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Wiley IFRS: Practical Implementation Guide and Workbook
7. DERIVATIVES
7.0.1 Derivatives are contracts such as options, forwards, futur es, and swaps. Because they are
often entered into at no cost. many times derivatives were not recogni zed in financial statements
prior to lAS 39. The potential gains and losses that may arise on settlement of derivatives,
however, bear little relation to their initial cost and can be significant. To provide more useful
informa tion about derivatives, therefore, lAS 39 requires derivatives to be measured at fair value in
the balance sheet (unless, as already discussed, they are linked to and must be settled by an
investment in an unquoted equity instrument that cannot be reliably measured at fair value).
7.0.2 Determining whether changes in fair value of a derivative should be recognized either in
profit or loss or in equity in part depends on whether the entity uses the derivative to speculate or
offse t risk. As a genera l rule, changes in fair value of a derivative are recognized in profit or loss.
However, when the derivative is used to offset risk and special hedge accounting conditions are
met, some or all changes in fair value are recognized as a separate component of equity.
7.0.3 To enable entities to properly identify derivatives, lAS 39 provides this definiti on:
Derivative. A financial instrument or other con tract with all three of the following characteris–
tics:
(I )
Its value changes in response to the change in a specified interest rate, financial instru–
ment price, commodity price, foreign exchange rate, index of prices or rates, credit
rating, credit index or other variable (sometimes called the
"unde rlying
").
For instance, a call option that gives the holder a right to purchase a share for a fixed price
increases in value when the price of that share increases . In that case, the share price is an under–
lying that affects the value of the option.
(2) It requires no
initial net in vestment
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.
For instance, a ca ll option on a share can usually be purchased for an amount much smaller than
what would be required to purchase the share itself.
(3) It is
se ttled
at a future date.
7.0.4 For instance, a call option on a share is settled on the future date on which the holder may
exercise the call option to purchase the share for a fixed price. Unde r lAS 39, the expiration of an
option is also considered to be a form of settlement.
Example
Assume Entity A enters into a call option contract on December 15, 20X5. that gives it a right, but
not an obligation,
to
purchase 1,000 shares issued by Entity B on April 15, 20X6, at an exercise
price (i.e., strike price) of $100 per share. The cost Entity A pays f or each option is
$3.
Theref ore.
Entity A makes this j ournal entry on December
15,
20X5:
Dr Derivative asset
3,000
Cr Cash
3,000
(To record the purchase 0/ 1,000 call options/o r $3.00per option)
Market data suggests that Entity A could sell each option fo r
$4.
Theref ore. on December 31, 20X5,
Entity A makes these journal entries to recognize the increase ill fair value:
Dr Derivative asset
1.000
Cr Derivative gain
1,000
(To record the increase in/ air value 0/ $1.00 per option)
On April
15,
20X6, the fa ir value of each option is $10. The share price on this date is $110. Since
the share price is higher than the exercise price, Entity A decides to exercise the option by buying
1.000 shares fo r $100 per share. Under lAS
39.
fi nancial assets are initially recognized
at
fair
value, so the shares are recognized at their f air value of $110 per share rather than the option
exercise price of$ 100 per share. In addition, the option asset is derecognized. Entity A makes these
journal entries:
Dr Derivative asset
6.000
Cr Derivative gain
6,000
(To record the increase in/air value 0/ $6.00 per option)