IAS 32, IFRS 9, and IFRS 7

CLASS NOTES & EXAMPLES

Adapted from: Descriptive Accounting 18th edition

CONTENTS
DERIVATIVES ........................................................................................................... 2

IFRS 9 – SCOPE OF THE STANDARD & OWN USE EXEMPTION ...................... 4

TERMINOLOGY ..................................................................................................... 5

IFRS 9 – DEFINITION OF DERIVATIVES .............................................................. 7

ACCOUNTING TREATMENT OF DERIVATIVES: ................................................. 7

IDENTIFICATION ................................................................................................... 9

DEFINITION OF DERIVATIVE FINANCIAL INSTRUMENTS ............................... 11

ACCOUNTING FOR FORWARD-TYPE DERIVATIVE FINANCIAL

INSTRUMENTS .................................................................................................... 14

ACCOUNTING FOR OPTION-TYPE DERIVATIVE FINANCIAL INSTRUMENTS 15

1
DERIVATIVES
An overview

Derivatives are contracts between two parties (i,e, financial instruments) that specify
conditions (especially the dates, resulting values and definitions of the underlying variables,
the parties' contractual obligations, and the notional amount) under which payments are to be
made between the parties.

In finance, a derivative derives its value from the performance of an underlying entity. This
underlying entity can be an asset, index, or interest rate, and is often simply called the
"underlying". Derivatives can be used either for risk management (i.e. to "hedge" by providing
offsetting compensation in case of an undesired event, a kind of "insurance") or for speculation
(i.e. making a financial "bet"). This distinction is important because the former is a prudent
aspect of operations and financial management for many firms across many industries; the
latter offers managers and investors a risky opportunity to increase profit, which may not be
properly disclosed to stakeholders

The most common underlying assets include commodities, stocks, bonds, interest rates and
currencies, but they can also be other derivatives, which adds another layer of complexity to
proper valuation.

From the economic point of view, financial derivatives are cash flows that are conditionally
uncertain / variable (stochastic) and discounted to present value using financial modelling
techniques. The market risk (exposure to price, interest rate of foreign exchange rates)
inherent in the underlying asset is attached to the financial derivative through contractual
agreements and is then traded separately. The underlying asset does not have to be acquired.

Derivatives therefore allow the breakup of ownership and participation in the market value of
an asset. This also provides a considerable amount of freedom regarding the contract design.
That contractual freedom allows to modify the participation in the performance of the
underlying asset almost arbitrarily – so you can choose which risks you want to be exposed
to and design a contract which only exposes you to these risks, without having to acquire the
whole instrument. So specifically, the market price risk of the underlying asset can be
controlled in almost every situation.

There are two groups of derivative contracts: the privately traded over-the-counter (OTC)
derivatives such as swaps that do not go through an exchange or other intermediary,
and exchange-traded derivatives (ETD) that are traded through specialized derivatives
exchanges or other exchanges.

2
In South Africa future there are two main traded exchanges for derivative instruments:
- JSE Commodity Derivatives Market provides a platform for price discovery and efficient
price risk management for the grains market in South and Southern Africa. The market
also offers a range of foreign-referenced derivatives on other commodities (e.g. gold and
oil).
- The Equity Derivatives Market, formerly Safex, was established in 1988 to provide a
secure and efficient on-exchange market for trading Derivatives in South Africa. Today
the market provides professional traders and private investors with a platform for trading
Futures, Exchange Traded CFDs, Options and other sophisticated Derivatives
Instruments in a liquid and transparent environment.
For more information see https://www.jse.co.za/trade/derivative-market/

Mechanics and valuation basics for derivatives

Forwards, swaps and future contracts (also known as “lock products”) obligate the contractual
parties to the terms over the life of the contract. I.e. an exercise price and date is specified
and the potential contractual obligations are unavoidable. These are theoretically valued at
zero at the time of execution and thus do not typically require an up-front exchange between
the parties (generally because both parties carry some risk of loss).

Based upon movements in the underlying asset over time, however, the value of the contract
will fluctuate, and the derivative may be either an asset (i.e. "in the money") or a liability (i.e.
"out of the money") at different points throughout its life. Importantly, either party is therefore
exposed to the credit quality of its counterparty and is interested in protecting itself in an event
of default. A forward or future is value with reference to the spot rate and the rate available on
similar instruments that mature on the same date as the derivative which is being measured.

