Chapter 1 — Introduction
Chapter 1 — Introduction
1.1 Overview
ASC 815 is the source of authoritative literature in U.S. GAAP on derivatives and hedging. The main principles of ASC 815 were derived from FASB Statement 133, which established comprehensive accounting and reporting requirements for derivatives (as defined in the standard) and qualifying hedging activities. Shortly after the issuance of Statement 133 in June 1998, the FASB established a
Derivatives Implementation Group (DIG) to provide interpretive guidance, which
became authoritative once formally cleared by the FASB. The FASB issued more than
130 DIG Issues (excluding transition issues). When the FASB Accounting Standards
Codification (the “Codification”) was released in 2009, ASC 815 became the
primary home of the collective guidance.
ASC 815-10
05-1 The
Derivatives and Hedging Topic includes the following
Subtopics:
- Overall
- Embedded Derivatives
- Hedging — General
- Fair Value Hedges
- Cash Flow Hedges
- Net Investment Hedges
- Contracts in Entity’s Own Equity
- Weather Derivatives.
05-2 The first
six Subtopics address the accounting for derivative
instruments, including certain derivative instruments
embedded in other contracts, and hedging activities. The
last two Subtopics provide guidance on accounting for
contracts that have characteristics of derivative
instruments but that are not accounted for as derivative
instruments under this Subtopic.
05-4 This Topic
requires that an entity recognize derivative instruments,
including certain derivative instruments embedded in other
contracts, as assets or liabilities in the statement of
financial position and measure them at fair value. If
certain conditions are met, an entity may elect, under this
Topic, to designate a derivative instrument in any one of
the following ways:
- A hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk (referred to as a fair value hedge)
- A hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk (referred to as a cash flow hedge)
- A hedge of the foreign currency
exposure of any one of the following:
- An unrecognized firm commitment (a foreign currency fair value hedge)
- An available-for-sale debt security (a foreign currency fair value hedge)
- A forecasted transaction (a foreign currency cash flow hedge)
- A net investment in a foreign operation.
10-1 Four
fundamental decisions serve as cornerstones underlying the
guidance in this Topic:
- Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.
- Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments. Derivative instruments should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (that is, gains or losses) that are attributable to the risk being hedged and that arise while the hedge is in effect.
- Only items that are assets or liabilities should be reported as such in financial statements.
- Special accounting for items designated as being hedged should be provided only for qualifying items. One aspect of qualification should be an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged.
ASC 815 establishes the accounting and reporting standards for
derivative instruments, including certain derivatives embedded in other contracts,
and hedging activities.1 A foundational principle of ASC 815 is that an entity should recognize
derivatives as either assets or liabilities in the statement of financial position
and measure those instruments at fair value. Fair value is the most relevant measure
for derivative contracts.
If certain conditions are met, ASC 815 allows an entity to designate
a derivative in a specialized hedge accounting relationship. The accounting for
changes in a derivative’s fair value (i.e., gains and losses) depends on the
intended use of the derivative and the resulting designation.2 For a derivative that is not designated as a hedging instrument, the gain or
loss is recognized in earnings in the period of change unless the derivative
qualifies for a scope exception under ASC 815.
Footnotes
1
See Deloitte’s Roadmaps Hedge Accounting and Contracts on an Entity’s Own
Equity for authoritative and interpretive guidance on
these topics. The guidance within this Roadmap is related to other ASC 815
matters.
2
See Deloitte’s Roadmap Hedge Accounting for more
information about the different types of hedging arrangements and the
resulting accounting consequences.
1.2 Types of Derivatives
The four major types of derivative contracts are as follows:
-
Forwards — A forward contract, which is a relatively simple derivative, is an agreement to buy or sell an asset on a future date for an agreed-upon price. It differs from a spot contract, which is an agreement to buy or sell an asset immediately. A forward contract is traded in the over-the-counter (i.e., noncentralized) market. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a specified future date for an agreed-upon price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Typically, it costs nothing to enter into a forward contract (i.e., it has a zero fair value on the date the counterparties enter into the contract).
