A Framework member posted a question to me on the popular bulletin board site Quora over the weekend. His question was “How do you properly account for a sold put option on financial statements?”
This is a bit of a specialized question, but feel free to read my answer here or on Quora.
Hi Tyler,
Thanks for the question.
Options are treated as assets or as liabilities. Options that are purchased are treated as assets; options that are sold are treated as liabilities because the option seller must fulfill a contractual obligation if requested by an option buyer.
So, in terms of sold put options on a financial statement, the first part of the transaction would be to debit restricted cash and credit the put option-related liability account. Debiting cash means one is increasing the account to an accountant, even though it’s just the opposite in common parlance. The cash is “restricted” because that cash cannot be freely spent. It is kept in the special escrow account known as margin. The liability account will probably be in the current accounts section (assuming that the put you’re writing expires within a year).
Each day, the value of the put option will change. Usually, the time decay of the option will make the option less valuable as time passes, all else held constant. Of course the value of options depends on price of the underlying and market expectations for the volatility of the asset over the life of the option, but let’s assume the simple case, where the underlying asset stays at about the same price and volatility, so that the put option becomes worth less.
As this happens, the value of the option — which can be priced each day using the exchange’s settlement quote whether the option has traded or not — will decrease. It’s been a long time since I’ve had to look at T-accounts or journal entries, so I can’t walk you through that exactly (perhaps a trained accountant will jump in?) but, essentially, the difference in value would show as a credit to reserve cash and a debit to the option liability. The debit to the liability account would create a credit to the unrealized profit account, which would be balanced by a debit to cash. (Some of these details may be a little off, but basically that’s what’s going on).
Let’s assume that the put option expires OTM. At this time, the remaining amount in the restricted cash account is debited and the remaining value of the liability is credited. The unrealized profit account is debited and the trading profit account is credited.
As I say, I’m a little shaky on the actual journal entries, but essentially, you are accounting for a wasting liability. Each time the liability wastes a little more, the liability is worth less, so you are further ahead. The option has value for its entire economic life, so you can’t count the “further ahead” bit as realized until the put has expired worthless.
Hope this helps. Please drop me a line if not!
All the best,
Erik