Derivatives Implementation Group

Statement 133 Implementation Issue No. A6

QUESTION

How does the lack of specification of a fixed number of units of a commodity to be bought or sold affect whether a commodity contract has a notional amount? Specifically, do each of the illustrative contracts below have a notional amount as discussed in paragraph 6(a) to meet Statement 133's definition of derivative instrument?

BACKGROUND

Paragraph 540 of Statement 133 defines notional amount as:

   A number of currency units, shares, bushels, pounds, or other units specified in a derivative instrument.

Many commodity contracts specify a fixed number of units of a commodity to be bought or sold under the pricing terms of the contract (for example, a fixed price). However, some contracts do not specify a fixed number of units. For example, consider the following four contracts that require one party to buy the following indicated quantities:

This issue solely focuses on whether the contracts under consideration have a notional amount pursuant to the definition in Statement 133. These types of contracts may not satisfy certain of the other required criteria in Statement 133 in order for them to meet the definition of a derivative instrument.

RESPONSE

Generally, the anticipated number of units covered by a requirements contract is equal to the buyer's needs. When a requirements contract is negotiated between the seller and buyer, both parties typically have the same general understanding of the buyer's estimated needs. Given the buyer's often exclusive reliance on the seller to supply all its needs of the commodity, it is imperative from the buyer's perspective that the supplier be knowledgeable with respect to anticipated volumes. In fact, the pricing provisions within requirements contracts are directly influenced by the estimated volumes. The conclusion that a requirements contract has a notional amount as defined in Statement 133 can be reached only if a reliable means to determine such a quantity exists. Application of this guidance to specific contracts is provided below.

Contract 1-Requirements Contract

It depends. If the requirements contract contains explicit provisions that support the calculation of a determinable amount reflecting the buyer's needs, then that contract has a notional amount pursuant to the definition in Statement 133. One technique to quantify and validate the notional amount in a requirements contract is to base the estimated volumes on the contract's settlement and default provisions. Often the default provisions of requirements contracts will specifically refer to anticipated quantities to utilize in the calculation of penalty amounts in the event of nonperformance. Other default provisions stipulate penalty amounts in the event of nonperformance based on average historical usage quantities of the buyer. If those amounts are determinable, they should be considered the notional amount of the contract. The identification of a requirements contract's notional amount may require the consideration of volumes or formulas contained in attachments or appendices to the contract or other legally binding side agreements. The determination of a requirements contract's notional amount must be performed over the life of the contract and could result in the fluctuation of the notional amount if, for instance, the default provisions reference a rolling cumulative average of historical usage. In circumstances where the notional amount is not determinable, making the quantification of such an amount highly subjective and relatively unreliable (for example, if a contract does not contain settlement and default provisions that explicitly reference quantities or provide a formula based on historical usage), such contracts are considered not to contain a notional amount as that term is used in Statement 133.

Contract 2-Requirements Contract with a Specified Maximum Quantity

It depends. The same considerations discussed above with respect to Contract 1 also apply to Contract 2; however, the notional amount cannot exceed 100 units.

Contract 3-Requirements Contract with a Specified Minimum Quantity

Yes.  The same considerations discussed above with respect to Contract 1 also apply to Contract 3; however, the notional amount of Contract 3 cannot be less than 60 units. A contract that specifies a minimum number of units always has a notional amount at least equal to the required minimum number of units. Only that portion of the requirements contract with a determinable notional amount would be accounted for as a derivative instrument under Statement 133.

Contract 4-Requirements Contract with a Specified Minimum and Maximum Quantities

Yes. The same considerations discussed above with respect to Contract 1 also apply to Contract 4; however, the notional amount of Contract 4 cannot be less than 60 units or greater than 100 units. A contract that specifies a minimum number of units always has a notional amount at least equal to the required minimum number of units. Only that portion of the requirements contract with a determinable notional amount would be accounted for as a derivative instrument under Statement 133.

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.