-
Futures — A futures contract is similar to a forward contract in that it is an agreement between two parties to buy or sell an asset on a future date for an agreed-upon price. However, unlike forward contracts, futures contracts are normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract. Since the two parties to the contract do not necessarily know each other, the exchange also provides a mechanism that gives the two parties a guarantee that the contract will be honored.
-
Options — An option gives the holder the right to either buy or sell the underlying asset, depending on the nature of the option, by a future date for an agreed-upon price. However, unlike parties to forwards and futures, an option holder is not obligated to buy or sell the underlying asset. In addition, whereas it typically costs nothing to enter into a forward or futures contract, there is a cost to acquiring an option (called the premium).Options are traded both on exchanges and in the over-the-counter market. There are two types of options:
-
A call option gives the holder the right to buy the underlying asset by a certain date for an agreed-upon price.
-
A put option gives the holder the right to sell the underlying asset by a certain date for an agreed-upon price.
For both types of options, the greater the amount of time until maturity, the more valuable they tend to be. An option contract specifies (1) the price at which the holder can exercise the option, known as the strike price or exercise price, and (2) the date the option expires, known as the expiration date or maturity date. American options can be exercised at any time up to the expiration date, while European options can be exercised only on the expiration date. Bermudan options are a restricted form of the American option that allows for early exercise but only on specified dates during the life of the option. -
-
Swaps — A swap is an agreement between two parties to exchange cash flows in the future. The agreement specifies the dates on which the cash flows are to be paid and the way in which they will be calculated. The most common type of swaps are interest rate swaps and currency swaps:
-
In an interest rate swap, one party agrees to pay to a second party cash flows equal to the interest on a notional principal, calculated at a specified fixed rate for a predetermined period. In return, the first party receives interest at a floating rate on the same notional principal for the same period from the other party.
-
In a currency swap, parties exchange principal and interest payments at a fixed or variable rate in one currency for principal and interest payments at a fixed or variable rate, respectively, in another currency. The agreement requires the principal to be specified in each of the two currencies. The principal amounts are usually exchanged at the beginning and end of the life of the swap. Usually, the principal amounts are calculated to be approximately equivalent on the basis of the spot exchange rate at the swap’s initiation.
-
1.3 Concept of Embedded Derivatives
ASC 815-15
05-1 Contracts that do not in
their entirety meet the definition of a derivative
instrument (see paragraphs 815-10-15-83 through 15-139),
such as bonds, insurance policies, and leases, may contain
embedded derivatives. The effect of embedding a derivative
instrument in another type of contract (the host contract)
is that some or all of the cash flows or other exchanges
that otherwise would be required by the host contract,
whether unconditional or contingent on the occurrence of a
specified event, will be modified based on one or more
underlyings.
15-2
The guidance in this Subtopic applies only to contracts that
do not meet the definition of a derivative instrument in
their entirety.
A contract that itself does not meet the definition of a derivative in its entirety
may have implicit or explicit terms that affect the cash flows or the value of the
contract in a manner similar to a derivative. Those implicit or explicit terms may
qualify as “embedded derivatives” under the guidance in ASC 815-15. A contract in
which the derivative is embedded is referred to as the “host contract”; when
combined, the host contract and the embedded derivative are referred to as a “hybrid
instrument.”
An embedded feature will only require separate accounting treatment
as a derivative if it meets the following three conditions in ASC 815-15-25-1:
-
The embedded derivative is “not clearly and closely related” to the host contract (see Section 4.3.2).
-
The instrument is not subject to recurring fair value measurement, with changes in fair value recorded through earnings (see Section 4.3.3).
-
The embedded derivative would meet the definition of a derivative within the scope of ASC 815 if it were issued on a freestanding (stand-alone) basis (see Section 1.4).
