise the option. The various terms forming an option contract have been enumerated below:

Ø      Underlying Asset:- The specific security or asset on which an option contract is based.

Ø      Option Writer/Seller:- The person who is obligated to buy/sell the underlying asset at the strike price in case the buyer decides to exercise the option.

Ø      Option Buyer:- The person who has the right to buy/sell the underlying asset at the strike price on or before a specified day.

Ø      Strike Price/Exercise Price:- It is the specified or pre-determined price at which the underlying asset can be bought or sold in case the buyer decides to exercise the option.

Ø      Option Premium:- It is the price paid by the buyer to the seller of the option for acquiring the option.

Ø      In-the-money:- An option is said to be In-the-money if it would lead to a positive cash flow to the holder if it were exercised immediately.

Ø      Out-of-money:- An option is said to be Out-of-Money if it would lead to a negative cash flow to the holder if it were exercised immediately.

           Option contracts are of two types

v     Call Option:- A call option gives the buyer the right to buy the underlying asset at the strike price on or before certain specified period. The investor can go ahead & exercise the option when the market price (MP) of the underlying asset is above the strike price (SP). A direct result of this is, he makes a gross pack which is the difference between market price & the strike price, & a net pack which is the surplus of MP over SP+Option premium. That is he will break even when MP=SP+Option Premium & reap profits when MP>SP+Option Premium.

v     Put Option:- A put option gives the buyer a right to sell the underlying asset at the strike price on or before certain specified period. The investor can go ahead & exercise the option when the market price of the underlying asset is less than the strike price. The break-even situation will be same as that of call option but the investor will reap profits when the MP is lower than SP-Option premium.

Accounting treatment is an indispensable component of any financial transaction & the option contracts are no exceptions. Since there is an absence of an accounting standard prescribing a specific accounting treatment we have to take recourse to the Guidance Note issued by ICAI

The ICAI has developed accounting guidelines for derivatives to ensure appropriate disclosure recognition and measurement of company’s financial statements and this move is also aimed at adoption of best international accounting practice. In order to achieve this objective, the following is required to be looked upon: 

Ø      If the Margin is paid in cash it will be treated as deposits in the Balance sheet under the head ‘Current assets, Loans & Advances’. The same if in the form of Bank guarantee will be treated as a ‘Contingent Liability’.

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Ø      In case the premium paid by the holder exceeds the premium as on balance sheet date, a provision has to be created which will be credited to say ‘Provision for loss on Equity index/Stock option a/c. By doing so he can reduce his loss to the extent of premium prevailing in the market by squaring up the transaction. Whereas if the premium prevailing in the market as on the Balance sheet date exceeds the premium paid, it will not be recognized keeping in mind the concept of prudence.

Ø      On the contrary in the writer’s books the excess provision received will not be recognized whereas the loss will be credited to ‘Provision for loss on Equity index/Stock option a/c with a corresponding debit to P/L a/c.

Ø      Options can be exercised either through Cash or Delivery Basis. The buyer is required to recognize Premium as an expense and hence Credits the ‘Equity Index/Stock Option premium a/c by giving a corresponding debit to P/L a/c.

Visa-versa treatment is done in the books of the seller.

1) When the settlement is on Cash basis, any favourable difference between the     final settlement price and the Strike price is acknowledged as an Income to the holder and the adverse difference will be acknowledged as a loss to the seller.

2) When the settlement is on delivery basis, the following is recommended :

If an Option expires unexercised the accounting entries will be the same as those in the case of settlement on Cash basis

A reverse contract is entered into between the parties when the Option Contract is squared up and any difference between the premium paid and received (after adjusting the brokerage charged) must be transferred to the P/L alc

Disclosure:-

1)      The enterprise should disclose the accounting policies and methods followed detailing the basis of measurement and criteria for recognition applied.

2)      The enterprise should clearly state the objectives of dealing in Options and must also include comments on the effectiveness of the internal control system and procedures setup as a part of financial risk management efforts to manage the trading.

From the Taxman’s point of view:

The Income Tax Act does not have any specific provision regarding taxability of derivatives. The only provision, which had an indirect bearing on derivative transactions, was section 43(5). The Finance Act, 2005 has, accordingly, amended section 43(5) to provide that a transaction in respect of trading in derivatives of securities carried out on a recognized stock exchange shall not be deemed as a speculative transaction. Consequently any profits or losses in the derivative transactions will be treated as normal business income and provisions relating to set off of business income (section 72 of the Income Tax Act 1961) will ipso facto apply to the derivative transactions.

The Derivatives pitch in as a boon for the investors as they prove to be a useful fork by the aid of which the investors can eat away the risk created by the equity markets. Derivatives as a whole & Option contracts in particular restrict the losses of the investors & with a proper combination of call & put options the investors can very well take the price rise/fall of the underlying asset to their advantage hence helping themselves to a cushion against the much feared risk factor. The Income Tax Act takes the show a step ahead by showering a carry forward benefit as explained in the foregoing Para. In more ways than one, derivatives form an important component of the investors’ kitty & can make the investors ‘laugh their way to the bank’.