1.4 Definition of a Derivative

Derivatives are instruments whose value depends on (or is derived from) the value of underlying variables, such as the prices of traded assets. A stock option, for example, is a derivative whose value depends on the price of the underlying stock. However, derivatives can be dependent on almost any variable, from the price of corn to the amount of snowfall during a period.

In essence, most derivatives are net-settled contracts that allow the holder to benefit from changes in the value of either a referenced asset or another market variable (while making a smaller initial investment than would be required to own that asset and experience similar gains and losses). A contract that allows a party to receive or make a payment on the basis of a specified event or condition may also represent a derivative (see discussion on payment provisions below). Although it may be fairly obvious that certain contracts such as swaps, options, futures, or warrants typically meet the accounting definition of a derivative, that definition sometimes encompasses other types of contracts that are not commonly thought of as derivatives, such as financial guarantees, contracts to purchase materials or power, or commodity contracts that require the physical delivery of assets that are readily convertible to cash (RCC).

However, for a contract to require derivative accounting, it (1) must meet all of the criteria in the definition of a derivative instrument in ASC 815-10-15-83 and (2) cannot qualify for any of the ASC 815-10 scope exceptions (see Chapter 2).

ASC 815-10

15-83 A derivative instrument is a financial instrument or other contract with all of the following characteristics:

Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
1. One or more underlyings
2. One or more notional amounts or payment provisions or both.
Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
Net settlement. The contract can be settled net by any of the following means:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

ASC 815-10 — Glossary

Financial Instrument

Cash, evidence of an ownership interest in an entity, or a contract that both:

Imposes on one entity a contractual obligation either:
1. To deliver cash or another financial instrument to a second entity
2. To exchange other financial instruments on potentially unfavorable terms with the second entity.
Conveys to that second entity a contractual right either:
1. To receive cash or another financial instrument from the first entity
2. To exchange other financial instruments on potentially favorable terms with the first entity.

The use of the term financial instrument in this definition is recursive (because the term financial instrument is included in it), though it is not circular. The definition requires a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument.

Contractual rights and contractual obligations encompass both those that are conditioned on the occurrence of a specified event and those that are not. All contractual rights (contractual obligations) that are financial instruments meet the definition of asset (liability) set forth in FASB Concepts Statement No. 6, Elements of Financial Statements, although some may not be recognized as assets (liabilities) in financial statements — that is, they may be off-balance-sheet — because they fail to meet some other criterion for recognition.

For some financial instruments, the right is held by or the obligation is due from (or the obligation is owed to or by) a group of entities rather than a single entity.

As noted in ASC 815-10-15-83, for a derivative instrument to exist, there must be “a financial instrument or other contract.” This is consistent with ASC 815-10-10-1(a), which states that “[d]erivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.”

ASC 815 defines a derivative as a financial instrument or other contract with all of the following characteristics:

An underlying and either a notional amount or payment provision, or both (see Section 1.4.1).
No or a smaller initial net investment (see Section 1.4.2).
Net settlement (see Section 1.4.3).

1.4.1 Underlying, Notional Amount, and Payment Provision

The first characteristic of a derivative in ASC 815-10-15-83 is that it has both “[o]ne or more underlyings” (see below) and “[o]ne or more notional amounts or payment provisions or both” (see Section 1.4.1.2).

1.4.1.1 Underlying

ASC 815-10 — Glossary

Underlying

A specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event such as a scheduled payment under a contract). An underlying may be a price or rate of an asset or liability but is not the asset or liability itself. An underlying is a variable that, along with either a notional amount or a payment provision, determines the settlement of a derivative instrument.

ASC 815-10

15-88 An underlying is a variable that, along with either a notional amount or a payment provision, determines the settlement of a derivative instrument. An underlying usually is one or a combination of the following:

A security price or security price index
A commodity price or commodity price index
An interest rate or interest rate index
A credit rating or credit index
An exchange rate or exchange rate index
An insurance index or catastrophe loss index
A climatic or geological condition (such as temperature, earthquake severity, or rainfall), another physical variable, or a related index
The occurrence or nonoccurrence of a specified event (such as a scheduled payment under a contract).

15-89 However, an underlying may be any variable whose changes are observable or otherwise objectively verifiable. An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.

15-90 Reference to either a notional amount or a payment provision is needed in relation to an underlying to compute the contract’s periodic settlements and resulting changes in fair value.

All derivatives have one or more underlyings. An underlying is a variable (e.g., a price, rate, index, or the occurrence or nonoccurrence of a specified event) that could cause the payments or other settlements required by a contract to change.

In the determination of the contractual cash flows or other exchanges required by a derivative and of the derivative’s value, the underlying is applied to a notional amount (e.g., an interest rate might be applied to the debt’s outstanding amount) or there is a payment provision (e.g., a fixed payment might be triggered if a specified event occurs).

ASC 815-10

Example 3: Underlying — Determination of an Underlying if a Commodity Contract Includes Both Fixed and Variable Price Elements

55-77 The following Cases illustrate the determination of an underlying if a commodity contract includes a fixed element and a variable element:

A commodity contract between two parties to transact a fixed quantity at a specified future date at a fixed price (such as the commodity’s forward price at the inception of the contract) (Case A)
A commodity contract between two parties to transact a fixed quantity at a specified future date at whatever the prevailing market price might be at that future date (Case B)
A commodity contract having features of both a fixed-price contract and variable-price contract; specifically, an agreement to purchase a commodity in the future at the prevailing market index price at that future date plus or minus a fixed basis differential set at the inception of the contract (Case C).

55-78 Assume that each of the contracts in Cases A, B, and C has the characteristics of notional amount, underlying, and no initial net investment and that the commodity to be delivered is readily convertible to cash as discussed beginning in paragraph 815-10-15-119.

Case A: Fixed-Price Commodity Contract

55-79 This fixed-price commodity contract is a derivative instrument because it meets all the criteria in paragraph 815-10-15-83, including having an underlying (namely, the price of the commodity), as required by paragraph 815-10-15-83(a)(1). The contract’s fair value will change as the underlying changes because the contract price is not the prevailing market price at the future transaction date. A party to this contract would need to determine if the normal purchases and normal sales exception (see discussion beginning in paragraph 815-10-15-22) applies to the contract.

Case B: Variable-Price Commodity Contract

55-80 This variable-price commodity contract is a derivative instrument because it meets all the criteria in paragraph 815-10-15-83, including having an underlying (namely, the price of the commodity), as required by paragraph 815-10-15-83(a)(1). However, because the contract price is the prevailing market price at the future transaction date, the variable-price commodity contract would not be expected to have a fair value other than zero. A party to this contract would need to determine if the normal purchases and normal sales exception (see discussion beginning in paragraph 815-10-15-22) applies to the contract.

Case C: Mixed-Price Commodity Contract

55-81 In a commodity contract between a buyer and seller of crude oil, the buyer is a refinery that seeks to use the crude oil in the production of unleaded gasoline. The buyer agrees in January to buy 1,000,000 barrels of a specific type of crude oil in July from the seller at the July 1 West Texas Intermediate index price plus $1.00 per barrel. The contract appears to be primarily a variable-price contract, but includes a fixed margin above that price. (If the buyer or the seller no longer wants exposure to fluctuations in the West Texas Intermediate index between January and July, it will separately use the futures market to fix the West Texas Intermediate index portion of the contract.)

55-82 The fixed $1.00 differential is commonly referred to as the basis differential, but it reflects multiple factors, such as timing, quality, and location. If not fixed, the basis differential can be very volatile, because it captures the passage of time (a financing element), changes in relative value of different qualities (or grades) of crude to each other (light versus heavy, sweet versus sour), and changes in the attractiveness of locations from the central pricing hub (Cushing, Oklahoma) relative to each other factor. Supply and demand is a critical factor in influencing the changes in basis due to quality and location; for example, an increase in imports of light crude through the Gulf of Mexico corridor will tend to lower the basis differential for light crude (falling prices due to increased supply) and tend to direct domestic supplies of light crude to northern U.S. locations (because the foreign oil fills southern U.S. demand), lowering the basis differential for contracts calling for delivery at northern points (again due to increased supply in the North). The basis differential therefore is not a simple fixed transport charge, but rather a complex and volatile variable in itself. For this reason, energy traders may specialize solely in trading basis and seeking the most attractive differential at all times relative to the West Texas Intermediate index — fixing and unfixing basis by selling contracts back to counterparties or entering into offsetting contracts with third parties.

55-83 The whole mixed-attribute contract is a derivative instrument because the basis differential is a market variable in determining the final transaction price under the contract, and this variable has been fixed in the contract, producing an underlying. (If the differential was a market pricing convention that typically would not be expected to change, the contract would be a derivative instrument with very minor, if any, fluctuations in fair value.) The fact that the base commodity price in the contract is variable will help to mute the fluctuations in fair value of the contract as a whole, but there still will be potential changes in fair value of the overall contract because of the fixed-basis element. A party to this contract would need to determine if the normal purchases and normal sales exception applies to the contract. (Paragraph 815-20-55-47 explains why such a mixed-attribute contract that is a derivative instrument would generally not be sufficiently effective if designated as the sole hedging instrument in a cash flow hedge of the anticipated purchase or sale of the commodity.)

Example 1-1

Identifying Underlyings in a Litigation Funding Arrangement

In 20X1, Entity A entered into a lawsuit regarding certain disputes. In 20X2, it enters into a litigation funding arrangement with Entity B, a private investment company that invests in commercial legal claims it believes are meritorious. In accordance with the agreement, B agrees to pay up to $1 million (“Investment”) of A’s litigation costs to pursue the claims.

In consideration for B’s entering into the agreement, A assigns to B the rights to a portion of the settlement proceeds. Upon a defendant’s payment of any cash proceeds to A, A and B will share them as follows:

First, 100 percent of all proceeds will be paid to B until B has received an amount equal to the base return.
Second, all remaining proceeds (after (1)) will be paid to A.

The computation of the base return will depend on the length of time since the investment date:

Less than three months — 1.5 × Investment.
More than three months but less than or equal to five months — 1.75 × Investment.
More than five months — 2 × Investment.

If A enters into a merger or other corporate transaction (i.e., a change in control) and, by mutual agreement with B and the successor entity, determines that the litigation should not be pursued further, B will be entitled to the payment of the base return from the proceeds of the applicable (change-in-control) transaction.

The agreement contains the following underlyings:

Proceeds from litigation — In the absence of a change in control, the payout to B will depend solely on the proceeds received from the litigation.
The occurrence or nonoccurrence of a change in control — If there is a change in control and litigation is halted, B receives the base return but the payout is funded by the proceeds from the change in control, as opposed to the proceeds from the litigation.

1.4.1.2 Notional Amount or Payment Provision

1.4.1.2.1 Notional Amount

ASC 815-10 — Glossary

Notional Amount

A number of currency units, shares, bushels, pounds, or other units specified in a derivative instrument. Sometimes other names are used. For example, the notional amount is called a face amount in some contracts.

ASC 815-10

Notional Amount

15-92 A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in the contract. Other names are used, for example, the notional amount is called a face amount in some contracts. The settlement of a derivative instrument with a notional amount is determined by interaction of that notional amount with the underlying. The interaction may be simple multiplication, or it may involve a formula with leverage factors or other constants. As defined in the glossary, the effective notional amount is the stated notional amount adjusted for any leverage factor. If a 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. See paragraphs 815-10-55-5 through 55-7 for related implementation guidance. For implementation guidance on identifying a commodity contract’s notional amount, see paragraph 815-10-55-5.

To meet the definition of a derivative, a contract must contain a notional amount or a payment provision. A notional amount is a quantity that interacts with an underlying in the determination of the cash flows or fair value of the contract. Examples of notional amounts include monetary quantities (e.g., the principal amount of debt) or a number of equity shares (e.g., the number of equity shares that would be received upon conversion of a convertible instrument).

