Derivatives Implementation Group

Statement 133 Implementation Issue No. C20

Title:	Scope Exceptions: Interpretation of the Meaning of Not Clearly and Closely Related in Paragraph 10(b) regarding Contracts with a Price Adjustment Feature
Paragraph references:	10(b)
Date cleared by Board:	June 25, 2003
Date posted to website:	June 27, 2003

QUESTION

For purposes of determining the applicability of the normal purchases and normal sales scope exception, how should not clearly and closely related to the asset being sold or purchased (as used in paragraph 10(b) of Statement 133) be applied to price adjustments in purchase or sales contracts?

BACKGROUND

In many cases, certain contracts that meet the definition of a derivative in their entirety and may otherwise qualify for the normal purchases and normal sales scope exception have a price adjustment feature the underlying of which is based on the fair value of an asset that is different from the asset to be delivered under the contract. In other cases, the underlying of the price adjustment feature is based on an index or other variable that is not related to the asset to be delivered under the contract.

The normal purchases and normal sales scope exception provided in paragraph 10(b) (as amended) states that “…contracts that have a price based on an underlying that is not clearly and closely related to the asset being sold or purchased (such as a price in a contract for the sale of a grain commodity based in part on changes in the S&P index)…shall not be considered normal purchases and normal sales.”

The phrase not clearly and closely related is also used in paragraphs 12(a) and 60 of Statement 133 with respect to the relationship between an embedded derivative and the host contract in which it is embedded. In that context, the phrase focuses on the “economic characteristics and risks” of the embedded derivative and the host contract.

RESPONSE

The phrase not clearly and closely related in paragraph 10(b) with respect to the normal purchases and normal sales scope exception is used to convey a different meaning than in paragraphs 12(a) and 60 of Statement 133 with respect to the relationship between an embedded derivative and the host contract in which it is embedded. The guidance in this Issue does not affect the use of the phrase not clearly and closely related in paragraphs other than paragraph 10(b) as amended.

For purposes of determining whether a contract qualifies for the normal purchases and normal sales scope exception, the application of the phrase not clearly and closely related to the asset being sold or purchased should involve an analysis of both qualitative and quantitative considerations. The analysis is specific to the contract being considered for the normal purchases and normal sales scope exception and may include identification of the components of the asset being sold or purchased.

The underlying in a price adjustment incorporated into a contract that otherwise satisfies the requirements for the normal purchases and normal sales exception would be considered to be not clearly and closely related to the asset being sold or purchased in any of the following three circumstances:

1. The underlying is extraneous (that is, irrelevant and not pertinent) to both the changes in the cost and the changes in the fair value of the asset being sold or purchased, including being extraneous to an ingredient or direct factor in the customary or specific production of that asset.
2. If the underlying is not extraneous as discussed in (1) above, the magnitude and direction of the impact of the price adjustment is not consistent with the relevancy of the underlying. That is, the magnitude of the price adjustment based on the underlying is significantly disproportionate to the impact of the underlying on the fair value or cost of the asset being purchased or sold (or of an ingredient or direct factor, as appropriate).
3. The underlying is a currency exchange rate involving a foreign currency that meets none of the criteria in paragraphs 15(a)-15(d) of Statement 133 (as amended) for that reporting entity. (The inclusion of this circumstance is consistent with the portion of paragraph 10(b) that states, “contracts that…are denominated in a foreign currency that meets none of the criteria in paragraphs 15(a)-15(d) shall not be considered normal purchases and normal sales.”)

For example, in the case in which the price adjustment focuses on the changes in the fair value of the asset being purchased or sold, if the terms of the price adjustment are expected, at the inception of the contract, to impact the purchase or sales price in a manner comparable to the outcome that would be obtained if, at each delivery date, the parties were to reprice the contract amount under the then-existing conditions for the asset being delivered on that date, the price adjustment’s underlying is considered to be clearly and closely related to the asset being sold or purchased and the price adjustment would not be an impediment to the contract qualifying for the normal purchases and normal sales scope exception.

The assessment of whether a contract qualifies for the normal purchases and normal sales scope exception (including whether the underlying of a price adjustment within the contract is not clearly and closely related to the asset being sold or purchased) must be performed only at the inception of the contract.

If the underlying in a price adjustment incorporated into a purchase or sales contract is not an impediment to qualifying for the normal purchases and normal sales scope exception because it is considered to be clearly and closely related to the asset being sold or purchased, the contract must meet the other requirements in paragraph 10(b) to qualify for that scope exception.

Statement 133 Implementation Issue No. C11, “Interpretation of Clearly and Closely Related in Contracts That Qualify for the Normal Purchases and Normal Sales Exception,” provided guidance regarding when a price adjustment feature in a contract would not be an impediment to the contract qualifying for the normal purchases and normal sales scope exception. Under Implementation Issue C11, a price adjustment feature based on an ingredient or direct factor in the production of the item being purchased or sold under the contract would be considered to be clearly and closely related to the asset being sold or purchased and thus the price adjustment feature would not be an impediment, that is, would not preclude election of the normal purchases and normal sales scope exception. That Issue did not permit the use of a broad market index to serve as a surrogate or proxy for an ingredient or direct factor. Thus, a price adjustment feature based on a broad market index that was not a direct factor or ingredient would be an impediment to the contract qualifying for the normal purchases or normal sales scope exception under Implementation Issue C11. (The guidance in Implementation Issue C11 is superseded by the guidance in Implementation Issue C20.)

Effective Date and Transition

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of the first fiscal quarter beginning after July 10, 2003. Early application to any fiscal quarter beginning after clearance of this Issue is permitted. The implementation guidance in this Issue should be applied prospectively for all existing contracts as of the effective date of this Issue and for all future transactions. In conjunction with initially applying the implementation guidance in this Issue, a special transition adjustment shall be recognized by an entity that had been applying the normal purchases and normal sales scope exception to a derivative contract that under Implementation Issue C11 (as discussed in the preceding paragraph) was not eligible for the application of that scope exception because the contract contains a price adjustment feature that was based on neither the fair value of the item being purchased or sold under the contract nor an ingredient or direct factor in its production. That entity should recognize the derivative contract (to which that scope exception had been applied) at fair value as of the date of the initial application of this Issue, with a corresponding adjustment of net income as the effect of a change in accounting principle and presented in a manner similar to the cumulative effect of a change in accounting principle as described in paragraph 20 of APB Opinion No. 20, Accounting Changes. However, in order to be consistent with the transition provisions of Statement 133 and because no retroactive designation of hedging relationships and no retroactive application of the implementation guidance are permitted, no pro forma disclosures of the effects of retroactive application are required or permitted. Similarly, to be consistent with the transition provisions of Statement 133, the cumulative-effect-type adjustment related to initially applying that implementation guidance at the beginning of a fiscal quarter that is not the first fiscal quarter of the entity’s fiscal year should not be reported pursuant to FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements.

The implementation guidance in this Issue does not impose any prohibitions against accounting for any contract as a derivative because application of the normal purchases and normal sales scope exception is never mandated. Statement 133 Implementation Issue No. C12, “Interpreting the Normal Purchases and Normal Sales Exception as an Election,” indicates that the application of the normal purchases and normal sales scope exception effectively is elective. A party to a contract with a price adjustment feature that was an impediment to the contract qualifying for the normal purchase or normal sale scope exception under Implementation Issue C11 but is not an impediment under this Implementation Issue may, if the contract meets the other requirements in paragraph 10(b), elect to apply prospectively that scope exception on the day of the initial application of this Implementation Issue or on a later date (regardless of whether that entity had to recognize the special transition adjustment described in the preceding paragraph).

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.