Chapter 2 — Scope and Scope Exceptions | DART – Deloitte Accounting Research Tool

2.3.1 Regular-Way Security Trades

ASC 815-10 — Glossary

Regular-Way Security Trades

Regular-way security trades are contracts that provide for delivery of a security within the period of time (after the trade date) generally established by regulations or conventions in the marketplace or exchange in which the transaction is being executed.

ASC 815-10

Regular-Way Security Trades

15-15 Regular-way security trades are defined as contracts that provide for delivery of a security within the period of time (after the trade date) generally established by regulations or conventions in the marketplace or exchange in which the transaction is being executed. For example, a contract to purchase or sell a publicly traded equity security in the United States customarily requires settlement within three business days. If a contract for purchase of that type of security requires settlement in three business days, the regular-way security trades scope exception applies, but if the contract requires settlement in five days, the regular-way security trades scope exception does not apply unless the reporting entity is required to account for the contract on a trade-date basis.

15-16 Except as provided in (a) in the following paragraph, a contract for an existing security does not qualify for the regular-way security trades scope exception if either of the following is true:

It requires or permits net settlement (as discussed in paragraphs 815-10-15-100 through 15-109).
A market mechanism exists to facilitate net settlement of that contract (as discussed in paragraphs 815-10-15-110 through 15-118).

15-17 The scope exception for regular-way security trades applies only to a contract that requires delivery of securities that are readily convertible to cash except that the scope exception also shall or may apply in any of the following circumstances:

If an entity is required, or has a continuing policy, to account for a contract to purchase or sell an existing security on a trade-date basis, rather than a settlement-date basis, and thus recognizes the acquisition (or disposition) of the security at the inception of the contract, then the entity shall apply the regular-way security trades scope exception to that contract.
If an entity is required, or has a continuing policy, to account for a contract for the purchase or sale of when-issued securities or other securities that do not yet exist on a trade-date basis, rather than a settlement-date basis, and thus recognizes the acquisition or disposition of the securities at the inception of the contract, that entity shall apply the regular-way security trades scope exception to those contracts.
Contracts for the purchase or sale of when-issued securities or other securities that do not yet exist, except for those contracts accounted for on a trade-date basis, are excluded from the requirements of this Subtopic as a regular-way security trade only if all of the following are true:
1. There is no other way to purchase or sell that security.
2. Delivery of that security and settlement will occur within the shortest period possible for that type of security.
3. It is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery of a security when it is issued. (The entity shall document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.)

Example 9 (see paragraph 815-10-55-118) illustrates the application of item (c) in this paragraph.

15-18 Note that contracts that require delivery of securities that are not readily convertible to cash (and thus do not permit net settlement) are not subject to the requirements of this Subtopic unless there is a market mechanism outside the contract to facilitate net settlement (as described in paragraph 815-10-15-110).

There is usually a time lag between the trade date and settlement date of a security trade, which technically creates a forward contract to purchase or sell the specified security on the settlement date. This type of forward contract often meets the definition of a derivative (before consideration of the applicability of any scope exceptions) because (1) it has an underlying (i.e., the fair value of the equity security) and a notional amount (the number of equity securities), (2) it requires no initial net investment, and (3) the underlying equity securities are often RCC. However, some securities trades may qualify for the scope exception for regular-way security trades.

As indicated in the ASC 815-10 definition above, regular-way security trades are “contracts that provide for delivery of a security within the period of time (after the trade date) generally established by regulations or conventions in the marketplace or exchange in which the transaction is being executed.” The concept of a regular-way security trade is not based on the normal practices of an individual entity but rather on marketplace conventions or regulations.

The scope exception for regular-way security trades would only apply to contracts that require the delivery of assets that qualify as RCC. Therefore, the market associated with the assets would typically be expected to have sufficient trading volume such that the conventions or regulations of the market would be well understood.

As noted in ASC 815-10-15-15 above, if it is either required or customary for certain securities on a specified exchange to settle within three days, a contract that requires settlement in more than three days is not a regular-way security trade even if the entity customarily enters into contracts to purchase securities that require settlement more than three days in the future. In the United States, most equity security trades now settle in one business day (see below). Given that the intent of the guidance in ASC 815-10-15-15 is that the period should be generally established by regulations or conventions in the marketplace, we believe that for U.S. security trades, a settlement period that is longer than the current convention of one day would not qualify for this scope exception.

Changing Lanes

On February 15, 2023, the SEC adopted a final rule to transition the securities settlement cycle for most broker-dealer transactions in the United States from two days to one. The rule became effective on May 28, 2024, and, therefore, the scope exception for regular-way security trades is now applicable to contracts settling within one day (instead of two days).

Example 2-1

Regular-Way Trades

Company XYZ purchases 100,000 shares of Company ABC, a NYSE-listed entity, through a U.S. broker on Monday, October 1, 20X0. The average daily trading volume of the stock is 1 million shares. The settlement date of the contract is Tuesday, October 2, 20X0. Because the settlement date (October 2) is after the trade date (October 1), the contract is considered to be a forward to purchase shares.

Further analysis indicates that the forward meets the definition of a derivative since it has an underlying (the fair value of ABC’s common stock) and a notional amount (100,000 shares), no initial net investment was made, and XYZ will take delivery of an asset (ABC’s stock) that is RCC.1 However, the contract qualifies for the derivative scope exception in ASC 815-10-15-13(a) for regular-way security trades since the customary delivery time for physical settlement of a forward purchase or sale of traded securities is one business day in the United States (as of May 28, 2024; see the Changing Lanes above). Therefore, this one-day forward purchase contract would not be accounted for as a derivative under ASC 815.

By contrast, if the contract was entered into on Monday, October 1, 20X0, and delivery was scheduled on Thursday, October 4, 20X0, it would not qualify for the scope exception because settlement would be outside the customary period in the market in which the contract was entered. In that case, the contract would be accounted for as a derivative at fair value.

ASC 815-10-15-16 states that a “contract for an existing security does not qualify for the regular-way security trades scope exception if either of the following is true:

It requires or permits net settlement (as discussed in paragraphs 815-10-15-100 through 15-109).
A market mechanism exists to facilitate net settlement of that contract (as discussed in paragraphs 815-10-15-110 through 15-118).”

As indicated in ASC 815-10-15-17(a), regardless of whether a contract allows or requires net settlement or whether there is a market mechanism to facilitate net settlement, “[i]f an entity is required, or has a continuing policy, to account for a contract to purchase or sell an existing security on a trade-date basis,”2 it can apply the exception for regular-way security trades to the contract. ASC 815-10-15-17(b) extends that guidance to “when-issued securities or other securities that do not yet exist.”

ASC 815-10-15-17(c) exempts forward purchases or sales of when-issued securities or other securities that do not yet exist from the provisions of ASC 815 for regular-way securities trades if all three of the following criteria are met:

There is no other way to purchase or sell that security.
Delivery of that security and settlement will occur within the shortest period possible for that type of security.
It is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery of a security when it is issued. (The entity shall document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.)

The implementation guidance below illustrates the application of the guidance on regular-way security trades.

ASC 815-10

Example 9: Regular-Way Security Trades — Shortest-Period Criterion

55-118 This Example illustrates the application of paragraph 815-10-15-17(c). Assume a variety of forward contracts exists for a when-issued security, such as a to-be-announced security, that provides a choice of settlement dates for each of the next three months (such as November, December, or January). An entity enters into a forward contract to purchase the to-be-announced security, which will otherwise meet the qualifications of paragraphs 815-10-15-13 through 15-20, that requires delivery in the second-nearest month (such as December), not the nearest month (such as November). The entity may not apply the regular-way security trade exception to the forward purchase contract that requires delivery of the to-be-announced security in the second-nearest month (such as December).

55-119 In this Example, the to-be-announced security (identified by issuer, contractual maturity of the underlying loans, and the net coupon, such as 30-year Government National Mortgage Association [GNMA] securities bearing interest of 7 percent) is available under multiple settlement periods (that is, the standardized settlement date in November, December, or January). The regular-way security trade exception may be applied only to forward contracts for that to-be-announced security that require delivery in November, the shortest period permitted for that type of to-be-announced security. The December and January settlement to-be-announced forward contracts must be accounted for as derivative instruments under this Subtopic.

55-120 If the forward contracts in this Example meet the hedge accounting criteria, they may be designated in cash flow hedges of the anticipated purchase of the securities, as discussed in paragraph 815-20-25-22.

2.3.2 Normal Purchases and Normal Sales

ASC 815-10

15-22 Normal purchases and normal sales are contracts that provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business.

15-23 The assessment of whether a contract qualifies for the normal purchases and normal sales scope exception (including whether the underlying of a price adjustment within the contract is not clearly and closely related to the asset being sold or purchased) shall be performed only at the inception of the contract.

15-24 The normal purchases and normal sales scope exception sometimes will result in different parties to a contract reaching different conclusions about whether the contract is required to be accounted for as a derivative instrument. For example, the contract may be for ordinary sales by one party but not for ordinary purchases by the counterparty.

15-25 Following are discussions of four important elements needed to qualify for the normal purchases and normal sales scope exception:

Normal terms (including normal quantity)
Clearly and closely related underlying
Probable physical settlement
Documentation.

As discussed in ASC 815-10-15-22, ASC 815 does not apply to contracts in which “something other than a financial instrument or derivative instrument” is purchased or sold “in quantities [that will be] used or sold by the reporting entity over a reasonable period in the normal course of business.” ASC 815-10-15-24 further notes that it is possible that counterparties to a contract may reach “different conclusions about whether the contract is required to be accounted for as a derivative instrument” because of the normal purchases and normal sales (NPNS) scope exception.

In assessing whether a contract qualifies for the NPNS scope exception, entities should consider the following:

Contracts whose price is based on an underlying index that is not clearly and closely related to the asset being sold or purchased (e.g., a grain commodity price based on changes in the S&P index) do not qualify (see ASC 815-10-15-30 through 15-34 for further interpretation of the meaning of “not clearly and closely related” as it applies to the NPNS scope exception).
Contracts that contain net settlement provisions may qualify for the exception if “[i]t is probable at inception and throughout the term of the contract that the contract will not settle net and will result in physical delivery” (see the net settlement provisions of ASC 815-10-15-100 through 15-109 and the market mechanism provisions of ASC 815-10-15-110 through 15-118). Net settlement of similar contracts would call into question the classification of such contracts as normal purchases or sales.
To qualify for the exception, the contracts must be denominated in (1) the functional or local currency of one of the substantial parties to the contract, (2) the currency in which the price of the underlying is routinely denominated in international commerce (e.g., U.S. dollars for crude oil transactions), or (3) the currency that one of the parties uses as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary (see ASC 815-15-55-83 through 55-98).
Contracts that either require or periodically call for cash settlements of gains and losses (e.g., futures contracts) do not qualify for the exception (see ASC 815-10-15-36).
Option contracts and forward contracts with optionality features that can modify the volume to be delivered generally do not qualify for the NPNS scope exception (see ASC 815-10-15-40 and ASC 815-10-15-42 through 15-44). However, if power purchase or sales agreements (that are options, forwards, or a combination of both) are capacity contracts for the purchase or sale of electricity, they may still qualify for the NPNS scope exception if certain criteria are met (see ASC 815-10-15-45 through 15-51 and ASC 815-10-55-31).
For contracts that qualify for the exception, entities are required to provide documentation supporting the conclusion “that it is probable that the contract will not settle net and will result in physical delivery.” This documentation can be applied to groups of similarly designated contracts or to each individual contract. Entities should not apply the NPNS scope exception until such documentation is in place, even if all other criteria are met (see ASC 815-10-15-37 through 15-39).
The intent of the guidance is for the NPNS scope exception to be applied to entities whose operations include the use of the physical commodity, either in their productive operations or through physical distribution to their end customers. Thus, the concept of trading is not consistent with the concept of NPNS, and contracts that an entity designates as trading derivatives will not qualify for the NPNS scope exception in ASC 815.

Keep in mind that the NPNS scope exception is an election. That is, even if an entity would qualify to apply the NPNS scope exception to its contracts, it would typically not be required to do so. More specifically, ASC 815-10-15-39 states, “[t]he normal purchases and normal sales scope exception could effectively be interpreted as an election in all cases.”

Further, even if an entity did not elect to apply the NPNS scope exception to a contract at inception, it can still make the election on a future date as long as it appropriately documents and supports the NPNS election at that time. In that circumstance, the scope exception would apply prospectively from the election date. The carrying amount of the derivative on the election date would become the new cost basis of the contract, and the entity would apply other appropriate U.S. GAAP to the contract prospectively. Further, all changes in the fair value from contract inception through the election date would remain recognized through earnings (i.e., it would be inappropriate to reverse such amounts).

An entity should generally obtain the documentation for an NPNS contract by consulting with, or surveying, the business groups that are familiar with the entity’s contractual arrangements and the normal requirements of its business. In the absence of such documentation, a contract that satisfies the criteria of a derivative under ASC 815 and does not meet any of the other scope exceptions should be accounted for as a derivative, even if the contract meets all of the other criteria for the NPNS scope exception.

Although it is possible to elect to apply the NPNS scope exception after contract inception, once an entity documents a contract as normal under ASC 815-10-15-22 through 15-51, it cannot change the designation to treat the contract as a derivative unless the contract ceases to qualify for the exception. For example, a contract would no longer qualify for the NPNS scope exception if delivery of the underlying was no longer probable; in such a case, the contract should be accounted for as a derivative asset or liability at its then current fair value, with an offsetting entry to earnings. See the sections below for further discussion of the NPNS requirements.

Example 2-2

NPNS Election for a Portion of Eligible Contracts

Big City Bakery Company has 100 individual contracts to purchase wheat for use in its operations. Each individual contract (1) satisfies the criteria for a derivative under ASC 815, (2) contains a provision that permits explicit net settlement, and (3) would satisfy all of the criteria to qualify for the NPNS scope exception, other than the required documentation of the contracts as normal. Big City Bakery wants to treat some of the contracts as derivatives and to document some of the contracts as normal. It is permitted under ASC 815 to simply choose not to document some of the contracts as normal. In such a case, the contracts that are documented as normal will receive the scope exception and those that are not documented as normal will be accounted for as derivatives under ASC 815.

2.3.2.1 Normal Terms (Including Normal Quantity)

ASC 815-10

15-27 To qualify for the scope exception, a contract’s terms must be consistent with the terms of an entity’s normal purchases or normal sales, that is, the quantity purchased or sold must be reasonable in relation to the entity’s business needs. Determining whether or not the terms are consistent requires judgment.

15-28 In making those judgments, an entity should consider all relevant factors, including all of the following:

The quantities provided under the contract and the entity’s need for the related assets
The locations to which delivery of the items will be made
The period of time between entering into the contract and delivery
The entity’s prior practices with regard to such contracts.

15-29 Further, each of the following types of evidence should help in identifying contracts that qualify as normal purchases or normal sales:

Past trends
Expected future demand
Other contracts for delivery of similar items
An entity’s and industry’s customs for acquiring and storing the related commodities
An entity’s operating locations.

For guidance on normal purchases and normal sales as hedged items, see paragraph 815-20-25-7.

When evaluating whether to use the NPNS scope exception, an entity should consider whether the contract provides for the delivery or sale of an asset in quantities that are expected to be used or sold by the entity over a reasonable period in the normal course of business. The entity should consider factors such as the following:

The quantities provided under the contract and the entity’s need for the related assets.3
The locations to which the items will be delivered.
The period between entering into the contract and the delivery.
The entity’s prior practices with regard to such contracts.

In addition, an entity should consider evidence such as past trends, expected future demand for the items, other contracts for delivery of similar items, the entity’s and industry’s customs for acquiring and storing the related commodities, and the entity’s operating locations.

The factors noted above may not all apply to both parties to the contract. As a result, the buyer and seller may reach different accounting conclusions (e.g., although the seller may consider the quantity sold as normal, the buyer may not consider it to be a quantity that will be used or sold in the normal course of its business over a reasonable period).