Typically, a commodity contract specifies the number of units of the commodity to be bought or sold under the contract’s pricing terms. However, some contracts (referred to as requirements contracts) do not specify the number of units to be bought or sold but instead just require the buyer to purchase the number of units that satisfies its actual needs for the commodity during the period of the contract. Since, under a requirements contract, the buyer typically depends exclusively on the seller for all of its commodity needs, it is important that the seller has an understanding of the buyer’s anticipated volumes. As indicated in ASC 815, a “notional” amount in a requirements contract can only exist if that quantity can be reliably determined. As illustrated in ASC 815-10-55-5 through 55-7, even if the notional amount is not specified in such contracts, the amount can often be reliably determined on the basis of other provisions within the contract or contemporaneous agreements.

ASC 815-10

Notional Amount — Identifying a Commodity Contract’s Notional Amount

55-5 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:

Contract 1: As many units as required to satisfy its actual needs (that is, to be used or consumed) for the commodity during the period of the contract (a requirements contract). The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).
Contract 2: Only as many units as needed to satisfy its actual needs up to a maximum of 100 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).
Contract 3: A minimum of 60 units and as many units needed to satisfy its actual needs in excess of 60 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).
Contract 4: A minimum of 60 units and as many units needed to satisfy its actual needs in excess of 60 units up to a maximum of 100 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).

55-6 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.

55-7 This guidance focuses solely on whether the contracts under consideration have a notional amount pursuant to the definition in this Subtopic. These types of contracts may not satisfy certain of the other required criteria in this Subtopic for them to meet the definition of a derivative instrument. The conclusion that a requirements contract has a notional amount as defined in this Subtopic can be reached only if a reliable means to determine such a quantity exists. Application of this guidance to specific contracts is as follows:

Contract 1 — requirements contract. The identification of a requirements contract’s notional amount may require the consideration of volumes or formulas contained in attachments or appendixes 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. If 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 this Subtopic. 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 shall be considered the notional amount of the contract.
Contract 2 — requirements contract with a specified maximum quantity. Whether the contract has a notional amount depends. The same considerations discussed in (a) 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. The contract has a notional amount. The same considerations discussed in (a) 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 this Subtopic.
Contract 4 — requirements contract with a specified maximum and minimum quantities. The contract has a notional amount. The same considerations discussed in (a) 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 this Subtopic.

Example 1-2

Identifying the Notional Amount in a Contract

Company XYZ enters into a contract to provide all of the aluminum that Company ABC will need in its manufacturing process. The contract specifies a fixed price and states that in the event that ABC does not take delivery of the aluminum from XYZ but instead purchases it from an unrelated entity, ABC must pay a penalty based on the change in the market price of aluminum plus a fixed penalty. The calculation of the penalties will be based on the average amount of aluminum used by ABC in its annual production, which is specified as 100 million tons in the contract.

While the contract between XYZ and ABC does not specify how much aluminum ABC must purchase, the contract does identify a notional amount that is based on ABC’s average use of aluminum, and therefore the contract has a notional amount equal to the amount specified in the contract’s penalty provisions (i.e., 100 million tons).

1.4.1.2.2 Payment Provision

ASC 815-10 — Glossary

Payment Provision

A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner.

ASC 815-10

Payment Provision

15-93 As defined in the glossary, a payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner. For example, a derivative instrument might require a specified payment if a referenced interest rate increases by 300 basis points.

A payment provision is a fixed or determinable payment that is triggered by specified changes in the underlying. Examples include the following:

A contract to pay a fixed amount upon the occurrence or nonoccurrence of an event (e.g., change of control or an event of default).
A contract to pay a fixed amount if the company’s share price falls below a particular dollar value.
A contract to pay a fixed amount if the company’s credit rating changes.

1.4.2 Initial Net Investment

ASC 815-10

15-83 A derivative instrument is a financial instrument or other contract with all of the following characteristics: . . .

b. Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. . . .

15-94 Many derivative instruments require no initial net investment. Some require an initial net investment as compensation for one or both of the following:

Time value (for example, a premium on an option)
Terms that are more or less favorable than market conditions (for example, a premium on a forward purchase contract with a price less than the current forward price).

Others require a mutual exchange of currencies or other assets at inception, in which case the net investment is the difference in the fair values of the assets exchanged.

15-95 A derivative instrument does not require an initial net investment in the contract that is equal to the notional amount (or the notional amount plus a premium or minus a discount) or that is determined by applying the notional amount to the underlying. For example:

A commodity futures contract generally requires no net investment, while purchasing the same commodity requires an initial net investment equal to its market price. However, both contracts reflect changes in the price of the commodity in the same way (that is, similar gains or losses will be incurred).
A swap or forward contract generally does not require an initial net investment unless the terms favor one party over the other.
An option generally requires that one party make an initial net investment (a premium) because that party has the rights under the contract and the other party has the obligations.

15-96 If the initial net investment in the contract (after adjustment for the time value of money) is less, by more than a nominal amount, than the initial net investment that would be commensurate with the amount that would be exchanged either to acquire the asset related to the underlying or to incur the obligation related to the underlying, the characteristic in paragraph 815-10-15-83(b) is met. The amount of that asset acquired or liability incurred should be comparable to the effective notional amount of the contract. This does not imply that a slightly off-market contract cannot be a derivative instrument in its entirety. That determination is a matter of facts and circumstances and shall be evaluated on a case-by-case basis. Example 16, Case C (see paragraph 815-10-55-166) illustrates the guidance in this paragraph.

15-98 The phrase initial net investment is stated from the perspective of only one party to the contract, but it determines the application of this Subtopic for both parties. . . .

Initial Net Investment — Initial Exchange Under Currency Swap Is Not an Initial Net Investment

55-8 The definition of a derivative instrument includes contracts that require gross exchanges of currencies (for example, currency swaps that require an exchange of different currencies at both inception and maturity). The initial exchange of currencies of equal fair values in those arrangements does not constitute an initial net investment in the contract. Instead, it is the exchange of one kind of cash for another kind of cash of equal value. The balance of the agreement, a forward contract that obligates and entitles both parties to exchange specified currencies, on specified dates, at specified prices, is a derivative instrument.

The second characteristic of a derivative in ASC 815-10-15-83 is that it has “no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.”

To evaluate this characteristic, an entity compares the following two amounts:

The contract’s initial net investment.
The amount needed to acquire (or incur) the effective notional amount of the asset (or liability) related to the contract’s underlying.

The characteristic is present if the initial net investment is smaller, by more than a nominal amount, than that for other types of contracts with a similar response to changes in market factors. For example, there is often no initial investment required for freestanding swaps and forward contracts. For freestanding option contracts, the initial investment (i.e., the premium) is usually smaller than the amount needed to invest in the option’s reference asset. If the contract’s initial investment approximates the initial investment needed to acquire (or incur) the related asset (or liability), the net investment characteristic is not met.

1.4.2.1 Smaller Initial Net Investment

A “smaller” initial net investment is an amount that is less, by more than a nominal amount, than a party would have to pay for other types of contracts that would have similar responses to changes in market conditions. A derivative contract provides the holder with the opportunity to participate in the price changes of the underlying without having to own the associated asset or liability.

ASC 815 does not include a quantitative threshold for determining what “less, by more than a nominal amount,” means in this context. In practice, an initial net investment of 90 percent or less of the effective notional amount is considered to meet the criterion in ASC 815-10-15-83(b). Said differently, an initial net investment would typically be considered “smaller” if it were at least 10 percent less that the initial net investment needed to acquire (or incur) the related asset (or liability).

As noted in ASC 815-10-15-98, “[t]he phrase initial net investment is stated from the perspective of only one party to the contract, but it determines the application of [ASC 815-10] for both parties.”

Example 1-3

Determining Whether There Is a Smaller Initial Net Investment

There are various ways an entity can participate in the increases and decreases in the price of 100 shares of ABC stock:

Purchase 100 shares of ABC stock at $10 per share, which represents the current market value.
Enter into a forward contract to buy 100 shares of ABC stock in the future at a fixed price. No exchange of cash is required on the date the forward contract is entered into.
Purchase an option that allows the holder to buy 100 shares of ABC stock in the future with a strike price of $10 per share.

The purchase of the shares (alternative 1) would require an initial investment equal to the current market price for 100 shares of ABC and would give the entity the right to vote the shares and receive dividends.

The purchase of the forward contract (alternative 2) at the current market forward price would require no initial investment but would provide the same opportunity to participate in stock price changes; however, the entity would not have the right to vote the shares or receive dividends.

The purchase of the option whose strike price is equal to the current market value (alternative 3) requires an initial net investment, but one that is typically smaller than that for the acquisition of the underlying shares themselves by more than a nominal amount. However, the instrument provides exposure to the same underlying (i.e., stock price changes) and the entity usually does not have voting or dividend rights.

Therefore, the “no or smaller initial net investment” criterion of the definition of a derivative would be met for both the forward and the option (alternatives 2 and 3). The criterion would not be met for the purchase of shares at market value (alternative 1).

Typically, the purchase or sale of an option contract involves an initial payment or the receipt of cash (the premium). Generally, this initial cash investment represents the option’s time value, which would be considered a “smaller” net investment under ASC 815. However, if the contract was in-the-money at issuance and significant cash was exchanged, further evaluation would be needed to determine whether the initial net investment would meet the “smaller” criterion in the FASB’s definition. As indicated in ASC 815-10-15-96, when the initial net investment in a contract is compared with the investment that would be exchanged to either acquire the asset or incur the obligation related to the underlying, the “amount of the asset acquired or liability incurred should be comparable to the effective notional amount,” which is the stated notional amount adjusted for any leverage factor.

Example 1-4

Initial Net Investment in a Deep-in-the-Money Option

XYZ Company purchases a deep-in-the-money American call option on MNO stock, which is priced at $100 per share. The option has a 180-day maturity and a strike price of $10 per share. XYZ pays a premium of $90. Therefore, the initial investment in the option ($90) is less, by more than a nominal amount, than the effective notional amount applied to the underlying ($100).

Although the option has a significant initial net investment, it is smaller, by more than a nominal amount, than the investment that would be required for other types of contracts expected to have a similar response to changes in market factors. The invested amount of $90 does not approximate the effective notional amount applied to the underlying and, therefore, the option meets the initial net investment criteria for a derivative instrument. If the initial net investment were greater than $90 (i.e., more than 90 percent of the effective notional amount), XYZ would be required to use judgment in determining whether the contract meets the initial net investment criteria and should be considered a derivative instrument.

In the evaluation of whether an embedded feature meets the definition of a derivative, the initial net investment in the embedded feature is the amount the entity would be required to invest in a freestanding contract with terms that are similar to those of the embedded feature (i.e., it would not be appropriate to consider the initial net investment in the hybrid contract in the evaluation of whether this criterion is met). Rather, the initial net investment of an embedded feature is the fair value of that feature at the inception of the arrangement.

1.4.2.2 Concept of Effective Notional Amount

If the initial net investment required in a contract equals or exceeds the amount calculated by applying the effective notional amount to the underlying, the contract cannot be considered a derivative instrument. Case A of Example 16 in ASC 815-10-55-150 through 55-154 illustrates a fact pattern in which the initial net investment equals the amount calculated by applying the effective notional amount to the underlying. Case B of Example 16 in ASC 815-10-55-156 through 55-158 illustrates a fact pattern in which the initial net investment exceeds the amount determined by applying the effective notional amount to the underlying.

ASC 815-10

15-97 A contract that requires an initial net investment in the contract that is in excess of the amount determined by applying the effective notional amount to the underlying is not a derivative instrument in its entirety. Example 16, Case A (see paragraph 815-10-55-150) illustrates such a contract.

Example 16: Prepaid Interest Rate Swap

Case A: Prepaid Interest Rate Swap

55-150 Entity A pays $1,228,179 to enter into a prepaid interest rate swap contract that requires the counterparty to make quarterly payments based on a $10,000,000 effective notional amount and a variable interest rate equal to 3-month U.S. dollar- (USD-) denominated London Interbank Offered Rate (LIBOR). The prepaid interest rate swap contract is characterized as an at-the-money 2-year interest rate swap with a $10,000,000 notional amount, a fixed interest rate of 6.65 percent, and a variable interest rate of the 3-month USD LIBOR (that is, the same terms as the swap in Example 6 [see paragraph 815-30-55-24], which has a zero fair value at inception), for which the fixed leg has been fully prepaid. The amount of $1,228,179 is the present value of the 8 quarterly fixed payments of $166,250 — that is, $10,000,000 × LIBOR swap rate of 6.65 percent / 4). The present value is based on the implied spot rate for each of the 8 payment dates under the assumed initial yield curve in that Example.

