Contingent liability on written options

Buying an option gives you a right — you can walk away with no further obligation if it does not suit you. Selling (writing) an option gives someone else that right, and leaves you on the hook if they choose to exercise it.

Because that obligation might or might not actually materialise, depending entirely on what the buyer decides, accounting treats it as a contingent liability — a probable, but not certain, future commitment.

The workbook draws a clear line between buying and selling options for accounting purposes. When selling calls and puts, the premium income is received with certainty and is recognised immediately in the profit and loss account. But alongside that immediate premium income, a contingent liability is shown for the probable liability or commitment — to pay for purchasing goods, in the case of a written put, or to deliver goods, in the case of a written call.

A written option's mark-to-market gains or losses cannot be matched against any underlying asset — they must be treated separately. On exercise of a written call, the seller raises a normal sale bill on the buyer; on exercise of a written put, the seller makes a normal purchase entry for the goods received. If the option lapses unexercised, or devolves into a futures position, no further accounting treatment is required for the option itself — though devolvement into futures does require its own separate accounting entries.

A trader writes (sells) one lot of a put option on castor seed futures, receiving a premium of Rs 40,000, which she recognises immediately in her profit and loss account. Because she has sold the put, she now carries an open-ended obligation: if the buyer exercises, she must buy the underlying castor seed futures position at the strike price, regardless of where the market has moved.

Her books show the Rs 40,000 premium as income now, and separately record a contingent liability representing her probable future commitment to purchase the goods if exercised. If the option lapses worthless because castor seed prices never fall to the strike, the contingent liability simply disappears with no further entry needed. If it is exercised instead, she records a normal purchase transaction at the strike price, and the contingent liability is discharged by that actual purchase.

Chapter 9, section 9.3 (Accounting of Options Contracts), sets out buying and selling treatment as a contrasting pair — purchased options as financial assets, written options carrying a contingent liability alongside immediate premium recognition. Expect a question asking what an option seller, as opposed to an option buyer, must record on the balance sheet.

• Only the option seller (writer) carries a contingent liability — the buyer does not. A purchased option is recognised as a financial asset, with no contingent liability involved.
• Premium income is recognised immediately on selling an option, not deferred until exercise or expiry — this is true regardless of whether the option is ultimately exercised.
• Written option MTM gains and losses are not matched against any underlying asset — they are treated as a separate exposure, unlike, for instance, a fair value hedge of inventory.