Contracts that are entered into with the objective of generating profits from market price changes are not eligible for the NPNS scope exception. Such an objective is inconsistent with the concept that the quantities delivered should be the expected quantities to be used or sold in the normal course of business.

Example 2-3

Probable Delivery of an Asset Not Used in an Entity’s Production, Manufacturing, or Operations

A manufacturer enters into a contract to purchase gold and asserts that it is probable that physical delivery will be made. The manufacturer does not use gold in its production, manufacturing, or other operations. Therefore, the gold purchase contract cannot be designated as a normal purchase because the manufacturer will not use it in its normal course of business. Similarly, if the manufacturer had an operation that bought and sold gold on the open market with the intent to speculate, trade, or deal in gold, the forward contract could not be designated as a normal purchase because trading operations cannot qualify for the NPNS scope exception.

2.3.2.2 Clearly-and-Closely-Related Underlying

ASC 815-10

15-30 Contracts that have a price based on an underlying that is not clearly and closely related to the asset being sold or purchased (such as a price in a contract for the sale of a grain commodity based in part on changes in the Standard and Poor’s index) or that are denominated in a foreign currency that meets none of the criteria in paragraph 815-15-15-10(b) shall not be considered normal purchases and normal sales.

15-31 The phrase not clearly and closely related in the preceding paragraph with respect to the normal purchases and normal sales scope exception is used to convey a different meaning than in paragraphs 815-15-25-1(a) and 815-15-25-16 through 25-51 with respect to the relationship between an embedded derivative and the host contract in which it is embedded. The guidance in this discussion of normal purchases and normal sales does not affect the use of the phrase not clearly and closely related in paragraphs other than the preceding paragraph. For purposes of determining whether a contract qualifies for the normal purchases and normal sales scope exception, the application of the phrase not clearly and closely related to the asset being sold or purchased shall involve an analysis of both qualitative and quantitative considerations. The analysis is specific to the contract being considered for the normal purchases and normal sales scope exception and may include identification of the components of the asset being sold or purchased.

15-32 The underlying in a price adjustment incorporated into a contract that otherwise satisfies the requirements for the normal purchases and normal sales scope exception shall be considered to be not clearly and closely related to the asset being sold or purchased in any of the following circumstances:

The underlying is extraneous (that is, irrelevant and not pertinent) to both the changes in the cost and the changes in the fair value of the asset being sold or purchased, including being extraneous to an ingredient or direct factor in the customary or specific production of that asset.
If the underlying is not extraneous as discussed in (a), the magnitude and direction of the impact of the price adjustment are not consistent with the relevancy of the underlying. That is, the magnitude of the price adjustment based on the underlying is significantly disproportionate to the impact of the underlying on the fair value or cost of the asset being purchased or sold (or of an ingredient or direct factor, as appropriate).
The underlying is a currency exchange rate involving a foreign currency that meets none of the criteria in paragraph 815-15-15-10(b) for that reporting entity.

15-33 For example, in the case in which the price adjustment focuses on the changes in the fair value of the asset being purchased or sold, if the terms of the price adjustment are expected, at the inception of the contract, to affect the purchase or sales price in a manner comparable to the outcome that would be obtained if, at each delivery date, the parties were to reprice the contract amount under the then-existing conditions for the asset being delivered on that date, the price adjustment’s underlying is considered to be clearly and closely related to the asset being sold or purchased and the price adjustment would not be an impediment to the contract qualifying for the normal purchases and normal sales scope exception.

15-34 If the underlying in a price adjustment incorporated into a purchase or sales contract is not an impediment to qualifying for the normal purchases and normal sales scope exception because it is considered to be clearly and closely related to the asset being sold or purchased, the contract must meet the other requirements in this Subsection to qualify for the normal purchases and normal sales scope exception.

For a contract to qualify for the NPNS scope exception, ASC 815-10-15-30 requires, among other things, that the price of the contract not be “based on an underlying that is not clearly and closely related to the asset being sold or purchased.” ASC 815-10-15-31 through 15-34 provide interpretations of what “clearly and closely related” means in the context of the NPNS scope exception.

Under ASC 815-10-15-31 through 15-34, “application of the phrase not clearly and closely related to the asset being sold or purchased shall involve an analysis of both qualitative and quantitative considerations.” Such analysis, which must be performed only at the inception of contract, “is specific to the contract being considered for the normal purchases and normal sales scope exception and may include identification of the components of the asset being sold or purchased.” ASC 815-10-15-32 notes three circumstances in which the underlying in a “price adjustment” incorporated into a contract would be considered to be “not clearly and closely related to the asset being sold or purchased,” thereby preventing the contract from qualifying for the NPNS scope exception:

The underlying is extraneous (that is, irrelevant and not pertinent) to both the changes in the cost and the changes in the fair value of the asset being sold or purchased, including being extraneous to an ingredient or direct factor in the customary or specific production of that asset.
If the underlying is not extraneous . . . , the magnitude and direction of the impact of the price adjustment are not consistent with the relevancy of the underlying. That is, the magnitude of the price adjustment based on the underlying is significantly disproportionate to the impact of the underlying on the fair value or cost of the asset being purchased or sold (or of an ingredient or direct factor, as appropriate).
The underlying is a currency exchange rate involving a foreign currency that meets none of the criteria in paragraph 815-15-15-10(b) for that reporting entity.

Accordingly, if a finished product made from raw material does not fall into any of the three categories described in ASC 815-10-15-32 above, the contract to purchase or sell the raw material may qualify for the NPNS scope exception if it meets the other requirements in ASC 815-10-15-22 through 15-51.

2.3.2.3 Probable Physical Settlement

ASC 815-10

15-35 For a contract that meets the net settlement provisions of paragraphs 815-10-15-100 through 15-109 and the market mechanism provisions of paragraphs 815-10-15-110 through 15-118 to qualify for the normal purchases and normal sales scope exception, it must be probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery.

15-36 The normal purchases and normal sales scope exception only relates to a contract that results in gross delivery of the commodity under that contract. The normal purchases and normal sales scope exception shall not be applied to a contract that requires cash settlements of gains or losses or otherwise settle gains or losses periodically because those settlements are net settlements. Paragraph 815-20-25-22 explains how an entity may designate such a contract as a hedged item in an all-in-one hedge if all related criteria are met.

15-36A Certain contracts for the purchase or sale of electricity on a forward basis that necessitate transmission through, or delivery to a location within, an electricity grid operated by an independent system operator result in one of the contracting parties incurring charges (or credits) for the transmission of that electricity based in part on locational marginal pricing differences payable to (or receivable from) the independent system operator. For example, this is the case when the delivery location under the contract (for example, a hub location) is not the same location as the point of ultimate consumption of the electricity or the point from which the electricity exits the electricity grid for transmission to a customer load zone. Delivery to the point of ultimate consumption or the exit point is facilitated by the independent system operator of the grid. The purchase or sale contract and the transmission services do not constitute a series of sequential contracts intended to accomplish the ultimate acquisition or sale of a commodity as discussed in paragraph 815-10-15-41, and the use of locational marginal pricing to determine the transmission charge (or credit) does not constitute net settlement, even in situations in which legal title to the associated electricity is conveyed to the independent system operator during transmission.

If a contract permits contractual net settlement or there is a market mechanism to facilitate net settlement, both of the following must be probable at inception and throughout the term of the individual contract for it to qualify for the NPNS scope exception:

The contract will not net settle.
The contract will result in physical delivery.

The NPNS scope exception is not available for contracts that require cash settlements of gains or losses or that otherwise settle gains or losses on a periodic basis.

Aside from certain capacity contracts (see further discussion in Section 2.3.2.6.4), contracts that are subject to unplanned netting (i.e., “bookouts”) do not qualify for the NPNS scope exception even if an entity can conclude that physical delivery is probable.

An entity is required to assess, on an ongoing basis, whether it is probable that a contract will result in physical delivery and will not net settle. A net settlement of one contract may cause similar contracts to not be eligible for the exception.

Example 2-4

Exchange-for-Physical Arrangements

In January 20X1, Natural Fabrics Co. enters into a futures contract to buy cotton to hedge the anticipated purchase of cotton for its fabric production planned for December 20X1. In the cotton industry, brokers are generally unwilling to enter into forward delivery contracts before the given year’s cotton crop has been planted unless the buyer pays a significant premium. However, futures contracts can be used to cover these longer periods. Futures contracts do not qualify for the NPNS scope exception, so Natural Fabrics Co. designates the contract it entered into as a cash flow hedge of the forecasted purchase of cotton in December because all the requirements for a cash flow hedge are met.

In May, when the acreage of cotton planted is known and weather patterns are forecasted, brokers are willing to enter into fixed-price forward contracts to sell cotton without significant premiums. Consequently, Natural Fabrics Co. assigns its rights and obligations under the futures contract to a broker, who “steps into” Natural Fabrics Co.’s position and simultaneously enters into a forward contract with Natural Fabrics Co. for the delivery of cotton in December. Since the price of cotton has increased between January and May, the futures contract has a positive fair value. The inherent gain in the contract is assumed by the broker, and Natural Fabrics Co. receives no cash premium from the broker. However, the price under the fixed-price forward agreement is adjusted so that the forward contract has a positive fair value equal to the fair value of the futures contract surrendered. Arrangements in which a futures contract is exchanged for a forward contract are typically called exchange-for-physical arrangements.

The forward contract that Natural Fabrics Co. purchases in May could qualify for the NPNS scope exception, even though it is not entered into at market, if it meets the criteria for a normal purchase contract as specified in ASC 815-10-15-22 through 15-51. To qualify for the NPNS scope exception, Natural Fabrics Co. needs to assert that the delivery of cotton under the forward contract is probable.

2.3.2.4 Net Settlement of a Contract to Which the NPNS Scope Exception Is Applied

The net settlement of a normal contract does not necessarily taint the designation of a company’s other normal contracts. ASC 815-10-15-41 states that “[n]et settlement . . . of contracts in a group of contracts similarly designated as normal purchases and normal sales would call into question the classification of all such contracts as normal purchases or normal sales.” Each time a company net settles a normal contract, it must consider how the facts and circumstances that resulted in net settlement (and any prior net settlements) affect the assertion that physical delivery under similar contracts is still probable.

For example, assume that a power supply company does not deliver on a normal delivery contract because its power plant was down for a day after a small fire. Such an occurrence would probably not affect the designation of the company’s other normal delivery contracts for the next month. However, if the power supply company net settled a normal contract at a significant gain to take advantage of a favorable change in the price of electricity, that would probably call into question its intent to deliver under similar contracts.

Example 2-5

NPNS Election When Assets Are Immediately Sold

SnackFood Company has a series of normal fixed-price forward contracts to purchase rice, which is used in the production of the rice cakes it sells. The forward contracts meet the definition of a derivative as well as the RCC criteria in ASC 815-10-15-119, but they do not meet the other net settlement criteria (i.e., no explicit net settlement, no market mechanism). SnackFood takes delivery of the rice and immediately sells it on the spot market instead of using it in its operations. The NPNS scope exception is available for contracts that provide for the delivery of an asset that is expected to be used by an entity over a reasonable period in the normal course of business. SnackFood effectively used the spot market to net settle the forward contracts. It should now consider how the net settlement of these normal purchase contracts affects the designation of similar normal contracts.

Example 2-6

NPNS Election and Changes in Anticipated Use of Assets

Bluebread Company has a series of normal fixed-price contracts to purchase wheat from Wheat Farmco. Wheat is an ingredient used in the production of the bread that Bluebread sells. The contracts meet the definition of a derivative as well as the RCC criteria in ASC 815-10-15-119, but they do not meet the other net settlement criteria (i.e., no explicit net settlement, no market mechanism). Before delivery under the contracts is scheduled, Bluebread’s employees go on strike. Bluebread does not need the monthly shipment of wheat, so it enters into a forward contract to sell the wheat to HealthyBakery and arranges for Wheat Farmco to deliver the wheat directly to HealthyBakery. However, Bluebread is not relieved of its rights and obligations under the forward purchase contract with Wheat Farmco. Bluebread must pay Wheat Farmco the full amount under the purchase contract, and HealthyBakery must pay Bluebread the full amount under the sale contract.

The NPNS scope exception is available for contracts that provide for the delivery of an asset that is expected to be used by an entity over a reasonable period in the normal course of business. Even though Bluebread did not explicitly net settle the forward contract with Wheat Farmco, it did not take delivery of the wheat. At the time it entered into the forward sale agreement with HealthyBakery, Bluebread could no longer support the assertion that delivery of the wheat under the normal purchase contract with Wheat Farmco was probable. Therefore, the contract would need to be dedesignated as “not normal” and accounted for as a derivative under ASC 815. Bluebread should also consider how the net settlement of this normal purchase contract affects the designation of similar normal contracts.

In addition, the forward sales contract with HealthyBakery would not qualify for the normal sales exception because Bluebread does not sell wheat as part of its normal operations.

2.3.2.5 Documentation

ASC 815-10

15-37 For contracts that qualify for the normal purchases and normal sales exception under any provision of paragraphs 815-10-15-22 through 15-51, the entity shall document the designation of the contract as a normal purchase or normal sale, including either of the following:

For contracts that qualify for the normal purchases and normal sales exception under paragraph 815-10-15-41 or 815-10-15-42 through 15-44, the entity shall document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.
For contracts that qualify for the normal purchases and normal sales exception under paragraphs 815-10-15-45 through 15-51, the entity shall document the basis for concluding that the agreement meets the criteria in that paragraph, including the basis for concluding that the agreement is a capacity contract.

15-38 The documentation requirements can be applied either to groups of similarly designated contracts or to each individual contract. Failure to comply with the documentation requirements precludes application of the normal purchases and normal sales scope exception to contracts that would otherwise qualify for that scope exception.

15-39 The normal purchases and normal sales scope exception could effectively be interpreted as an election in all cases. However, once an entity documents compliance with the requirements of paragraphs 815-10-15-22 through 15-51, which could be done at the inception of the contract or at a later date, the entity is not permitted at a later date to change its election and treat the contract as a derivative instrument.

In the event that an entity elects to apply the NPNS scope exception for a qualifying contract, it should document the designation of the contract as NPNS, including either of the following:

Its basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.
Its basis for concluding that the agreement meets the criteria in ASC 815-10-15-43 through 15-51 (see Section 2.3.2.6), including the basis for concluding that the agreement is a capacity contract.

It is possible to apply the documentation requirements either to groups of similarly designated contracts or to each individual contract. If the documentation requirements are not met, the NPNS scope exception cannot be applied to a contract that would otherwise qualify for the NPNS scope exception.

2.3.2.6 Applicability of the NPNS Scope Exception to Specific Types of Contracts

To help entities determine whether a contract is eligible for the NPNS scope exception, ASC 815 distinguishes between options, forward contracts, and forward contracts with optionality.

2.3.2.6.1 Freestanding Option Contracts

ASC 815-10

15-26 Also discussed is guidance that should be considered in determining whether each of the following specific types of contracts qualifies for the normal purchases and normal sales scope exception:

Freestanding option contracts
Forward (non-option-based) contracts
Forward contracts that contain optionality features
Power purchase or sale agreements.

15-40 Option contracts that would require delivery of the related asset at an established price under the contract only if exercised are not eligible to qualify for the normal purchases and normal sales scope exception, except as indicated in paragraphs 815-10-15-45 through 15-51.

Option contracts are not eligible for this scope exception unless they are capacity contracts that meet certain criteria (see Section 2.3.2.6.4). Because of the nature of option contracts, an entity cannot determine at the inception of the contract that it will be probable throughout the contract’s term that physical delivery under that specific contract will occur.

