Solution

In the above case – B Limited has written an option, which if exercised by C Limited will result in B Limited selling equity shares of Target Limited for fixed cash of $ 100 per share. Such option will be exercised by C Limited only if the market price of shares of Target Limited increases beyond $ 100, thereby resulting in contractual obligation over B Limited to settle the contract under potential unfavorable terms.

In the above case, if the market price is already $ 120 which means that if option is exercised by C Limited, then B Limited shall buy shares from the market at $ 120 per share and sell at $ 100, thereby resulting in a loss or exchange at unfavorable terms to B Limited. Hence, it meets the definition of financial liability in books of B Limited.

The additional question that arises here is the nature of this financial liability and if it meets the definition of derivative. A derivative is a financial instrument that meets following conditions

a)    Its value changes in response to change in specified variable like interest rate, equity index, commodity price, etc. If the variable is non-financial, it is not specific to party to the contract

b)    It requires no or little initial net investment

c)    It is settled at a future date.

Evaluating the above instrument, B Limited has written an option whose value changes based on change in market price of equity share, it requires no initial net investment and is settled at a future date (anytime in 90 days). Hence, it meets definition of derivative financial liability in books of B Limited. For detailed analysis on derivatives, refer Unit 5 : Derivatives and Embedded Derivatives.

Solution:

The option contract written by B Limited is a financial instrument as per the definition given in IAS 32. The option contract is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a fixed price, within a specified time period. In this case, the underlying asset is shares of Target Limited, and the fixed price is $100 per share.

The option contract is classified as a derivative as per IFRS 9, because its value is derived from the value of an underlying asset. B Limited is the writer or seller of the option contract, while C Limited is the holder or buyer of the option contract.

Under IFRS 9, the option contract would be initially recognized at fair value, which is the amount that B Limited would receive from C Limited in exchange for writing the option contract. The fair value of the option contract would be determined based on a range of factors, including the current price of the underlying asset, the exercise price of the option contract, the time remaining until expiration, and the volatility of the underlying asset.

The option contract would subsequently be measured at fair value on each reporting date, with changes in fair value recognized in profit or loss or other comprehensive income, depending on the nature of the instrument and the entity's accounting policy.

In summary, the option contract written by B Limited is a financial instrument and a derivative as per IAS 32 and IFRS 9, respectively. It would be initially recognized at fair value, with changes in fair value recognized in profit or loss or other comprehensive income on each reporting date.

The option contract written by B Limited meets the definition of financial liability as it creates a contractual obligation for B Limited to sell shares of Target Limited at a fixed price if the option is exercised by C Limited.

Furthermore, the option contract also meets the definition of a derivative as it meets the three criteria:

a) Its value changes in response to changes in the market price of equity shares of Target Limited, which is a specified variable.

b) It requires no or little initial net investment from B Limited.

c) It is settled at a future date (anytime within 90 days), which is the expiry date of the option contract.

Hence, the option contract written by B Limited is a derivative financial liability.