• The accounting treatment of call options prima facie will depend upon the intention with which the call options are purchased—hedging or speculation (nonhedging).
• If the position is taken as a hedge against some other position, then the relevant accounting standards for hedge accounting will be applicable and there are certain conditions that are to be fulfilled for the same.
• If the call is purchased purely as a speculative trade, then the premium paid towards purchase of the call option is taken to the expense and the premium received on sale of the options is treated as revenue.
• However, the value of the option is written back on the valuation date and shown as an asset in the case of purchase of call options. In effect, the net result of this method of accounting and the one shown for hedging activity would be the same.

Journal Questions

Mr. Berkowitz buys 1,000 equity call options of Normal Electricals for $4 per share for a strike price of $25 on June 12, expiry date being July 16. Brokerage is 0.25 percent and is settled on T + 2 basis. Pass necessary journal entries for the following events:

1. Purchase of the options.

2. Brokerage paid for purchase.

3. At the end of the reporting period, June 30, the shares are quoted at $28 per share and the options were worth $2 per share. Ascertain the fair value at that time and pass entries.

4. Assume the options are exercised on the expiry date and for the price of $27. Pass relevant journal entries on July 16, the expiry date.

Long Call, Nonhedging—Functional Currency US$

Prepare journal entries, general ledgers, trial balance, income statement, and balance sheet for the following scenario.
Freedom Fund had the following trades in GE in the options market through ADC brokers, and on January 1 introduced $100,000 as capital.
Date            Product     StrikePrice    Expiry            Quantity     Rate        B/S     Brokerage
25-Jan-X1    Call           $50              16-Mar-X1    10,000      $5.00        B         $540
22-Feb-X1   Call           $50              16-Mar-X1    16,000      $4.00        B         $620
11-Mar-X1   Call           $50              16-Mar-X1    16,000      $3.00        S         $320

Liquidation Method
  FIFO

Market Rate of Underlying Stock, GE
  January 31: 40.00
  February 28: 55.00
  March 16: $55

Market Rate of GE Call Option with Strike Price $50, Expiry March 16
  January 31: 2
  February 28: 6.00

Functional Currency
  US$

Long Call, Nonhedging—Trade Currency AUD

Prepare journal entries, general ledgers, trial balance, income statement, and balance sheet for the following scenario.
AA Fund had the following trades in Metadata in the options market through DDT Man brokers. The stock exchange requires that the writer of the options maintain 10 percent of the value of the contract as margin money throughout the life of the contract. On January 1, AA Fund introduced $100,000 as capital and converted US$50,000 into AUD at the rate of 1.25.
Date            Product       StrikePrice         Expiry        Quantity      Rate (AUD)    B/S    Brokerage (AUD)
21-Jan-X1      Call          AUD 40        15-Mar-X1      12,000         4.00              B            $500
20-Feb-X1     Call          AUD 40        15-Mar-X1      13,000         5.00              B            $600
12-Mar-X1     Call         AUD 40         15-Mar-X1      15,000         4.00              S            $300

Liquidation Method
  FIFO

Market Rate of Underlying Stock, Metadata (AUD)
  January 31: 35.00
  February 28: 40.00
  March 16:45

Market Rate of Metadata Call Option with Strike Price $40, Expiry March 15
  January 31: 3
  February 28: 5.00

FX Rate AUD/US$
  January 21: 1.2178
  January 31: 1.28964
  February 20: 1.26345
  February 28: 1.24789
  March 12: 1.23645
  March 15: 1.27893

Functional Currency
  US$

Short Call, Nonhedging—Trade Currency JPY

Prepare journal entries, general ledgers, trial balance, income statement, and balance sheet for the following scenario.
Stone Fund had the following trades in Gamut in the options market through MML brokers. The stock exchange requires that the writer of the options maintain 15 percent of the value of the contract as margin money throughout the life of the contract. On February 1, Stone Fund introduced $150,000 as capital and converted half of it into JPY at 122.50.
Date              Product       StrikePrice      Expiry       Quantity      Rate (JPY)     B/S    Brokerage (JPY)
23-Feb-X1     Call              JPY 55        16-Apr-X1   10,000         6.00             S           520
22-Mar-X1     Call              JPY 55        16-Apr-X1   16,000         5.00             S           600
10-Apr-X1     Call              JPY 55        16-Apr-X1   16,000         4.00             B           300

