Derivatives Implementation Group

Statement 133 Implementation Issue No. F10

QUESTIONS

Many contracts to supply materials on a long-term basis include a provision whereby the selling price is subject to a cap, a floor, or both, even though the holder of the related option does not pay to receive the option. Is a supply contract for which the contract price is fixed only under certain circumstances (such as when market prices are above an embedded price cap) a firm commitment for purposes of designating the hedged item in a fair value hedge? Is either party to the contract eligible to apply fair value hedge accounting in a hedge of the fair value exposure of the cap or floor in such contracts?

BACKGROUND

Entity A enters into a long-term supply contract with a customer to sell a specified amount of a certain material. The selling price is the current monthly average list price for the quantity delivered each month but not to exceed $15 per pound. The current list price at the contract signing date is $12 per pound. The contract can be settled only by physical delivery. The contract also includes a penalty provision that is sufficiently large to make performance probable. The customer is not required to make an up-front cash payment for the written option (that is, the price cap) in the supply contract. Consequently, the supply contract is neither a recognized asset nor a recognized liability at inception.

The supply contract in its entirety does not meet the definition of a derivative due to the absence of a net settlement characteristic (that is, the contract does not permit or require net settlement [paragraph 9(a)], there is no market mechanism [paragraph 9(b)], and it does not require delivery of an asset that is readily convertible to cash [paragraph 9(c)]). Pursuant to the guidance in Statement 133 Implementation Issue No. B14, "Purchase Contracts with a Selling Price Subject to a Cap and a Floor," the embedded cap on the selling price is an option that does not warrant separate accounting under Statement 133 because it is clearly and closely related to the host supply contract. In addition, because the supply contract is not remeasured with changes in fair value reported currently is earnings, it meets the criteria in paragraph 21(c) of Statement 133 to qualify as a hedged item in a fair value hedge.

Entity A wishes to enter into a transaction to hedge the risk of changes in the fair value of the embedded written price cap in the supply contract. Accordingly, it purchases a cash-settled call option with a strike price of $15 per pound and a notional amount equal to the quantity specified in the supply contract.

Paragraph 21 of Statement 133 and related footnote 8, which was amended by Statement 149, states, in part,

  An asset or a liability is eligible for designation as a hedged item in a fair value hedge if all of the following criteria are met:

1. The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment.⁸

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⁸A firm commitment (as defined in paragraph 540) that represents an asset or liability that a specific accounting standard prohibits recognizing (such as a noncancelable operating lease or an unrecognized mortgage servicing right) may nevertheless be designated as the hedged item in a fair value hedge. A mortgage banker’s unrecognized “interest rate lock commitment” (IRLC) does not qualify as a firm commitment (because as an option it does not obligate both parties) and thus is not eligible for fair value hedge accounting as the hedged item. (However, a mortgage banker’s “forward sale commitments,” which are derivatives that lock in the prices at which the mortgage loans will be sold to investors, may qualify as hedging instruments in cash flow hedges of the forecasted sales of mortgage loans.) A supply contract for which the contract price is fixed only in certain circumstances (such as when the selling price is above an embedded price cap or below an embedded price floor) meets the definition of a firm commitment for purposes of designating the hedged item in a fair value hedge. Provided the embedded price cap or floor is considered clearly and closely related to the host contract and therefore is not accounted for separately under paragraph 12, either party to the supply contract can hedge the fair value exposure arising from the cap or floor.

Paragraph 540 of Statement 133 defines the term firm commitment as follows:

An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

1. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield.
2. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.

RESPONSE

In accordance with the guidance of paragraph 21(a), footnote 8, as amended by Statement 149, a supply contract for which the contract price is fixed only under certain circumstances (such as when market prices are above an embedded price cap) meets the definition of a firm commitment for purposes of designating the hedged item in a fair value hedge. Therefore, when the selling price in a supply contract is subject to a cap, a floor, or both, either party to the contract is eligible to apply fair value hedge accounting in a hedging relationship to hedge the fair value exposure of the cap or floor.

In the example above, for the range of monthly average list prices above $15 per pound, the contract has a fixed $15 per pound price. Thus, Entity A may designate the written cap embedded in the supply contract as the hedged item in a fair value hedging relationship provided the other criteria for a fair value hedge are met.

The criterion in paragraph 21(a) of Statement 133 specifies that “The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment.” Paragraph 21(a)(2)(c), as amended by Statement 149, further stipulates that the hedged item in a fair value hedge can be a specific portion of an asset or liability-a put option or call option (including an interest rate or price cap as well as an interest rate or price floor) embedded in an existing asset or liability that is not an embedded derivative accounted for separately pursuant to paragraph 12 of this Statement. The embedded written cap in the example is a specific portion of the contract that is subject to the risk of changes in fair value due to changes in the list price of the underlying materials. Since it is not accounted for separately from the supply contract, the embedded written cap may be designated as the hedged item in a fair value hedge.

Footnote 2 to paragraph 4(a) of Statement 133 states that "subsequent references to an asset or a liability in this Statement include a firm commitment." Accordingly, the reference to "an existing asset or liability" in paragraph 21 of Statement 133 also includes an unrecognized firm commitment. Paragraph 21 allows a non-bifurcated call option that is embedded in a supply contract to be the hedged item in a fair value hedge regardless of whether that supply contract is a recognized asset or liability or an unrecognized firm commitment.

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 July 10, 2001, the date that the Board-cleared guidance was posted on the FASB website. The revisions made on March 26, 2003, do not affect the effective date.

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.