2.3.2.6.2 Forward Contracts

ASC 815-10

15-41 Forward contracts are eligible to qualify for the normal purchases and normal sales scope exception. However, forward contracts that contain net settlement provisions as described in either paragraphs 815-10-15-100 through 15-109 or 815-10-15-110 through 15-118 are not eligible for the normal purchases and normal sales scope exception unless it is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery. Contracts that are subject to unplanned netting (referred to as a book-out in the electric utility industry) do not qualify for this scope exception except as specified in paragraph 815-10-15-46. Net settlement (as described in paragraphs 815-10-15-100 through 15-109 and 815-10-15-110 through 15-118) of contracts in a group of contracts similarly designated as normal purchases and normal sales would call into question the classification of all such contracts as normal purchases or normal sales. Contracts that require cash settlements of gains or losses or are otherwise settled net on a periodic basis, including individual contracts that are part of a series of sequential contracts intended to accomplish ultimate acquisition or sale of a commodity, do not qualify for the normal purchases and normal sales scope exception.

Forward contracts for a quantity that is expected to be used or sold by the entity over a reasonable period in the normal course of business generally qualify for the NPNS scope exception; however, a contract that contains net settlement provisions as described in either ASC 815-10-15-100 through 15-109 or ASC 815-10-15-110 through 15-118 would only qualify for the NPNS scope exception if it is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery.

Requirements contracts, such as those described in ASC 815-10-55-5 through 55-7 and discussed further in Section 1.4.1.2.1, should be carefully considered to determine whether they both meet the definition of a derivative and qualify for the NPNS scope exception. See below for further discussion of whether requirements contracts should be considered forwards or options.

2.3.2.6.3 Forward Contracts That Contain Optionality Features

ASC 815-10

15-42 Forward contracts that contain optionality features that do not modify the quantity of the asset to be delivered under the contract are eligible to qualify for the normal purchases and normal sales scope exception. Except for power purchase or sales agreements addressed in paragraphs 815-10-15-45 through 15-51, if an option component permits modification of the quantity of the assets to be delivered, the contract is not eligible for the normal purchases and normal sales scope exception, unless the option component permits the holder only to purchase or sell additional quantities at the market price at the date of delivery. For forward contracts that contain optionality features to qualify for the normal purchases and normal sales scope exception, the criteria discussed in the preceding paragraph must be met.

15-43 If the optionality feature in the forward contract can modify the quantity of the asset to be delivered under the contract and that option feature has expired or has been completely exercised (even if delivery has not yet occurred), there is no longer any uncertainty as to the quantity to be delivered under the forward contract. Accordingly, following such expiration or exercise, the forward contract would be eligible for designation as a normal purchase or normal sale, provided that the other applicable conditions in this Subsection are met. Example 10 (see paragraph 815-10-55-121) illustrates this guidance.

15-44 The inclusion of a purchased option that would, if exercised, require delivery of the related asset at an established price under the contract within a single contract that meets the definition of a derivative instrument disqualifies the entire contract from being eligible to qualify for the normal purchases and normal sales scope exception in this Subsection except as provided in the following paragraph through paragraph 815-10-15-51 with respect to certain power purchase or sales agreements.

Contracts That Combine a Forward Contract and a Purchased Option Contract

55-24 Paragraph 815-10-15-44 states that the inclusion of a purchased option that would, if exercised, require delivery of the related asset at an established price under the contract within a single contract that meets the definition of a derivative instrument disqualifies the entire contract from being eligible to qualify for the normal purchases and normal sales scope exception in this Subsection except as provided in paragraphs 815-10-15-45 through 15-51 with respect to certain power purchase or sales agreements. Although the guidance that follows discusses such circumstances in the context of utilities and independent power producers, it applies to all entities that enter into contracts that combine a forward contract and a purchased option contract, not just to utilities and independent power producers. Some utilities and independent power producers have fuel supply contracts that require delivery of a contractual minimum quantity of fuel at a fixed price and have an option that permits the holder to take specified additional amounts of fuel at the same fixed price at various times. Essentially, that option to take more fuel is a purchased option that is combined with the forward contract in a single supply contract. Typically, the option to take additional fuel is built into the contract to ensure that the buyer has a supply of fuel to produce the electricity during peak demands; however, the buyer may have the ability to sell to third parties the additional fuel purchased through exercise of the purchased option. Due to the difficulty in estimating peak electricity load and thus the amount of fuel needed to generate the required electricity, those fuel supply contracts are common in the electric utility industry (though similar supply contracts may exist in other industries).

55-25 Those fuel supply contracts are not requirements contracts that are addressed in paragraphs 815-10-55-5 through 55-7. Many of those contracts meet the definition of a derivative instrument because they have a notional amount and an underlying, require no or a smaller initial net investment, and provide for net settlement (for example, through their default provisions or by requiring delivery of an asset that is readily convertible to cash). The fuel supply contract cannot qualify for the normal purchases and normal sales exception because of the optionality regarding the quantity of fuel to be delivered under the contract.

55-26 An entity shall not bifurcate the forward contract component and the option component of a fuel supply contract that in its entirety meets the definition of a derivative instrument and then assert that the forward contract component is eligible to qualify for the normal purchases and normal sales exception.

55-29 If the option component does not provide any benefit to the holder beyond the assurance of a guaranteed supply of the underlying commodity for use in the normal course of business and that option component only permits the holder to purchase additional quantities at the market price at the date of delivery (that is, that option component will always have a fair value of zero), that option component would not require delivery of the related asset at an established price under the contract.

Forward purchase and sale contracts may include optionality, including optionality related to the price or quantity to be purchased or sold. Pricing optionality does not generally prevent a contract from being eligible for the NPNS scope exception. If, however, the pricing optionality is attributable to a price adjustment clause based on an underlying that is unrelated to the asset to be delivered, the contract may not qualify for the NPNS scope exception.

By contrast to pricing optionality, optionality related to quantity may cause a contract to be ineligible for the NPNS scope exception. However, a forward contract that requires the purchase of a specified quantity at an established price but also provides the option of purchasing additional quantities at the market price on the date of delivery is eligible for the NPNS scope exception.

There is a limited exception for capacity contracts for the purchase and sale of electricity (see ASC 815-10-15-45 through 15-51, ASC 815-10-55-31, and Section 2.3.2.6.4).

Example 2-7

Option Contracts at a Fixed Price and the NPNS Scope Exception

A manufacturer enters into a contract to buy a fixed quantity of 10,000 gallons of heating oil from its local supplier each month at a fixed price for the next two years. The contract gives the manufacturer an option to increase the quantity to 12,000 gallons each month at a fixed price. The existence of the embedded purchase option disqualifies the entire instrument from being eligible for the NPNS scope exception since the option permits modification of the quantity of the assets to be delivered.

Example 2-8

Option Contracts at Market Price and the NPNS Scope Exception

Assume the same facts as Example 2-7, except that optional purchases of additional heating oil (i.e., above the 10,000-gallon minimum) would be executed at the applicable market price on the date the supplier delivers the heating oil. In this case, the contract could potentially qualify for the NPNS scope exception (provided that all other conditions are met), since the optional purchases in excess of the 10,000 gallons (i.e., the fixed quantity at the fixed price) would be made at the then-market price.

ASC 815-10-15-40 states that option contracts cannot qualify for the NPNS scope exception. Further, as indicated in ASC 815-10-15-42 through 15-44, if a forward contract includes any embedded volumetric options (i.e., options that provide for the purchase or sale of additional units at a fixed price), the entire forward contract may be disqualified from being considered normal. Bifurcation of the forward and option components of the contract is not permitted under the guidance in ASC 815-15-15-4 and ASC 815-10-55-24 through 55-30. Therefore, because (1) an option cannot qualify as a normal purchase or normal sale under ASC 815-10-15-40 and (2) the instrument cannot be bifurcated into components, the entire instrument must be accounted for as a derivative under ASC 815.

ASC 815-10-15-9 prohibits an entity from structuring an arrangement to circumvent the provisions of ASC 815 through multiple separate transactions. However, ASC 815-10-55-27 creates an exception to this principle for the application of the NPNS scope exception to an arrangement involving optional purchases. That is, this paragraph indicates that an entity can enter into two distinct contracts — a forward contract and an option contract — that achieve the same economic outcome as a single contract. This exception allows the forward contract to potentially qualify for the NPNS scope exception, subject to meeting other requirements of ASC 815; in such case, only the freestanding option would be accounted for as a derivative. This concept is further elaborated in ASC 815-10-55-30.

ASC 815-10

55-27 An entity may wish to enter into two separate contracts — a forward contract and an option — that economically achieve the same results as the single derivative instrument and determine whether the normal purchases and normal sales scope exception (as discussed beginning in paragraph 815-10-15-22) applies to the separate forward contract.

55-30 If an entity’s single supply contract included at its inception both a forward contract and an option and, in subsequent renegotiations, that contract is negated and replaced by two separate contracts (a forward contract for a specific quantity that will be purchased and an option for additional quantities whose purchase is conditional upon exercise of the option), the new forward contract would be eligible to qualify for the normal purchases and normal sales exception (as discussed beginning in paragraph 815-10-15-22), whereas the new option would not be eligible for that exception. From its inception the new separate option would be accounted for under this Subtopic.

Given this guidance, if the entity in Example 2-7 wanted to avoid treating the entire option contract as a derivative, it could structure the transaction in two separate contracts: (1) a forward to meet its expected needs and (2) an option contract to meet any forecasted but less certain needs. In this case, the forward contract may qualify as a normal purchase and only the purchased option would be accounted for as a derivative. In addition, as noted in ASC 815-10-15-42, a contract may qualify for the NPNS scope exception if the option contract (or component of a contract) only permits the holder to purchase or sell additional quantities at the market price on the delivery date.

The preclusion from qualifying for the NPNS scope exception for forward contracts with embedded optionality that may affect the quantity to be delivered does not necessarily apply to all such contracts. Therefore, the forward component and option component of a contract still must be analyzed under the provisions of ASC 815 to determine whether each component meets the definition of a derivative. A forward component or embedded option component of the contract may or may not contain a notional amount4 if either component is a requirements contract, as noted in ASC 815-10-55-5 through 55-7. For example, assume that a contract is similar to contract 3 in ASC 815-10-55-5 (see Section 1.4.1.2.1), in which the buyer must purchase a minimum of 60 units (the forward component) and has an option to purchase as many units as needed above 60 to satisfy its actual needs. In such a contract, the forward component does have a notional amount and may meet the definition of a derivative. Evaluation of the option component should include consideration of whether this component contains a notional amount.5 If the option component does not have a notional amount because of the lack of “explicit provisions,” such a contract, in its entirety, may qualify for the NPNS scope exception.

Because the type of arrangement described above (i.e., a requirements contract) does not permit the purchase or sale of a quantity that is greater than or less than the buyer needs, it differs from the contracts discussed in Examples 2-7 and 2-8, which provide an election to buy or sell above a specified amount or to exercise an additional purchase option. Unlike contracts with true optionality, a requirements contract does not allow the counterparties to choose whether, or at what volume, to exercise an option, since the buyer and seller are required to purchase and deliver, respectively, the amount that satisfies the specified needs of the buyer. Accordingly, it is possible for a requirements contract to qualify for the NPNS scope exception if it contains a forward (for the minimum amount under the contract) and optionality for an additional quantity above the minimum amount, whereas similar contracts that are not considered requirements contract may not qualify.

Example 2-9

Requirements Contracts and the NPNS Scope Exception

Company G, a producer of packaged baked goods, enters into a purchase agreement with Company F to supply all the corn that G needs as an input to production at its facility in Chicago, IL, between March 1, 20X4, and February 28, 20X5. Under the terms of the agreement, G is required to purchase at least 100 bushels per day but can elect to purchase additional amounts to satisfy its needs, so long as the purchased corn is only for use at the Chicago facility. Company G is specifically precluded from reselling corn purchased under the terms of this agreement to third parties.

This contract represents a requirements contract. The optional additional quantity above 100 bushels per day is not included in the notional amount; instead, the notional amount is related only to the required 100 bushels per day. Accordingly, provided that all other relevant criteria are met, the contract could qualify for the NPNS scope exception.

The FASB implementation guidance below illustrates the concepts discussed above.

ASC 815-10

Example 10: Normal Purchases and Normal Sales — Application to Forward Contracts That Contain Optionality Features

55-121 In some circumstances, an option may be combined with a forward contract. In some instances, the optionality feature in the forward contract can modify the quantity of the asset to be delivered under the contract. In other cases, the optionality feature in the forward contract can modify only the price to be paid or the timing of the delivery.

55-122 This Example presents three Cases of forward contracts with optionality features:

Optionality feature involving price floor (cash-settled put option) written by purchaser and price cap (cash-settled call option) written by seller (Case A)
Optionality feature involving cash-settled put option written by purchaser (Case B)
Optionality feature involving physically settled put option written by purchaser (Case C).

55-123 In Cases A, B, and C, the optionality feature must be analyzed to determine whether it could modify the quantity of the asset to be delivered under the contract. In doing so, the conclusion as to whether the contract is eligible for the normal purchases and normal sales scope exception applies in the same way to both counterparties — the purchaser and the writer of the option (within the forward contract).

55-124 The contracts addressed in this Example do not have a price based on an underlying that is not clearly and closely related to the asset being purchased, nor do they require cash settlement of gains or losses as stipulated in paragraph 815-10-15-22.

55-125 Paragraph 815-10-15-43 explains that, if the optionality feature in the forward contract can modify the quantity of the asset to be delivered under the contract, but that option feature has expired or has been completely exercised (even if delivery has not yet occurred), there is no longer any uncertainty as to the quantity to be delivered under the forward contract. That paragraph explains that, following such expiration or exercise, the forward contract would be eligible for designation as a normal purchase or normal sale, provided that the other conditions in paragraph 815-10-15-22 are met.

Case A: Optionality Feature Involving Price Floor (Cash-Settled Put Option) Written by Purchaser and Price Cap (Cash-Settled Call Option) Written by Seller

55-126 Entity A enters into a forward contract to purchase on a specified date a specified quantity of a raw material that is readily convertible to cash. The purchase price is the current market price on the date of purchase, not to exceed a specified maximum price (a cap) nor to be less than a specified minimum price (a floor).

55-127 In this Case, the optionality feature cannot modify the quantity to be delivered; thus, the contract is eligible to qualify for the normal purchases and normal sales scope exception.

Case B: Optionality Feature Involving Cash-Settled Put Option Written by Purchaser

55-128 Entity B enters into a forward contract to purchase on a specified date a specified quantity of a raw material that is readily convertible to cash. The contract’s purchase price is a fixed amount per unit that is below the current forward price; however, if the market price on the date of purchase has fallen below a specified level, Entity B’s purchase price would be adjusted to a higher fixed amount significantly in excess of the current forward price at the inception of the contract. (The contract entered into by Entity B is a compound derivative consisting of a forward contract to purchase raw material at the original fixed price and a written option that obligates Entity B to purchase the raw material for the higher adjusted price if the market price of the raw material falls below the specified level. In exchange for the written option, Entity B received a premium representing the difference between the purchase price in the contract and the forward market price of the raw material at the inception of the contract.)

55-129 The forward purchase contract in this Case is eligible to qualify for the normal purchases and normal sales scope exception because the optionality feature in the contract cannot modify the quantity to be delivered.

Case C: Optionality Feature Involving Physically Settled Put Option Written by Purchaser

55-130 Entity C enters into a forward contract to purchase on a specified date a specified quantity of a raw material that is readily convertible to cash. The contract’s purchase price is a fixed amount per unit that is below the current forward price. However, if the market price on the date of purchase has fallen below a specified level that is below the contract’s fixed purchase price, Entity C would be required to purchase a specified additional quantity of the raw material at the contract’s fixed purchase price (which is above the current market price on the date of purchase). (The contract entered into by Entity C is a compound derivative consisting of a forward contract to purchase raw material at the original fixed price and a written option that obligates Entity C to purchase additional quantities of the raw material at an above-market price if the market price of the raw material falls below the specified level.)

55-131 The contract in this Case is not eligible to qualify for the normal purchases and normal sales scope exception because the optionality feature in the contract can modify the quantity of the asset to be delivered under the contract.

