Derivatives Implementation Group

Statement 133 Implementation Issue No. G2

QUESTION

May a derivative instrument that is expected to be settled gross be designated as the hedging instrument in a cash flow hedge of the forecasted transaction that will be consummated upon gross settlement of the derivative contract itself? If a derivative instrument also satisfies the definition of a firm commitment, how does that affect the accounting for the instrument?

BACKGROUND

Settling a forward contract gross involves delivery of an asset in exchange for the payment of cash or other assets and is differentiated from settling net, which typically involves a payment for the change in a contract's value as the method of settling the contract.

The following are examples of transactions covered by this Issue:

Example 1
Company A plans to purchase a nonfinancial asset. To fix the price to be paid (that is, to hedge the price), Company A enters into a contract that meets Statement 133's definition of a firm commitment with an unrelated party to purchase the asset at a fixed price at a future date. Assume that the terms of the contract (such as net settlement under the default provisions) or the nature of the asset cause the contract to meet Statement 133's definition of a derivative instrument and the contract is not excluded by paragraph 10 from the scope of Statement 133. As such, Company A has entered into a derivative contract under which it is expected to take delivery of the asset. The issue is whether Company A may designate the fixed-price purchase contract (that is, the derivative instrument) as a cash flow hedge of the variability of the consideration to be paid for the purchase of the asset (that is, the forecasted transaction) given that the derivative instrument is the same contract under which the asset itself will be acquired.

Example 2
Company B plans to purchase U.S. government bonds and expects to classify those bonds in its available-for-sale portfolio. To fix the price to be paid (that is, to hedge the price), Company B enters into a contract that meets Statement 133's definition of a firm commitment with an unrelated party to purchase the bonds at a fixed price at a future date. Assume the contract meets Statement 133's definition of a derivative instrument and is not excluded by paragraph 10 from the scope of Statement 133. As such, Company B has entered into a derivative contract under which it is expected to take delivery of the asset. The issue is whether Company B may designate the fixed-price purchase contract (that is, the derivative instrument) as a cash flow hedge of the variability of the consideration to be paid for the purchase of the bonds (that is, the forecasted transaction) given that the derivative instrument is the same contract under which the asset itself will be acquired.

RESPONSE

Yes, assuming other cash flow hedge criteria are met, a derivative instrument that will involve gross settlement may be designated as the hedging instrument in a cash flow hedge of the variability of the consideration to be paid or received in the forecasted transaction that will occur upon gross settlement of the derivative contract itself.

If a contract meets the definition of both a derivative instrument and a firm commitment under Statement 133, then an entity must account for the contract as a derivative instrument unless one of the exceptions in Statement 133 applies. A forecasted purchase or sale meets the definition of forecasted transaction in paragraph 540 of Statement 133 and, if it is probable, meets the criteria of paragraph 29 of Statement 133 for designation as a hedged transaction. An entity concerned about variability in cash flows from its forecasted purchases or sales can economically fix the price of those purchases or sales by entering into a fixed-price contract. Since the fixed-price purchase or sale contract is a derivative instrument, it is eligible for use as a hedging instrument. (The forecasted purchase or sale at a fixed price is eligible for cash flow hedge accounting because the total consideration paid or received is variable. The total consideration paid or received for accounting purposes is the sum of the fixed amount of cash paid or received and the fair value of the fixed price purchase or sale contract, which is recognized as an asset or liability, and which can vary over time.)

As demonstrated in the examples in the background section, (1) the forecasted transaction and the derivative used to hedge it can, in certain circumstances, be with the same counterparty and (2) the derivative instrument can be the same contract under which the entity executes the forecasted transaction. The above guidance applies to fixed-price contracts to acquire or sell a nonfinancial or financial asset that are accounted for as derivative instruments under Statement 133 provided the criteria for a cash flow hedge are met.

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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