Option products (such as interest rate caps) provide the buyer the right, but not the
obligation to enter the contract under the terms specified. I.e. the buyer or holder of the option
contract has a choice (option) to exercise the contract. There is no up-side for the issuer of an
option, as the holder of the option will only exercise the option if it is an asset to them (in the
money). Because of this, option products have immediate value at the outset because they
provide specified protection (intrinsic value) over a given time period (time value).

Because of the immediate option value, the option purchaser typically pays an up-front
premium. Just like for lock products, movements in the underlying asset will cause the option's
intrinsic value to change over time while its time value deteriorates steadily until the contract
expires.

An important difference between a lock product is that, after the initial exchange, the option
purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute
the option if it has positive value (i.e. if it is "in the money") or expire at no cost (other than to
the initial premium) (i.e. if the option is "out of the money"). The measurement of the value of
an option requires the use of complex valuation methodologies and will normally be calculated
be actuaries.

Source: https://en.wikipedia.org/wiki/Derivative_(finance)
For more information on derivatives see https://en.wikipedia.org/wiki/Derivative_(finance)

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IFRS 9 – SCOPE OF THE STANDARD & OWN USE EXEMPTION
Contracts to buy or sell a non-financial item at a future date are included within the scope of
the Accounting Standards dealing with derivative financial instruments if they meet specified
criteria. The assessment process to determine whether a contract to buy or sell a non-financial
item falls within the scope can be illustrated as follows:
(IFRS 9.2.4 to 9.2.7)

IF YES TO ANY OF
THESE, IN SCOPE OF FI

a) Contract permits net

settlement

b) Past practice of net

Settled NET in: settlement
(i) cash or
(ii) other FI or
(iii) exchanging FI, as if the c) Take delivery, but on-sell
contracts were FI
soon after receipt

d) Non-financial item is
readily convertible to cash
Contract to (e.g. gold)
buy or sell
NON-FINANCIAL
assets

Written options that can be

Except: Contracts entered into net settled is exlcuded from
& continue to hold to receieve/ this exemption
deliver non-financial items
IN ACCORDANCE WITH THE
ENTITY’S EXPECTED Own-use contracts may be
PURCHASE, SALE OR USAGE DESIGNATED as FVTPL
REQUIREMENTS - On intial recogntion;
- Irrevocable
AKA "own-use exemption"
- IF eliminates mismatch

IF EXCEPTION APPLIES:
OUT OF SCOPE FOR FI

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TERMINOLOGY
An understanding of the following types of instruments and related terms is necessary
before the definitions in the Accounting Standards are explored:

Basic types of derivative financial instruments:

Forward: A contractual agreement to buy or sell a particular commodity or financial

instrument at the forward price in the future. Both parties are obligated to
act. The delivery of the underlying asset in exchange for the forward price
is therefore deferred until after the contract has been concluded. Although
the delivery is made in the future, the forward price is determined on the
initial trade date.
Future: A forward contract that is standardised to facilitate trading on a futures
exchange. Some futures contracts may call for physical delivery of the
asset, while others are settled in cash.
Option: A contractual agreement that gives the holder the right, but not the
obligation, to buy (for a call option) or sell (for a put option) a specific amount
of a commodity or financial instrument during a specified period of time.
Each option contract has a buyer, referred to as the holder, and a seller,
known as the writer. If the option contract is exercised, the writer is
responsible for fulfilling the terms of the contract by delivering the
underlying asset or cash to the appropriate party. For the holder, the
potential gain is unlimited but the potential loss is limited to the premium
paid to acquire the option. For the writer, the potential loss is unlimited but
the potential gain is limited to the premium received to write the option.
When an option is not exercised, it expires. The two basic option types are:
(i) European options: this type of option provides the holder with one date
to exercise the option; and (ii) American options: this type of option provides
the holder with the right to choose to exercise the option at any time over
the life of the option.
Swap: A contract between two parties in which the parties promise to make
payments to one another on scheduled dates in the future. In other words,
the counterparties agree to exchange one stream of cash flows against
another stream. These streams are called the “legs” of the swap. The
payments are determined using different criteria or formulas. Swaps are
equivalent to a series of forward contracts, each with the same price.
However, the structure of a swap can be far more efficient than a package
of individual forward contracts. There are four types of swaps defined by
the type of their underlying financial risk; i.e., interest rate, equity, currency,
and commodity swaps.