2.3.2.6.4 Capacity Contracts

ASC 815-10

15-45 Notwithstanding the criteria in paragraphs 815-10-15-41 through 15-44, a power purchase or sales agreement (whether a forward contract, option contract, or a combination of both) that is a capacity contract for the purchase or sale of electricity also qualifies for the normal purchases and normal sales scope exception if all of the following applicable criteria are met:

For both parties to the contract, both of the following criteria are met:
1. The terms of the contract require physical delivery of electricity. That is, the contract does not permit net settlement, as described in paragraphs 815-10-15-100 through 15-109. For an option contract, physical delivery is required if the option contract is exercised. Certain contracts for the purchase or sale of electricity on a forward basis that necessitate transmission through, or delivery to a location within, an electricity grid operated by an independent system operator result in one of the contracting parties incurring charges (or credits) for the transmission of that electricity based in part on locational marginal pricing differences payable to (or receivable from) the independent system operator. For example, this is the case when the delivery location under the contract (for example, a hub location) is not the same location as the point of ultimate consumption of the electricity or the point from which the electricity exits the electricity grid for transmission to a customer load zone. Delivery to the point of ultimate consumption or the exit point is facilitated by the independent system operator of the grid. The use of locational marginal pricing to determine the transmission charge (or credit) does not constitute net settlement, even in situations in which legal title to the associated electricity is conveyed to the independent system operator during transmission.
2. The power purchase or sales agreement is a capacity contract. Differentiating between a capacity contract and a traditional option contract (that is, a financial option on electricity) is a matter of judgment that depends on the facts and circumstances. For power purchase or sale agreements that contain option features, the characteristics of an option contract that is a capacity contract and a traditional option contract, which are set forth in paragraph 815-10-55-31 shall be considered in that evaluation; however, other characteristics not listed in that paragraph may also be relevant to that evaluation.
For the seller of electricity: The electricity that would be deliverable under the contract involves quantities that are expected to be sold by the reporting entity in the normal course of business.
For the buyer of electricity, all of the following criteria are met:
1. The electricity that would be deliverable under the contract involves quantities that are expected to be used or sold by the reporting entity in the normal course of business.
2. The buyer of the electricity under the power purchase or sales agreement is an entity that meets both of the following criteria:
  1. The entity is engaged in selling electricity to retail or wholesale customers.
  2. The entity is statutorily or otherwise contractually obligated to maintain sufficient capacity to meet electricity needs of its customer base.
3. The contracts are entered into to meet the buyer’s obligation to maintain a sufficient capacity, including a reasonable reserve margin established by or based on a regulatory commission, local standards, regional reliability councils, or regional transmission organizations.

15-46 Power purchase or sales agreements that meet only the applicable criteria in paragraph 815-10-15-45 qualify for the normal purchases and normal sales scope exception even if they are subject to being booked out or are scheduled to be booked out.

15-47 Forward contracts for the purchase or sale of electricity that do not meet those applicable criteria as well as other forward contracts are nevertheless eligible to qualify for the normal purchases and normal sales scope exception by meeting the criteria in this Subsection (other than paragraph 815-10-15-45), unless those contracts are subject to unplanned netting (that is, subject to possibly being booked out).

15-48 Because electricity cannot be readily stored in significant quantities and the entity engaged in selling electricity is obligated to maintain sufficient capacity to meet the electricity needs of its customer base, an option contract for the purchase of electricity that meets the criteria in paragraph 815-10-15-45 qualifies for the normal purchases and normal sales scope exception in that paragraph.

15-49 This guidance does not affect the accounting for requirements contracts that would not be required to be accounted for under the guidance in this Subtopic pursuant to paragraphs 815-10-55-5 through 55-7.

15-50 Contracts that qualify for the normal purchases and normal sales scope exception based on this guidance do not require compliance with any additional guidance in paragraphs 815-10-15-22 through 15-44. However, contracts that have a price based on an underlying that is not clearly and closely related to the electricity being sold or purchased or that are denominated in a foreign currency that meets none of the criteria in paragraph 815-15-15-10(b) shall not be considered normal purchases and normal sales.

15-51 This guidance shall not be applied by analogy to the accounting for other types of contracts not meeting the stated criteria.

55-31 The following table lists characteristics of an option that is a capacity contract and a traditional option. The characteristics listed may be relevant to the application of paragraph 815-10-15-45(a)(2). Other characteristics not listed may also be relevant.

Option Contract That Is a Capacity Contract	Financial Option Contract on Electricity
1 The contract usually specifies the power plant or group of power plants providing the electricity.	No reference is made to the generation origination of the electricity.
2 The strike price (paid upon exercise) includes pricing terms to compensate the plant operator for variable operations and maintenance costs expected during the specified production periods.	The strike price is structured based on the expected forward prices of power.
3 The specified quantity is based on individual needs of parties to the agreement.	The specified quantity reflects standard amounts of electric energy, which facilitate market liquidity (for example, exercise in increments of 10,000 kilowatt-hours).
4 The title transfer point is usually at one or a group of specified physical delivery point(s), as opposed to a major market hub.	The specified index transfer point is a major market hub (liquid trading hub), not seller- or buyer-site specific.
5 The contract usually specifies certain operational performance by the facility (for example, the achievement of a certain heat rate).	No operational performance is specified (not plant specific).
6 The contract sometimes incorporates requirements for interconnection facilities, physical transmission facilities, or reservations for transmission services.	None specified.
7 The contract may specify jointly agreed-to plant outages (for example, for maintenance) and provide for penalties in the event of unexpected outages.	Penalties for outages are not specified (not plant specific).
8 Damage provisions upon default are usually based on a reduction of the capacity payment (which is not market based). If default provisions specify market liquidating damages, they usually contain some form of floor, ceiling, or both. The characteristics of the default provision are usually tied to the expected generation facility.	Damage provisions upon default are based on market liquidating damages.
9 The contract’s term is usually long (one year or more).	The contract’s term is not longer than 18 to 24 months because financial options on electricity are currently illiquid beyond that period.

ASC 815-10-15-45 through 15-51 and ASC 815-10-55-31 clarify the application of the NPNS scope exception specifically to capacity contracts for the purchase or sale of electricity (i.e., power purchase and sale contracts). In providing such guidance, the FASB acknowledged the unique nature of arrangements in that industry.

For example, electricity cannot be readily stored in significant quantities; however, electricity suppliers are often obligated to maintain a specified level of electricity supply to meet demand. As a result, some contracts to buy and sell electricity give the buyer some flexibility in determining when to take delivery of electricity and in what quantities to match the fluctuating demand for power.

In accordance with ASC 815-10-15-45, regardless of whether an agreement includes optionality features that can modify the quantity under the contract (i.e., even if the agreement does not meet the criteria in ASC 815-10-15-22 through 15-44), an entity is permitted to apply the NPNS scope exception to a capacity contract for the purchase or sale of electricity6 if the following conditions are met:

“The power purchase or sales agreement is a capacity contract” (see below).
“The terms of the contract require physical delivery of electricity.”
“For the seller of electricity: The electricity that would be deliverable under the contract involves quantities that are expected to be sold by the reporting entity in the normal course of business.”
For the buyer of electricity:
- “The electricity that would be deliverable under the contract involves quantities that are expected to be used or sold by the reporting entity in the normal course of business.”
- “The entity is engaged in selling electricity to retail or wholesale customers” and “[t]he entity is statutorily or otherwise contractually obligated to maintain sufficient capacity to meet electricity needs of its customer base.”
- “The contracts are entered into to meet the buyer’s obligation to maintain a sufficient capacity, including a reasonable reserve margin established by or based on a regulatory commission, local standards, regional reliability councils, or regional transmission organizations.”

ASC 815-10-20 defines a capacity contract as an “agreement by an owner of capacity to sell the right to that capacity to another party so that it can satisfy its obligations. For example, in the electric industry, capacity (sometimes referred to as installed capacity) is the capability to deliver electric power to the electric transmission system of an operating control area.” The characteristics listed in ASC 815-10-55-31 above should be used to determine whether an option contract or a forward contract with option features meets the definition of a capacity contract. Therefore, an entity should consider different criteria in determining whether a firm forward contract (i.e., a forward contract without option features) meets the definition of a capacity contract.

2.3.2.6.5 Firm Forward Power Purchase and Sale Contract That Is Subject to Unplanned Netting

A firm forward power purchase and sale contract that is subject to unplanned netting may qualify for the NPNS scope exception if it meets the criteria in ASC 815-10-15-45 through 15-51. While an entity can consider the characteristics in ASC 815-10-55-31 to help determine whether an option contract meets the definition of a capacity contract (which is one criterion in ASC 815-10-15-45(a)(2)), ASC 815-10-55-31 is not relevant to firm forward contracts because it only applies to contracts with option features. For forward contracts, entities should look to the definition of a capacity contract in ASC 815-10-20. In addition, they may consider the criteria below when applying that definition to a forward contract subject to unplanned netting to determine whether it qualifies for the NPNS scope exception.

The following criteria are applicable to the purchaser, as indicated in ASC 815-10-15-45 through 15-51:

“The terms of the contract require physical delivery of electricity. That is, the contract does not permit net settlement, as described in paragraphs 815-10-15-100 through 15-109.”
“The electricity that would be deliverable under the contract involves quantities that are expected to be used or sold by the reporting entity in the normal course of business.” Under this criterion, if the quantities purchased exceed the purchaser’s obligations, including load and reserve capacity requirements, they could not be designated as normal by the purchaser.
“The buyer of the electricity under the power purchase or sales agreement is an entity that . . . is engaged in selling electricity to retail or wholesale customers [and] is statutorily or otherwise contractually obligated to maintain sufficient capacity to meet electricity needs of its customer base.”
“The contracts are entered into to meet the buyer’s obligation to maintain a sufficient capacity, including a reasonable reserve margin established by or based on a regulatory commission, local standards, regional reliability councils, or regional transmission organizations.” This criterion would not be met if the purchaser was buying more than is needed to serve estimated obligations (including load requirements and contractual obligations), when compared with existing generating capacity and other purchase contracts.
“The power purchase or sales agreement is a capacity contract. Differentiating between a capacity contract and a traditional [forward] contract (that is, a financial [forward] on electricity) is a matter of judgment that depends on the facts and circumstances.” For a forward contract to qualify as a capacity contract, both of the following criteria must be met:
1. The purchaser is buying the amount that meets its obligation (same as criterion 4 above).
2. The seller has the capacity to back the contract.
  To meet this criterion, the contract does not have to specify the source of the power. However, the buyer must have evidence (beyond satisfying the regulatory requirements for the contract to qualify as a “firm energy forward”) that the seller has access to capacity at or near the delivery point at the time the contract is designated as normal. In addition to the broad regulatory requirement, the buyer would have to consider evidence of the seller’s existing capacity. This requirement could be met if:
  1. The seller is known to have generating capacity at or near the delivery point.
  2. The sale occurs at a location where the seller has access to a power pool (e.g., New England Power Pool [NEPOOL] and Pennsylvania, New Jersey, and Maryland [PJM]7) that makes generating capacity available to all participants, in which case the buyer can assume such capacity since the power pool would, if necessary, provide it to the seller.
  3. Other evidence is obtained that demonstrates that the seller has the available capacity, either through direct ownership of the generating plant or by contract.
  For example, if the seller is a power broker that does not have access to a pool, the buyer would have to obtain evidence supporting a conclusion that the seller has access to capacity at or near the delivery point (e.g., a long-term power purchase contract or tolling agreement) to back the contract. Similarly, such evidence would have to be obtained if the seller or a sister company is a known owner of generation but the delivery point in the contract is a location that cannot be served from their owned capacity.

The following criteria are applicable to the seller, as indicated in ASC 815-10-15-45 through 15-51:

“The terms of the contract require physical delivery of electricity. That is, the contract does not permit net settlement, as described in paragraphs 815-10-15-100 through 15-109.”
“The electricity that would be deliverable under the contract involves quantities that are expected to be . . . sold by the reporting entity in the normal course of business.”
“The power purchase or sales agreement is a capacity contract. Differentiating between a capacity contract and a traditional [forward] contract (that is, a financial [forward] on electricity) is a matter of judgment that depends on the facts and circumstances.” For a forward contract to qualify as a capacity contract, both of the following criteria must be met:
1. The purchaser is buying the amount that meet its obligation.
  
  The seller could meet this requirement on the basis of its knowledge (including publicly available information) of the buyer’s existing load commitments (i.e., the seller could presume the buyer is purchasing under the contract to meet its load requirements if the buyer is known to have such a requirement at or near the delivery point under the contract). Load requirements would include retail and wholesale requirements and certain contractual requirements. The seller would not have to verify whether the specific quantity being purchased, when added to the buyer’s existing generating capacity and other purchases, would exceed the buyer’s projected power needs. There is a presumption that a sale to a non-load-serving entity (including a power broker or a load-serving utility with no load at or near the delivery point) would not qualify under this criterion. However, that presumption could be overcome if evidence is obtained that demonstrates that the ultimate use of the power will be to fulfill a load-serving requirement (e.g., of a customer of the non-load-serving purchaser). Such evidence can be assumed to exist if the purchaser is a sister company of a load-serving entity that has a load requirement at or near the delivery point.
2. The seller has the capacity to back the contract.
  
  To determine whether it meets this requirement, the seller must consider its own existing generating assets plus firm capacity purchase contracts and deduct existing native load requirements and any other existing power sales contracts. In other words, the seller cannot double count the same capacity (i.e., it cannot count existing capacity as both meeting its native load capacity requirements and at the same time backing a sales contract it wishes to qualify as normal). On the other hand, the seller may consider available power resources because the seller has access to a power pool (e.g., NEPOOL and PJM) that makes generating capacity available to all participants. In addition, the seller would have to meet this requirement on the date of the normal designation (i.e., a sales contract would not qualify if the seller intends to obtain the quantity through a future purchase unless (1) the future purchase will be from a power pool that makes generating capacity available to all participants or (2) access to the power pool provides a back-up source to fulfill the delivery obligation).

Companies that are members of a consolidated group should apply the above criteria on the basis of facts existing at the consolidated level. Thus, for example, if a power-broker subsidiary buys power to sell to a load-serving sister company, the broker subsidiary’s purchase transaction would both (1) meet purchaser-criterion 3 (the purchaser has an obligation to maintain sufficient capacity) and (2) qualify as a capacity contract (provided that the other criteria are met) at both the subsidiary and consolidated levels. Similarly, in applying the criteria, companies may assume certain facts about intercompany relationships with respect to a contract counterparty’s consolidated group if the circumstances support such an assumption. For example, a sale to the power-broker subsidiary of a consolidated group that includes a load-serving entity would meet seller-criterion 3(a) (i.e., the contract would qualify as a capacity contract) only if the purchase is at a location where the load-serving sister company is known to have a load requirement. On the other hand, without further evidence of the intended use of the power, seller-criterion 3(a) would not be met in a sale to a power-broker subsidiary of a consolidated group that includes a load-serving entity if the delivery point is not at or near the load requirement of the sister company.

The assessment of whether a contract qualifies for the NPNS scope exception in ASC 815-10-15-45 through 15-51 must be performed only at the time the reporting entity elects to apply that exception and documents compliance with the requirements of ASC 815-10-15-45 through 15-51 (see ASC 815-10-15-37(b)). Therefore, entities should apply these criteria at that time (which is typically the inception of the contract).

2.3.2.7 Contract Subsequently Fails to Qualify for the NPNS Scope Exception

As discussed throughout this section, an entity evaluates whether a contract qualifies for the NPNS scope exception at the inception of the contract. It is not permitted to “un-elect” this exception on a future date and choose to instead account for the contract as a derivative instrument (see ASC 815-10-15-39).

However, ASC 815 also acknowledges that a contract may lose its NPNS status. More specifically, ASC 815-10-15-41 notes that a forward contract containing a net settlement alternative is not eligible for the NPNS scope exception “unless it is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery” (emphasis added). The paragraph also states that “[n]et settlement . . . of contracts in a group of contracts similarly designated as normal purchases and normal sales would call into question the classification of all such contracts as normal purchases or normal sales” (emphasis added). Such guidance implies that subsequent events or management actions can trigger a reassessment of the appropriateness of continued NPNS designation (i.e., a change in facts or circumstances may indicate that it is no longer probable the contract will not settle net). It is clear, however, that an entity’s management cannot arbitrarily opt to account for a previously designated NPNS contract as a derivative.

