Derivatives Implementation Group

Statement 133 Implementation Issue No. G14

QUESTION

An entity holds a purchased option or warrant and seeks to designate it as a cash flow hedge of the forecasted acquisition of the marketable security to which the option or warrant relates. If the entity has elected to assess the effectiveness of the hedge based solely on changes in the option's (or warrant's) intrinsic value and thus that assessment is relevant only for those periods in which the option or warrant has an intrinsic value other than zero, may the probability of the forecasted transaction likewise be evaluated only during those periods in which the option or warrant has an intrinsic value other than zero? (Assume that all changes in time value will be recorded directly in earnings.)

BACKGROUND

An entity seeking to reduce the variability of the price at which it will acquire a marketable security in the future might use a forward contract to fix the price today, or a warrant or purchased option to lock in a ceiling on the price it will eventually pay. With a forward, the typical settlement is the delivery of the marketable security at a later date at the pre-fixed price. With a warrant or purchased option, the typical settlement might be the delivery of the marketable security at the ceiling price, or the holder may allow the warrant or purchased option to expire unexercised.

Paragraph 28(b) of Statement 133 requires that if a hedging instrument, such as an at-the-money option contract provides only one-sided offset against the hedged risk, the cash inflows (outflows) from the hedging instrument must be expected to be highly effective in offsetting the corresponding change in the cash outflows or inflows of the hedged transaction. Paragraph 29(b) states that the occurrence of the hedged forecasted transaction must be "probable." Paragraph 464 states that "probable" means that the future event or events are likely to occur. Paragraph 463 also states that the transaction's probability should be supported by observable facts and the attendant circumstances and that consideration should be given to the following circumstances in assessing the likelihood that a transaction will occur:

1. The frequency of similar past transactions
2. The financial and operational ability of the entity to carry out the transaction
3. Substantial commitments of resources to a particular activity
4. The extent of loss or disruption of operations that could result if the transaction does not occur
5. The likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (for example, an entity that intends to raise cash may have several ways of doing so, ranging from a short-term bank loan to a common stock offering).

RESPONSE

No. In determining whether an option or warrant designated as a hedge of the forecasted acquisition of a marketable security may qualify for cash flow hedge accounting, the probability of the forecasted transaction being consummated must be evaluated without consideration of whether the option or warrant designated as the hedging instrument has an intrinsic value other than zero. The evaluation of whether the forecasted acquisition of the marketable security is probable of occurring must be independent of the terms and nature of the derivative designated as the hedging instrument.

In order to qualify for cash flow hedge accounting for an option or warrant designated as a hedge of the forecasted acquisition of a marketable security, an entity must be able to establish at the inception of the hedging relationship that the acquisition of the marketable security is probable, without regard to the means of acquiring it. In documenting the hedging relationship, the entity must specify the date on or period within which the forecasted acquisition of the security will occur. Therefore, to qualify for cash flow hedge accounting in this case, the entity must be able to establish that it is probable that it will acquire the security by (a) exercising the option or warrant designated as the hedging instrument if it is in-the-money or (b) purchasing the security in the marketplace at its prevailing market price if the option or warrant is out-of-the-money. If the entity expects to acquire the marketable security only by exercising the option or warrant and only if the option or warrant were in-the-money, a cash flow hedging relationship typically would not be designated because acquisition of the security is contingent and thus would not be considered probable.

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.