5
Related terms – important for understanding and reading scenarios
Initial margin: The security margin that is required by an exchange to be paid by the
buyers and/or sellers of a commodity or financial instrument. The security
margin will be used to honour the contract should the buyer or seller
default.
Intrinsic value RELEVANT FOR PGDAS (CTA)
The profit or loss if a derivative instrument was exercised at the current spot
price of the underlying asset. It is therefore calculated as the difference
between the spot price and the strike price of the underlying asset.
In-the-money: When an option contract results in an exchange that is favourable for the
holder of the option, i.e., the option has value for the holder. This will imply
that the holder will exercise the option. An option is “deeply in the money”
when it is so far in the money that it is highly unlikely (i.e., more likely than
not) to go out of the money before it expires (IFRS 9.B3.2.5(d)).
Mark-to-market: The process of recalculating the net profit or loss on each client’s open
positions at the end of each trading day. Funds are withdrawn from or
deposited into the client’s margin account so that the balance reflects his
net profit or loss.
Out-of-the-money: When an option contract results in an exchange that is unfavourable for
the holder of the option, i.e., the option has no value for the holder. This
will imply that the holder will not exercise the option. An option is “deeply
out of the money” when it is so far out of the money that it is highly unlikely
(i.e., more likely than not) to go into the money before it expires
(IFRS 9.B3.2.4(c)).
Premium: The amount paid by the holder to acquire an option. The premium
generally represents the fair value of the option at inception.
Spot price: The price at which an instrument trades in the current market for a
transaction settled in the immediate market.
Strike price: The set price (forward price) at which an option holder has the right to
buy/sell the underlying asset.

Forward price
FYI ONLY – to build your understanding, but you will not be expected to calculate a forward price
The predetermined delivery price for an underlying commodity or financial instrument decided upon by the
buyer and the seller to be paid at the predetermined date in the future. It is the price quoted in a forward or
future contract. For example, the forward price stated in a forward exchange contract (FEC) can be
determined using the following formula (assuming covered interest rate parity):
F = S × [(1 + id)/(1 + if)]
where:
F = the forward exchange rate
S = the spot exchange rate
id = interest rate in domestic currency
if = interest rate in foreign currency

The difference between the forward price and the spot price is known as “forward points”.

6
IFRS 9 – DEFINITION OF DERIVATIVES
DERIVATIVE - need to be able to do as a discussion question; apply definition as per
IFRS 9 Appendix A

A FINANCIAL INSTRUMENT or other contract within the scope of this Standard with all three
of the following characteristics:

1) its value changes in response to an ‘underlying’

e.g. value changes in response to 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, provided in the case of a non-financial variable that the variable is not
specific to a party to the contract;
AND
2) 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
3) it is settled at a future date

REMEMBER to CONCLUDE

Why do we have derivatives?

• Financial risk management tools

• Speculation

**
Accounting treatment of derivatives:

All derivative financial instruments (assets and liabilities), not classified as equity instruments
or designated as hedging instruments, are classified as fair value through profit or loss
financial instruments:

• Shall be measured at fair value through profit or loss.

• Transaction costs related to derivative financial instruments are always expensed in

profit or loss.

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How to calculate the fair value?

1) Forwards and futures:

Find fair value for a SIMILAR instrument i.e. same underlying, similar quantities, maturing
on the same date
Difference between contractual forward/future price and similar instrument = fair value gain
or loss for the year:
- If you are “better off” for owning the instrument, you have made a fair value gain and
have a financial asset;
- If you are “worse off” for owning the instrument, you have made a fair value loss and
have a financial liability.
Only compare contract price to spot on the maturity date. Transaction costs are expensed,
but day 1 premiums to acquire the derivative paid by the holder represents the cost of the
instrument acquired. (Dr Financial instrument, Cr Cash)

2) Options

Fair value is calculated using complex fair value option pricing models. Thus, fair value will
have to provided in assessments to students.
An option will not be exercised if it is not in the holder’s favour, therefore it is either an asset
or have no value. The issuer of an option either has a liability or no value. It can’t be an
asset from the issuer’s perspective.
Because of this, the issuer generally charges an option premium on day 1 (Dr Cash; Cr
Financial liability). The option holder pays the premium (Dr Financial asset; Cr Cash).