The following are some circumstances that might lead an entity to reassess whether it still is appropriate to apply the NPNS scope exception to a given contract:

The entity is no longer able to assert that it is probable throughout the remaining term of a contract previously designated as NPNS that the contract will not settle net and will result in physical delivery.
Changes occur in an entity’s operations, so that quantity purchased or sold under the contract is no longer reasonable in relation to the entity’s projected business needs.
The commodity to be purchased under the contract will be resold to third parties instead of used in production.
The commodity to be purchased under the contract will be redirected to another entity.
The facility to which the commodity will be delivered will no longer be able to use the commodity (or the quantity of the commodity denoted in the contract) in its normal operations, and it is not practical for the quantity of the commodity to be used elsewhere in the entity’s normal operations. This could occur, for example, if there is an anticipated inoperability of the facility for an extended period because of damage sustained in a catastrophe (e.g., fire) or natural disaster (e.g., tornado or hurricane).
A significant deterioration in the credit standing of the counterparty to the NPNS contract calls into question the counterparty’s ability to perform under the contract (i.e., delivery is no longer probable).
The NPNS contract is amended, and the modified terms are inconsistent with an assertion that it is probable that the NPNS contract will not net settle and the entity will take physical delivery of the commodity.
The entity opts to net settle a similar contract that was previously designated as NPNS, instead of taking physical delivery of a commodity.

When a previously designated NPNS contract no longer meets the NPNS criteria, an entity must also review similar NPNS contracts to ensure that their continued NPNS designation is appropriate.

If an entity determines that an NPNS contract no longer qualifies for the scope exception, it should recognize and record the derivative at an amount equal to the fair value of the contract on the date the NPNS designation no longer applies, with an offsetting entry to current-period earnings. The derivative contract may be designated as a hedging instrument in a qualified hedging relationship if it meets the hedging criteria in ASC 815.

2.3.3 Certain Insurance Contracts

ASC 815-10

15-52 A contract is not subject to the requirements of this Subtopic if it entitles the holder to be compensated only if, as a result of an identifiable insurable event (other than a change in price), the holder incurs a liability or there is an adverse change in the value of a specific asset or liability for which the holder is at risk. Only those contracts for which payment of a claim is triggered only by a bona fide insurable exposure (that is, contracts comprising either solely insurance or both an insurance component and a derivative instrument) may qualify for this scope exception. To qualify, the contract must provide for a legitimate transfer of risk, not simply constitute a deposit or form of self-insurance.

15-53 The following types of contracts written by insurance entities or held by the insureds are not subject to the requirements of this Subtopic for the reasons given:

Traditional life insurance contracts. The payment of death benefits is the result of an identifiable insurable event (death of the insured) instead of changes in a variable.
Traditional property and casualty contracts. The payment of benefits is the result of an identifiable insurable event (for example, theft or fire) instead of changes in a variable.

15-54 In addition, some contracts with insurance or other entities combine derivative instruments with other insurance products or nonderivative contracts, for example, indexed annuity contracts, variable life insurance contracts, and property and casualty contracts that combine traditional coverages with foreign currency options. Contracts that consist of both derivative portions and nonderivative portions are addressed in paragraph 815-15-25-1. However, insurance entities enter into other types of contracts that may be subject to the provisions of this Subtopic.

55-44 If the contract contains a payment provision that requires the issuer to pay to the holder a specified dollar amount based on a financial variable, the contract is subject to the requirements of this Subtopic.

If a contract entitles the holder to be compensated only when (1) there is an identifiable insurable event (other than a price change), (2) the holder incurs a liability, or (3) there is a change in the value of a specific asset or liability that the contract holder is exposed to, such contract does not meet the requirements of ASC 815. A traditional life insurance or property and casualty contract typically qualifies for this scope exception because the payment of benefits is the result of an identifiable insurable event (e.g., death of the insured, theft, or fire) rather than changes in a variable.

The section below discusses contracts that provide for payment as a result of both an identifiable insurance event and some other financial variable.

2.3.3.1 Dual-Trigger Property and Casualty Insurance Contracts

ASC 815-10

15-55 A property and casualty contract that provides for the payment of benefits or claims as a result of both an identifiable insurable event and changes in a variable would in its entirety not be subject to the requirements of this Subtopic (and thus not contain an embedded derivative that is required to be separately accounted for as a derivative instrument) provided all of the following conditions are met:

Benefits or claims are paid only if an identifiable insurable event occurs (for example, theft or fire).
The amount of the payment is limited to the amount of the policyholder’s incurred insured loss.
The contract does not involve essentially assured amounts of cash flows (regardless of the timing of those cash flows) based on insurable events highly probable of occurrence because the insured would nearly always receive the benefits (or suffer the detriment) of changes in the variable.

Certain Insurance Contracts — Dual-Trigger Property and Casualty Insurance Contracts

55-37 A common characteristic of dual-trigger policies is that the payment of a claim is triggered by the occurrence of two events (that is, the occurrence of both an insurable event and changes in a separate pre-identified variable). Because the likelihood of both events occurring is less than the likelihood of only one of the events occurring, the dual-trigger policy premiums are lower than traditional policies that insure only one of the risks. The policyholder is often purchasing the policy to provide for coverage against a catastrophe because if both events occur, the combined impact may be disastrous to its business.

ASC 815-15

55-12 Paragraphs 815-10-55-37 through 55-39 provide guidance on dual-trigger insurance contracts and whether such a contract, in its entirety, is a derivative instrument subject to the requirements of Subtopic 815-10. If a contract issued by an insurance entity involves essentially assured amounts of cash flows based on insurable events that are highly probable of occurrence (as discussed in paragraph 815-10-15-55(c)), an embedded derivative related to changes in the separate pre-identified variable for that portion of the contract would be required to be separately accounted for as a derivative instrument.

Since a contract that requires the issuer to pay to the holder a specified dollar amount based on a financial variable would typically be subject to the requirements of ASC 815, it may seem counterintuitive that ASC 815 would typically not apply to a dual-trigger policy that pays benefits and claims in response to both (1) an identifiable insurable event and (2) changes in a variable. However, such a contract would be outside the scope of ASC 815 if all of the following conditions are met:

The benefits or claims are paid only when the insurable event occurs.
The payment amount is limited to the loss incurred.
The contract does not involve essentially assured cash flows based on highly probable insurable events.

Normally, a dual-trigger policy results in the payment of a claim when two events happen at the same time (i.e., when both an insurable event occurs and a previously identified variable changes). Dual-trigger policies are less expensive than traditional policies that cover only one risk since the probability of both events occurring is lower than the chance that only one will occur.

The FASB implementation guidance below illustrates the application of the scope exception described above.

ASC 815-10

55-38 Paragraph 815-10-55-40 addresses seven contracts that illustrate the characteristics of dual-trigger policies offered to different types of policyholders that have different risk management needs. All seven contracts qualify for either the exception in paragraph 815-10-15-53(b) for traditional property and casualty contracts or the exception in paragraph 815-10-15-59(b) for non-exchange-traded contracts involving nonfinancial assets. Therefore, the dual-trigger variable in those contracts is not separated and accounted for separately as a derivative instrument.

55-39 In contrast, paragraph 815-15-55-12 states that, if a contract issued by an insurance entity involves essentially assured amounts of cash flows based on insurable events that are highly probable of occurrence (as discussed in paragraph 815-10-15-55(c)), an embedded derivative related to changes in the separate pre-identified variable for that portion of the contract would be required to be separately accounted for as a derivative instrument.

55-40 Following are descriptions of seven contracts:

Contract A — electric utility. A dual-trigger policy pays for a level of actual losses caused by the following two events occurring simultaneously:
1. A power outage resulting from equipment failure or storm-related damage causes more than 500 megawatts of lost power.
2. The spot market price for power exceeds $65 per megawatt hour during the storm or equipment failure period.
The contract pays the difference between the strike price and the actual market price for the lost power (that is, the cost of replacement power).
Contract B — trucking delivery entity. A dual-trigger policy pays extra expenses associated with rerouting trucks over a certain time period if snowfall exceeds a specified level during that time period. The snowfall causes delays and creates the need to reroute trucks to meet delivery demands.
Contract C — hospital. A dual-trigger policy pays actual medical malpractice claims above a specified level only if the value of the hospital’s equity portfolio falls below a specified level during the same period.
Contract D — iron ore mining entity. A dual-trigger policy pays a specified level of workers’ compensation claims (not to exceed actual claims) if the claims exceed a specified level at the same time iron ore prices decrease below a specified level.
Contract E — golf resort in Florida. A dual-trigger policy pays property damage from hurricanes incurred by a specific golf resort in Florida; however, the losses are covered only if other golf courses in the region incur hurricane-related losses and the claims cannot exceed the average property damages incurred by the other golf resorts in the county.
Contract F — cherry orchard in Michigan. A dual-trigger policy pays crop losses incurred due to bad weather during growing season, and the claims are at risk of being reduced based on changes in the inflation rate in Brazil. The cherry producer has no operations in Brazil or any transactions in Brazilian currency. However, a Brazilian cherry producer exports cherries to the United States and is a competitor of the Michigan cherry producer.
Contract G — property-casualty reinsurance contract. Reinsurance contracts, which indemnify the holder of the contract (the reinsured) against loss or liability relating to insurance risk, are accounted for under the provisions of Topic 944. Reinsurance contract provisions often adjust the amount at risk or the price of the amount at risk for a number of events or circumstances, such as loss experience or premium volume, while continuing to provide indemnification related to insurance risk. One type of reinsurance contract, an excess contract, provides the reinsured with indemnification against a finite amount of insured losses in excess of a defined level of insured losses retained by the reinsured. Example 11 (see paragraph 815-10-55-132) illustrates a reinsurance contract with a provision that adjusts the retention amount downward based on the performance of a specified equity index.

Example 11: Certain Insurance Contracts — Dual-Trigger Property-Casualty Reinsurance Contract

55-132 This Example illustrates a reinsurance contract with a provision that adjusts the retention amount downward based on the performance of a specified equity index as discussed in paragraph 815-10-55-40(g). Reinsurer enters into a reinsurance contract with Reinsured to indemnify Reinsured for certain insured losses in excess of a defined retention. The intent of the coverage is to protect Reinsured from significant or catastrophic property-casualty losses. The coverage would include a retention amount that would be adjusted downward according to a scale tied to the Dow Jones Industrial Average. If a catastrophic loss occurs, Reinsured would likely have to liquidate some of its investment holdings (bonds or equities) to pay its losses, which exposes Reinsured to significant investment risk in a down market. The adjustment feature provides protection against investment risk by allowing Reinsured to recover more losses in a declining investment market. Reinsured has no ability to receive appreciation in the Dow Jones Industrial Average.

Parties: Reinsurer and Reinsured
Coverage: Property losses
Period: January 1, X1, through December 31, X1
Retention: $20 million per occurrence, adjusted downward in the same percentage as period-to-date (from January 1, X1, to measurement date) decreases in the Dow Jones Industrial Average, not to exceed 50%
Limit: $15 million per occurrence, $15 million per annum
Premium: $1.4 million per annum.

55-133 Both of the following scenarios assume that the Dow Jones Industrial Average on January 1, X1, was 10,000.

55-133A As discussed in paragraph 815-10-55-38, the contract qualifies for the exception in paragraph 815-10-15-53(b) for traditional property and casualty contracts and, so, the dual-trigger variable in the contract is not separated and accounted for separately as a derivative instrument.

Example 12: Certain Insurance Contracts — Essentially Assured Amounts

55-134 This Example illustrates the guidance in paragraph 815-10-15-55(c) for a contract involving essentially assured amounts. Insured Entity has received at least $2 million in claim payments from its insurance entity (or at least $2 million in claim payments were made by the insurance entity on the insured entity’s behalf) for each of the previous 5 years related to specific types of insured events that occur each year. That minimum level of coverage would not qualify for the insurance contract scope exclusion.

2.3.3.2 Contracts With Highly Probable Insured Events

ASC 815-10

15-56 If there is an actuarially determined minimum amount of expected claim payments that are the result of insurable events that are highly probable of occurring under the contract, that portion of the contract does not qualify for the insurance scope exception if both of the following conditions are met:

Those minimum payment cash flows are indexed to or altered by changes in a variable.
Those minimum payment amounts are expected to be paid each policy year (or on another predictable basis).

15-57 If an insurance contract has an actuarially determined minimum amount of expected claim payments that are highly probable of occurring, then effectively the amount of those claims is the contract’s minimum notional amount in determining the embedded derivative under Section 815-15-25.

ASC 815-10-15-56 notes that when “an actuarially determined minimum amount of expected claim payments [results from] insurable events that are highly probable of occurring under the contract, that portion of the contract does not qualify for the insurance scope exception if both of [the conditions in ASC 815-10-15-56 shown above] are met.” The FASB implementation guidance below illustrates the application of this guidance.

ASC 815-10

15-55 A property and casualty contract that provides for the payment of benefits or claims as a result of both an identifiable insurable event and changes in a variable would in its entirety not be subject to the requirements of this Subtopic (and thus not contain an embedded derivative that is required to be separately accounted for as a derivative instrument) provided all of the following conditions are met: . . .

c. The contract does not involve essentially assured amounts of cash flows (regardless of the timing of those cash flows) based on insurable events highly probable of occurrence because the insured would nearly always receive the benefits (or suffer the detriment) of changes in the variable.

Example 12: Certain Insurance Contracts — Essentially Assured Amounts

55-134 This Example illustrates the guidance in paragraph 815-10-15-55(c) for a contract involving essentially assured amounts. Insured Entity has received at least $2 million in claim payments from its insurance entity (or at least $2 million in claim payments were made by the insurance entity on the insured entity’s behalf) for each of the previous 5 years related to specific types of insured events that occur each year. That minimum level of coverage would not qualify for the insurance contract scope exclusion.

2.3.4 Certain Financial Guarantee Contracts

ASC 815-10

15-58 Financial guarantee contracts are not subject to this Subtopic only if they meet all of the following conditions:

They provide for payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a nonderivative contract, either:
1. At prespecified payment dates
2. At accelerated payment dates as a result of either the occurrence of an event of default (as defined in the financial obligation covered by the guarantee contract) or notice of acceleration being made to the debtor by the creditor.
Payment under the financial guarantee contract is made only if the debtor’s obligation to make payments as a result of conditions as described in (a) is past due.
The guaranteed party is, as a precondition in the contract (or in the back-to-back arrangement, if applicable) for receiving payment of any claim under the guarantee, exposed to the risk of nonpayment both at inception of the financial guarantee contract and throughout its term either through direct legal ownership of the guaranteed obligation or through a back-to-back arrangement with another party that is required by the back-to-back arrangement to maintain direct ownership of the guaranteed obligation.

In contrast, financial guarantee contracts are subject to this Subtopic if they do not meet all three criteria, for example, if they provide for payments to be made in response to changes in another underlying such as a decrease in a specified debtor’s creditworthiness.

Credit Derivatives

55-45 Many different types of contracts are indexed to the creditworthiness of a specified entity or group of entities, but not all of them are derivative instruments. Credit-indexed contracts that have certain characteristics described in paragraph 815-10-15-58 are guarantees and are not subject to the requirements of this Subtopic. Credit-indexed contracts (often referred to as credit derivatives) that do not have the characteristics necessary to qualify for the exception in that paragraph are subject to the requirements of this Subtopic. One example of the latter is a credit-indexed contract that requires a payment due to changes in the creditworthiness of a specified entity even if neither party incurs a loss due to the change (other than a loss caused by the payment under the credit-indexed contract).

It is somewhat common for one entity to provide a financial guarantee to another entity. For example, a subsidiary may be the legal issuer of a debt instrument but the lender requires the parent to provide a financial guarantee on the borrowed amount. A typical financial guarantee would be likely to qualify for this scope exception.