55-151 The prepaid interest rate swap contract could also be characterized as a 2-year, structured note (contract) with a principal amount of $1,228,179 and loan payments based on a formula equal to 8.142 times 3-month USD LIBOR. (Note that 8.142 = 10,000,000 / 1,228,179.) The terms of the structured note specify no repayment of the principal amount either over the two-year term of the structured note or at the end of its term. The 8.142 leverage factor causes the effective notional amount of the structured note also to be $10,000,000.

55-152 The prepaid interest rate swap contract meets the characteristic of a derivative instrument in paragraph 815-10-15-83(a) because it has an underlying and an effective notional amount. It also meets the characteristic of a derivative instrument in paragraph 815-10-15-83(c) because neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (see paragraph 815-10-15-100). At issue is whether the prepaid interest rate swap contract meets the characteristic of a derivative instrument described in paragraph 815-10-15-83(b) related to the initial net investment in a contract.

55-153 The prepaid interest rate swap contract does not meet the definition of a derivative instrument because it does not satisfy the characteristic of a derivative instrument described in paragraph 815-10-15-83(b) related to the initial net investment in the contract. Specifically, the prepaid interest rate swap contract is excluded from the definition of a derivative instrument by the clarifying guidance on initial net investment beginning in paragraph 815-10-15-94. The prepaid interest rate swap contract in this Case requires an initial net investment that is determined by applying the effective notional amount of $10,000,000 to the underlying (3-month USD LIBOR) for each of the 8 payment dates specified by the terms of the contract. The initial net investment of $1,228,179 required to enter into the contract is the present value of the 8 quarterly fixed-leg swap payments of $166,250 — that is, $10,000,000 × 6.65 percent / 4. Because the LIBOR swap rate reflects the applicable portions of the forward three-month USD LIBOR rate curve for the settlement dates that relate to the specific payments under the swap, the initial net investment is considered to have been determined by applying the effective notional amount to the underlying and then adjusted for the time value of money.

55-154 That is, as stated in paragraph 815-10-15-97, a contract that requires an initial net investment in the contract that is in excess of the amount determined by applying the effective notional amount to the underlying is also not a derivative instrument in its entirety.

Case B: Prepaid Interest Rate Swap That Must Be Bifurcated

55-156 Entity B pays $1,782,245 to enter into a prepaid interest rate swap contract that requires the counterparty to make quarterly payments based on a $10,000,000 effective notional amount and a variable interest rate equal to the sum of 3-month USD LIBOR and 300 basis points. The prepaid interest rate swap contract is characterized as an at-the-money 2-year interest rate swap with a $10,000,000 notional amount, a fixed interest rate of 9.65 percent, and a variable interest rate of 3-month USD LIBOR plus 300 basis points, for which the fixed leg has been fully prepaid. The amount of $1,782,245 is the present value of the 8 quarterly fixed payments of $241,250 — that is, $10,000,000 × the fixed rate of 9.65 percent / 4. The present value is based on the implied spot rate for each of the 8 payment dates under the assumed initial yield curve in Example 6 (see paragraph 815-30-55-24).

55-157 In this Case, the underlying is 3-month USD LIBOR (even though the variable rate is 3-month USD LIBOR plus 300 basis points) and the amount determined by applying the effective notional amount to the underlying (and then adjusted for the time value of money) is $1,228,179, the same as in Case A. The initial net investment for the prepaid interest rate swap in this Case is $1,782,245, an amount that is in excess of $1,228,179 — the amount referred to in paragraph 815-10-15-95 as being determined by applying the effective notional amount to the underlying. Consequently, the prepaid interest rate swap in this Case is not a derivative instrument in its entirety.

55-158 Because the prepaid interest rate swap contract is not a derivative instrument in its entirety, it should be evaluated to determine whether the contract contains an embedded derivative that, pursuant to paragraph 815-15-25-1, requires separate accounting as a derivative instrument.

As indicated in ASC 815-10-15-96, “[i]f the initial net investment [required] in the contract is less, by more than a nominal amount, than the [amount calculated by applying the effective notional amount to the underlying], the characteristic in paragraph 815-10-15-83(b) is met.” Case C of Example 16 in ASC 815-10-55-166 through 55-168 illustrates a fact pattern in which the initial net investment is smaller than the amount determined by applying the effective notional amount to the underlying.

ASC 815-10

Example 16: Prepaid Interest Rate Swap

Case C: Prepaid Interest Rate Swap Variation

55-166 Entity C pays $1,043,490 to enter into a contract that requires the counterparty to make quarterly payments based on a $10,000,000 effective notional amount and a variable interest rate equal to the 3-month USD LIBOR minus 100 basis points. In the event that 3-month USD LIBOR is less than 100 basis points, Entity C is obligated to make payments to the counterparty. The prepaid interest rate swap contract is characterized as an at-the-money 2-year interest rate swap with a $10,000,000 notional amount, a fixed interest rate of 5.65 percent, and a variable interest rate of 3-month USD LIBOR minus 100 basis points, for which the fixed leg has been fully prepaid. The amount of $1,043,490 is the present value of the 8 quarterly fixed payments of $141,250 — that is, $10,000,000 × the fixed rate of 5.65 percent / 4. The present value is based on the implied spot rate for each of the 8 payment dates under the assumed initial yield curve in Example 6 (see paragraph 815-30-55-24).

55-167 In this Case, the underlying is 3-month USD LIBOR (even though the variable rate is 3-month USD LIBOR minus 100 basis points) and the amount determined by applying the effective notional amount to the underlying (and then adjusted for the time value of money) is $1,228,179, the same as in Case A. The initial net investment for the contract in this Case is $1,043,490, an amount that is less than $1,228,179. (The contract is considered not to be fully prepaid because Entity C has not prepaid all obligations imposed on it by the contract; Entity C is obligated to make future payments under certain conditions, as noted in the preceding paragraph.) The difference of $184,689 (about 15 percent) is more than a nominal amount if compared to $1,228,179. Consequently, the contract in this Case is a derivative instrument in its entirety.

55-168 The amounts in this Case are not intended to provide quantitative guidance for distinguishing between being less by more than a nominal amount and being less by only a nominal amount. The initial net investment for a contract could be less than the amount determined by applying the effective notional amount to the underlying by a percentage lower than 15 percent and still be considered to be less, by more than a nominal amount under paragraph 815-10-15-96.

Connecting the Dots

We are aware that the steep drop in U.S. interest rates before 2022 posed challenges for some entities using interest rate swaps to hedge variable-rate debt obligations. As interest rates decreased significantly, many such entities hoped to exit those interest rate swaps since they had become significant balance sheet liabilities; however, the counterparties to those swaps would have required significant cash payments to terminate them. Alternatively, some lenders and borrowers used a “blend and extend” strategy in which the lenders agreed to restructure borrowers’ existing pay-fixed, receive-variable interest rate swaps. Under this strategy, the lender agrees to (1) extend the maturity date of the existing interest rate swap and (2) revise the fixed interest rate. The new fixed interest rate is determined such that the fair value of the new swap (with the extended maturity date) approximates the current fair value of the existing swap. The new swap’s fixed rate would be higher than the rate of a new at-the-market swap but lower than the existing swap’s rate.

Practitioners have questioned whether the modified derivative contracts should continue to be accounted for as derivatives in their entirety or, instead, as hybrid debt instruments. We believe that the fair value of the existing derivative contract should be considered the entity’s initial net investment in the new contract under ASC 815-10-15-83(b). If the fair value of the existing swap is large enough (i.e., greater than 90 percent of the effective notional amount of the new derivative contract), the new derivative contract would not meet the definition of a derivative under ASC 815-10-15-83 and should be considered a hybrid instrument with an embedded derivative.

1.4.3 Net Settlement

1.4.3.1 Background

ASC 815-10

15-83 A derivative instrument is a financial instrument or other contract with all of the following characteristics: . . .

c. Net settlement. The contract can be settled net by any of the following means:

Its terms implicitly or explicitly require or permit net settlement.
It can readily be settled net by a means outside the contract.
It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

15-99 A contract fits the description in paragraph 815-10-15-83(c) if its settlement provisions meet criteria for any of the following:

Net settlement under contract terms
Net settlement through a market mechanism
Net settlement by delivery of derivative instrument or asset readily convertible to cash.

Under ASC 815, net settlement can be accomplished in three different ways:

Neither party is required to deliver an asset that is associated with the underlying and whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the notional amount (which may include a premium or discount). The contract is settled net (either in cash or any other asset) on the basis of changes in the price of the underlying (see Section 1.4.3.2).
One of the parties is required to deliver an asset as described in criterion 1; however, there is a market mechanism that facilitates net settlement (see Section 1.4.3.3).
One of the parties is required to deliver an asset as described in criterion 1; however, the asset either is RCC or is itself a derivative instrument (see Section 1.4.3.4).

The assessment of whether a contract meets the net settlement criteria is done both at the inception of the contract and throughout the contract’s life. For example, an arrangement may not meet the definition of a derivative at contract inception because there is no net settlement, but changes external to the contract (e.g., shares underlying the contract become publicly traded in an active market) may cause the contract to meet net settlement at a later date. See Section 1.4.3.4.5 for further discussion of this ongoing assessment.

1.4.3.2 Net Settlement Under Contract Terms

ASC 815-10

Net Settlement Under Contract Terms

15-100 In this form of net settlement, neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount). (For example, most interest rate swaps do not require that either party deliver interest-bearing assets with a principal amount equal to the notional amount of the contract.) Net settlement may be made in cash or by delivery of any other asset (such as the right to receive future payments — see the discussion beginning in paragraph 815-10-15-104), whether or not that asset is readily convertible to cash.

15-101 Further considerations in the application of this form of net settlement are addressed as follows:

Net share settlement
Net settlement in the event of nonperformance or default
Structured settlement as net settlement
Net settlement of a debt instrument through exercise of an embedded put option or call option.

As stated in ASC 815-10-15-100, in a contractual net settlement, “neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount.” One form of contractual net settlement is a one-way transfer of cash or assets, such as a net amount of cash or a net number of shares (“cashless exercise”) that is equivalent to the gain or loss on the contract. If the contractual terms require or permit either party to elect net settlement, the net settlement characteristic is met even if the item that may be delivered upon settlement is not RCC (e.g., a net share settlement involving private company shares).

Example 1-5

Net Settlement of Interest Rate Swaps

Company XYZ enters into an interest rate swap with a counterparty that requires XYZ to pay a fixed rate of 8 percent and receive three-month LIBOR, reset on a quarterly basis. The fixed and variable amounts are determined on the basis of a $100 million notional amount. Company XYZ (1) pays the fixed-rate amount on a semiannual basis to the counterparty and (2) receives the variable amount on a quarterly basis from the counterparty. The interest payments are not settled on a net basis. Thus, the interest rate swap constitutes a series of forward contracts to exchange and receive cash on potentially favorable or unfavorable terms. Each of the forward contracts is a derivative instrument.

1.4.3.2.1 Net Share Settlement

ASC 815-10

Net Share Settlement

15-102 The net settlement criterion as described in paragraph 815-10-15-83(c) and related paragraphs in this Subsection is met if a contract provides for net share settlement at the election of either party. Therefore, if either counterparty could net share settle a contract, then it would be considered to have the net settlement characteristic of a derivative instrument regardless of whether the net shares received were readily convertible to cash as described in paragraph 815-10-15-119 or were restricted for more than 31 days as discussed beginning in paragraph 815-10-15-130. While this conclusion applies to both investors and issuers of contracts, issuers of those net share settled contracts shall consider whether such contracts qualify for the scope exception in paragraph 815-10-15-74(a). See Example 5 (paragraph 815-10-55-90).