Net settlement vs gross settlement?

Net settled: Only the fair value difference between the market price and the contract prices is
settled in cash on the maturity date. Futures and forwards are generally net settled.

Gross settled: Full cash value is delivered by one party, and the full underlying instruments /
assets are delivered by the counter party. Options are generally gross settled, as you take out
the option to buy or sell something in the future, but it can also be net settled.

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IDENTIFICATION
EXAMPLE ILLUSTRATING SCOPE – FOR UNDERSTANDING:

Contract to buy or sell a non-financial item

Raven Ltd owns an office building in a prime location in Johannesburg and acquires a put option
from PropFund Ltd that permits Raven Ltd to put (sell) the building to the PropFund Ltd for
R150 million. Raven Ltd paid a premium of R10 million to acquire the put option. The current market
value of the building is R175 million. The option expires in five years. The option, if exercised, may
be settled through physical delivery or net cash, at the option of Raven Ltd. This is the first time
Raven Ltd has entered into a contract of this type. If Raven Ltd exercises the option, it intends to
physically transfer the legal title of the building to PropFund Ltd.
The assessment process to determine whether the contract to sell the office building falls within
the scope of IFRS 7, IFRS 9, and IAS 32 can be illustrated as follows:

Definition of a financial asset/liability

The acquired put option does not meet the definition of a financial asset/liability as it does not
represent a right obligation to exchange financial assets. Instead, it represents a contract to
exchange a non-financial item (the office building) for a financial asset (cash) (IAS 32.11) at a
future date. I.e. we’re out of scope as we don’t have a financial asset/liability.

Definition of a derivative
▪ The value of the put option changes in response to changes in the market price of the office
building.
▪ The put option requires a small initial net investment of R10 million.
▪ The put option will be settled over the remaining life of five years.
Thus, the put option does meet the definition of a derivative and is now potentially scoped back
into IAS 32/ IFRS 9/ IFRS 7

Additional criteria to be included within the scope

We consider pg. 4 decision tree (IFRS 9.2.4 to 9.2.7) - Contract to buy/sell NON-FINANCIAL assets
Raven Ltd does not have a practice of settling similar contracts net in cash seeing that this is the
first time Raven Ltd has entered into a contract of this type. The office building is not an asset that
is readily convertible into cash. The contract does however permit settlement through physical
delivery or net in cash. If Raven Ltd exercises the option, it intends to physically transfer the legal
title of the building to PropFund Ltd. As such we aren’t scoped into IAS 32/ IFRS 9/ IFRS 7 on the
basis of net settlement.
Now we consider if the own-use exemption (and related exception about written put options would
apply. Raven Ltd acquired the put option. It does not represent a written put option (a written put
option would have been issue / written by Raven; Raven bought the option from Propfund who
wrote the option).
We can therefore conclude that this is not within the scope of IFRS 7, IFRS 9, IAS 32 and IAS 39,
even though it meets the definition of a derivative.
If the net settlement in cash was considered like, the contract would have been in scope.

Comment
➢ PropFund Ltd, however, cannot conclude that the option was entered into to meet its expected
purchase, sale or usage requirements, because the contract is a written put option from their
perspective. In addition, the option may be settled net in cash. Therefore, PropFund Ltd has to
account for the contract as a derivative within the scope of IFRS 7, IFRS 9, IAS 32 and IAS 39.