However, if a financial guarantee does not meet one (or more) criterion in ASC 815-10-15-58 and would otherwise meet the definition of a derivative instrument in ASC 815, the guarantee contract would be accounted for as a derivative instrument. It is important to note that in the application of the guidance in ASC 815-10-15-58, a financial guarantee with a non-payment-based trigger (e.g., a credit downgrade) would not qualify for the scope exception because the guarantor payments would not be made “solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations” (emphasis added).

Paragraphs A21 and A22 of the Background Information and Basis for Conclusions of FASB Statement 149 (which, although not part of ASC 815, are relevant to this topic) provide further background on this requirement, stating, in part:

In considering this issue, the Board discussed two possible alternatives: (a) amend paragraph 10(d) to permit financial guarantee contracts that provide protection to a guaranteed party in any event of default to qualify for the scope exception or (b) clarify paragraph 10(d) to emphasize the need for the guaranteed party to demand payment prior to collecting any payment from the guarantor in order for a guarantee contract to be eligible for the scope exception. Both alternatives contemplate that, as part of the financial guarantee arrangement, the guarantor receives either the rights to any payments subsequently advanced to the guaranteed party or delivery of the defaulted receivable upon an event of default.

The Board selected the second alternative, because it is more consistent with the Board’s original intent in Statement 133. The Board concluded that the intent of the scope exception for guarantee contracts in paragraph 10(d) of Statement 133 was to more closely align that exception with the scope exception for traditional insurance contracts addressed in paragraph 10(c). The Board reasoned that guarantees eligible for the scope exception are similar to insurance contracts in that they entitle the holder to compensation only if, as a result of an insurable event (other than a change in price), the holder incurs a liability or there is an adverse change in the value of a specific asset or liability for which the holder is at risk. Accordingly, the Board determined that, in order for a financial guarantee contract to qualify for the scope exception in paragraph 10(d), the guaranteed party must demand payment from the debtor and that once it is determined that the required obligation will not be satisfied by the debtor, the guaranteed party must relinquish to the guarantor its rights to receive payment from the debtor in order to receive payment from the guarantor. [Emphasis added]

Example 2-10

Non-Payment-Based Financial Guarantee

Entity S purchases a guarantee contract from Entity P on a portfolio of S’s debt securities. Under the terms of the guarantee, S can deliver a debt security to P in return for the par amount of the debt security if the underlying debtor enters into bankruptcy (broadly defined as including liquidations and creditor protection/standstill agreements). Because the trigger on the financial guarantee contract is not payment-based (i.e., payment under the guarantee is not based on the debtor’s failure to make a past-due contractual payment), the financial guarantee contract would not qualify for the financial guarantee scope exception.

Example 2-11

Payment-Based Financial Guarantee

Entity E purchases a guarantee contract from Entity M on a portfolio of E’s originated loans. Under the terms of the guarantee, M pays E if a debtor on an underlying loan contract fails to make a contractually specified payment (e.g., principal or interest shortfall).

Because the trigger on the financial guarantee contract is payment-based (i.e., payment under the guarantee is based on the debtor’s failure to make a past-due contractual payment), the financial guarantee contract would qualify for the financial guarantee scope exception.

Example 2-12

Guarantee Scope Exception

Entity A issues a loan to Entity B, and Entity C guarantees B’s payments. Under the terms of the guarantee, C will make a payment to A in the event that B misses a loan payment. The terms of the guarantee also stipulate that in the event that B subsequently makes the missed loan payment after it has already been paid by C, A is entitled to keep the duplicate payment and has no obligation to reimburse C.

In this scenario, because A does not relinquish its rights to receive and keep payments from B, the scope exception in ASC 815-10-15-58 is not met and the guarantee would require derivative accounting.

The implementation example below illustrates the application of the aforementioned guidance to dual-trigger financial guarantee contracts.

ASC 815-10

Dual-Trigger Financial Guarantee Contracts

55-32 Entity ABC extends credit to consumers through credit cards and personal loans of various sorts. Entity ABC is exposed to credit losses from its managed asset portfolio, including owned and securitized receivables. Entity ABC would like to purchase an insurance policy to protect itself against high levels of consumer default.

55-33 The proposed insurance policy will entitle Entity ABC to collect claims to the extent that its credit losses exceed a specified minimum level but limited to the amount by which the credit losses on a customized pool or index of consumer loans exceed that same specified minimum level. Thus, Entity ABC will collect claims based on the lesser of the following:

Entity ABC’s actual credit losses
The credit losses on a customized pool or index of consumer loans.

55-34 Although the insurer’s payment to Entity ABC may be affected by credit losses on a customized pool, the payment nevertheless represents compensation for actual credit losses Entity ABC incurred. Entity ABC purchases this insurance to obtain a lower premium because claims are limited by external charge-off rates and the insurer is not exposed to Entity ABC’s underwriting performance.

55-35 This type of control may also exist in property and casualty reinsurance policies. For example, an insurance entity may purchase reinsurance that covers actual hurricane losses in excess of a specified level in their block of business, but the coverage does not apply to losses in excess of a geographically diversified index of hurricane losses.

55-36 Financial guarantee insurance contracts are not subject to this Subtopic only if all of the conditions in paragraph 815-10-15-58 are met. The description of the financial guarantee insurance contract in paragraph 815-10-55-32 is insufficient for determining whether those conditions are met. The following provisions of that contract represent a type of deductible and do not affect the application of the conditions in paragraph 815-10-15-58:

The provision that limits any claims to the extent that Entity ABC’s actual credit losses exceed a specified minimum level
The provision that limits any payments for those claims to the amount by which the credit losses on a customized pool or index of consumer loans exceed that same specified minimum level.

2.3.5 Certain Contracts That Are Not Traded on an Exchange

ASC 815-10

15-59 Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following:

A climatic or geological variable or other physical variable. Climatic, geological, and other physical variables include things like the number of inches of rainfall or snow in a particular area and the severity of an earthquake as measured by the Richter scale. (See Example 13 [paragraph 815-10-55-135].)
The price or value of a nonfinancial asset of one of the parties to the contract provided that the asset is not readily convertible to cash. This scope exception applies only if both of the following are true:
1. The nonfinancial assets are unique.
2. The nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset. (If the contract is a call option, the scope exception applies only if that nonfinancial asset is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset above the option’s strike price.)
The fair value of a nonfinancial liability of one of the parties to the contract provided that the liability does not require delivery of an asset that is readily convertible to cash.
Specified volumes of sales or service revenues of one of the parties to the contract. (This scope exception applies to contracts with settlements based on the volume of items sold or services rendered, for example, royalty agreements. This scope exception does not apply to contracts based on changes in sales or revenues due to changes in market prices.)

15-60 If a contract has more than one underlying and some, but not all, of them qualify for one of the scope exceptions in the preceding paragraph, the application of this Subtopic to that contract depends on its predominant characteristics. That is, the contract is subject to the requirements of this Subtopic if all of its underlyings, considered in combination, behave in a manner that is highly correlated with the behavior of any of the component variables that do not qualify for a scope exception.

15-61 A contract based on any variable that is not specifically excluded by paragraph 815-10-15-59 is subject to the requirements of this Subtopic if it has the other two characteristics (initial net investment and net settlement) identified in this Subsection.

ASC 815 also provides a series of potential scope exceptions for certain contracts that are not traded on an exchange. These exceptions, listed in paragraphs (a) through (d) of ASC 815-10-15-59, are discussed in more detail in the sections below.

The determination of whether a specific scope exception applies depends on an assessment of a contract’s predominant characteristics, as outlined in ASC 815-10-15-60. If the underlyings, in combination, are highly correlated with the behavior of the components that do not qualify for the specified scope exception, the contract or embedded feature does not qualify for that scope exception.

Questions often arise, in practice, on how to apply the predominance assessment, and consultation with an entity’s accounting advisers is encouraged.

Changing Lanes

As part of the FASB’s current recognition and measurement project on derivatives scope refinements, the Board tentatively decided to refine the predominance assessment in ASC 815-10-15-60 by proposing an assessment that focuses on the fair value impact of the underlyings, rather than their correlations. Under the proposed fair value assessment, an entity would assess how each underlying affects the fair value of the contract and determine which underlying has the largest expected effect on changes in the contract’s fair value. The underlying that has the largest expected effect would be considered the predominant underlying and would be evaluated to determine whether it is eligible for a scope exception in ASC 815-10-15-59. The Board issued a proposed ASU on July 23, 2024, with a 90-day comment period. It has yet to deliberate on the potential effective date of the amendments, if finalized.

2.3.5.1 Climatic, Geological, or Other Physical Variables

ASC 815-10-15-59(a) includes a scope exception for non-exchange-traded contracts whose settlement is based on a climatic, geological, or other physical variable. Examples of payment features that may qualify for this exception include those based on measures of rainfall, snow, wind velocity, floodwater, or the severity of an earthquake or the occurrence of a hurricane. However, this scope exception is not available if the payment feature is also indexed to a financial variable, such as the dollar amount of hurricane losses (see ASC 815-10-55-137). Nevertheless, such a feature may be exempt from ASC 815 under the scope exception in ASC 815-10-15-52 through 15-57 for insurance contracts if “it entitles the holder to be compensated only if, as a result of an identifiable insurable event (other than a change in price), the holder incurs a liability or there is an adverse change in the value of a specific asset or liability for which the holder is at risk” (e.g., a decline in revenue as a result of a hurricane event). ASC 815-10-55-135 through 55-141 provide three examples of contracts that illustrate how to distinguish between physical and financial variables, as shown below.

ASC 815-10

Example 13: Certain Contracts That Are Not Traded on an Exchange — Distinguishing Between Physical and Financial Variables

55-135 The following Cases illustrate the difference between physical and financial variables for purposes of applying the scope exception in paragraph 815-10-15-59(a):

Contract containing both a physical variable and a financial variable (Case A)
Contract containing only a physical variable (Case B)
Contract containing only a financial variable (Case C).

Case A: Contract Containing Both a Physical Variable and a Financial Variable

55-136 A contract’s payment provision specifies that the issuer will pay to the holder $10,000,000 if aggregate property damage from all hurricanes in the state of Florida exceeds $50,000,000 during the year 2001.

55-137 In this Case, the payment under the contract occurs if aggregate property damage from all hurricanes in the state of Florida exceeds $50,000,000 during the year 2001. The contract contains 2 underlyings — a physical variable (that is, the occurrence of at least 1 hurricane) and a financial variable (that is, aggregate property damage exceeding a specified or determinable dollar limit of $50,000,000). Because of the presence of the financial variable as an underlying, the derivative instrument does not qualify for the scope exclusion in paragraph 815-10-15-59(a).

Case B: Contract Containing Only a Physical Variable

55-138 A contract specifies that the issuer pays the holder $10,000,000 in the event that a hurricane occurs in Florida in 2001.

55-139 If a contract contains a payment provision that requires the issuer to pay to the holder a specified dollar amount that is linked solely to a climatic or other physical variable (for example, wind velocity or flood-water level), paragraph 815-10-15-59(a) provides that the contract is not subject to the requirements of this Subtopic.

55-140 In this Case, the payment provision is triggered if a hurricane occurs in Florida in 2001. The underlying is a physical variable (that is, occurrence of a hurricane). Therefore, the contract qualifies for the scope exclusion in paragraph 815-10-15-59(a).

Case C: Contract Containing Only a Financial Variable

55-141 A contract would be a traditional insurance contract that is excluded from the scope of this Subtopic under the exception discussed beginning in paragraph 815-10-15-52 if the contract requires a payment only if the holder incurs a decline in revenue or an increase in expense as a result of an event (for example, a hurricane) and the amount of the payoff is solely compensation for the amount of the holder’s loss.

2.3.5.2 Certain Nonfinancial Items of One of the Parties to the Contract

ASC 815-10

15-59 Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following: . . .

b. The price or value of a nonfinancial asset of one of the parties to the contract provided that the asset is not readily convertible to cash. This scope exception applies only if both of the following are true:

1. The nonfinancial assets are unique.

2. The nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset. (If the contract is a call option, the scope exception applies only if that nonfinancial asset is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset above the option’s strike price.) . . .

Example 14: Certain Contracts That Are Not Traded on an Exchange — Nonfinancial Asset of One of the Parties to a Contract

55-142 This Example addresses the application of the scope exception in paragraph 815-10-15-59(b). Entity A enters into a non-exchange-traded forward contract to buy from Entity B 100 interchangeable (fungible) units of a nonfinancial asset that are not readily convertible to cash. The contract permits net settlement through its default provisions. Entity A already owns more than 100 units of that nonfinancial asset, but Entity B does not own any units of that nonfinancial asset.

55-143 The scope exception in paragraph 815-10-15-59(b) does not apply to the accounting for the contract for both of the following reasons:

The contract’s settlement is based on an underlying associated with a nonfinancial asset that is not unique (because it is based on the price or value of an interchangeable, nonfinancial unit).
The entity that owns the nonfinancial asset related to the underlying (that is, Entity A) is the buyer of the units and thus would benefit from the forward contract if the price or value increases.

Consequently, neither Entity A nor Entity B qualifies for the scope exception in paragraph 815-10-15-59(b).

ASC 815-10-15-59 contains a scope exception for certain non-exchange-traded contracts whose settlement is based on the “price or value of a nonfinancial asset of one of the parties to the contract” (i.e., property owned by the debtor) or the “fair value of a nonfinancial liability of one of the parties to the contract.” This scope exception is not available for underlyings associated with nonfinancial assets that are (1) RCC or (2) not unique (e.g., fungible, interchangeable items).

Original works of art or real estate would be considered unique nonfinancial assets (i.e., they do not have interchangeable units). Assets that are newly produced on an assembly line (have not been used) and available from multiple sellers are not unique since a new asset is interchangeable with another new asset from the same production. However, once the manufactured asset has been used, the asset would be considered unique (e.g., a used car is considered unique).

Further, the scope exception for certain nonfinancial assets of one of the parties is only available if the nonfinancial asset is owned by the party that would not benefit under the contract from an increase in the price or value of the nonfinancial asset. In other words, the scope exception is not available if the contract benefits the owner of the nonfinancial asset when the fair value of the nonfinancial asset increases. For example, the scope exception is not available if payments required under a debt obligation decrease when the fair value of a nonfinancial asset owned by the debtor increases (i.e., the owner of the nonfinancial asset — the debtor — benefits under the contract from an increase in the fair value of the asset because such increase results in a decrease in the payments to be made on the debt obligation).

ASC 815-15

55-8 Under an example participating mortgage, the investor receives a below-market interest rate and is entitled to participate in the appreciation in the fair value of the project that is financed by the mortgage upon sale of the project, at a deemed sale date, or at the maturity or refinancing of the loan. The mortgagor must continue to own the project over the term of the mortgage.

55-9 This instrument has a provision that entitles the investor to participate in the appreciation of the referenced real estate (the project). However, a separate contract with the same terms would be excluded by the exception in paragraph 815-10-15-59(b) because settlement is based on the value of a nonfinancial asset of one of the parties that is not readily convertible to cash. (This Subtopic does not modify the guidance in Subtopic 470-30.)

55-10 Paragraph 310-10-05-9 explains that loans granted to acquire operating properties sometimes grant the lender a right to participate in expected residual profit from the sale or refinancing of the property. An equity kicker (or expected residual profit) would typically not be separated from the host contract and accounted for as an embedded derivative because paragraph 815-15-25-1(c) exempts a hybrid contract from bifurcation if a separate instrument with the same terms as the embedded equity kicker is not a derivative instrument subject to the requirements of this Subtopic. Under paragraph 815-10-15-59(b), an embedded equity kicker would typically not be subject to the requirements of this Subtopic because the separate instrument with the same terms is not exchange traded and is indexed to nonfinancial assets that are not readily convertible to cash. Similarly, if an equity kicker is based on a share in net earnings or operating cash flows, it would also typically qualify for the scope exception in paragraph 815-10-15-59(d). If the embedded derivative does not need to be accounted for separately under this Subtopic, the Acquisition, Development, and Construction Arrangements Subsections of Subtopic 310-10 shall be applied.

