Derivatives Implementation Group

Statement 133 Implementation Issue No. C16

QUESTION

If a purchased option that would, if exercised, require delivery of the related asset at an established price under the contract is combined with a forward contract in a single supply contract and that single supply contract meets the definition of a derivative, is that single supply contract eligible to qualify for the normal purchases and normal sales exception in paragraph 10(b)?

BACKGROUND

Some utilities and independent power producers (also called IPPs) have fuel supply contracts that require delivery of a contractual minimum quantity of fuel at a fixed price and have an option that permits the holder to take specified additional amounts of fuel at the same fixed price at various times. Essentially, that option to take more fuel is a purchased option that is combined with the forward contract in a single supply contract. Typically, the option to take additional fuel is built into the contract to ensure that the buyer has a supply of fuel in order to produce the electricity during peak demands; however, the buyer may have the ability to sell to third parties the additional fuel purchased through exercise of the purchased option. Due to the difficulty in estimating peak electricity load and thus the amount of fuel needed to generate the required electricity, those fuel supply contracts are common in the electric utility industry (though similar supply contracts may exist in other industries). Those fuel supply contracts are not requirements contracts that are addressed in Statement 133 Implementation Issue No. A6, "Notional Amounts of Commodity Contracts."

Many of those contracts meet the definition of a derivative because they have a notional amount and an underlying, require no or a smaller initial net investment, and provide for net settlement (for example, through their default provisions or by requiring delivery of an asset that is readily convertible to cash). For purposes of applying Statement 133 to contracts that meet the definition of a derivative, it is necessary to determine whether the fuel supply contract qualifies for the normal purchases and normal sales exception, whether bifurcation of the option is permitted if it does not qualify for the normal purchases and normal sales exception, or whether the entire contract is accounted for as a derivative.

Statement 133 Implementation Issue No. C15, "Normal Purchases and Normal Sales Exception for Certain Option-Type Contracts and Forward Contracts in Electricity," indicates that power purchase or sales agreements (including combinations of a forward contract and an option contract) that meet the criteria in that Implementation Issue qualify for the normal purchases and normal sales exception in paragraph 10(b).

Although the above background information discusses utilities and independent power producers, this Implementation Issue applies to all entities that enter into contracts that combine a forward contract and a purchased option contract, not just to utilities and independent power producers.

RESPONSE

The inclusion of a purchased option that would, if exercised, require delivery of the related asset at an established price under the contract within the single supply contract that meets the definition of a derivative disqualifies the entire derivative fuel supply contract from being eligible to qualify for the normal purchases and normal sales exception in paragraph 10(b) except as provided in paragraph 10(b)(4) of Statement 133, as amended, and Implementation Issue C15 with respect to certain power purchase or sales agreements. Statement 133 Implementation Issue No. C10, “Can Option Contracts and Forward Contracts with Optionality Features Qualify for the Normal Purchases and Normal Sales Exception,” states? “Option contracts only contingently provide for such purchase or sale since exercise of the option contract is not assured. Thus, in accordance with paragraph 10(b)(2) of Statement 133, as amended, freestanding option contracts (including in-the-money options contracts) are not eligible to qualify for the normal purchases and normal sales exception.” Paragraph 10(b)(3) of Statement 133, as amended, and Implementation Issue C10 further indicate that forward contracts with embedded optionality can qualify for the normal purchases and normal sales exception only if the embedded optionality (such as price caps) does not affect the quantity to be delivered. The fuel supply contract cannot qualify for the normal purchases and normal sales exception because of the optionality regarding the quantity of fuel to be delivered under the contract.

An entity is not permitted to bifurcate the forward contract component and the option contract component of a fuel supply contract that in its entirety meets the definition of a derivative and then assert that the forward contract component is eligible to qualify for the normal purchases and normal sales exception. Paragraph 18 indicates that an entity is prohibited from separating a compound derivative in components representing different risks. (The provisions of paragraph 12 require that certain derivatives that are embedded in non-derivative hybrid instruments must be split out from the host contract and accounted for separately as a derivative; however, paragraph 12 does not apply to a contract that meets the definition of a derivative in its entirety.)

An entity may wish to enter into two separate contracts—a forward contract and an option contract—that economically achieve the same results as the single derivative contract described in the background section and determine whether the exception in paragraph 10(b) applies to the separate forward contract.

Similar to the option contracts discussed in Implementation Issue C10, this Issue addresses option components that would require delivery of the related asset at an established price under the contract. If the option component does not provide any benefit to the holder beyond the assurance of a guaranteed supply of the underlying commodity for use in the normal course of business and that option component only permits the holder to purchase additional quantities at the market price at the date of delivery (that is, that option component will always have a fair value of zero), that option component would not require delivery of the related asset at an established price under the contract.

If an entity’s single supply contract included at its inception both a forward contract and an option contract and, in subsequent renegotiations, that contract is negated and replaced by two separate contracts (a forward contract for a specific quantity that will be purchased and an option contract for additional quantities whose purchase is conditional upon exercise of the option), the new forward contract would be eligible to qualify for the normal purchases and normal sales exception under paragraph 10(b), whereas the new option contract would not be eligible for that exception. From the inception of that new separate option contract, it would be accounted for under Statement 133. However, the guidance in this Implementation Issue would not retroactively affect the accounting for the combination derivative contract that was negated prior to the effective date of this Implementation Issue.

If on the effective date of this Implementation Issue, an entity was party to a combination derivative contract that included both a forward contract and an option contract but the entity had not been accounting for that derivative contract under Statement 133 because it had documented an asserted compliance with paragraph 10(b), that combination derivative contract would be reported at its fair value on the effective date of this Implementation Issue, with the offsetting entry recorded in current period earnings. The combination derivative contract cannot be bifurcated into a forward contract that would have been eligible to qualify for the normal purchases and normal sales exception and an option contract.

EFFECTIVE DATE

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of its second fiscal quarter beginning after October 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.