Example 5: Net Settlement Under Contract Terms — Net Share Settlement

55-90 This Example illustrates the concept of net share settlement. Entity A has a warrant to buy 100 shares of the common stock of Entity X at $10 a share. Entity X is a privately held entity. The warrant provides Entity X with the choice of settling the contract physically (gross 100 shares) or on a net share basis. The stock price increases to $20 a share. Instead of Entity A paying $1,000 cash and taking full physical delivery of the 100 shares, the contract is net share settled and Entity A receives 50 shares of stock without having to pay any cash for them. (Net share settlement is sometimes described as a cashless exercise.) The 50 shares are computed as the warrant’s $1,000 fair value upon exercise divided by the $20 stock price per share at that date.

ASC 815-10-15-100 indicates that explicit net settlement in a contract as discussed in ASC 815-10-15-83(c) and ASC 815-10-15-99 can be achieved by delivery of (1) net cash or (2) net assets other than cash, regardless of whether those net assets are RCC. ASC 815-10-15-102 notes that a net share-settled contract satisfies the net settlement provision through the delivery of net assets. Since the net settlement provision can be satisfied regardless of whether the net shares received are RCC, even an equity instrument whose underlying is private-company stock would satisfy the net settlement provisions of ASC 815.

The following are examples of common wording that is typically located in the “manner of exercise” section of the instrument:

“Cashless exercise.”
“In lieu of payment of the exercise price.”
“In lieu of cash payment.”

Example 1-6

Impact of Restrictions on the Net Settlement Determination

Company M acquires a warrant to purchase 1,000 shares of Company P’s publicly traded stock for $10 per share. Under the terms of the warrant, M cannot sell any of P’s stock that it receives from exercising the warrant for 60 days. The warrant agreement allows for a “cashless exercise” option, so that the fair value of the shares delivered will equal the difference between the fair value of 1,000 shares of P’s stock and $10,000 (the strike price of the warrant). In other words, if P’s stock is trading for $20, M could exercise the warrant and elect to receive 500 shares, which is calculated as [($20 – $10) × 1,000] ÷ $20, without paying any cash. Even though the shares received are not RCC because of the 60-day restriction period (see Section 1.4.3.4.3), the cashless exercise option would satisfy the explicit net settlement criterion and the warrants would meet the definition of a derivative.

Example 1-7

Cashless Exercise and Net Settlement

Company M acquires a warrant to purchase 20,000 shares of Company Q’s stock, which is not publicly traded, for $4 per share. The warrant agreement allows for a “cashless exercise” option, so that the fair value of the shares delivered will equal the difference between the fair value of 20,000 shares of Q stock and $80,000 (the strike price of the warrant). In other words, if the fair value of Q’s stock is $5, M could exercise the warrant and elect to receive 4,000 shares, which is calculated as [($5 – $4) × 20,000] ÷ $5, without paying any cash. Even though the shares received are not RCC because Q is not a public company, the cashless exercise option would satisfy the explicit net settlement criterion and the warrants would meet the definition of a derivative.

1.4.3.2.2 Net Settlement in the Event of Nonperformance or Default

ASC 815-10

15-103 Penalties for nonperformance may give a contract the characteristic of net settlement. For example:

A penalty for nonperformance in a purchase order is a net settlement provision if the amount of the penalty is based on changes in the price of the items that are the subject of the contract.
A fixed penalty for nonperformance is not a net settlement provision.
A contract that contains a variable penalty for nonperformance based on changes in the price of the items that are the subject of the contract does not contain a net settlement provision as discussed beginning in paragraph 815-10-15-100 if it also contains an incremental penalty of a fixed amount (or fixed amount per unit) that would be expected to be significant enough at all dates during the remaining term of the contract to make the possibility of nonperformance remote. If a contract includes such a provision, it effectively requires performance, that is, requires the party to deliver an asset that is associated with the underlying. The assessment of the fixed incremental penalty shall be performed only at the contract’s inception. The magnitude of the fixed incremental penalty shall be assessed on a standalone basis as a disincentive for nonperformance, not in relation to the overall penalty. . . .

As indicated in ASC 815-10-15-103(a), penalties for nonperformance might satisfy the criterion of net settlement “if the amount of the penalty is [computed on the basis of] changes in the price of the items that are [covered by] the contract.” However, if the penalty is a fixed amount or fixed amount per unit, it is not considered a net settlement provision under ASC 815. In general, contracts that contain only a variable penalty for nonperformance based on the changes in the price of the underlying items satisfy the net settlement provision and, depending on the other terms of the contract, may qualify as derivatives under ASC 815.

Under ASC 815-10-15-103(c), if the liquidating damages provisions require both a fixed penalty and a variable penalty that are based on changes in the price of the underlying asset, entities must use judgment to determine whether the fixed penalty is sufficiently large “to make the possibility of [net settlement] remote.” Entities should only assess the fixed incremental penalty at the inception of the contract. ASC 815-10-15-103(c) also notes that “the magnitude of the fixed penalty [should] be assessed on a standalone basis as a disincentive for nonperformance, not in relation to the overall penalty.” If the fixed penalty is determined to be sufficiently large to effectively require performance, a net settlement provision is not present. See also ASC 815-10-55-10 through 55-18, which are discussed in Section 1.4.3.2.3.

Example 1-8

Fixed Versus Variable Penalty for Nonperformance

Entity A entered into a forward contract to sell fixed volumes of crude oil per day to Entity B for five years starting in 20X5. For each barrel of crude oil delivered, B will pay A the price equal to NYMEX West Texas Intermediate calendar month average for the month of delivery. If A fails to deliver the contracted daily volumes of crude oil, and such failure is not due to a force majeure event, it pays a penalty per barrel as follows:

Case A — $10

The penalty is not based on the price of the crude oil but rather is a fixed amount per barrel (i.e., $10). Since a fixed penalty for nonperformance is not a net settlement, the penalty does not result in net settlement of the forward contract.

Case B — 1 Percent of the Price

The penalty is based on the price of the crude oil (i.e., a variable penalty). Since the amount of the penalty is computed on the basis of changes in the prices of the items covered by the contract, the forward can be net settled on the basis of the contract terms.

Case C — 1 Percent of the Price Plus a Significant Fixed Penalty per Unit

The penalty is based on the price of the crude oil (i.e., a variable penalty) but also includes a significant fixed penalty per unit. The presence of a fixed significant penalty makes the possibility of nonperformance remote on all dates during the remainder of the contract. Therefore, the penalty does not result in net settlement of the forward contract.

1.4.3.2.3 Asymmetrical Default Provision Does Not Constitute Net Settlement

ASC 815-10

15-103 Penalties for nonperformance may give a contract the characteristic of net settlement. For example: . . .

d. An asymmetrical default provision does not give a commodity forward contract the characteristic described as net settlement beginning in paragraph 815-10-15-100. For related implementation guidance, see the discussion beginning in paragraph 815-10-55-10.

Asymmetrical Default Provision Does Not Constitute Net Settlement

55-10 Many commodity forward contracts contain default provisions that require the defaulting party (the party that fails to make or take physical delivery of the commodity) to reimburse the nondefaulting party for any loss incurred as illustrated in the following examples:

If the buyer under the forward contract (Buyer) defaults (that is, does not take physical delivery of the commodity), the seller under that contract (Seller) will have to find another buyer in the market to take delivery. If the price received by Seller in the market is less than the contract price, Seller incurs a loss equal to the quantity of the commodity that would have been delivered under the forward contract multiplied by the difference between the contract price and the current market price. Buyer must pay Seller a penalty for nonperformance equal to that loss.
If Seller defaults (that is, does not deliver the commodity physically), Buyer will have to find another seller in the market. If the price paid by Buyer in the market is more than the contract price, Seller must pay Buyer a penalty for nonperformance equal to the quantity of the commodity that would have been delivered under the forward contract multiplied by the difference between the contract price and the current market price.

55-11 For example, Buyer agreed to purchase 100 units of a commodity from Seller at $1.00 per unit:

Assume Buyer defaults on the forward contract by not taking delivery and Seller must sell the 100 units in the market at the prevailing market price of $.75 per unit. To compensate Seller for the loss incurred due to Buyer’s default, Buyer must pay Seller a penalty of $25.00 — that is, 100 units × ($1.00 – $.75).
Similarly, assume that Seller defaults and Buyer must buy the 100 units it needs in the market at the prevailing market price of $1.30 per unit. To compensate Buyer for the loss incurred due to Seller’s default, Seller must pay Buyer a penalty of $30.00 — that is, 100 units × ($1.30 – $1.00).

55-12 Note that an asymmetrical default provision is designed to compensate the nondefaulting party for a loss incurred. The defaulting party cannot demand payment from the nondefaulting party to realize the changes in market price that would be favorable to the defaulting party if the contract were honored.

55-13 Under the forward contract in the example, if Buyer defaults when the market price is $1.10, Seller will be able to sell the units of the commodity into the market at $1.10 and realize a $10.00 greater gain than it would have under the contract. In that circumstance, the defaulting Buyer is not required to pay a penalty for nonperformance to Seller, nor is Seller required to pass the $10.00 extra gain to the defaulting Buyer.

55-14 Similarly, if Seller defaults when the market price is $.80, Buyer will be able to buy the units of the commodity in the market and pay $20.00 less than under the contract. In that circumstance, the defaulting Seller is not required to pay a penalty for nonperformance to Buyer, nor is Buyer required to pass the $20.00 savings on to the defaulting Seller.

55-15 In a forward contract with only an asymmetrical default provision, neither Buyer nor Seller can realize the benefits of changes in the price of the commodity through default on the contract. That is, Buyer cannot realize favorable changes in the intrinsic value of the forward contract except in both of the following circumstances:

By taking delivery of the physical commodity
In the event of default by Seller (which is an event beyond the control of Buyer).

55-16 Similarly, Seller cannot realize favorable changes in the intrinsic value of the forward contract except in either of the following circumstances:

By making delivery of the physical commodity
In the event of default by Buyer, which is an event beyond the control of Seller.

55-17 However, a pattern of having the asymmetrical default provision applied in contracts between certain counterparties would indicate the existence of a tacit agreement between those parties that the party in a loss position would always elect the default provision, thereby resulting in the understanding that there would always be net settlement. In that situation, those kinds of commodity contracts would meet the characteristic described as net settlement in paragraph 815-10-15-100.

55-18 In contrast, a contract that permits only one party to elect net settlement of the contract (by default or otherwise), and thus participate in either favorable changes only or both favorable and unfavorable price changes in the underlying, meets the derivative characteristic described in paragraph 815-10-15-83(c) and discussed in paragraph 815-10-15-100 for all parties to that contract. Such a default provision allows one party to elect net settlement of the contract under any pricing circumstance and consequently does not require delivery of an asset that is associated with the underlying. That default provision differs from the asymmetrical default provision in the example contract in paragraph 815-10-55-10 because it is not limited to compensating only the nondefaulting party for a loss incurred and is not solely within the control of the defaulting party.

As noted in ASC 815-10-55-10, commodity forward contracts often “contain default provisions that require the defaulting party (the party that fails to make or take physical delivery of the commodity) to [compensate] the nondefaulting party for any losses incurred.” Such provisions are referred to as asymmetrical default provisions. In such cases, the defaulting party would compensate the nondefaulting party for losses but neither party can demand payment to realize favorable price changes. Therefore, the terms do not meet the explicit or implicit net settlement criteria.

Example 1-9

Asymmetrical Liquidating Damages Provisions

Party A has a contract to purchase 1,000 units of a raw material for $10 per unit. The default provisions of the agreement require A to pay Counterparty B in the event that A defaults and the market price that B can obtain is less than $10 per unit. In addition, the same penalty is required if B defaults and A is required to purchase the raw material in the market for more than $10 per unit. The provisions are shown below.

Contract price: $10 per unit for 1,000 units.

Market Price per Unit	Buyer Defaults	Seller Defaults
$8.00	Buyer pays $2 per unit to the seller.	No payment. Buyer purchases in the market for less.
$12.00	No payment. Seller sells in the market for more.	Seller pays $2 per unit to the buyer.

The liquidating damages provisions in this contract are asymmetrical because the defaulting party only compensates the nondefaulting party for losses but neither party can demand payment to realize favorable price changes. Therefore, the terms do not meet the explicit or implicit net settlement criteria.