An example of a feature for which the scope exception in ASC 815-10-15-59 would typically be available is the participation feature in a participating mortgage, which would instead be accounted for under ASC 470-30.

Example 2-13

Milestone and Regulatory Approval Payments

RevoMed Company enters into a contract to acquire intellectual property (IP) (e.g., a license) from ResearchOrg, which represents a development platform designed to provide drug developers with a revolutionary approach to delivering a particular medicine (the “product”). In connection with the acquisition of the IP, RevoMed is required to make milestone payments to ResearchOrg related to clinical development milestones and subsequent product approvals that leverage the acquired platform in the development of the product.

The underlying on which the settlement is based is related to a nonfinancial asset — the acquired IP. The milestone payments become due after clinical development milestones and the successful product approvals that leverage the acquired IP. Although there may or may not be an asset recorded on the balance sheet for each milestone payment (i.e., some of the payments may not qualify for capitalization), the achievement of the milestones is highly correlated to the IP’s fair value (i.e., once the milestones are achieved, the fair value increases).

In this example, the acquired IP is considered a unique nonfinancial asset because any products that leverage this technology represent complex, scientifically engineered therapies supported by a one-of-a-kind platform that are not readily interchangeable with similar products in the market (i.e., the products are not “assembly line widgets”). Further, the product rights are owned by RevoMed, and RevoMed would not benefit under the terms of the contract from an increase in the fair value of the acquired IP. This is because in the evaluation of whether the scope exception in ASC 815-10-15-59(b) applies, the contract is the milestone payment arrangement between RevoMed and ResearchOrg. Since RevoMed can only make a payment to the counterparty under this arrangement, it cannot benefit under the contract. While RevoMed obviously does benefit from the achievement of reaching clinical development milestones and the ultimate regulatory approval of new product offerings that leverage the acquired IP, the benefit to RevoMed arises from owning the underlying nonfinancial asset and not from the contract that results in milestone payments to ResearchOrg.

Hence, the scope exception described in ASC 815-10-15-59(d) for certain contracts that are not traded on an exchange may be applied in this fact pattern.

Note that if the above fact pattern applied to an R&D funding arrangement, as opposed to the acquisition of a license (see Section 2.3.5.4), it is most likely that the entity would not reach the same conclusion regarding the applicability of the scope exception.

2.3.5.3 Certain Revenue-Based Payments

ASC 815-10

15-59 Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following: . . .

d. Specified volumes of sales or service revenues of one of the parties to the contract. (This scope exception applies to contracts with settlements based on the volume of items sold or services rendered, for example, royalty agreements. This scope exception does not apply to contracts based on changes in sales or revenues due to changes in market prices.)

15-60 If a contract has more than one underlying and some, but not all, of them qualify for one of the scope exceptions in the preceding paragraph, the application of this Subtopic to that contract depends on its predominant characteristics. That is, the contract is subject to the requirements of this Subtopic if all of its underlyings, considered in combination, behave in a manner that is highly correlated with the behavior of any of the component variables that do not qualify for a scope exception.

ASC 815-10-15-59(d) provides a scope exception for derivatives in which the underlying is based on “[s]pecified volumes of sales or service revenues of one of the parties to the contract.” This scope exception in many circumstances may be applied to contracts for which the underlying is a broad performance measure of one of the parties to the contract (e.g., net earnings, EBITDA, or operating cash flows). Discussions with the FASB staff have indicated that the application of this exception is limited by the wording of ASC 815-10-15-59(d), which states, in part:

This scope exception does not apply to contracts based on changes in sales or revenues due to changes in market prices.

Accordingly, if the performance measure is based primarily or wholly on the volume of items sold or services rendered of one of the parties to the contract, an embedded feature whose underlying is based on that performance measure potentially could qualify for the ASC 815-10-15-59(d) scope exception. However, the scope exception is not available if changes in the performance measure are highly correlated with changes in the market price of an asset or liability (e.g., changes in the market price of investments held or goods sold).

Example 2-14

Payments Based on Revenue

B Pharma LLC is a life sciences company formed on June 26, 20X8. On February 14, 20X9, B completed an equity financing transaction with Company P. On the same date, B executed a revenue-sharing agreement (RSA) with P. The RSA grants P the right to receive 2 percent of the net sales of any of B’s products (1) over a period of 12 years from the first sale of that product or (2) until the product’s patent has expired, whichever is later. All payments required by the terms of the RSA must be made in immediately available funds from a bank account domiciled in the United States (i.e., in U.S. dollars) unless otherwise agreed by P.

The RSA meets the definition of a derivative because it has an underlying (B’s net sales) and a payment provision (cash payments to P), and P’s initial net investment is smaller than the amount that would be exchanged to acquire the asset related to the underlying. Finally, the contract provides for net settlement in cash.

Although the arrangement meets the components of the derivative definition, it is not required to be accounted for as a derivative if it qualifies for a scope exception. The RSA includes settlements that are based on the volume of sales of B’s products and therefore meets the scope exception in ASC 815-10-15-59(d). Therefore, B is not required to account for the RSA as a derivative instrument under ASC 815.

Example 2-15

Payments Based on Policy Claims

Company P holds business interruption insurance policies with various insurers and is seeking indemnity under those policies for losses and damages arising from, or directly related to, recent events (the “policy claims”). The policy claims are in various stages of litigation.

On February 26, 20X1, P enters into a participation agreement with Company B (the participant), an unrelated third party. Under that agreement, P sells a participation interest in future insurance recoveries under the policy claims. In exchange for that interest, P receives cash consideration of $80 million (the participation price) and is entitled to future amounts, subject to a distribution waterfall (i.e., a schedule that prescribes the distributions to P and B) outlined in the participation agreement, in the event that recoveries (proceeds) are collected from its insurers.

The participation agreement meets the definition of a derivative because:

The occurrence or nonoccurrence of this specified event (i.e., the receipt of proceeds from the policy claims) represents an underlying in the participation agreement. Upon receiving proceeds from the policy claims, P is required to pay B a determinable amount based on the waterfall outlined in the agreement. This represents a payment provision because there are specified determinable settlements to be made if the underlying (i.e., the receipt of proceeds) behaves in a certain manner.
The agreement did not result in B’s acquiring ownership of the policy claims. Rather, P remains the sole owner of the policy claims, and B will receive a portion of the proceeds related to such claims. In addition, the participation price is significantly less than the maximum potential proceeds from those claims, and it is also less than the anticipated proceeds from the policy claims. Therefore, the initial net investment that B makes in the form of participation price is smaller than the amount that would be exchanged to acquire the asset related to the underlying (i.e., reimbursement of losses and damages arising from the insurable events).
The participation agreement provides that upon receipt of proceeds from the policy claims, P must make its payments to B in cash.

The underlying in the contract is based on the receipt of the potential proceeds from the policy claims, which is a measure of P’s net earnings and operating cash flows. Furthermore, under the waterfall, the distributions of potential proceeds from the policy claims to B are not highly correlated with changes in the market price of an asset or liability (e.g., changes in the market price of investments held or goods sold). Instead, such payments to B are based upon a specified percentage of proceeds (i.e., P’s operational results) received from the policy claims, which is not determined on the basis of changes in the market price of an asset or liability. That is, the potential proceeds from the policy claims are directly related to P’s business and represent reimbursement for losses and damages incurred as a result of the insured events. Therefore, in accordance with ASC 815-10-15-59(d), the participation agreement is outside the scope of ASC 815.

Example 2-16

Lease Contracts That Contain Provisions for Rental Increases That Are Based on Sales Volume8

Company ABC leases property in Germany from Company XYZ. The lease provides for annual rent increases that are based on a percentage of ABC’s retail sales in Germany during the calendar year. Each increase is an adjustment to the following year’s rent payments.

The lease contains an embedded contingent rent payment that is based on ABC’s retail sales in Germany. The embedded derivative does not require separate accounting because ABC’s retail sales would qualify for the scope exception in ASC 815-10-15-59(d) for non-exchange-traded contracts with underlyings that are “the sales or service revenues of one of the parties to the contract.” Therefore, this embedded derivative on a percentage of ABC’s German retail revenues would not meet the definition of a derivative on a freestanding basis and would not require bifurcation in accordance with ASC 815-15-25-1(c).

Example 2-17

Debt That Contains Interest Payments Indexed to EBITDA

Company H has issued debt that includes an additional interest payment based on an increase in H’s EBITDA that exceeds a specified threshold. Thus, increases in EBITDA above the threshold increase the amount of additional interest payments required. Company H determined that EBITDA is not an interest-rate index but an earnings measure that is not clearly and closely related to the debt host. Company H evaluates whether the additional interest payment feature that is based on EBITDA is an embedded derivative that must be accounted for separately.

It would be appropriate for H to apply the scope exception in ASC 815-10-15-59(d) as long as the changes in EBITDA are not primarily driven by market price changes. A contingent interest feature based on EBITDA would not qualify for the ASC 815-10-15-59(d) scope exception if changes in EBITDA are highly correlated with changes in the market price of an asset or liability (e.g., changes in the market price of investments held or goods sold).

2.3.5.4 R&D Funding Arrangements

In a typical R&D funding arrangement (common for life sciences entities), passive third-party investors often provide funds to offset the cost of R&D programs in exchange for milestone payments or other forms of consideration (typically sales-based royalties) that are contingent on the successful completion of such R&D programs and the related approval for the compound or compounds being developed. To determine the appropriate accounting treatment, an entity should first consider whether the arrangement includes elements that need to be accounted for under the guidance on derivatives in ASC 815.

Depending on the terms of the transaction, an R&D funding arrangement may contain an underlying (e.g., the underlying net sales, which are dependent on regulatory approval) and a payment provision (e.g., sales-based royalty payments to the investor, which are based on future levels of net sales of the compound being developed) without an initial net investment (i.e., the investor may only be required to fund the R&D costs because such costs are incurred). In addition, R&D funding arrangements often contain the characteristic of explicit net settlement since they are settled in cash.

If the R&D funding arrangement meets the definition of a derivative instrument, an entity should assess whether the arrangement represents a contract that would meet any of the scope exceptions in ASC 815. For example, in certain transactions, the fund recipient is only required to make royalty payments to the investor if the compound is approved and net sales occur. In these circumstances, the scope exception described in ASC 815-10-15-59(d) for certain contracts that are not traded on an exchange may apply.

Changing Lanes

On July 23, 2024, the FASB issued a proposed ASU that, among other things, would provide a new derivative scope exception for “contracts with underlyings based on operations or activities specific to one of the parties to the contract.” The occurrence (or nonoccurrence) of a specified event is considered an underlying (e.g., obtaining regulatory approval for an R&D project or achieving a product development milestone). Therefore, under the proposed standard, many R&D funding arrangements would be exempt from the scope of derivative accounting because a life sciences company performing an R&D project is one of the parties to the contract. Although some R&D arrangements may already qualify for existing derivative scope exceptions, as described in the section above, we would expect even more contracts to qualify for a scope exception under the proposed ASU.

2.3.6 Derivative Instruments That Impede Sale Accounting

ASC 815-10

15-63 A derivative instrument (whether freestanding or embedded in another contract) whose existence serves as an impediment to recognizing a related contract as a sale by one party or a purchase by the counterparty is not subject to this Subtopic. An example is the existence of a call option enabling a transferor to repurchase transferred assets that is an impediment to sales accounting under Topic 860. Such a call option on transferred financial assets that are not readily obtainable would prevent accounting for that transfer as a sale. The consequence is that to recognize the call option would be to count the same thing twice. The holder of the option already recognizes in its financial statements the assets that it has the option to purchase.

15-64 A derivative instrument held by a transferor that relates to assets transferred in a transaction accounted for as a financing under Topic 860, but which does not itself serve as an impediment to sale accounting, is not subject to the requirements of this Subtopic if recognizing both the derivative instrument and either the transferred asset or the liability arising from the transfer would result in counting the same thing twice in the transferor’s balance sheet. However, if recognizing both the derivative instrument and either the transferred asset or the liability arising from the transfer would not result in counting the same thing twice in the transferor’s balance sheet, the derivative instrument shall be accounted for in accordance with this Subtopic. For related implementation guidance, see paragraph 815-10-55-41.

55-41 The following guidance illustrates application of the scope exception (as discussed beginning in paragraph 815-10-15-63) for a derivative instrument that impedes sales accounting to situations in which the transferor accounts for the transfer as a financing:

If a transferor transfers financial assets but retains a call option on those assets, the net settlement criterion (as discussed beginning in paragraph 815-10-15-119) may be satisfied because the assets transferred are readily obtainable; however, the transfer may fail the isolation criterion in paragraph 860-10-40-5(a) because of significant continued involvement by the transferor. In that example, because the transferor is required to continue to recognize the assets transferred, recognition of the call option on those assets would effectively result in recording the assets twice. Therefore, the derivative instrument is not subject to the scope of this Subtopic.
In the situation described in (a), the transferor may have sold to the transferee a put option. Exercise of the put option by the transferee would result in the transferor repurchasing certain assets that it has transferred, but which it still records as assets in its balance sheet. Because the transferor is required to recognize the borrowing, recognition of the put option would result in recording the liability twice. Therefore, the derivative instrument is not subject to the scope of this Subtopic.
A transferor may transfer fixed-rate financial assets to a transferee and guarantee a variable-rate return. If the transfer is accounted for as a sale and an interest-rate swap is entered into as part of the contractual provisions of the transfer, the transferor records the interest rate swap as one of the financial components. In that case, the interest rate swap should be accounted for separately in accordance with this Subtopic. However, if the transfer is accounted for as a financing, the transferor records on its balance sheet the issuance of variable-rate debt and continues to report the fixed-rate financial assets; no derivative instrument is recognized under this Subtopic.
In a securitization transaction, a transferor transfers $100 of fixed-rate financial assets and the contractual terms of the beneficial interests incorporate an interest rate swap with a notional principal of $1 million. If the transfer is accounted for as a sale and the interest rate swap is entered into as part of the contractual provisions of the transfer, the transferor identifies and records the interest rate swap as one of the financial components. In that case, the interest rate swap would be accounted for separately in accordance with this Subtopic. However, if the transfer is accounted for as a financing, the transferor records in its balance sheet a $100 variable-rate borrowing and continues to report the $100 of fixed-rate financial assets. In this instance, because the liability is leveraged, requiring computation of interest flows based on a $1 million notional amount, the liability (which does not meet the definition of a derivative instrument in its entirety) is a hybrid instrument that contains an embedded derivative — such as an interest rate swap with a notional amount of $999,900. That embedded derivative is not clearly and closely related to the host contract under Section 815-15-25 (see paragraph 815-15-25-1[c]) because it could result in a rate of return on the counterparty’s asset that is at least double the initial rate and that is at least twice what otherwise would be the then-current market return for a contract that has the same terms as the host contract and that involves a debtor with credit quality similar to the issuer’s credit quality at inception. Therefore, the derivative instrument must be recorded separately under paragraph 815-15-25-1.

Certain instruments that hinder sale accounting are exempt from the scope of ASC 815. As an example, if a call option prevented a transfer of receivables from being accounted for as a sale under ASC 860, the call option would be excluded from ASC 815 and the transfer would be accounted for under ASC 860 as a financing.

If a derivative instrument held by a transferor is related to assets transferred in a transaction accounted for as a financing under ASC 860 but it does not itself serve as an impediment to sale accounting, the derivative is not subject to the requirements of ASC 815 if recognizing both the derivative instrument and either the transferred asset or the liability arising from the transfer would result in counting the same item twice in the transferor’s balance sheet. However, such derivative would be subject to the requirements of ASC 815 if recognizing both the derivative and either the transferred asset or liability does not result in double counting in the transferor’s balance sheet.

