Derivatives Implementation Group

Statement 133 Implementation Issue No. A19

QUESTIONS

1. 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?

    

2. 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:

1. Neither party is required to deliver an asset that is associated with the underlying....
   
2. 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.
   
3. 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.