Derivatives Implementation Group
Statement 133 Implementation Issue No. A19
| Title: |
Definition of a Derivative:
Impact of a Multiple Delivery Long-Term Supply Contract on
Assessment of Whether an Asset Is Readily Convertible to Cash |
| Paragraph
references: |
9(b), 9(c), Footnote 5
(to paragraph 9), 57(c) |
| Date cleared by
Board: |
September 19, 2001 |
| Date posted to
website: |
October 10, 2001 |
QUESTIONS
- Does a five-year commodity supply contract
meet the net settlement characteristic in paragraph 9(b) and
related paragraph 57(c)(2) of Statement 133 if a forward market for
the commodity contract does not exist beyond the next 12 months
even though a spot market exists?
- Does a five-year commodity supply contract meet the net
settlement characteristic in paragraph 9(c) and related paragraph
57(c)(3) of Statement 133 if a forward market for the commodity
does not exist beyond the next 12 months even though a spot market
exists?
This issue does not address whether or not the
contract would qualify for the "normal purchases and normal sales"
scope exception in paragraph 10(b) of Statement 133.
BACKGROUND
An entity has a five-year supply contract that
obligates it to deliver at a specified price each month a specified
quantity of a commodity that has interchangeable (fungible) units
and for which quoted prices are available in an active market.
However, the quoted prices that are available are for either a spot
sale or a forward sale of the commodity with a maturity of 12
months or less. In other words, the forward market for the
commodity beyond the next 12 months does not currently exist and is
not expected to develop. There are brokers who are willing to take
over the rights and obligations relating to the next 12 months of
the supply contract, but not for periods beyond the next 12 months.
With respect to the active spot market for the commodity, it can
rapidly absorb the quantity specified in the supply contract for
each individual month but not the total quantity for the entire
five-year period in a single transaction (or in multiple
transactions over the course of a day or so).
Paragraph 9 of Statement 133 states, in part,:
Net
settlement. A contract fits the description in paragraph 6(c)
if its settlement provisions meet one of the following
criteria:
- Neither party is required to deliver an asset that is
associated with the underlying....
- One of the parties is required to deliver an asset of the type
described in paragraph 9(a), but there is a market mechanism that
facilitates net settlement, for example, an exchange that offers a
ready opportunity to sell the contract or to enter into an
offsetting contract.
- One of the parties is required to deliver an asset of the type
described in paragraph 9(a), but that asset is readily convertible
to cash [refer to footnote 5 below]....
Footnote 5 (to paragraph 9) states:
FASB Concepts Statement
No. 5, Recognition and Measurement in Financial Statements of
Business Enterprises, states that assets that are readily
convertible to cash "have (i) interchangeable (fungible) units and
(ii) quoted prices available in an active market that can rapidly
absorb the quantity held by the entity without significantly
affecting the price" (paragraph 83(a)). For contracts that involve
multiple deliveries of the asset, the phrase in an active market
that can rapidly absorb the quantity held by the entity should
be applied separately to the expected quantity in each
delivery.
Paragraph 57(c)(2) states, in part, that "Any
institutional arrangement or other agreement that enables either
party to be relieved of all rights and obligations under the
contract and to liquidate its net position without incurring a
significant transaction cost is considered net settlement."
The supply contract does not contain a net settlement
provision as described in paragraph 9(a) and related paragraph
57(c)(1) of Statement 133.
RESPONSE
Question 1
No. The 5-year commodity supply contract does not meet the net
settlement characteristic in paragraph 9(b) at its inception
because there is no market mechanism to net settle the entire
5-year contract—the forward market exists only for the next 12
months while the contract period is for the next 5 years.
Accordingly, there is no market mechanism for the company to settle
the entire contract on a net basis. However, if the contract
contained contractually separable increments that individually met
the net settlement criteria, those contractually separable
increments may be embedded derivatives.
In the example, the brokers in the market will not
assume the rights and obligations of the entire contract. Note that
the market mechanism in the net settlement characteristic in
paragraph 9(b) relates to whether a party to the contract can be
relieved of its rights and obligations under the entire contract,
not merely whether an independent broker in the market stands ready
to assume the selected rights and obligations.
The definition of a derivative in Statement 133 must
be applied based on the actual terms of the contract, including its
maturity date and the total quantity of the underlying. The
Statement does not permit bifurcation of a 5-year contract into 5
annual contracts, 60 monthly contracts, or 1826 daily contracts in
an attempt to assert that only a portion of the contract meets the
definition of a derivative. To do so would be to disregard one of
the critical terms of the contract, that is, the term to the
maturity date of the contract. The guidance to Question 2 in
Statement 133 Implementation Issue No. A12, "Impact of Daily
Transaction Volume on Assessment of Whether an Asset Is Readily
Convertible to Cash," also emphasizes the importance of the terms
of the individual contract.
Based on the guidance in Implementation Issue A18,
"Application of Market Mechanism and Readily Convertible to Cash
Subsequent to the Inception or Acquisition of a Contract," the
five-year commodity supply contract in the example, would, at the
beginning of the fifth year, be re-evaluated to determine whether
the contract meets the net settlement characteristic in paragraph
9(b) and would likely meet the characteristic because a forward
market for the contract would then exist for the remaining term of
the contract.
Question 2
Yes. The five-year commodity supply contract meets the net
settlement characteristic in paragraph 9(c) of Statement 133. The
criterion in paragraph 9(c) is met because an active spot market
for the commodity exists today and is expected to be in existence
in the future for each delivery date (for example, for quantities
to be delivered each day or each month for the next five years)
under the multiple delivery supply contract. The spot market can
rapidly absorb the quantities specified for each monthly delivery
without significantly affecting the price.
The fact that the spot market may not be able to
absorb within a few days the quantity specified in the entire
five-year contract is irrelevant because the performance of the
contract is spread out over a five-year period and, therefore, is
not expected to occur within a few days. Footnote 5 indicates that,
"for contracts that involve multiple deliveries of the asset, the
phrase in an active market that can rapidly absorb the quantity
held by the entity should be applied separately to the expected
quantity in each delivery."
EFFECTIVE DATE
The effective date of the implementation guidance in
this Issue for each reporting entity is the first day of its first
fiscal quarter beginning after October 10, 2001, the date that the
Board-cleared guidance was posted on the FASB website.
The above response has been authored by the FASB
staff and represents the staff's views, although the Board has
discussed the above response at a public meeting and chosen not to
object to dissemination of that response. Official positions of the
FASB are determined only after extensive due process and
deliberation.
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