In developing the derivative accounting requirements that are now located in ASC 815
(such as the requirement to measure derivatives at fair value on a recurring basis),
the FASB concluded that an entity should not be able to circumvent those
requirements by incorporating derivatives into the contractual terms of
nonderivative contracts (e.g., outstanding debt or equity). Accordingly, it decided
that when certain criteria are met (described above), derivatives embedded in the
terms of nonderivative contracts should be accounted for as derivatives separately
from the contracts in which they are embedded. An entity is thus unable to avoid the
recognition and measurement requirements of ASC 815 merely by embedding a derivative
instrument in a nonderivative financial instrument or another contract.
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:
- One or more underlyings
- 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:
- 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.
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:
- To deliver cash or another financial instrument to a second entity
- To exchange other financial instruments on potentially unfavorable terms with the second entity.
- Conveys to that second entity a contractual right
either:
- To receive cash or another financial instrument from the first entity
- 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
15-95 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. .
. .
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
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.
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:
- The asset associated with the underlying is financial or nonfinancial.
- 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
55-84 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).
- 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
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.
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.
1.5 Application of the ASC 815 Definition of a Derivative to Specific Contracts
The table below illustrates the
application of the ASC 815 definition of a derivative to different types of
contracts (before any scope exceptions are considered).
|
Contract
|
Does the contract have an underlying?
|
Does the contract have a notional amount or
payment provision?
|
Does the contract involve no or a smaller
initial net investment?
|
Does the contract require or permit net
settlement?
|
Does the contract need to be accounted for
as a derivative?3
|
|---|---|---|---|---|---|
|
1,000 warrants to purchase 1,000 shares of an entity’s common
stock at a fixed exercise price
|
Yes, the price of the common stock.
|
Yes, the number of shares.
|
Yes, if the price paid for each warrant is at least 10
percent less than the fair value of a share of the entity’s
common stock.
|
Yes, (1) for contracts that provide for cashless exercise
(even if only contingently exercisable4) or whose settlement involves the delivery of shares
that are RCC or (2) if a market mechanism exists to net
settle the contract.
|
Warrants would typically meet the definition of a derivative
if net settlement is present.
|
|
Contract to pay a fixed dollar amount if the company’s common
stock rises above $10
|
Yes, the price of the common stock.
|
Yes, the fixed dollar amount is a payment provision.
|
Yes, if the price paid for the instrument is at least 10
percent less than the fixed dollar amount (i.e., the payoff
from the instrument).
|
Yes, the contract provides for a one-way transfer of cash, so
it is contractually net settled.
|
Typically, yes.
|
|
Short sales of securities (contract under which the short
seller borrows a security with a promise to return it to the
lender)
|
Yes, the price of the security.
|
Yes, the face amount of the security or the number of
shares.
|
No, the short seller received the fair value of the
security.
|
Yes, if the underlying securities are RCC.
|
No.
|
|
Managers’ options or overallotment provisions
|
Yes, the price of the underlying security.
|
Typically, yes.
|
Yes, if the price paid for the option is at least 10 percent
less than the fair value of the instrument underlying the
option.
|
Yes, if the underlying securities are RCC.
No, if the underlying securities are not RCC.
|
It depends, typically on the basis of whether the underlying
securities are RCC.
|
|
Banker’s acceptance agreement
|
Yes, the fair value of the receivable.
|
Yes, the aggregate dollar value of the receivable.
|
Typically, no, because the initial investment in the
instrument is not lower than 90 percent of the receivable’s
fair value.
|
No, there is typically no market mechanism to net settle the
contract, and the underlying is not RCC.
|
Typically, no, because it does not provide for net
settlement.
|
|
Irrevocable letter of credit
|
Yes, the fair value of the receivable.
|
Yes, the dollar value of the receivable.
|
It depends.
|
No, the receivable generally is not RCC and there is no
market mechanism.
|
Typically, no. A letter of credit would not meet the
definition of a derivative because it does not provide for
de facto net settlement.
|
Footnotes
3
The discussion in the table does not
consider the applicability of any of the scope
exceptions from derivative accounting provided by
ASC 815-10. In practice, more analysis would
typically be necessary before concluding that such
instruments must be accounted for as
derivatives.