9
Accounting for contracts to buy or sell non-financial items

Caesar Ltd owns a large copper mine, smelter and refinery in the Limpopo province of South Africa.
Caesar Ltd has a Rand functional currency. On 15 December 20.12, Caesar Ltd entered into a fixed-
priced forward contract with a client based in the United States to sell 1 000 tons of copper on 15
March 20.13 for US$8 000 per ton. The contract has a Rnil cost. If settled through physical delivery
of the copper, the date that the risk and rewards associated with the copper will transfer to the client
is 15 March 20.13. The forward copper price for a similar contract on 31 December 2012 (year-end)
amounts to US$7 900 per ton. On 15 March 20.13, the spot copper price amounts to US$7 600 per
ton. The prices are derived from the copper prices as quoted on COMEX (Commodity Exchange Inc.
a division of the New York Mercantile Exchange (NYMEX)). Assume a constant US$1:Rand spot
exchange rate of R8. Also assume that the effect of discounting is immaterial.

The journal entries to account for the forward contract, depending on whether the contract is within
the scope of IFRS 7, IFRS 9, IAS 32 and IAS 39, in the financial statements of Caesar Ltd are as
follows:

Within the scope of IFRS 7. IFRS 9, IAS 32 Not within the scope of IFRS 7. IFRS 9,
and IAS 39 IAS 32 and IAS 39
Dr Cr Dr Cr
R’000 R’000 R’000 R’000
15 December 20.12 15 December 20.12
No entry as the derivative has No entry
a Rnil cost

31 December 20.12 31 December 20.12

Derivative financial asset No entry
(SFP) 800
Fair value gain (P/L) 800
Subsequent measurement of derivative
instrument at fair value through profit or loss
(1 000 × (US$7 900 – US$8 000) × R8)
15 March 20.13 15 March 20.13
Derivative financial asset No entry
(SFP) 2 400
Fair value gain (P/L) 2 400
Subsequent measurement of derivative
instrument at fair value through profit or loss
(1 000 × (US$7 600 – US$7 900) × R8)
15 March 20.13 15 March 20.13
Cash (SFP) 3 200 Cash (SFP) 64 000
Derivative financial asset Revenue (P/L)
(SFP) 3 200 64 000
Settlement of derivative instrument net in cash Physical settlement of supply contract in terms
(1 000 × (US$7 600 – US$8 000) × R8) of IFRS 15 (1 000 × US$8 000 × R8)

10
DEFINITION of derivative financial instruments

Application of definitions on derivative financial instruments – basic instruments

Farma Ltd is an agricultural services provider, focusing on agricultural producers, agri-processors

and consumers of agricultural and related products, both locally and internationally. The business
of Farma Ltd is greatly impacted by changes in the ZAR/US$ exchange rate, rainfall, the white and
yellow maize prices, and market interest rates. As a result, Farma Ltd has a number of basic open
contracts as at 31 December 20.13.
The following criteria needs to be assessed for each contract:
1. It is a right/contractual obligation to exchange financial assets or financial liabilities with another
entity.
2. Its value changes in response to the change in an underlying.
3. It requires no or little initial net investment or an initial net investment.
4. It is settled at a future date.
Assume the effect of discounting to be immaterial.

1) Forward Exchange Contract (FEC)

Background
Farma Ltd entered into a 3-month forward exchange contract (FEC) on 1 December 2013 to
acquire US$1 000 000 on 28 February 2014 at US$1:R9,44. The FEC has a Rnil cost. The forward
exchange rate for a similar FEC at 31 December 20.13 amounts to US$1:R9,63.
Assessment
1. The FEC represents a contractual right and obligation to exchange South African Rand (cash)
for US Dollar (cash) in three months’ time.
2. The fair value of the FEC at 1 December 20.13 amounts to Rnil (R9,44 (forward price in the
market) – R9,44 (forward price in the contract)). The fair value of the FEC at 31 December 20.13
amounts to R0,19 (R9,63 (forward price in the market) – R9,44 (forward price in the contract)).
Thus, the fair value of the FEC changes in response to the US$:Rand forward exchange rate.
3. The FEC requires no initial investment as it has a Rnil cost.
4. The FEC is settled on 28 February 2014 when Farma Ltd pays R9 440 000 and receives
US$1 000 000.
Conclusion
The FEC meets the definition of a derivative.
Favourable vs. unfavourable
At 31 December 20.13, the FEC has a favourable fair value of R190 000 (R0,19 × US$1 000 000)
as Farma Ltd can acquire the amount of US$ for a lesser amount of Rand (R9 440 000) compared
to other market participants (R9 630 000). The FEC will therefore be classified as a financial asset.