If the liquidating damages provisions stipulate a fixed penalty (e.g., in the event of nonperformance, a penalty of $500,000 is assessed), a net settlement provision is not present because the penalty is not based on price changes but rather a predetermined fixed amount.

A contract that only permits one party to elect net settlement of the contract (by default or otherwise), and thus participate in either favorable or unfavorable price changes in the underlying, meets the derivative characteristic described in ASC 815-10-15-83(c) (and discussed in ASC 815-10-15-100) for all parties to that contract. Such a default provision permits one party to elect net settlement of the contract under any pricing circumstance, thereby avoiding the need to deliver an asset associated with the underlying. By contrast, this default provision differs from the asymmetrical default provision in ASC 815-10-55-10 because it is not limited to compensating only the nondefaulting party for losses incurred.

1.4.3.2.4 Structured Settlement as Net Settlement

ASC 815-10

15-104 Upon settlement of a contract, in lieu of immediate net cash settlement of the gain or loss under the contract, the holder may receive a financial instrument involving terms that would provide for the gain or loss under the contract to be received or paid over a specified time period. A contract that provides for such a structured payout of the gain (or loss) resulting from that contract meets the characteristic of net settlement in paragraphs 815-10-15-100 through 15-109 if the fair value of the cash flows to be received (or paid) by the holder under the structured payout are approximately equal to the amount that would have been received (or paid) if the contract had provided for an immediate payout related to settlement of the gain (or loss) under the contract. The fact that a contract accomplishes settlement by requiring the party in a loss position under the contract to make cash payments over a specified timeframe to the party in a gain position (in lieu of immediate cash settlement of the gain) does not preclude the contract from meeting the characteristic of net settlement in those paragraphs.

15-105 A contract that requires additional investing or borrowing to obtain the benefits of the contract’s gain only over time as a traditional adjustment of the yield on the amount invested or the interest element on the amount borrowed does not meet the characteristic of net settlement.

15-106 Contracts that require one party to the contract to invest funds in or borrow funds from the other party so that the party in a gain position under the contract can obtain the value of that gain over time as a nontraditional adjustment of the yield on the amount invested or the interest element on the amount borrowed may meet the characteristic of net settlement. See related implementation guidance beginning in paragraph 815-10-55-19.

Determining Whether a Structured Payout Constitutes Net Settlement

55-19 Paragraph 815-10-15-104 explains that, upon settlement of a contract, in lieu of immediate net cash settlement of the gain or loss under the contract, the holder may receive a financial instrument involving terms that would provide for the gain or loss under the contract to be received or paid over a specified time period. Such a structured payout of the gain on a contract could also be described as an abnormally high yield on a required investment or borrowing in which the overall return is related to the amount of that contract’s gain, in which case the contract would be considered to have met the characteristic of net settlement in paragraph 815-10-15-100.

55-20 Assume, instead, that, upon settlement of a contract, in lieu of immediate net cash settlement of the gain or loss under the contract, the holder is required to invest funds in or borrow funds from the other party so that the party in a gain position under the contract can obtain the value of that gain only over time as a traditional adjustment of the yield on the amount invested or the interest element on the amount borrowed. (A fixed-rate mortgage loan commitment is an example of a contract that requires the party in a gain position under the contract to borrow funds at a below-market interest rate at the time of the borrowing to obtain the benefit of that gain.) Paragraph 815-10-15-105 indicates that such a contract does not meet the characteristic of net settlement in paragraph 815-10-15-100.

55-21 In contrast, paragraph 815-10-15-106 explains that a contract that requires one party to the contract to invest funds in or borrow funds from the other party so that the party in a gain position under the contract can obtain the value of that gain over time as a nontraditional adjustment of the yield on the amount invested or the interest element on the amount borrowed may meet the characteristic of net settlement in paragraph 815-10-15-100. For example, if a contract required the party in a gain position under the contract to invest $100 in the other party’s debt instrument that paid an abnormally high interest rate of 5,000 percent per day for a term whose length is dependent on the changes in the contract’s underlying, an analysis of those terms would lead to the conclusion that the contract’s settlement terms were in substance a structured payout of the contract’s gain and thus that contract would be considered to have met the characteristic of net settlement in that paragraph.

In a structured payout, the net gain or loss under the contract is paid over several periods rather than as an immediate cash payment. The holder of the contract may receive a financial instrument that provides for the gain or loss to be received or paid over a specific period. As indicated in ASC 815-10-15-104, “if the fair value of the cash flows to be received (or paid) by the holder under the structured payout are approximately equal to the amount that would have been received (or paid) if the contract had provided for an immediate payout related to settlement of the gain (or loss) under the contract,” the contract meets the requirements for net settlement in ASC 815-10-15-100 through 15-109. In other words, even a contract that calls for settlement through cash payments over a specified period (instead of immediate payment) from the party in a loss position to the party in a gain position can still meet the criteria for net settlement.

1.4.3.2.5 Net Settlement of a Debt Instrument Through Exercise of an Embedded Put Option or a Call Option

ASC 815-10

15-107 The potential settlement of the debtor’s obligation to the creditor that would occur upon exercise of a put option or call option embedded in a debt instrument meets the net settlement criterion as discussed beginning in paragraph 815-10-15-100 because neither party is required to deliver an asset that is associated with the underlying. Specifically:

The debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option.
The creditor does not receive an asset associated with the underlying.

15-108 The guidance in the preceding paragraph shall be applied under both of the following circumstances:

When applying paragraph 815-15-25-1(c) to a put option or call option (including a prepayment option) embedded in a debt instrument
When analyzing the net settlement criterion (see guidance beginning in paragraph 815-10-15-100) for a freestanding call option held by the debtor on its own debt instrument and for a freestanding put option issued by the debtor on its own debt instrument.

15-109 The guidance in paragraph 815-10-15-107 shall not be applied under either of the following circumstances:

To put or call options that are added to a debt instrument by a third party contemporaneously with or after the issuance of a debt instrument. (In that circumstance, see paragraph 815-10-15-6.)
By analogy to an embedded put or call option in a hybrid instrument that does not contain a debt host contract.

Under ASC 815-10-15-107 through 15-109, the “potential settlement of a debtor’s obligation to the creditor that would occur upon the exercise of a put option or call option [(including a prepayment option)] embedded in a debt instrument meets the net settlement criterion . . . in paragraph 815-10-15-100.” That paragraph states, in part, that “neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount.” Accordingly, a call, put, or other redemption feature embedded in a debt host meets the net settlement characteristic in the definition of a derivative irrespective of whether the debt host contract is RCC. The guidance in ASC 815-10-15-107 through 15-109 does not apply to calls, puts, or other redemption features that are embedded in equity host contracts. See Section 6.4.4 for further discussion of this analysis for embedded features in debt hosts.

1.4.3.2.6 Contractual Net Settlement Only in Contingent Scenarios

Freestanding contracts may have terms that permit net settlement only upon the occurrence of a contingent event. Guidance in ASC 815 does not explicitly address whether such contracts meet the net settlement criterion under ASC 815-10-15-83(c)(1), which states that the criterion is satisfied if the contract’s “terms implicitly or explicitly require or permit net settlement.”

We believe that contracts that provide for contingent net settlement contain the characteristic of net settlement. In practice, freestanding contracts that explicitly permit net settlement at the election of either party to the contract are considered to meet the net settlement criterion under ASC 815-10-15-83(c)(1) irrespective of whether the net settlement feature is dependent on the occurrence or nonoccurrence of a contingent event. Further, ASC 815-10-15-103 indicates that a “penalty for nonperformance in a purchase order is a net settlement provision if the amount of the penalty is based on changes in the price of the items that are the subject of the contract.” That is, such guidance implies that net settlement upon the occurrence of a contingent event (nonperformance) constitutes net settlement as defined in ASC 815. In addition, we believe that ignoring provisions that are only contingently exercisable is generally inconsistent with ASC 815 principles (e.g., contingent embedded features are still evaluated for potential bifurcation).

Example 1-10

Contingent Net Settlement

ABC issues a warrant to XYZ to purchase shares of ABC’s common stock. The warrant may be (1) exercised on a gross basis at XYZ’s discretion by notice of exercise and delivery of cash to ABC or (2) net share settled upon an initial public offering (IPO) or a sale of ABC. The warrant meets the conditions under ASC 815-10-15-83(a) and (b).

Although net settlement of the warrant is contingent upon an IPO or sale of ABC, the criterion in ASC 815-10-15-83(c)(1) is met because the warrant explicitly permits and provides for net share settlement.

Note that the fact pattern described above differs from that of a warrant that can only be exercised on a gross basis but whose shares could theoretically become RCC after an IPO. It would not be appropriate to conclude that a warrant meets the net settlement criterion simply because the warrant would meet the net settlement criterion if the shares became RCC in the future. (See Section 1.4.3.4 for further discussion of instruments that are RCC.)

1.4.3.3 Net Settlement Through a Market Mechanism

ASC 815-10

15-110 In this form of net settlement, one of the parties is required to deliver an asset of the type described in paragraph 815-10-15-100, but there is an established market mechanism that facilitates net settlement outside the contract. (For example, an exchange that offers a ready opportunity to sell the contract or to enter into an offsetting contract.) Market mechanisms may have different forms. Many derivative instruments are actively traded and can be closed or settled before the contract’s expiration or maturity by net settlement in active markets.

15-111 The term market mechanism is to be interpreted broadly and includes any institutional arrangement or other agreement having the requisite characteristics. Regardless of its form, an established market mechanism must have all of the following primary characteristics:

It is a means to settle a contract that enables one party to readily liquidate its net position under the contract. A market mechanism is a means to realize the net gain or loss under a particular contract through a net payment. Net settlement may occur in cash or any other asset. A method of settling a contract that results only in a gross exchange or delivery of an asset for cash (or other payment in kind) does not satisfy the requirement that the mechanism facilitate net settlement.
It results in one party to the contract becoming fully relieved of its rights and obligations under the contract. A market mechanism enables one party to the contract to surrender all future rights or avoid all future performance obligations under the contract. Contracts that do not permit assignment of the contract from the original issuer to another party do not meet the characteristic of net settlement through a market mechanism. The ability to enter into an offsetting contract, in and of itself, does not constitute a market mechanism because the rights and obligations from the original contract survive. The fact that an entity has offset its rights and obligations under an original contract with a new contract does not by itself indicate that its rights and obligations under the original contract have been relieved. This applies to contracts regardless of whether either of the following conditions exists:
1. The asset associated with the underlying is financial or nonfinancial.
2. The offsetting contract is entered into with the same counterparty as the original contract or a different counterparty (unless an offsetting contract with the same counterparty relieves the entity of its rights and obligations under the original contract, in which case the arrangement does constitute a market mechanism). (Example 6 [see paragraph 815-10-55-91] illustrates this guidance.)
Liquidation of the net position does not require significant transaction costs. For purposes of assessing whether a market mechanism exists, an entity shall consider transaction costs to be significant if they are 10 percent or more of the fair value of the contract. Whether assets deliverable under a group of futures contracts exceeds the amount of assets that could rapidly be absorbed by the market without significantly affecting the price is not relevant to this characteristic. The lack of a liquid market for a group of contracts does not affect the determination of whether there is a market mechanism that facilitates net settlement because the test focuses on a singular contract. An exchange offers a ready opportunity to sell each contract, thereby providing relief of the rights and obligations under each contract. The possible reduction in price due to selling a large futures position is not considered to be a transaction cost.
Liquidation of the net position under the contract occurs without significant negotiation and due diligence and occurs within a time frame that is customary for settlement of the type of contract. A market mechanism facilitates easy and expedient settlement of the contract. As discussed under the primary characteristic in (a), those qualities of a market mechanism do not preclude net settlement in assets other than cash.

15-113 Entities shall consider the indicators in the following paragraph for each of the primary characteristics in determining whether a method of settling a contract qualifies as an established market mechanism. All of the indicators need not be present for an entity to conclude that a market mechanism exists for a particular contract.

15-114 The following are indicators that the primary characteristic in paragraph 815-10-15-111(a) is met:

Access to potential counterparties is available regardless of the seller’s size or market position.
Risks assumed by a market maker as a result of acquiring a contract can be transferred by a means other than by repackaging the original contract into a different form.

