Derivatives Implementation Group
Statement 133 Implementation Issue No. A5
| Title: |
Definition of a Derivative:
Penalties for Nonperformance That Constitute Net Settlement |
| Paragraph
references: |
6(c), 9(a), 57(c)(1) |
| Date cleared by
Board: |
November 23, 1999 |
QUESTION
Does a contract contain a net settlement provision
under paragraphs 9(a) and 57(c)(1) if it contains both (a) a
variable penalty for nonperformance based on changes in the price
of the items that are the subject of the contract and (b) a fixed
incremental penalty for nonperformance that is sufficiently large
to make the possibility of net settlement remote?
BACKGROUND
Certain contracts may require payment of (a) a
variable penalty for nonperformance based on changes in the price
of the items that are the subject of the contract and (b) an
incremental penalty for nonperformance stated as a fixed amount or
fixed amount per unit. The contract may or may not characterize the
incremental payment upon nonperformance as a penalty.
Paragraph 57(c)(1) elaborates on the criterion in
paragraph 6(c) regarding whether the terms of a contract require or
permit net settlement which is discussed in paragraph 9(a).
Paragraph 57(c)(1) states:
Its terms implicitly or explicitly require
or permit net settlement. For example, a penalty for nonperformance
in a purchase order is a net settlement provision if the amount of
the penalty is based on changes in the price of the items that are
the subject of the contract. Net settlement may be made in cash or
by delivery of any other asset, whether or not it is readily
convertible to cash. A fixed penalty for nonperformance is not a
net settlement provision.
RESPONSE
No. A contract that contains a variable penalty for
nonperformance based on changes in the price of the items that are
the subject of the contract does not contain a net settlement
provision under paragraphs 9(a) and 57(c)(1) if it also contains an
incremental penalty of a fixed amount (or fixed amount per unit)
that would be expected to be significant enough at all dates during
the remaining term of the contract to make the possibility of
nonperformance remote. If a contract includes such a provision, it
effectively requires performance, that is, requires the party to
deliver an asset that is associated with the underlying. Thus, the
contract does not meet the criterion for net settlement under
paragraphs 9(a) and 57(c)(1) of Statement 133. The assessment of
the fixed incremental penalty in the manner described above should
be performed only at the contract's inception.
The magnitude of the fixed incremental penalty should
be assessed on a standalone basis as a disincentive for
nonperformance, not in relation to the overall penalty.
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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