Accounting for a call option relating to purchase of property

All topics related to IFRS Standards.
Post Reply
Porus
Posts: 59
Joined: 13 Aug 2020, 20:13

Accounting for a call option relating to purchase of property

Post by Porus »

Hi there,

A company pays a "deposit" of $200,000 to a seller on Dec 1 2019 to book an apartment for staff accommodation. The terms of the contract are that if the buyer pays an additional $320,000 on or before Dec 31 2020, then he gets ownership of the apartment. If he does not pay that amount by that date, then he will forfeit the "deposit". However, if the buyer formally notifies the seller, before Dec 31 2020, that he does not want to proceed with the transaction, then the seller will repay the $200,000 "deposit" to the buyer.

Questions:
1) By paying $200,000, has the buyer purchased a call option on the underlying property ?

2) If yes, how would the buyer value the components of the call option - time value and intrinsic value - on the reporting date Dec 31 2019 ? Would it be Intrinsic value = market price of the apartment on that date minus exercise price of $320,000 ? And would time value of the call option be the difference between the "deposit" of 200,000 and the intrinsic value ?

3) How would the buyer account for the respective components - time value and intrinsic value - in his books on the report date Dec 31 2019 ?

3) If there is no call option involved, presumably the $200,000 is simply accounted as an advance paid for the purchase of the property, and then depending upon what happens on or before Dec 31 2020, the buyer will either forfeit his "deposit", or will create a fixed asset for a total of $520,0000, or will be repaid the deposit ?
JRSB
Trusted Expert
Posts: 1309
Joined: 01 Mar 2020, 01:10
Location: UK

Re: Accounting for a call option relating to purchase of property

Post by JRSB »

Is $520,000 the market value of the apartment, throughout?
pub_acco
Trusted Expert
Posts: 328
Joined: 19 Mar 2020, 16:40

Re: Accounting for a call option relating to purchase of property

Post by pub_acco »

Does the buyer forfeit the deposit in any chance? Why does it not just notify the seller on Dec 30, 2020?
User avatar
exIFRS
Trusted Expert
Posts: 234
Joined: 01 Mar 2020, 08:44
Location: London

Re: Accounting for a call option relating to purchase of property

Post by exIFRS »

One of the things I always used to tell young auditors was when you have a transaction that seems difficult to account for you have to first tease out the economics. Why is this being done. When you had a transaction that the more you looked at it the less sense it made, almost invariably it was some related party transaction that was designed to achieve some other outcome. The more I look at this transaction the less sense it makes.

1) The forfeit clause, surely it would be criminally negligent to "forget" to notify, so why even mention or include it. Immediately provide a letter that formally notifies the seller that failure to pay the $320,000 on or before the 31/12/20 constitutes notice that the company does not wish to proceed with the transaction. Or is this designed to transfer funds to a related party?

Setting this aside, I did wonder if this was just some kind of secured loan?

2) A call is forfeited when not executed not returned.

2) So what's in it for the seller? They are giving up the right to sell their apartment to someone else for a period of 13 months, but receiving no fee (other than use of the $200,000 maybe).

4) If the potential sale actually has substance, is the cost of the call actually the lost interest on the $200,000?

5) So maybe it is a loan of $200,000 and the interest component of which constitutes the cost of the call.

6) By chance is the £200,000 secured by the property, ie. what are the consequences of failure to pay the money back if requested.

Other questions:

7) Is the "deposit" repaid immediately on notification or only on 31/12/20?

8) In the intervening period is the apartment being used for company accommodation, are commercial rates being paid etc?

It really feels like there is a lot more to this transaction.
User avatar
Marek Muc
Site Admin
Posts: 3228
Joined: 15 Oct 2018, 17:21
Contact:

Re: Accounting for a call option relating to purchase of property

Post by Marek Muc »

I totally agree that understanding the underlying economics is most important here

It is not uncommon to pay an advance deposit to secure a real estate deal, but then it is uncommon that this deposit gets repaid in full if the buyer withdraws its offer.

as for the option questions: I wouldn't go this way, there is an 'own use exemption':
https://ifrscommunity.com/knowledge-bas ... -contracts
JRSB
Trusted Expert
Posts: 1309
Joined: 01 Mar 2020, 01:10
Location: UK

Re: Accounting for a call option relating to purchase of property

Post by JRSB »

Hi Porus - it's a interesting one - would be good to hear your thoughts in light of the above!
Porus
Posts: 59
Joined: 13 Aug 2020, 20:13

Re: Accounting for a call option relating to purchase of property

Post by Porus »

Hi All,

My clarifications as follows (your questions in quotes)

1. "Is $520,000 the market value of the apartment, throughout"

- I need to get the market value, but it is likely to be slightly higher than $520,000 throughout the period from date of "deposit" till date.

2. "Does the buyer forfeit the deposit in any chance? Why does it not just notify the seller on Dec 30, 2020?"
"The forfeit clause, surely it would be criminally negligent to "forget" to notify, so why even mention or include it. Immediately provide a letter that formally notifies the seller that failure to pay the $320,000 on or before the 31/12/20 constitutes notice that the company does not wish to proceed with the transaction."

- True, the buyer will not be so criminally negligent as to forget to notify the seller on or before 31/12/20, so the chances of him forfeiting the deposit are probably 0.0001%.

3. "Or is this designed to transfer funds to a related party?"

- The buyer and seller are not related parties based on our inquiries

4. "A call is forfeited when not executed not returned"

- Sorry, did not understand exactly what you meant by 'not executed not returned'

5. "By chance is the £200,000 secured by the property, ie. what are the consequences of failure to pay the money back if requested"
"Is the "deposit" repaid immediately on notification or only on 31/12/20?"

- Within 15 days of being notified by the buyer that he does not want to proceed with the transaction, the seller has agreed to pay the money back. Presumably, if seller does not do so within the agreed time period, the buyer can proceed to recover his money through legal channels.

6. "In the intervening period is the apartment being used for company accommodation, are commercial rates being paid etc?"

- No, the apartment has not been occupied yet.

7. "As for the option questions: I wouldn't go this way, there is an 'own use exemption'"

- Having read the extract relating to 'own-use' exemption, it appears to say that call options on physical assets are not accounted for as financial instruments ? Is that understanding correct ? In which case, one would not need to think about how to measure and account for the call option if there is one ?

Look forward to discussing this further and coming to a conclusion on this interesting issue.
pub_acco
Trusted Expert
Posts: 328
Joined: 19 Mar 2020, 16:40

Re: Accounting for a call option relating to purchase of property

Post by pub_acco »

I would go for the own use exemption, too. You don’t need to (though you may) account for call options on non-financial assets as if they were financial instruments if you hold the options for your own use of the non-financial assets (see Marek’s knowledge base for details). Otherwise, you have to account for the options as if they were financial instruments.

IMO though the $200,000 still meet the criteria of a financial asset (ie deposit) rather than a prepayment and need to be measured at amortized cost because the buyer can reasonably expect the full repayment of the deposit.
User avatar
Marek Muc
Site Admin
Posts: 3228
Joined: 15 Oct 2018, 17:21
Contact:

Re: Accounting for a call option relating to purchase of property

Post by Marek Muc »

yes, own use exemption

as a side note: when looking at this arrangement as if it was a call option, the exercise price is $520k IMO. The $200k is not a premium paid, because premium is 'sunk cost' irrespective of whether you exercise an option or not, and in your case, $200k can be set off against the price or refunded if the option lapses
Porus
Posts: 59
Joined: 13 Aug 2020, 20:13

Re: Accounting for a call option relating to purchase of property

Post by Porus »

Many thanks guys!
Post Reply