15-115 The following are indicators that the primary characteristic in paragraph 815-10-15-111(b) is met:

There are multiple market participants willing and able to enter into a transaction at market prices to assume the seller’s rights and obligations under a contract.
There is sufficient liquidity in the market for the contract, as indicated by the transaction volume as well as a relatively narrow observable bid-ask spread.

15-116 The following are indicators that primary characteristic in paragraph 815-10-15-111(d) is met:

Binding prices for the contract are readily obtainable.
Transfers of the instrument involve standardized documentation (rather than contracts with entity-specific modifications) and standardized settlement procedures.
Individual contract sales do not require significant negotiation and unique structuring.
The closing period is not extensive because of the need to permit legal consultation and document review.

15-118 The evaluation of whether a market mechanism exists shall be performed at inception and on an ongoing basis throughout a contract’s life. Example 4, Case A (see paragraph 815-10-55-86) illustrates this guidance.

Example 4: Net Settlement at Inception and Throughout a Contract’s Life

55-84 As required by paragraphs 815-10-15-110 through 15-118 and 815-10-15-119 through 15-120, respectively, the evaluation of whether a market mechanism exists and whether items to be delivered under a contract are readily convertible to cash must be performed at inception and on an ongoing basis throughout a contract’s life. For example, if a market develops, if an entity effects an initial public offering, or if daily trading volume changes for a sustained period of time, then those events need to be considered in reevaluating whether the contract meets the definition of a derivative instrument. Similarly, if events occur after the inception or acquisition of a contract that would cause a contract that previously met the definition of a derivative instrument to cease meeting the criteria (for example, an entity becomes delisted from a national stock exchange), then that contract cannot continue to be accounted for under this Subtopic. The guidance in paragraphs 815-10-15-125 through 15-127 about assessing the significance of transaction costs is not relevant when determining whether such a contract no longer meets the definition of a derivative instrument.

55-85 The following Cases illustrate the importance of ongoing evaluation:

Market mechanism develops after contract inception (Case A). . . .

Case A: Market Mechanism Develops After Contract Inception

55-86 A purchase contract for future delivery of commodity X is entered into and, at the inception of the contract, the market for contracts on commodity X is a relatively thin market, such that brokers do not stand ready to buy and sell the contracts. As time passes, the market for commodity X matures and broker-dealer networks develop. The existence of the broker-dealer market and the ability of the purchaser to be relieved of its rights and obligations under the purchase contract are consistent with the characteristics of a market mechanism as discussed beginning in paragraph 815-10-15-110. Accordingly, the purchase contract will have the characteristics of net settlement as defined by paragraph 815-10-15-110 as broker-dealer networks develop.

A market mechanism enables one of the parties to a contract, which otherwise requires physical delivery, to net settle. The determination of whether a market mechanism exists should be made at the contract’s inception, throughout the life of the contract, and when its terms are modified. Such a determination should be made independently by each of the contract’s counterparties.

ASC 815-10-15-111 states that “[t]he term market mechanism is to be interpreted broadly and includes any institutional arrangement or other agreement having the requisite characteristics” described in that paragraph. Accordingly, an institutional arrangement or other agreement that provides a party with the ability to enter into an offsetting contract (without significant transaction costs) and relieves that party of all of its rights and obligations under the original contract is a market mechanism.

The net settlement characteristic is met if an established market mechanism exists that facilitates net settlement outside of the contract, such as the ability to sell the derivative on an exchange. This condition does not apply to embedded features since they cannot be settled separately from their host contracts. If a feature is legally detachable and separately exercisable from a contract, it is considered a separate freestanding financial instrument, not an embedded feature.

Example 1-11

Determining Whether a Market Mechanism Exists

On January 1, 20X1, XYZ enters into a long futures contract (contract to buy) with a futures exchange. The contract requires XYZ to take physical delivery of 100,000 bushels of corn on March 1, 20X1. On February 1, 20X1, XYZ enters into an offsetting short futures contract (contract to sell), with the same futures exchange, to deliver 100,000 bushels of corn on March 1, 20X1. Upon entering into the offsetting short position, the futures exchange relieves XYZ of its rights and obligations under both the long and short futures contracts since the futures exchange in the United States acts as the legal counterparty for all transactions. The existence of the futures exchange means that there is a market mechanism for net settling the original derivative contract; therefore, a futures contract will always be a derivative at its inception regardless of whether the party intends to close out its futures position at a future date and take delivery of the asset.

By contrast, assume the same fact pattern as described above, except that XYZ enters into a long over-the-counter commodity contract that is not traded on a futures exchange. Even though the contract is not exchange-traded, there are brokers who stand ready to buy and sell commodity contracts. XYZ can enter into an offsetting short position and be relieved of its right to accept delivery of the commodity and its obligation to make payment under the contract. To do so, it would arrange for a broker to accept delivery and pay the broker a commission plus any difference between the contract price and the current market price of the commodity. The commission paid to the broker would not be significant. Since brokers stand ready to relieve entities of their rights and obligations and XYZ will not incur significant transaction costs, a market mechanism for net settling the contract exists.

Alternatively, if XYZ had entered into the original contract in an over-the-counter market and had the ability to enter into an offsetting short position that would not relieve it of all of its rights and obligations under the original over-the-counter contract, a market mechanism would not have existed. See also ASC 815-10-15-113 through 15-116.

1.4.3.3.1 Contracts With Market Makers

Most contracts entered into with a market maker would appear to have a market mechanism because the market maker should be willing to enter into an offsetting contract and relieve the entity of all of its rights and obligations under the original contract.

Example 1-12

Market Mechanism and Market Maker Contracts

Company A enters into a power purchase agreement with Market Maker B that requires A to purchase 1,000 megawatts of electricity at a fixed price on certain dates. It is presumed that B will enter into an offsetting contract (power sales agreement) with A if A chooses to close its original position. Therefore, A would be able to obtain relief from all of its rights and obligations under most contracts entered into with the market maker.

An exception to the general conclusion reached in the example above would be if the two contracts could not be netted because of the bankruptcy of one of the parties. In such a case, Company A would retain the counterparty risk with respect to Market Maker B. However, since most such transactions are conducted under enforceable master netting arrangements, this circumstance is expected to be rare. The determination of whether a market mechanism exists should be made throughout the life of the contract (see ASC 815-10-55-84 through 55-89).

1.4.3.3.2 Market Mechanism on Non-Exchange-Traded Contracts

ASC 815-10

15-117 As noted in the primary characteristic in paragraph 815-10-15-111(b), an assessment of the substance of any assignment clause is required to determine whether that assignment clause precludes a party from being relieved of all rights and obligations under the contract. Although permission to assign a contract shall not be unreasonably withheld by the counterparty in accordance with the terms of a contract, an assignment feature cannot be viewed simply as a formality because it may be invoked at any time to prevent the nonassigning party from being exposed to unacceptable credit or performance risk. Accordingly, the existence of an assignment clause may or may not permit a party from being relieved of its rights and obligations under the contract. If it is remote that the counterparty will withhold permission to assign the contract, the mere existence of the clause shall not preclude the contract from possessing the net settlement characteristic described in paragraph 815-10-15-110 as a market mechanism. Such a determination requires assessing whether a sufficient number of acceptable potential assignees exist in the marketplace such that assignment of the contract would not result in imposing unacceptable credit risk or performance risk on the nonassigning party. Consideration shall be given to past counterparty and industry practices regarding whether permission to be relieved of all rights and obligations under similar contracts has previously been withheld. However, if it is reasonably possible or probable that the counterparty will withhold permission to assign the contract, the contract does not possess the net settlement characteristic described in paragraph 815-10-15-110 as a market mechanism.

ASC 815 provides limited guidance on evaluating whether a market mechanism exists when a contract is not exchange-traded. The primary consideration in such an evaluation is determining whether one of the parties to the contract could be relieved of all of its rights and obligations under the terms of the contract other than through physical settlement. This relief could be obtained through a transfer or assignment provision that permits one party (or both parties) to the contract to transfer its contract to a third party and to be relieved of all of its rights and obligations under the contract. However, if a contract could be transferred but there are no parties who would accept such a transfer or assignment, no market mechanism would exist. If an entity retains counterparty risk when transferring a contract, it has not been relieved of its rights and obligations.

For example, a contract may state that an entity should obtain the counterparty’s prior written approval before transferring its interest in the contract and that such approval would not be unreasonably withheld. If the counterparty approves the transfer or assignment and the party is relieved of its rights and obligations under the contract, a market mechanism exists. An entity should use judgment in evaluating whether permission will be granted in such a case.

Under ASC 815-10-15-117, if it is reasonably possible or probable that permission to transfer or assign a contract would be withheld, the transfer or assignment provision does not provide a mechanism to access a market. In other words, for a market mechanism to exist, the likelihood that the counterparty will withhold such permission should be remote (there also needs to be a market for such assignment). If approval has not previously been granted (either by that counterparty or other counterparties in similar transactions), that factor in and of itself is not necessarily sufficient to determine that approval would not be granted in the future. However, barring any other indicators, the lack of history of granting approval may be strong evidence that it is not remote that such permission would be withheld, which would support a conclusion that no market mechanism exists.

On the other hand, some contracts specifically state that neither counterparty may transfer its position to a third party. In this circumstance, unless there is evidence to the contrary (e.g., a history or pattern of settling the contract net or through an assignment), a market mechanism for net settlement does not exist.

Some contracts are silent on transferability, which raises questions about whether they could be transferred to another party and, if so, whether the rights and obligations of the transferring party would be relieved by doing so. In such contracts, whether an entity has the ability to access a market is a legal issue that should be evaluated by a legal specialist under the laws governing the contract. In some situations, a contract may be silent regarding transferability but one of the counterparties may have a previous pattern of settling such contracts net by transferring them and being relieved of its rights and obligations. An entity’s ability to transfer and be relieved of its rights and obligations, while not contractually permitted, may provide strong evidence that a formal or informal side agreement exists.

In some industries, an entity may have the ability to enter into a contract to pair off its long or short position. Generally, a pair-off provides an economic offset to the original contract, but it does not provide for a release of the party’s rights and obligations under the original contract (see ASC 815-10-55-91 through 55-98). The ability to enter into a pair-off should be evaluated on the basis of individual facts and circumstances to determine whether the pair-off constitutes a market mechanism that relieves the party of its rights and obligations under the original contract.

1.4.3.4 Net Settlement by Delivery of a Derivative Instrument or an Asset That Is RCC

ASC 815-10 — Glossary

Readily Convertible to Cash

Assets that are readily convertible to cash have both of the following:

Interchangeable (fungible) units
Quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.

(Based on paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises.)

ASC 815-10

15-119 In this form of net settlement, one of the parties is required to deliver an asset of the type described in paragraph 815-10-15-100, but that asset is readily convertible to cash or is itself a derivative instrument.

15-120 An example of a contract with this form of net settlement is a forward contract that requires delivery of an exchange-traded equity security. Even though the number of shares to be delivered is the same as the notional amount of the contract and the price of the shares is the underlying, an exchange-traded security is readily convertible to cash. Another example is a swaption — an option to require delivery of a swap contract, which is a derivative instrument.

15-121 Examples of assets that are readily convertible to cash include a security or commodity traded in an active market and a unit of foreign currency that is readily convertible into the functional currency of the reporting entity.

15-122 An asset (whether financial or nonfinancial) shall be considered to be readily convertible to cash only if the net amount of cash that would be received from a sale of the asset in an active market is either equal to or not significantly less than the amount an entity would typically have received under a net settlement provision. The net amount that would be received upon sale need not be equal to the amount typically received under a net settlement provision. Parties generally should be indifferent as to whether they exchange cash or the assets associated with the underlying, although the term indifferent is not intended to imply an approximate equivalence between net settlement and proceeds from sale in an active market.

15-123 The form of a financial instrument is important; individual instruments cannot be combined for evaluation purposes to circumvent compliance with the criteria beginning in paragraph 815-10-15-119. Example 8 (see paragraph 815-10-55-111) illustrates this guidance.

