Hi All,
In operations involving structured derivatives and OTC options, we'd appreciate your guidance on the appropriate accounting treatment for the premium paid.
Should this amount be recognized as an asset under a 'Premium Paid' account or should it be incorporated directly into the MTM (mark-to-market) calculation from inception?
Thank You & Best Regards.
Hello,
Depends on what the derivative is used for. If used for speculation, the premium is recognized at cost and subsequently adjusted to fair value (market price) with changes recorded in profit or loss (more or less what you said). If used to hedge fair value, the accounting is similar except changes in fair value are offset with the changes in the hedged item. If used to hedge cash flow, it is bifurcated, with intrinsic value changes recognized in OCI and the time value amortized (expensed) over the hedge term. This page (/financial-assets) has a discussion including examples.
EXAMPLE:
□ Bank ABC charges a premium payment of $10,000 to DH Corp to provide the interest rate cap. The $10,000 premium is assumed to be equal to the fair value of the interest rate cap on the date the contract was executed.
□ The interest rate cap is not designated in a hedging relationship.
How should DH Corp initially record the interest rate cap on January 1, 20X1?
Analysis
On January 1, 20X1, DH Corp should initially record the interest rate cap on its balance sheet at fair value, which is equal to the premium amount paid.
Dr. Derivative asset - $10,000
Cr. Cash - 10,000
Subsequently, the interest rate cap should be marked to fair value each reporting period with any change in fair value being recorded through earnings.
Is this example applicable to Options Trading Premium Paid?
Yes Dr. Derivative asset - $10,000
Cr. Cash - 10,000
Both interest rate caps and options are marked to fair value at each reporting date. Changes in fair value are recognized directly in earnings if not designated as hedges.
It's clear. Thank you! It helps a lot.
One more question: is it also applicable to IFRS and USGaap?
US GAAP and IFRS are comparable except if an option is used as a cash flow hedge. In US GAAP, the time value is expensed while in IFRS it is capitalized.
Super! Thank you very much, Mladek.