11
2) Commodity future contracts
Background
Farma Ltd needs to purchase white maize (grade 1) in March 20.14 and wishes to protect itself
against rising prices. On 15 December 20.13, it acquired 100 March 800 WM1 call options for
R15/ton (R1 500 per contract or R150 000 in total) on the commodity futures market. Thus, the
seller (writer) of the March 800 call is obliged to sell March white maize futures at R800/ton at any
time during the life of the option, no matter how high the price is actually trading in the futures
market. In return for this obligation, the seller of the option will receive the premium of R150 000,
which it keeps no matter what happens in the underlying futures market. Farma Ltd has the right,
but not the obligation, to acquire March white maize futures at R800/ton at any time during the life
of the option. At 15 December 20.13 and 31 December 20.13, the March white maize futures prices
amount to R780/ton and R750/ton respectively.

Assessment
1. The call option represents a contractual right to exchange R800/ton (cash) for white maize
futures (derivative) in three months’ time.
2. The intrinsic value of the call option at 15 December 20.13 amounts to – R20 (R780 (market
price) – R800 (strike price)). The intrinsic value of the call option at 31 December 20.13 amounts
to – R50 (R750 (market price) – R800 (strike price)). Thus, the value of the call option changes
in response to the March white maize futures price.
3. The call option requires an initial net investment of R150 000 that is smaller than would be
required for other types of contracts to acquire white maize at the March futures price
(R780 000).
4. The call option is settled in March 20.14 if Farma Ltd pays R800/ton and receives March white
maize futures.

Conclusion
The call option meets the definition of a derivative.

Favourable vs. unfavourable

At 31 December 20.13, the call options have an unfavourable intrinsic value of – R50 000 (– R50
× 1 000) as Farma Ltd can acquire the March white maize futures for R750/ton in the market,
compared to the strike price in the call option of R800/ton. The call option is therefore out-of-the-
money. The call option will therefore be classified as a financial liability. The value recorded in the
financial statements will however be limited to Rnil, as Farma Ltd has the right to not exercise the
call option when it is unfavourable.
Comment
➢ Expiry of an option at its maturity is a form of settlement, even though no additional consideration
is exchanged (IFRS 9.B.7).

12
3) Interest rate swaps
Background
Farma Ltd entered into an interest rate swap agreement with Bank Ltd. The terms state that
Farma Ltd pays a fixed interest rate of 10% and receives a variable amount based on the three-
month JIBAR variable interest rate, reset on a quarterly basis. The amounts are based on a notional
of R1 000 000. The swap has a cost of Rnil. Settlement will occur on a net basis each quarter,
based on the difference between 10% and the three-month JIBAR interest rate. The fair value of
the interest rate swap changes in response to changes in the swap yield curve used to value the
swap in relation to the interest rates in the swap.

Assessment
1. The interest rate swap represents a contractual obligation to exchange fixed interest payments
(cash) for variable interest payments (cash) over the life of the swap.
2. The fair value of the interest rate swap changes in response to changes in the swap yield curve
used to value the swap in relation to the interest rates in the swap.
3. The swap requires no initial investment as it has a Rnil cost.
4. The swap is settled on a net basis each quarter (a future date), based on the difference between
10% and the three-month JIBAR interest rate

Conclusion
The FEC meets the definition of a derivative.

Favourable vs. unfavourable

This will depend on the three-month JIBAR variable interest rate; Farma pays 10% and receives a
variable return. If the expecected three-month JIBAR rates are higher than 10% the swap is in-the-
money and favourable to Farma; if it is lower than 10% Farma will pay more than what it receives
from Bank Ltd and the contract will be out-of-the-money and unfavourable to Farma.

13
ACCOUNTING FOR FORWARD-TYPE DERIVATIVE FINANCIAL INSTRUMENTS

All derivative financial instruments (assets and liabilities), not classified as equity instruments
or designated as hedging instruments, shall be measured at fair value through profit or loss.
Transaction costs related to derivative financial instruments are always expensed in profit or
loss.