Asset’s Suitability as Collateral Does Not Equate to Asset Being Readily Convertible to Cash

15-129 The ability to use a security that is not publicly traded or an agricultural or mineral product without an active market as collateral in a borrowing does not, in and of itself, mean that the security or the commodity is readily convertible to cash.

The net settlement characteristic is met if the contract is settled in a manner in which the recipient’s position is not substantially different from that in a contractual net settlement. Thus, if a contract is settled as a result of a two-way (gross) exchange of items that are RCC or are derivatives, the net settlement characteristic is met. ASC 815-10-20 specifies that an item is RCC if it has both “[i]nterchangeable (fungible) units” and “[q]uoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.”

As stated in ASC 815-10-15-129, even if any entity is able to use as loan collateral “a security that is not publicly traded or [a commodity] without an active market,” such ability “does not, in and of itself, mean that the security or the commodity is readily convertible to cash.”

1.4.3.4.1 Determining Whether There Is an Active Market That Can Rapidly Absorb Shares of Stock

ASC 815-10

Determining Whether Shares of Stock Are Readily Convertible to Cash

15-130 A security that is publicly traded but for which the market is not very active is readily convertible to cash if the number of shares or other units of the security to be exchanged is small relative to the daily transaction volume. That same security would not be readily convertible if the number of shares to be exchanged is large relative to the daily transaction volume.

Example 7: Net Settlement — Readily Convertible to Cash — Effect of Daily Transaction Volumes

55-99 The following Cases illustrate consideration of the relevance of daily transaction volumes to the characteristic of net settlement in deciding whether, from the investor’s perspective, the convertible bond contains an embedded derivative that must be accounted for separately:

Single bond with multiple conversion options (Case A)
Multiple bonds each having single conversion option (Case B).

55-100 The Cases illustrate that the form of the financial instrument is important; paragraph 815-10-15-123 explains that individual instruments cannot be combined for evaluation purposes to circumvent compliance with the criteria beginning in paragraph 815-10-15-119. Further, paragraph 815-10-15-111(c) explains that contracts shall be evaluated on an individual basis, not on an aggregate-holdings basis.

Case A: Single Bond With Multiple Conversion Options

55-101 Investor A holds a convertible bond classified as an available-for-sale security under Topic 320. The bond has all of the following additional characteristics:

It is not exchange-traded and can be converted into common stock of the debtor, which is traded on an exchange.
It has a face amount of $100 million and is convertible into 10 million shares of common stock.
It may be converted in full or in increments of $1,000 immediately or at any time during the next 2 years.
If it were converted in a $1,000 increment, Investor A would receive 100 shares of common stock.

55-102 Assume further that the market condition for the debtor’s stock is such that up to 500,000 shares of its stock can be sold rapidly without the share price being significantly affected.

55-103 The embedded conversion option meets the criteria in paragraph 815-10-15-83(a) through (b) but does not meet the criteria in paragraphs 815-10-15-100 and 815-10-15-110, in part because the option is not traded and it cannot be separated and transferred to another party.

55-104 It is clear that the embedded equity conversion feature is not clearly and closely related to the debt host instrument.

55-105 The bond may be converted in $1,000 increments and those increments, by themselves, may be sold rapidly without significantly affecting price, in which case the criteria discussed beginning in paragraph 815-10-15-119 would be met. However, if the holder simultaneously converted the entire bond, or a significant portion of the bond, the shares received could not be readily converted to cash without incurring a significant block discount.

55-106 From Investor A’s perspective, the conversion option should be accounted for as a compound embedded derivative in its entirety, separately from the debt host, because the conversion feature allows the holder to convert the convertible bond in 100,000 increments and the shares converted in each increment are readily convertible to cash under the criteria discussed beginning in paragraph 815-10-15-119. Investor A need not determine whether the entire bond, if converted, could be sold without affecting the price.

55-107 Because the $100 million bond is convertible in increments of $1,000, the convertible bond is essentially embedded with 100,000 equity conversion options, each with a notional amount of 100 shares. Each of the equity conversion options individually has the characteristic of net settlement discussed beginning in paragraph 815-10-15-119 because the 100 shares to be delivered are readily convertible to cash. Because the equity conversion options are not clearly and closely related to the host debt instrument, they must be separately accounted for. However, because an entity cannot identify more than 1 embedded derivative that warrants separate accounting, the 100,000 equity conversion options must be bifurcated as a single compound derivative. (Paragraphs 815-15-25-7 through 25-10 say an entity is not permitted to account separately for more than one derivative feature embedded in a single hybrid instrument.)

55-108 There is a substantive difference between a $100 million convertible debt instrument that can be converted into equity shares only at one time in its entirety and a similar instrument that can be converted in increments of $1,000 of tendered debt; the analysis of the latter should not presume equality with the former.

Case B: Multiple Bonds Each Having Single Conversion Option

55-109 Investor B has 100,000 individual $1,000 bonds that each convert into 100 shares of common stock. Assume those bonds are individual instruments but they were issued concurrently to Investor B.

55-110 From Investor B’s perspective, the individual bonds each contain an embedded derivative that must be separately accounted for. Each individual bond is convertible into 100 shares, and the market would absorb 100 shares without significantly affecting the price of the stock.

When a company enters into a contract, it should evaluate whether there is an active exchange or market that quotes market prices for the type of asset to be delivered under the contract. The entity should continue to make such evaluations throughout the life of the contract.

If a contract requires physical settlement but the asset under the contract is RCC, the contract can be de facto net settled according to ASC 815. In a manner consistent with the RCC definition in the ASC master glossary, an element of whether a contract is RCC depends on determining how much the market can “rapidly absorb” without significantly affecting the price. This is a matter of judgment and will depend primarily upon the daily average trading volume of the asset under contract. This evaluation should be made on an ongoing basis over the life of the contract (as discussed in ASC 815-10-55-84 through 55-89).

When determining what the market can rapidly absorb upon the settlement of a contract without significantly affecting the price, an entity should contemplate this amount on the basis of the smallest increment that can be exercised at any given time. This concept is illustrated by the guidance in ASC 815-10-55-99 through 55-110, shown above. For example, when evaluating whether the shares issuable upon settlement of the convertible bond described in Case A of Example 7 in ASC 815-10-55-101 through 55-108 are RCC, the entity does not need to determine whether the market could rapidly absorb all of the shares that would be issuable upon conversion of the entire bond. Rather, since the conversion feature is exercisable in $1,000 increments of the bond, it would only be necessary to determine that the market could rapidly absorb the shares issuable upon the settlement of a single $1,000 bond to conclude that the underlying shares are RCC.

In practice, contracts requiring delivery, on a single day, of 10 percent or less of the average daily volume are considered RCC. If contracts require delivery, on a single day, of more than 10 percent of the average daily volume, entities should consider consulting a market specialist who is knowledgeable about whether the number of shares stipulated could be rapidly absorbed in the market without significantly affecting the price.

As illustrated in ASC 815-10-55-99 through 55-110, the evaluation of whether a contract is RCC is performed on the basis of the smallest increment in which it can be settled.

Example 1-13

Shares of Stock Are RCC

Company T has a forward contract to purchase 100,000 shares of Company C’s common stock, which is traded on the Nasdaq exchange, in one year. The forward price on the contract is $100 per share. On a specified single date in the future, the contract requires T to take delivery of the 100,000 shares in exchange for $10 million in cash (i.e., the contract does not provide for explicit net settlement and, in this example, it is assumed that no market mechanism exists for the forward contract). The average daily trading volume of C’s common shares is 1 million shares. Because 100,000 shares only represents 10 percent of the average daily trading volume, T determines that a block of 100,000 of C’s common shares could be rapidly absorbed in the market without significantly affecting the price. Therefore, the asset to be delivered under the forward contract is RCC.

Example 1-14

Shares of Stock May Not Be RCC

Assume the same facts as in the example above, except that Company T’s contract allows for the purchase of 500,000 shares of Company C’s common stock. Since the average daily trading volume of C’s common shares is 1 million shares and thus 500,000 shares equals 50 percent of the average daily trading volume, it would typically be reasonable to conclude that the shares could not be rapidly absorbed in the market without significantly affecting the price. As a result, T determines that the shares would not be RCC.

ASC 815-10-15-128 indicates that when considering whether the market “can rapidly absorb the quantity held by the entity” upon settlement of a contract that involves multiple deliveries of the same asset, an entity should perform separate evaluations for the quantity expected in each delivery. Example 8 in ASC 815-10-55-111 through 55-117 illustrates this concept.

ASC 815-10

Contracts Involving Multiple Deliveries

15-128 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 in the definition of readily convertible to cash shall be applied separately to the expected quantity in each delivery.

Example 8: Net Settlement — Effect of Multiple Deliveries

55-111 This Example illustrates the effect of multiple deliveries on the consideration of net settlement described in Section 815-10-15. 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).

55-112 The supply contract does not contain a net settlement provision as described in paragraphs 815-10-15-100 through 15-109.

55-113 The 5-year commodity supply contract does not meet the net settlement characteristic in paragraph 815-10-15-110 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 entity 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 this instance, 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 815-10-15-110 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.

55-114 The definition of a derivative instrument in this Subtopic must be applied based on the actual terms of the contract, including its maturity date and the total quantity of the underlying. This Subtopic does not permit bifurcation of a 5-year contract into 5 annual contracts, 60 monthly contracts, or 1,826 daily contracts in an attempt to assert that only a portion of the contract meets the definition of a derivative instrument. 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.

55-115 Based on the guidance in paragraph 815-10-15-3, the five-year commodity supply contract in the example, would, at the beginning of the fifth year, be reevaluated to determine whether the contract meets the net settlement characteristic in paragraph 815-10-15-110 and would likely meet the characteristic because a forward market for the contract would then exist for the remaining term of the contract.

55-116 The five-year commodity supply contract meets the net settlement characteristic as discussed beginning in paragraph 815-10-15-119. The criterion discussed beginning in that paragraph 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.

55-117 This Example does not address whether or not the contract would qualify for the normal purchases and normal sales scope exception as discussed beginning in paragraph 815-10-15-22.

1.4.3.4.2 Evaluating the Impact of Conversion Costs on the RCC Assessment

ASC 815-10

Effect of Conversion Costs

15-125 If an entity determines that the estimated costs that would be incurred to immediately convert the asset to cash are not significant, then receipt of that asset puts the entity in a position not substantially different from net settlement. Therefore, an entity shall evaluate, in part, the significance of the estimated costs of converting the asset to cash in determining whether those assets are readily convertible to cash.

15-126 For purposes of assessing significance of such costs, an entity shall consider those estimated conversion costs to be significant only if they are 10 percent or more of the gross sales proceeds (based on the spot price at the inception of the contract) that would be received from the sale of those assets in the closest or most economical active market.

15-127 The assessment of the significance of those conversion costs shall be performed only at inception of the contract.

An equity conversion feature embedded in a debt host would be considered RCC if the shares that would be delivered upon conversion could be rapidly absorbed in the market without significantly affecting the stock price. If the conversion costs (e.g., sales commissions on the quoted price) would exceed 10 percent of the spot price at the inception of the contract, however, the feature would not be considered RCC (see ASC 815-10-15-126).

When evaluating whether a physically settled commodity contract is RCC, an entity should consider all costs it would expect to incur in taking possession of the asset and converting it to cash (e.g., transportation, temporary storage). Similarly, if such costs exceed 10 percent of the spot price at the contract’s inception, the contract would not be considered RCC.

1.4.3.4.3 Evaluating the Impact of Transfer Restrictions on the RCC Assessment

ASC 815-10

Determining Whether Shares of Stock Are Readily Convertible to Cash

15-131 Shares of stock in a publicly traded entity to be received upon the exercise of a stock purchase warrant do not meet the characteristic of being readily convertible to cash if both of the following conditions exist:

The stock purchase warrant is issued by an entity for only its own stock (or stock of its consolidated subsidiaries).
The sale or transfer of the issued shares is restricted (other than in connection with being pledged as collateral) for a period of 32 days or more from the date the stock purchase warrant is exercised.

