[Kairos]

The answer is c)

but i’m not quite understanding the answer explanation. could someone walk me through it in layman’s terms? Thanks!

On December 1 of the current year, Bann Co. entered into an option contract to purchase 2,000 shares of Norta Co. stock for $40 per share (the same as the current market price) by the end of the next two months. The time value of the option contract is $600. At the end of December, Norta’s stock was selling for $43, and the time value of the option is now $400. If Bann does not exercise its option until January of the subsequent year, which of the following changes would reflect the proper accounting treatment for this transaction on Bann’s December 31, year-end financial statements?

a

The option value will be disclosed in the footnotes only.

b

Other comprehensive income will increase by $6,000.

c

Net income will increase by $5,800.

d

Current assets will decrease by $200.

[greg2015]

It is an option, which is a derivative, which is required to be reported in the financial statements at fair value. Fair value of an option is made up of two components: 1) intrinsic value and 2) time value. Intrinsic value is a simple calculation that compares the current market price to the exercise price to determine the value. The time value is more complicated to calculate (which is why it is just given in the question) and relates to the potential additional value the option could have as a function of the remaining time left until it expires.

C is the correct response because the option is recorded at fair value. The change in fair value will be recorded in the income statement by default, since there was no mention of hedge accounting treatment elected. The change in fair value is the change in the two components: intrinsic value and time value. Intrinsic value increased from 0 (($40 – $40)X 2,000 shares) to $6,000 (($43 – $40)X2,000). Time value decreased by $200 ($600 – $400). Therefore, the change in fair value is $6,000 – 200 = $5,800, which will be recorded in the income statement.

FYI – Here are the journal entries:

December 1 – Debit Derivative (current asset) $600, Credit Cash $600 (this is implied)

December 31 Debit Derivative (current asset) $5,800, Credit Gain of $5,800

A is incorrect because all derivatives are recorded in the financial statements at fair value. Footnote-only disclosure is not acceptable under GAAP.

B is incorrect because there was no mention of application of cash flow hedge accounting, so recording fair value changes through other comprehensive income would not be acceptable. Additionally, even if cash flow hedge accounting were elected, the question does not address how the entity will assess effectiveness and treat the time value component.

D is incorrect because current assets will increase $5,800 at December 31 due to recording the gain, not $200.

AUD: 99
FAR: 95
BEC: 89
REG: 87

AICPA Ethics: 91

Licensed Illinois CPA

[Kairos]

This is a really good explanation. Thanks!

[Author]

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