4
See Section 1.4.3.2.6 for additional
guidance on how to evaluate contingent net
settlement provisions.
1.6 Unit of Account
ASC 815-10
Viewing a Contract as Freestanding or Embedded
15-5
The notion of an embedded derivative, as discussed in
paragraph 815-15-25-1, does not contemplate features that
may be sold or traded separately from the contract in which
those rights and obligations are embedded. Assuming they
meet this Subtopic’s definition of a derivative instrument,
such features shall be considered attached freestanding
derivative instruments rather than embedded derivatives by
both the writer and the current holder.
15-6 A
put or call option that is added or attached to a debt
instrument by a third party contemporaneously with or after
the issuance of the debt instrument shall be separately
accounted for as a derivative instrument under this Subtopic
by the investor (that is, by the creditor). An option that
is added or attached to an existing debt instrument by
another party results in the investor having different
counterparties for the option and the debt instrument and,
thus, the option shall not be considered an embedded
derivative. Paragraph 815-15-25-2 states that notion of an
embedded derivative in a hybrid instrument refers to
provisions incorporated into a single contract, and not to
provisions in separate contracts between different
counterparties.
15-7
If a debt instrument includes in its terms at issuance an
option feature that is explicitly transferable independent
of the debt instrument and thus is potentially exercisable
by a party other than either the issuer of the debt
instrument (the debtor) or the holder of the debt instrument
(the investor), that option shall be considered under this
Subtopic as an attached freestanding derivative instrument,
rather than an embedded derivative, by both the writer and
the holder of the option.
Viewing Two or More Contracts as a Unit in Applying the Scope
of This Subtopic
15-8
In some circumstances, an entity could enter into two or
more legally separate transactions that, if combined, would
generate a result that is economically similar to entering
into a single transaction that would be accounted for as a
derivative instrument under this Subtopic. For guidance on
circumstances in which two or more contracts that have been
determined to be derivative instruments within the scope of
this Subtopic must be viewed as a unit, see the guidance
beginning in paragraph 815-10-25-6. For guidance on
circumstances in which two or more contracts that have been
determined to be options within the scope of this Subtopic
must be viewed in combination, see the guidance beginning in
paragraph 815-10-25-7.
15-9
If two or more separate transactions may have been entered
into in an attempt to circumvent the provisions of this
Subtopic, the following indicators shall be considered in
the aggregate and, if present, shall cause the transactions
to be viewed as a unit and not separately:
- The transactions were entered into contemporaneously and in contemplation of one another.
- The transactions were executed with the same counterparty (or structured through an intermediary).
- The transactions relate to the same risk.
- There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.
A Transferable Option Is Considered Freestanding, Not
Embedded
55-3
Certain structured transactions involving the issuance of a
bond incorporate transferable options to call or put the
bond. As such, those options are potentially exercisable by
a party other than the debtor or the investor. For example,
certain put bond structures involving three separate parties
— the debtor, the investor, and an investment bank — may
incorporate options that are ultimately held by the
investment bank, giving that party the right to call the
bond from the investor. For example, a call option that is
transferable either by the debtor to a third party and thus
is potentially exercisable by a party other than the debtor
or by the original investor based on the legal agreements
governing the debt issuance can result in the investor
having different counterparties for the option and the
original debt instrument. Accordingly, even if incorporated
into the terms of the original debt agreement, such an
option may not be considered an embedded derivative by
either the debtor or the investor because it can be
separated from the bond and effectively sold to a third
party.
In the application of ASC 815, the unit of account is typically an
individual contract or an embedded feature within a contract. Unless a scope
exception applies, both freestanding derivative instruments and embedded derivative
components must be accounted for as derivatives under ASC 815. It is important to
identify whether a feature is embedded or freestanding because the incremental
guidance in ASC 815-15 affects whether an embedded feature requires separate
accounting recognition.