15-132 Restrictions imposed by a stock purchase warrant on the sale or transfer of shares of stock that are received from the exercise of that warrant issued by an entity for other than its own stock (whether those restrictions are for more or less than 32 days) do not affect the determination of whether those shares are readily convertible to cash. The accounting for restricted stock to be received upon exercise of a stock purchase warrant shall not be analogized to any other type of contract.

15-133 Newly outstanding shares of common stock in a publicly traded company to be received upon exercise of a stock purchase warrant cannot be considered readily convertible to cash if, upon issuance of the shares, the sale or transfer of the shares is restricted (other than in connection with being pledged as collateral) for more than 31 days from the date the stock purchase warrant is exercised (not the date the warrant is issued), unless the holder has the power by contract or otherwise to cause the requirement to be met within 31 days of the date the stock purchase warrant is exercised.

15-134 In contrast, if the sale of an actively traded security is restricted for 31 days or less from the date the stock purchase warrants are exercised, that limitation is not considered sufficiently significant to serve as an impediment to considering the shares to be received upon exercise of those stock purchase warrants as readily convertible to cash.

15-135 The guidance that a restriction for more than 31 days prevents the shares from being considered readily convertible to cash applies only to stock purchase warrants issued by an entity for its own shares of stock, in which case the shares being issued upon exercise are newly outstanding (including issuance of treasury shares) and are restricted with respect to their sale or transfer for a specified period of time beginning on the date the stock purchase warrant is exercised.

15-136 However, even if the sale or transfer of the shares is restricted for 31 days or less after the stock purchase warrant is exercised, an entity still must evaluate both of the following criteria:

Whether an active market can rapidly absorb the quantity of stock to be received upon exercise of the warrant without significantly affecting the price
Whether the other estimated costs to convert the stock to cash are expected to be not significant. (The assessment of the significance of those conversion costs shall be performed only at inception of the contract.)

Thus, the guidance in paragraph 815-10-15-122 shall be applied to those stock purchase warrants with sale or transfer restrictions of 31 days or less on the shares of stock.

15-137 If the shares of an actively traded common stock to be received upon exercise of the stock purchase warrant can be reasonably expected to qualify for sale within 31 days of their receipt, such as may be the case under SEC Rule 144, Selling Restricted and Control Securities, or similar rules of the SEC, any initial sales restriction is not an impediment to considering those shares as readily convertible to cash, as that phrase is used in paragraph 815-10-15-119. (However, a restriction on the sale or transfer of shares of stock that are received from an entity other than the issuer of that stock through the exercise of another option or the settlement of a forward contract is not an impediment to considering those shares readily convertible to cash, regardless of whether the restriction is for a period that is more or less than 32 days from the date of exercise or settlement.)

15-138 Paragraph 815-10-15-141 explains that the guidance in the Certain Contracts on Debt and Equity Securities Subsections applies to those warrants that are not derivative instruments subject to this Topic but that involve the acquisition of securities that will be accounted for under either Topic 320 or Topic 321. However, such warrants are not eligible to be hedging instruments.

ASC 815-10-15-133 states, in part, that “[n]ewly outstanding shares of common stock in a publicly traded company to be received upon exercise of a stock purchase warrant cannot be considered readily convertible to cash if, upon issuance of the shares, the sale or transfer of the shares is restricted (other than in connection with being pledged as collateral) for more than 31 days from the date the stock purchase warrant is exercised (not the date the warrant is issued).” However, ASC 815-10-15-136 notes that even when the restriction period is 31 days or less, entities still need to evaluate “[w]hether an active market can rapidly absorb the quantity of the issuing company’s stock to be received upon exercise of the warrant without significantly affecting the price [and whether] the other estimated costs to convert the stock to cash are expected to not be significant.” Entities should only assess the significance of those conversion costs at the inception of the contract. Accordingly, entities should apply the guidance in ASC 815-10-15-125 through 15-127 to shares of stock received from stock purchase warrants that are restricted for 31 days or less. Conversely, if the shares are restricted for more than 31 days, the shares would not be considered RCC.

In any case in which the underlying shares are restricted, securities law counsel should be consulted to determine the nature of the restriction and whether such restriction precludes any sale of the shares.

As noted in ASC 815-10-15-132, “[r]estrictions imposed by a stock purchase warrant on the sale or transfer of shares of stock that are received from the exercise of that warrant issued by an entity for other than its own stock (whether those restrictions are for more or less than 32 days) do not affect the determination of whether those shares are readily convertible to cash.”

Example 1-15

Assessment of RCC Criterion When Restrictions Exceed 31 Days

Company X acquires a warrant from Company Z to purchase 1,000 shares of Z’s stock, which is traded on the New York Stock Exchange. The average daily volume traded is 5 million shares. Under the terms of the warrant, X cannot sell any shares of Z’s stock it receives upon the exercise of the warrant for 45 days. Therefore, the shares of Z’s stock underlying the warrant are not considered RCC because the restriction period (45 days) is longer than 31 days.

Example 1-16

Assessment of RCC Criterion When Sales Are Limited to Qualified Institutional Buyers

Company X acquires a warrant from Company Y to purchase 1,000 shares of Y’s stock, which is traded on the New York Stock Exchange. The average daily volume of trading is 4 million shares. Under the terms of the warrant, all shares of Y’s stock received by X upon the exercise of the warrant are subject to Rule 144 of the Securities Act of 1933 (the “Securities Act”) (i.e., they may only be sold to qualified institutional buyers [QIBs]). Under ASC 815-10-15-137, if shares of an actively traded common stock that would be received upon exercise of a stock purchase warrant are subject to Rule 144 restrictions, such shares can reasonably be expected to qualify for sale within 31 days of their receipt; accordingly, they could be considered RCC. Therefore, despite the Rule 144 restrictions, X can conclude that it will be able to sell Y’s stock (i.e., it may be sold to QIBs during the restriction period). In this case, the number of shares underlying the warrant (1,000) could be rapidly absorbed by the market without significantly affecting the price (see ASC 815-10-15). If the costs to convert Y’s stock to cash are not expected to be significant, the stock would be considered RCC and X would consider the warrant to be a derivative (before considering the applicability of any relevant scope exceptions).

See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for more information about this scope exception.

1.4.3.4.4 Determining Whether an Asset Is RCC for Both Parties to the Contract

Example 1-17

Impact of Contract Costs on the Assessment of RCC Criterion

EnergyCo enters into a contract to provide 5,000 kilowatts of electricity to Customer ABC at a fixed price for the next 24 months. Although the market is deregulated, ABC does not have the ability to trade in the market (i.e., resell any excess electricity) because it lacks the required licensing and permits. However, ABC can use either EnergyCo or another party to resell the electricity into the spot market on its behalf for a fee. The total costs incurred by ABC would include the true cost to resell the electricity into the spot market (the market rate for transmission, scheduling, etc.) plus the commission charged by EnergyCo (or another party) to resell on ABC’s behalf. Those costs would be deemed significant since they would exceed 10 percent of the gross sale proceeds based on the spot rate at inception of the contract. Therefore, the asset to be delivered under the contract would not be considered RCC for ABC.

In determining whether a contract meets the net settlement criterion, each counterparty should make that assessment from its own perspective. ASC 815-10-15-119 states, in part, that “one of the parties is required to deliver an asset of the type described in paragraph 815-10-15-100, but that asset is readily convertible to cash or is itself a derivative instrument.” In the above example, the inability of the buyer (Customer ABC) to resell the electricity and receive an amount that is “not significantly less than the amount an entity would typically have received under a net settlement provision” (see ASC 815-10-15-122) does not affect the seller’s ability to net settle the contract. The seller under this contract (EnergyCo) can wait until immediately before the contractual delivery date and purchase the assets (electricity) to be delivered on the spot market, effectively net settling the contract. The determination of whether the assets are considered RCC from the seller’s perspective should take into account whether the assets have (1) interchangeable or fungible units and (2) a quoted market price that is available in an active market that can rapidly sell the quantity of the asset that needs to be purchased by the seller without significantly affecting its price.

In such a circumstance, in a manner consistent with the concept of RCC, the seller (EnergyCo) would not have to accept the risks and costs related to owning the asset associated with the underlying and therefore should not have to consider the buyer’s costs to resell the electricity. As long as the seller’s costs to purchase and deliver the asset are not significant (see ASC 815-10-15-125 through 15-127), the asset may be considered RCC from the seller’s perspective. In performing its analysis, the seller would consider the costs incurred to get the asset from the closest or most economical active market to the delivery point specified in the contract.

1.4.3.4.5 Ongoing Evaluation

ASC 815-10

15-127 The assessment of the significance of . . . conversion costs shall be performed only at inception of the contract.

15-139 The evaluation of whether items to be delivered under a contract are readily convertible to cash shall be performed at inception and on an ongoing basis throughout a contract’s life (except that, as stated in paragraph 815-10-15-127, the assessment of the significance of those conversion costs shall be performed only at inception of the contract). Example 4, Cases B, C, and D (see paragraphs 815-10-55-87 through 55-89) illustrate this guidance.

Example 4: Net Settlement at Inception and Throughout a Contract’s Life

55-85 The following Cases illustrate the importance of ongoing evaluation:

Market mechanism develops after contract inception (Case A).
Initial public offering makes shares readily convertible to cash after contract inception (Case B).
Increased trading activity makes shares readily convertible to cash after contract inception (Case C).
Delisting makes shares not readily convertible to cash after contract inception (Case D).

Case A: Market Mechanism Develops After Contract Inception

Case B: Initial Public Offering Makes Shares Readily Convertible to Cash After Contract Inception

55-87 A nontransferable forward contract on a nonpublic entity’s stock that provides only for gross physical settlement is generally not a derivative instrument because the net settlement criteria are not met. If the entity, at some point in the future, accomplishes an initial public offering of its shares and the original contract is still outstanding, the shares to be delivered would be considered to be readily convertible to cash (assuming that the shares under the contract could be rapidly absorbed in the market without significantly affecting the price).

Case C: Increased Trading Activity Makes Shares Readily Convertible to Cash After Contract Inception

55-88 A nontransferable forward contract on a public entity’s stock provides for delivery on a single date of a significant number of shares that, at the inception of the contract, would significantly affect the price of the public entity’s stock in the market if sold within a few days. As a result, the contract does not satisfy the readily-convertible-to-cash criterion. However, at some later date, the trading activity of the public entity’s stock increases significantly. Upon a subsequent evaluation of whether the shares are readily convertible to cash, the number of shares to be delivered would be minimal in relation to the new average daily trading volume such that the contract would then satisfy the net settlement characteristic.

Case D: Delisting Makes Shares Not Readily Convertible to Cash After Contract Inception

55-89 A nontransferable forward contract on a public entity’s stock meets the net settlement criteria (as discussed beginning in paragraph 815-10-15-119) in that, at inception of the contract, the shares are expected to be readily convertible to cash when delivered under the contract. Assume that there is no other way that the contract meets the net settlement criteria. The public entity subsequently becomes delisted from the stock exchange, thus causing the shares to be delivered under the contract to no longer be readily convertible to cash.

As stated in ASC 815-10-15-139, the evaluation of whether a contract meets the criteria in ASC 815-10-15-99(c) for RCC should be made over the life of the contract (see ASC 815-10-55-87 through 55-89 for further guidance). However, an entity should not reassess whether the costs to immediately convert the asset to cash would exceed 10 percent of the spot price.

Options or warrants on nonpublic stock that require gross physical settlement may not meet the definition of a derivative if the underlying stock is not RCC. After an IPO, the stock underlying the warrants may be RCC and the warrants could then meet the definition of a derivative. If the number of shares underlying a warrant can be rapidly absorbed by the market without significantly affecting the price and there are no significant restrictions on the sale of the stock, the warrants would be RCC and would therefore meet the definition of a derivative under ASC 815. (As discussed in Example 1-10, such warrants would generally not meet the definition of a derivative until the IPO occurs.)

In addition, warrants for the purchase of a public company’s stock may not be considered RCC when they are initially acquired because the number of shares underlying the warrants could not be rapidly absorbed by the market. However, if the average daily trading volume of the stock increases, the number of shares underlying the warrant may become RCC and would then meet the definition of a derivative under ASC 815.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.