Liquidation Method
  FIFO

Market Rate of Underlying Stock, Gamut
  February 28: 59.00
  March 31: 58
  April 16: 61

Market Rate of Gamut Call Option with Strike Price $55, Expiry April 16
  February 28: 5
  March 31: 4

FX Rate JPY/US$
  February 23: 123.589
  February 28:122.569
  March 22: 124.587
  March 31: 124.7891
  April 10: 123.1562
  April 16: 123.4569

Functional Currency
  US$

Objective Questions

1. Accounting standard FAS 133 applies to
a. Accounting for certain investments in debt and securities.
b. Accounting for derivative instruments and hedging activities.
c. Fair value measurements.
d. None of the above.

2. Premium paid towards purchase of call options purchased for speculative trade should be treated as
a. Expense.
b. Revenue.
c. Loss.
d. Gain.

3. For an options contract, the commission/brokerage paid is treated as follows:
a. Part of the cost of options contract.
b. Debited to commission/brokerage account.
c. Adjusted later in the broker account at the time of sale.
d. None of the above.

4. For ascertaining fair value at the end of the reporting period, the value of the entire position will be written back to the
a. Profit and loss account.
b. Expense account.
c. Income account.
d. None of the above.

5. Reversal of marked-to-market entry will happen on
a. Next business day.
b. Next valuation day.
c. Same day itself.
d. None of the above.

6. For call options (bought), if the market value of the underlying asset is over the strike price of the contact, then the excess amount denotes
a. Profit.
b. Loss.
c. Breakeven.
d. None of the above.

7. When the options contract is expired, then the option premium paid denotes
a. Expense.
b. Income.
c. Gain.
d. None of the above.

8. Exercising of an options contract means
a. Creation of underlying asset.
b. Breaking the options contract.
c. Paying the margin amount.
d. None of the above.

9. Buyback of the call options results in
a. Creating a fresh contract.
b. Squaring up of the existing short position.
c. Creating a long position.
d. None of the above.

10. Account treatment for a call options contract is decided based on
a. Position of the contract.
b. Intention of the purchase.
c. Size of the contract.
d. None of the above.

11. Assume that a call option with a quantity of 10,000 shares and a premium of $6,000 has a value of $9 at the end of the reporting period. Which of the following amounts is recognized as income which reflects as an asset on the balance sheet?
a. $9,000
b. $96,000
c. $84,000
d. $90,000
e. $9,600

12. The accounting entry for mark-to-market reversal of a call option is not required if the valuation is done using the
a. Reversal method at the end of reporting period.
b. Black-Scholes model.
c. Incremental value method.
d. End of period market price.
e. Beginning of period market price.

13. When the call options are exercised, the investor has to pay for the underlying at
a. The current market price of the stock.
b. The rate at which the exchange decides.
c. The contracted strike price.
d. The previous day’s closing price.
e. None of the above.

14. If an investor writes a call option, then the investor ______________on such writing of the call option.
a. Would pay the premium on the exercise date.
b. Would collect the premium on the exercise date.
c. Would pay the premium on the settlement date.
d. Would collect the premium on the settlement date.
e. Would neither collect nor pay any premium.

15. When a call margin is initiated the investor would be required to pay an amount equal to ______ of the value of the position in addition to the potential loss as of that date.
a. 8 percent.
b. 15 percent.
c. 25 percent.
d. 12 percent.
e. 10 percent.

Theory Questions

1. Explain the trade life cycle for call options.

2. Is accounting for call options any different if the options were to be held as hedge and not as investment?