ASC 815-10-15-7 notes that if, upon issuance, an instrument includes “an option
feature that is explicitly transferable independent of the instrument and thus is
potentially exercisable by a party other than either the issuer or holder,” both the
option writer and holder should treat the option as a freestanding derivative
attached to the instrument instead of a derivative embedded in the instrument. As
noted in ASC 815-10-15-6, a “put or call option that is added or attached . . . by a
third party [either] contemporaneously with or after [initial] issuance of the debt
instrument” is an example of an attached feature that is considered
freestanding.
As indicated in ASC 815-10-15-8, there may be circumstances in which an entity enters
into legally separate transactions “that, if combined, would generate a result that
. . . would be accounted for as a derivative instrument” under ASC 815. ASC 815-10
contains additional guidance to help an entity determine whether two or more
separate transactions should be viewed as separate units of account or combined for
accounting purposes.
Nevertheless, ASC 815 ordinarily does not permit an entity to treat two or more
freestanding financial instruments as a single combined unit of account. DIG Issue
F6 (not codified) notes the following:
[ASC 815] is a transaction-based
standard.
Similarly, ASC 815-10-25-6 states, in part:
[ASC 815-10] generally does not
provide for the combination of separate financial instruments to be evaluated as
a unit.
However, if two or more freestanding financial instruments have characteristics
suggesting that they were structured to circumvent GAAP, they may need to be
combined and treated as a single unit of account. Specifically, ASC 815-10 requires
two or more separate transactions to be combined and viewed in combination as a
single unit of account if they were entered into in an attempt to circumvent the
accounting requirements for derivatives (i.e., measured at fair value, with
subsequent changes in fair value recognized in earnings except for qualifying
hedging instruments in cash flow or net investment hedges). ASC 815-10-15-9 states
that such combination is required if the transactions have all of the following
characteristics:
- They “were entered into contemporaneously and in contemplation of one another.”
- They “were executed with the same counterparty (or structured through an intermediary).”
- They “relate to the same risk” (e.g., the fair value of the issuer’s equity shares).
- “There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.”
ASC 815-10-25-6 identifies characteristics similar to those listed above from ASC
815-10-15-98 and adds the following commentary:
If separate derivative
instruments have all of [these] characteristics, judgment shall be applied to
determine whether the separate derivative instruments have been entered into in
lieu of a structured transaction in an effort to circumvent GAAP: . . . If such
a determination is made, the derivative instruments shall be viewed as a
unit.
ASC 815 does not specify a period of separation between transactions (e.g., one day,
one week) that would disqualify them from being treated as contemporaneous. A
one-week period between transactions may be sufficient evidence that the
transactions are not contemporaneous if the entity is exposed to market fluctuations
during this time. Thus, even when transactions occur at different times, entities
must consider all available evidence to ensure that no side agreements or other
contracts were entered into that call into question whether the transactions were
contemporaneous (e.g., there are no earlier agreements for trades to be entered into
simultaneously).
In the implementation guidance below, the FASB illustrates the unit of account
concepts:
- Example 1 in ASC 815-10-55-66 through 55-72 shows whether an attached (Case A) or transferable (Case B) call feature should be seen as a freestanding or embedded feature.
- Example 18 in ASC 815-10-55-171 through 55-174 and Example 19 in ASC 815-10-55-175 through 55-180 illustrate how to determine whether two transactions should be combined.
ASC 815-10
Example 1: Viewing a Contract as Freestanding or
Embedded
55-66 The following
Cases illustrate the application of paragraph 815-10-15-6:
- Attached call option (Case A)
- Transferable call option (Case B).
Case A: Attached Call Option
55-67 This Case
presents a transaction that involves the addition of a call
option contemporaneously with or after the issuance of
debt.
55-68 Entity X issues
15-year puttable bonds to an Investment Banker for $102. The
put option may be exercised at the end of five years.
