Old rules: derivative contracts: basic rules pre FA 2004: mark to market examples
Examples of marking to market
This guidance applies to periods of account beginning before 1 January 2005
Barntub plc is a financial trader using mark to market accounting. Anticipating upward movements in cocoa prices, it enters into a forward contract on 1 July 2004 to purchase 10,000 tonnes of cocoa on 1 July 2005 at £1,000 per tonne. At 31 December 2004 the July 2005 forward price for cocoa is £1,100 per tonne. Taking interest rates and other factors into account an independent person would pay Barntub £95 per tonne for the contract. Barntub Ltd’s balance sheet at 31 December would therefore record the fair value of the investment as £950,000 and the same amount would be credited to profit and loss. If the future were trading at a discount to the contract rate, so that it had a negative value, this would give rise to a loss.
As an alternative to entering into the futures contract Barntub could have purchased a call option, the advantage being that the company would not then be exposed to downward movements in cocoa prices. If so, the premium would be charged to profit and loss account in the period in which it was incurred (FA02/SCH26/PARA17(4)).
If at the balance sheet date the option was in the money the fair value would be recorded in the balance sheet and credited to profit and loss. (Alternatively the cost of the option might be netted off against fair value and the excess taken to profit and loss). If, for instance, a premium equivalent to £10 per tonne had been paid this would be debited to profit and loss, while the amount which an independent person would pay Barntub for its rights under the option would be recorded in the balance sheet at fair value. Apart from the premium paid no loss could arise on the option.