IE12-16-Example 3 Purchased call option on shares

Last Updated on 12/02/2020 by 75385885

IAS 32 Financial Instruments: PresentationIE12-16-Example 3 Purchased call option on shares

IE12-16-Example 3 Purchased call option on shares

This example illustrates the journal entries for a purchased call option right on the entity’s own shares that will be settled (a) net in cash, (b) net in shares or (c) by delivering cash in exchange for the entity’s own shares. It also discusses the effect of settlement options (see (d) below):

Assumptions:

Contract date                                                                                               1 February 20X2

Exercise date1                                                                                            31 January 20X3

Exercise right holder                                                                   Reporting entity (Entity A)

Market price per share on 1 February 20X2                                                             CU100

Market price per share on 31 December 20X2                                                        CU104

Market price per share on 31 January 20X3                                                             CU104

Fixed exercise price to be paid on 31 January 20X3                                                CU102

Number of shares under option contract                                                                   1,000

Fair value of option on 1 February 20X2                                                                CU5,000

Fair value of option on 31 December 20X2                                                           CU3,000

Fair value of option on 31 January 20X3                                                                CU2,000

(a) Cash for cash (‘net cash settlement’)

IE13 On 1 February 20X2, Entity A enters into a contract with Entity B that gives Entity B the obligation to deliver, and Entity A the right to receive the fair value of 1,000 of Entity A’s own ordinary shares as of 31 January 20X3 in exchange for CU102,000 in cash (ie CU102 per share) on 31 January 20X3, if Entity A exercises that right. The contract will be settled net in cash. If Entity A does not exercise its right, no payment will be made. Entity A records the following journal entries.

1 February 20X2

The price per share when the contract is agreed on 1 February 20X2 is CU100. The initial fair value of the option contract on 1 February 20X2 is CU5,000, which Entity A pays to Entity B in cash on that date. On that date, the option has no intrinsic value, only time value, because the exercise price of CU102 exceeds the market price per share of CU100 and it would therefore not be economic for Entity A to exercise the option. In other words, the call option is out of the money.

Dr Call option asset                                                        CU5,000

Cr Cash                                                                                                CU5,000

To recognise the purchased call option.

31 December 20X2

On 31 December 20X2, the market price per share has increased to CU104. The fair value of the call option has decreased to CU3,000, of which CU2,000 is intrinsic value ([CU104 – CU102] × 1,000), and CU1,000 is the remaining time value.

Dr Loss                                                                             CU2,000

Cr Call option asset                                                                           CU2,000

To record the decrease in the fair value of the call option.

31 January 20X3

On 31 January 20X3, the market price per share is still CU104. The fair value of the call option has decreased to CU2,000, which is all intrinsic value ([CU104 – CU102] × 1,000) because no time value remains.

Dr Loss                                                                             CU1,000

Cr Call option asset                                                                           CU1,000

To record the decrease in the fair value of the call option.

On the same day, Entity A exercises the call option and the contract is settled net in cash. Entity B has an obligation to deliver CU104,000 (CU104 × 1,000) to Entity A in exchange for CU102,000 (CU102 × 1,000) from Entity A, so Entity A receives a net amount of CU2,000.

Dr Cash                                                                             CU2,000

Cr Call option asset                                                                           CU2,000

To record the settlement of the option contract.

(b) Shares for shares (‘net share settlement’)

IE14 Assume the same facts as in (a) except that settlement will be made net in shares instead of net in cash. Entity A’s journal entries are the same as those shown in (a) except for recording the settlement of the option contract as follows:

31 January 20X3

Entity A exercises the call option and the contract is settled net in shares. Entity B has an obligation to deliver CU104,000 (CU104 × 1,000) worth of Entity A’s shares to Entity A in exchange for CU102,000 (CU102 × 1,000) worth of Entity A’s shares. Thus, Entity B delivers the net amount of CU2,000 worth of shares to Entity A, ie 19.2 shares (CU2,000/CU104).

Dr Equity                                                                           CU2,000

Cr Call option asset                                                                           CU2,000

To record the settlement of the option contract. The settlement is accounted for as a treasury share transaction (ie no gain or loss).

(c) Cash for shares (‘gross physical settlement’)

IE15 Assume the same facts as in (a) except that settlement will be made by receiving a fixed number of shares and paying a fixed amount of cash, if Entity A exercises the option. Similarly to (a) and (b) above, the exercise price per share is fixed at CU102. Accordingly, Entity A has a right to receive 1,000 of Entity A’s own outstanding shares in exchange for CU102,000 (CU102 × 1,000) in cash, if Entity A exercises its option. Entity A records the following journal entries.

1 February 20X2

Dr Equity                                                                           CU5,000

Cr Cash                                                                                                CU5,000

To record the cash paid in exchange for the right to receive Entity A’s own shares in one year for a fixed price. The premium paid is recognised in equity.

31 December 20X2

No entry is made on 31 December because no cash is paid or received and a contract that gives a right to receive a fixed number of Entity A’s own shares in exchange for a fixed amount of cash meets the definition of an equity instrument of the entity.

31 January 20X3

Entity A exercises the call option and the contract is settled gross. Entity B has an obligation to deliver 1,000 of Entity A’s shares in exchange for CU102,000 in cash.

Dr Equity                                                                           CU102,000

Cr Cash                                                                                                CU102,000

To record the settlement of the option contract.

(d) Settlement options

IE16 The existence of settlement options (such as net in cash, net in shares or by an exchange of cash and shares) has the result that the call option is a financial asset. It does not meet the definition of an equity instrument because it can be settled otherwise than by Entity A repurchasing a fixed number of its own shares in exchange for paying a fixed amount of cash or another financial asset. Entity A recognises a derivative asset, as illustrated in (a) and (b) above. The accounting entry to be made on settlement depends on how the contract is actually settled.

Source EU rules on financial information disclosed by companies

 

Last Updated on 12/02/2020 by 75385885

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