Falcon Ltd, for speculative purposes, entered into a forward contract to acquire 1 000 Retail Ltd
shares in three months’ time on 15 December 20.12. Falcon Ltd incurred and paid transaction
costs of R100 on this date. The quoted spot price (level 1 input) at inception is R20 per share and
the 3-month forward price is R25 per share. On 31 December 20.12 (year-end), the quoted spot
price is R22 per share and the forward price for a similar forward contract is R26 per share. The
spot price on 15 March 20.13 (maturity date) is R24 per share. The forward contract has a Rnil
cost. The forward will settle on a net basis in cash. Assume that the effect of discounting is
immaterial. The forward contract is not designated as a hedging instrument.
The journal entries to account for the forward contract in the financial statements of Falcon Ltd will
be as follows:
Dr Cr
R R
15 December 20.12
No entry as the forward contract has a Rnil cost
Recognition of forward contract
15 December 20.12
Transaction cost expense (P/L) 100
Cash (SFP) 100
Recognition of transaction cost
31 December 20.12
Derivative instrument: forward contract (SFP) 1 000
Fair value gain (P/L) 1 000
Subsequent measurement at fair value through profit or loss
(1 000 × (R26 (forward price in the market) – R25
(forward price in the contract)))
15 March 20.13
Fair value loss (P/L) 2 000
Derivative instrument: forward contract (SFP) 2 000
Subsequent measurement at fair value through profit or loss
(1 000 × (R24 (spot price) – R26 (previous forward price
in the market)))
15 March 20.13
Derivative instrument: forward contract (SFP) 1 000
Cash (SFP) 1 000
Settlement of forward contract on a net basis in cash
Comment
➢ The undiscounted fair value of a forward-type derivative instrument is the difference between
the forward price of a similar derivative instrument at the measurement date and the forward
price quoted in the derivative contract held.
➢ The fair value of a derivative at maturity date equals its intrinsic value.
➢ The forward price for the forward contract at maturity equals the spot price as the time to maturity
is nil.

14
ACCOUNTING FOR OPTION-TYPE DERIVATIVE FINANCIAL INSTRUMENTS

In order to evaluate whether an option contract is favourable or unfavourable, one needs to

understand the rights and obligations of the party for whom the assessment is performed:
WRITER HOLDER
of the contract of the contract
Call Option
Obligation to SELL Right to BUY
(Contract to buy)

Put Option
Obligation to BUY Right to SELL
(Contract to sell)

Falcon Ltd, for speculative purposes, acquired a put option to sell 1 000 Retail Ltd shares in three
months’ time on 15 December 20.12. The strike price amounts to R23 per share. At inception, the
spot price (level 1 input) is R20 per share. On 31 December 20.12 (year-end), the quoted spot price
is R22 per share. The spot price on 15 March 20.13 (maturity date) is R25 per share. The option
contract has a premium equal to the fair value at inception. The option contract will settle on a net
basis in cash. The option contract is not designated as a hedging instrument. The fair values of the
put option on various dates are as follows:
Date Fair value
15 December 20.12 R5 000
31 December 20.12 R4 000 R1000
15 March 20.13 – R2 000
The journal entries to account for the option contract in the financial statements of Falcon Ltd will
be as follows:
15 December 20.12 Dr Cr
Derivative instrument: put option (SFP) 5 000
Cash (SFP) 5 000
Recognition of option contract
31 December 20.12
Fair value loss (P/L) 1 000
Derivative instrument: put option (SFP) 1 000
Subsequent measurement at fair value through profit or loss
(4 000 – 5 000)
15 March 20.13
Fair value loss (P/L) 4 000
Derivative instrument: put option (SFP) 4 000
Subsequent measurement at fair value through profit or loss
(Rnil – R4 000)
15 March 20.13
No entry
Option contract expires unexercised
Comment
➢ The fair value loss for the period 1 January 20.13 to 15 March 20.13 is limited to R4 000, as
Falcon Ltd will not exercise the option when it is out-of-the-money.
➢ The total loss suffered by Falcon Ltd amounts to R5 000 (R1 000 + R4 000). This represents a
loss of the premium paid to acquire the option and then not exercise it.

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Dr Cash 23000
Cr FA 22000 Asset owned (FI)
Cr FV gain 1000

Dr FV Loss 4000
Cr Option 4000

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