Contemporaneously, the Investment Banker sells the bonds
with an attached call option to Investor A for $100. (The
call option is a written option from the perspective of
Investor A and a purchased option from the perspective of
the Investment Banker.) The Investment Banker also sells to
Investor B for $3 the call option purchased from Investor A
on those bonds. The call option has an exercise date that is
the same as the exercise date on the embedded put option. At
the end of five years, if interest rates increase, Investor
A would presumably put the bonds back to Entity X, the
issuer. If interest rates decrease, Investor B would
presumably call the bonds from Investor A.
55-69 As required by
paragraph 815-10-15-6, the call option that is attached by
the Investment Banker is a separate derivative instrument
from the perspective of Investor A.
Case B: Transferable Call Option
55-70 This Case
presents a group of transactions with a similar overall
effect to that in Case A.
55-71 Entity Y issues
15-year puttable bonds to Investor A for $102. The put
option may be exercised at the end of five years.
Contemporaneously, Entity Y purchases a transferable call
option on the bonds from Investor A for $2. Entity Y
immediately sells that call option to Investor B for $3. The
call option has an exercise date that is the same as the
exercise date of the embedded put option. At the end of five
years, if rates increase, Investor A would presumably put
the bonds back to Entity Y, the issuer. If rates decrease,
Investor B would presumably call the bonds from Investor
A.
55-72 As required by
paragraph 815-10-15-6, the call option is a separate
freestanding derivative instrument that must be reported at
fair value with changes in value recognized currently in
earnings unless designated as a hedging instrument.
Example 18: Recognition — Viewing Separate Transactions
as a Unit
55-171 The following
Cases illustrate when separate transactions should be viewed
as a unit:
- Swaps that should be viewed as a unit (Case A)
- Swaps that should not be viewed as a unit (Case B).
55-172 In Cases A and
B, an entity that is the issuer of fixed-rate debt enters
into an interest rate swap (Swap 1) and designates it as a
hedge of the fair value exposure of the debt to interest
rate risk. The fair value hedge of the fixed-rate debt
involving Swap 1 meets the required criteria in Section
815-20-25 to qualify for hedge accounting. The entity
simultaneously enters into a second interest rate swap (Swap
2) with the same counterparty with the exact mirror terms as
Swap 1 and does not designate Swap 2 as part of that hedging
relationship.
Case A: Swaps That Should Be Viewed as a Unit
55-173 If Swap 2 was
entered into in contemplation of Swap 1 and the overall
transaction was executed for the sole purpose of obtaining
fair value accounting treatment for the debt, it should be
concluded that the purpose of the transaction was not to
enter into a bona fide hedging relationship involving Swap
1. In that instance, the two swaps should be viewed as a
unit and the entity would not be permitted to adjust the
carrying value of the debt to reflect changes in fair value
attributable to interest rate risk.
Case B: Swaps That Should Not Be Viewed as a Unit
55-174 If Swap 2 was
not entered into in contemplation of Swap 1 or there is a
substantive business purpose for structuring the
transactions separately, and if both Swap 1 and Swap 2 were
entered into in arm’s-length transactions (that is, at
market rates), then the swaps should not be viewed as a
unit. For example, some entities have a policy that requires
a centralized dealer subsidiary to enter into third-party
derivative contracts on behalf of other subsidiaries within
the entity to hedge the subsidiaries’ interest rate risk
exposures. The dealer subsidiary also enters into internal
derivative contracts with those subsidiaries to
operationally track those hedges within the entity. (As
discussed beginning in paragraph 815-20-25-61, internal
derivatives do not qualify in consolidated financial
statements as hedging instruments for risks other than
foreign exchange risk.)
Example 19: Recognition — Viewing Separate Transactions
as a Unit for Purposes of Evaluating Net
Settlement
55-175 The following
Cases illustrate the guidance in paragraphs 815-10-15-8
through 15-9 on whether separate transactions should be
viewed as a unit for purposes of evaluating the
characteristic of net settlement:
- Two forward contracts viewed as a unit (Case A)
- Borrowing and lending transactions viewed as a unit (Case B).
