An equity put gives the owner the right to sell 100 shares of an underlying stock for a set amount –the strike price — on or before an expiration date. The purchase price of the put is its premium and is composed of its intrinsic value and time value. Together, they establish the put’s fair value. Puts gain value when the underlying stock’s price drops.
The intrinsic component of a put’s fair value is the difference between the strike price and the current price of the underlying stock. The minimum intrinsic value is zero, which is the case when the strike is below the stock price. The time component is an estimate of the volatility of the intrinsic value over time, which decays as the expiration date approaches. When a company purchases a put, it debits an asset account for equity options for the premium amount, which is the fair value at the time of purchase. It credits cash for the same amount.
Unrealized Gain and Loss
At the end of a reporting period, a company recognizes any unrealized holding gain or loss on a put option. It makes separate entries for changes in intrinsic and time value. In each entry, the offsetting debit or credit is the equity options asset account. For example, suppose a put gains $500 in intrinsic value and loses $100 in time value as of the last day of the period. Record $500 as a debit to equity options and a credit to income. Also record $100 as a debit to income and a credit to the asset. The net effect is to recognize $400 in income and to increase the fair value of the put by the same amount.
If the put expires without value, the loss decreases the value of the put to zero. You recognize the loss by a debit to income and a credit to equity options for an amount equal to the previously reported fair value of the put. If you settle the put for a gain, record a debit to cash for the settlement amount. Also record the gains and losses to income based on changes to the intrinsic value and time value of the put at settlement. Credit the put option by its previous fair value to zero out the asset.
Fair Value Hedge
A company might purchase a put option to hedge a position in the underlying stock. Financial Accounting Standards Board Statement 133 requires that the company record the two positions together as a fair value hedge. The net effect is to book to the income account the gain or loss due to the ineffective portion of the hedge — if the hedge was fully effective, the two positions would exactly offset and the gain would be zero.
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Copyright 2017 Eric Bank, Freelance Writer