55-176 In Cases A and
B, the transactions were entered into with the same
counterparty, were executed simultaneously, and relate to
the same risk.
Case A: Two Forward Contracts Viewed as a Unit
55-177 Entity A enters
into a forward contract to purchase 1,500,000 units of a
particular commodity in 3 months for $10 per unit.
Simultaneously, Entity A enters into a forward contract to
sell 1,400,000 units of the same commodity in 3 months for
$10 per unit. The purchase and sale contracts are with the
same counterparty. There is no market mechanism to
facilitate net settlement of the contracts, and both
contracts require physical delivery of the commodity at the
same location in exchange for the forward price. On a gross
basis, neither contract is readily convertible to cash
because the market cannot rapidly absorb the specified
quantities without significantly affecting the price.
However, on a net basis, Entity A has a forward purchase
contract for 100,000 units of the commodity, a quantity that
can be rapidly absorbed by the market and thus is readily
convertible to cash.
55-178 In this Case, it
appears that there is no clear business purpose for
structuring the transactions separately. Therefore, the
facts point to the conclusion that the purchase and sale
were done as a structured transaction with one counterparty
to circumvent the definition of a derivative instrument
under this Subtopic. However, if the facts indicated that
both contracts required physical delivery of the commodity
at different locations that are significantly distant from
one another and each counterparty is expected to deliver the
gross amount of the commodity to the other, those facts may
reflect a valid substantive business purpose for the
transaction.
Case B: Borrowing and Lending Transactions Viewed as a
Unit
55-179 Entity C loans
$100 to Entity B. The loan has a 5-year bullet maturity and
an 8 percent fixed interest rate, payable semiannually.
Entity B simultaneously loans $100 to Entity C. The loan has
a five-year bullet maturity and a variable interest of
LIBOR, payable semiannually and reset semiannually. Entity B
and Entity C enter into a netting arrangement that permits
each party to offset its rights and obligations under the
agreements. The netting arrangement meets the criteria for
offsetting in Subtopic 210-20. The net effect of offsetting
the contracts for both Entity B and Entity C is the economic
equivalent of an interest rate swap arrangement, that is,
one party receives a fixed interest rate from, and pays a
variable interest rate to, the other.
55-180 In this Case,
based on the facts presented, there is no clear business
purpose for the separate transactions, and they should be
accounted for as an interest rate swap under this Subtopic.
However, in other instances, a clear substantive business
purpose for entering into two separate loan transactions may
exist (for example, as a means to overcome foreign currency
expatriation restrictions).
Note that the SEC staff has indicated that it will challenge the
accounting for transactions that have been structured to circumvent GAAP. EITF Issue
02-2 (not codified) states, in part:
The SEC Observer
encouraged the [FASB] to examine the broader issue of when to combine
transactions and noted that, in the interim, the SEC staff will continue to
challenge the accounting for transactions for which it appears that multiple
contracts have been used to circumvent generally accepted accounting
principles.
ASC 815-10
Viewing Combinations of Options as Separate Options or
as a Single Forward Contract
25-7
This guidance addresses a combination of two options — one
that is a purchased call (put) option and another that is a
written put (call) option — having all of the following
characteristics:
- They have the same strike price, notional amount, and exercise date.
- They have the same underlying.
- Neither is required to be exercised.
25-8
The guidance addresses such options in two contexts:
- Combinations of two freestanding options or a freestanding and embedded option
- Combinations of two embedded options.
25-9
Derivative instruments that are transferable are, by their
nature, separate and distinct contracts. Accordingly, a
separate freestanding purchased call (put) option and
written put (call) option with all of the characteristics in
paragraph 815-10-25-7 convey rights and obligations that are
distinct whether involving the same or different
counterparties and do not warrant bundling as a single
forward contract for accounting purposes under this Subtopic
by any party to the contracts. (The separate purchased
option and written option can be viewed in combination and
jointly designated as the hedging instrument pursuant to
paragraph 815-20-25-45.)
Combinations of Two Freestanding Options or a Freestanding
and Embedded Option
25-9A
A combination of a freestanding purchased call (put) option
and a freestanding or embedded (nontransferable) written put
(call) option shall be considered for accounting purposes as
separate option contracts, rather than a single forward
contract, by both parties to the contracts even though all
of the following conditions are met:
- The options have the same terms.
- The options have the same underlying.
- The options are entered into contemporaneously with the same counterparty at inception.
25-9B
Both a combination of a freestanding purchased call (put)
option and a freestanding or embedded (nontransferable)
written put (call) option and a combination of a
freestanding written call (put) option and an embedded
(nontransferable) purchased put (call) option shall be
considered for accounting purposes as separate option
contracts, rather than a single forward contract, by both
parties to the contracts even though all of the following
conditions are met:
- The options have the same terms.
- The options have the same underlying.
- The options are entered into contemporaneously with different counterparties at inception.
Combinations of Two Embedded Options
25-10
A combination of an embedded (nontransferable) purchased
call (put) option and an embedded (nontransferable) written
put (call) option in a single hybrid instrument with all of
the characteristics in paragraph 815-10-25-7 and that are
entered into contemporaneously with the same counterparty
shall be considered as a single forward contract for
purposes of applying the provisions of this Subtopic. The
notion of the same counterparty encompasses contracts
entered into directly with a single counterparty and
contracts entered into with a single party that are
structured through an intermediary. (Note that a share of
stock being puttable by the holder and callable by the
issuer under the same terms does not render the stock
mandatorily redeemable under the provisions of Topic 480.)
Topic 480 requires that mandatorily redeemable financial
instruments be classified as liabilities.
25-11
The embedded options are in substance an embedded forward
contract because they meet both of the following conditions:
- They convey rights (to the holder) and obligations (to the writer) that are equivalent from an economic and risk perspective to an embedded forward contract.
- They cannot be separated from the hybrid instrument in which they are embedded.
25-12
Even though neither party is required to exercise its
purchased option, the result of the overall structure is a
hybrid instrument that will likely be redeemed at a point
earlier than its stated maturity. That result is expected by
both the hybrid instrument’s issuer and investor regardless
of whether the embedded feature that triggers the redemption
is in the form of two separate options or a single forward
contract.
25-13
However, if either party is required to exercise its
purchased option before the stated maturity date of the
hybrid instrument, the hybrid instrument shall not be viewed
for accounting purposes as containing one or more embedded
derivatives. In substance, the debtor (issuer) and creditor
(investor) have agreed to terms that accelerate the stated
maturity of the hybrid instrument and the exercise date of
the option is essentially the hybrid instrument’s actual
maturity date. As a result, it is inappropriate to
characterize the hybrid instrument as containing either of
the following:
- Two embedded option contracts that are exercisable only on the actual maturity date
- An embedded forward contract that is a combination of an embedded purchased call (put) and a written put (call) with the same terms.
In each of the scenarios contemplated by the guidance in ASC 815-10-25-7 through
25-13, both the purchased call (put) option and the written call (put) option have
the same strike price, notional amount, exercise date, and underlying, and neither
option is required to be exercised. To ascertain whether options must be bundled as
a single forward contract for accounting purposes under ASC 815, an entity must
determine whether they are freestanding or embedded:
- A “freestanding purchased call (put) option and written put (call) option with all of the characteristics in paragraph 815-10-25-7 convey [distinct] rights and obligations [regardless of whether the counterparties are] the same or different . . . and do not warrant bundling as a single forward contract for accounting purposes” (see ASC 815-15-25-9).
- The combination of two embedded options “that are entered into contemporaneously with the same counterparty shall be considered as a single forward contract for purposes of applying the provisions of [ASC 815]” (see ASC 815-15-25-10).