2.3.7 Investments in Life Insurance

ASC 815-10

15-67 A policyholder’s investment in a life insurance contract that is accounted for under Subtopic 325-30 is not subject to this Subtopic. This scope exclusion does not affect the accounting by the issuer of the life insurance contract.

While issuers of life insurance contracts are subject to the requirements of ASC 815-10, a policyholder’s investment in a life insurance contract is specifically excluded from its scope.

2.3.8 Certain Investment Contracts

ASC 815-10

15-68 A contract that is accounted for under either paragraph 960-325-35-1 or 960-325-35-3 is not subject to this Subtopic. This scope exception applies only to the party that accounts for the contract under Topic 960.

15-68A The wrapper of a synthetic guaranteed investment contract that meets the definition of a fully benefit-responsive investment contract that is held by an employee benefit plan is excluded from the scope of this Subtopic.

A contract that is accounted for under either ASC 960-325-35-1 or ASC 960-325-35-3 is not subject to ASC 815. The scope exception applies only to the party that accounts for the contract under ASC 960.

2.3.9 Certain Loan Commitments

ASC 815-10

15-69 For the holder of a commitment to originate a loan (that is, the potential borrower), that commitment is not subject to the requirements of this Subtopic. For issuers of commitments to originate mortgage loans that will be held for investment purposes, as discussed in paragraphs 948-310-25-3 through 25-4, those commitments are not subject to this Subtopic. In addition, for issuers of loan commitments to originate other types of loans (that is, other than mortgage loans), those commitments are not subject to the requirements of this Subtopic.

15-70 The preceding paragraph does not affect the accounting for commitments to purchase or sell mortgage loans or other types of loans at a future date. Those types of loan commitments must be evaluated under the definition of a derivative instrument to determine whether this Subtopic applies.

15-71 Notwithstanding the characteristics discussed in paragraph 815-10-15-83, loan commitments that relate to the origination of mortgage loans that will be held for sale, as discussed in paragraph 948-310-25-3, shall be accounted for as derivative instruments by the issuer of the loan commitment (that is, the potential lender).

A loan commitment (i.e., an agreement to lend a specified amount of money during a specified period in the future) generally would fail to meet the definition of a derivative because it does not provide for net settlement. However, some loan commitments contain assignment clauses or provide for delivery of an asset that is RCC and would meet the definition of a derivative.

ASC 815-10-15-69 provides a scope exception under which the “holder of a commitment to originate a loan” (the potential borrower in the arrangement) need not account for a loan commitment as a derivative. In the case of a borrower, the loan commitment scope exception applies to commitments to originate all types of loans, both mortgage and nonmortgage loans. As noted in ASC 815-10-15-70, the guidance in ASC 815-10-15-69 should not be applied to commitments to purchase or sell loans on a future date.

The issuer’s accounting for a loan commitment depends on several factors, including the type of loan to be funded, the issuer’s intent and elections, and whether industry-specific guidance applies. In evaluating the appropriate accounting for the commitment, an issuer should consider the following questions:

Must the commitment be accounted for as a derivative? Commitments to originate mortgage loans that will be held for sale must be accounted for as derivatives at fair value (see ASC 815-10-15-71 and SAB 105, codified as SAB Topic 5.DD9).
Has the fair value option been elected? The issuer of a loan commitment is permitted to elect the fair value option for the commitment (see ASC 825-10-15-4(c)). Loan commitments for which the fair value option has been elected are measured at fair value, with changes in fair value recognized in earnings. (See Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for additional discussion.)
Does industry-specific guidance apply? In some industries, issuers account for financial instruments, including loan commitments, at fair value (e.g., broker-dealers that are subject to the AICPA Audit and Accounting Guide Brokers and Dealers in Securities).
Does the loan to be acquired meet the definition of a debt security? The accounting for forward (and purchased option) contracts to acquire debt securities is addressed in ASC 815-10-25-17 and ASC 815-10-15-141. That guidance requires that forward contracts to acquire debt securities (other than forwards required to be accounted for as derivatives) be classified and accounted for in a manner consistent with ASC 320. Accordingly, the accounting for changes in the value of such forward contracts depends on whether the debt securities to be acquired will be classified as trading, available for sale (AFS), or held to maturity (HTM).
Does the entity intend to sell the loan to be funded or hold it for investment? If the loan to be funded is not a debt security and the loan commitment is not required to be accounted for at fair value under ASC 815, ASC 825, or industry-specific guidance, the accounting depends on whether the entity intends to hold the loan to be funded for sale or investment, as follows:
1. Loans held for sale — A white paper issued by the CAQ in October 2007 identifies two acceptable accounting policy alternatives if the entity intends to hold the loan for sale:
  1. Alternative A — Entities may use a lower-of-cost-or-market model to account for the commitment by analogy to ASC 815. Under this approach, the terms of the committed loan are compared with current market terms; if the terms of the committed loan are below market, a loss is recorded to reflect the current fair value of the commitment.
  2. Alternative B — Entities may account for the commitment under ASC 450-20. Under this approach, an entity assesses whether a loss is probable and reasonably estimable. If it is probable that the loan will be (1) funded under the terms of the commitment and (2) held for sale at a loss, the entity should measure the loss on the basis of the current fair value of the commitment.
  For commitments to fund loans held for sale, any losses are measured on the basis of the current fair value of the commitment under both Alternative A and Alternative B. To determine fair value, an entity considers both interest rate risk and credit risk. For instance, even though it may not be probable that a credit loss has been incurred, a decline in fair value may have occurred if interest rates or credit spreads have increased after the issuance of the loan commitment (note that under Alternative B, the decline would be recognized only if both conditions above are satisfied).
2. Loans held for investment — If the entity intends to hold the loan for investment (i.e., for the foreseeable future), the loan commitment should be evaluated for credit losses if it is within the scope of ASC 326-20. (See Section 2.1.1 of Deloitte’s Roadmap Current Expected Credit Losses for more information on evaluating whether unfunded loan commitments are within the scope of ASC 326-20.)

2.3.9.1 Mandatory Sales Contracts Versus “Best Efforts” Sales Contracts

An entity may also enter into a commitment to purchase or sell loans on a future date. There are two different types of forward loan sale contracts:

Mandatory sales contracts.
“Best-efforts” sales contracts.

In a mandatory sales contract, an entity must deliver the stated notional amount of loans. Any shortfall in the loans delivered results in the payment of a penalty based on the amount of the shortfall (i.e., on the market value of the undelivered loans). In a best-efforts contract, there is no penalty for nonperformance.

A mandatory sales contract will meet the definition of a derivative if it satisfies any of the net settlement criteria in ASC 815-10-15-99. Forward loan sale contracts typically do not permit explicit net settlement (ASC 815-10-15-99(a)). Therefore, an entity should consider whether there is a market mechanism that facilitates net settlement of the forward loan sale contract or whether the loans underlying the forward loan sale contract are RCC. Note that although an entity must analyze the loans subject to the forward loan sale contract to determine whether the RCC net settlement criterion is satisfied, the evaluation of whether a market mechanism exists should be made with respect to the forward loan sale contract. ASC 815-10-15-70 clarifies that an entity should not analogize to the guidance on loan commitments in ASC 815-10-15-69.

Some best-efforts sales contracts obligate the originator (seller) to deliver and the buyer to purchase all originated loans that meet certain criteria. However, if no loans are originated, there is no penalty for nonperformance. These types of contracts are similar to contingent forward sale contracts. At inception of such a contract, until loan commitments are made for qualifying loans, there is no notional amount and the contract does not meet the definition of a derivative. If and when a qualifying loan commitment is made, a notional amount exists and the contract may meet the definition of a derivative. However, the fair value of the contract will be affected by the probability that the existing loan commitments will result in originated loans.

Other best-efforts sales contracts only obligate the buyer to purchase qualifying loans delivered by the originator (seller) and do not obligate the originator to deliver any loans under the contract. These types of contracts are more option-like. If a notional amount can be established and the contract meets any of the net settlement criteria in ASC 815-10-15-99, the contract represents an option written by the buyer to the originator (seller), which meets the definition of a derivative.

2.3.9.2 Exercise or Expiration of a Loan Commitment Accounted for as a Derivative

Upon a mortgage banker’s exercise of a derivative loan commitment and origination of a mortgage loan, the mortgage banker should derecognize the derivative loan commitment and recognize the originated mortgage loan initially at cost, which includes the fair value of the derivative loan commitment that is extinguished on the origination of the loan. Accordingly, the initial carrying amount of the loan is the net amount of the (1) actual loan proceeds, (2) net fees and costs recognized in accordance with ASC 310-20, and (3) fair value of the derivative loan commitment immediately before exercise (i.e., the derivative loan commitment should be remeasured at fair value just before exercise, with any changes recognized in earnings). Any difference between the loan’s contractual principal amount and adjusted carrying amount should be recognized over the life of the loan in accordance with the provisions of ASC 310-20.

Upon expiration of a loan commitment that has been accounted for as a derivative, the mortgage banker should derecognize the carrying amount of the derivative loan commitment, and the extinguished amount should be recognized in earnings.

2.3.10 Certain Interest-Only Strips and Principal-Only Strips

ASC 815-10

Interests in Securitized Financial Assets

15-11 The holder of an interest in securitized financial assets (other than those identified in paragraphs 815-10-15-72 through 15-73) shall determine whether the interest is a freestanding derivative instrument or contains an embedded derivative that under Section 815-15-25 would be required to be separated from the host contract and accounted for separately.

15-72 An interest-only strip or principal-only strip is not subject to the requirements of this Subtopic provided the strip has both of the following characteristics:

It represents the right to receive only a specified proportion of the contractual interest cash flows of a specific debt instrument or a specified proportion of the contractual principal cash flows of that debt instrument.
It does not incorporate any terms not present in the original debt instrument.

15-73 An allocation of a portion of the interest or principal cash flows of a specific debt instrument as reasonable compensation for stripping the instrument or to provide adequate compensation to a servicer (as defined in Topic 860) would meet the intended narrow nature of the scope exception provided in this paragraph. However, an allocation of a portion of the interest or principal cash flows of a specific debt instrument to provide for a guarantee of payments, for servicing in excess of adequate compensation, or for any other purpose would not meet the intended narrow nature of the scope exception.

ASC 815-10-15-72 provides a narrow exception from ASC 815 for the simplest interest-only (IO) and principal-only (PO) strips. Strips meeting the criteria in ASC-815-10-15-72 are not subject to the requirements of ASC 815.

An entity must analyze a senior interest in a securitization transaction to determine whether it contains one or more embedded derivatives (unless the entire interest is recorded at fair value, with changes in fair value reported in earnings). Accordingly, unless it meets the criteria for the ASC 815-10-15-72 exemption, an entity must consider potential ASC 815-15 ramifications for all interests in securitized financial assets issued or acquired. See Chapter 4 for further discussion of embedded derivatives.

Under ASC 815-15-25-1, the evaluation of whether a beneficial interest includes an embedded derivative involves an analysis of the implicit and explicit terms of the beneficial interest that affect some or all of the cash flows or value of the interest in a manner similar to a derivative instrument. The analysis begins with the explicit contractual terms of the beneficial interest such as interest rate, maturity, payment priority, and payoff structure. However, it is also necessary to understand the nature and amount of assets, liabilities, and other financial instruments included in the securitization vehicle.

If the terms of the beneficial interest do not indicate that an embedded derivative exists and the underlying financial instruments held by the securitization vehicle will provide the necessary cash flows (excluding credit-related shortfalls), a beneficial interest in a vehicle that holds one or more derivative instruments would not necessarily indicate the existence of an embedded derivative. As demonstrated in the cases in ASC 815-15-55-222 (currency swap) and ASC 815-15-55-223 (interest rate swap), the inclusion of a derivative instrument in a securitization vehicle may eliminate a mismatch in a securitization structure that would otherwise result in an embedded derivative.

2.3.10.1 Interest-Only and Principal-Only Strips Arising From Pools of Loans or Mortgage-Backed Securities

In limited circumstances, IO and PO strips that arise from pools of loans or mortgage-backed securities (MBSs) can qualify for the scope exception. However, only principal and interest strips resulting from the simplest separation of cash flows are eligible. Specifically, as indicated in ASC 815-10-15-72, an IO or PO strip is exempt from ASC 815-15 only when it has both of the following characteristics:

It represents the right to receive only a specified proportion of the contractual interest cash flows of a specific debt instrument or a specified proportion of the contractual principal cash flows of that debt instrument. [Emphasis added]
It does not incorporate any terms not present in the original debt instrument.

If pools of loans are aggregated in a securitization, IO and PO strips from that securitization are exempt from ASC 815 if the above requirements are satisfied. It does not matter whether the cash flows are derived from a specific debt instrument or a pool of debt instruments as long as the separation does not contain any terms that were not present in the original debt instruments. Further, ASC 815-10-15-73 excludes from the exemption in ASC 815-10-15-72 any IO or PO strip that is issued in connection with a resecuritization of financial assets when the cash flows on the underlying assets are used to pay (1) guarantee fees or (2) more than adequate compensation to a servicer, as defined in ASC 860-50.

Example 2-18

IO and PO Strips That Meet the Scope Exception

An insurance company securitizes a pool of “vanilla” commercial loans it has originated in a nonrevolving securitization. The loans do not embed any derivatives that would require bifurcation under ASC 815 and the securitization vehicle holds no other positions. The securitization vehicle issues IO and PO strips to third-party investors as follows:

The investor in the IO strip is entitled to 100 percent of the interest payments on the underlying loans but not to principal payments.
The investor in the PO strip is entitled to 100 percent of the principal payments on the underlying loans but not to interest payments.

The IO and PO strips meet the exemption in ASC 815-10-15-72 because (1) the cash flows are used for no purpose other than to support the IO and PO strips, (2) the cash flows supporting the IO and PO strips are fixed and determinable, (3) there are no modifications to the underlying cash flows, and (4) the securitization does not involve the payment of a guarantee fee or servicing in excess of adequate compensation.

Example 2-19

IO and PO Strips That Do Not Meet the Scope Exception

A government-sponsored agency issues an IO strip and a PO strip backed by a fixed-rate MBS that it has guaranteed (e.g., a FNMA Mega or a FHLMC Giant). An investor in the IO strip is entitled to 100 percent of the interest payments but not to principal payments from the underlying MBS. The investor in the PO strip receives 100 percent of the principal payments but does not receive any interest payments from the underlying MBS. Because the mortgages underlying the MBS were securitized in earlier transactions involving the payment of guarantee fees, the IO and the PO strips would not meet the exemption in ASC 815-10-15-72 and would not be exempt from the provisions of ASC 815 (i.e., they must be analyzed to determine whether each is a freestanding derivative or embeds a derivative in accordance with ASC 815-15-25-1).

Example 2-20

IO and PO Strips With Contingent Features

An IO strip in a pool of loans contains a contingent feature that reallocates a portion of the future principal payments on the original financial instruments to holders of the IO strip if interest rates decline by a specified amount. Because the IO and PO strips both contain contingent features, they would not meet the exemption in ASC 815-10-15-72 and therefore would not be exempt from the provisions of ASC 815 (i.e., they must be analyzed to determine whether each is a freestanding derivative or embeds a derivative in accordance with ASC 815-15-25-1).

If an IO or PO strip does not meet the scope exception in ASC 815-10-15-72, the entity is required to evaluate whether the financial instrument is a freestanding derivative instrument or contains an embedded derivative that otherwise would have to be accounted for separately as a derivative in accordance with ASC 815-15-25-1. If the entity determines that an embedded derivative meets the conditions in ASC 815-15-25-1, it may either (1) account for the embedded derivative separately from the host contract or (2) elect to measure the entire instrument at fair value under ASC 815-15-25-4 if the embedded derivative would have to be accounted for separately from the host without this election.

2.3.10.2 Guarantee Fees and Servicing Fees Greater Than Adequate Compensation

As noted previously, only principal and interest strips resulting from the simplest separation of cash flows are eligible for the exemption provided in ASC 815-10-15-72. The separated cash flows cannot contain any terms that were not present in the original debt instruments. Further, ASC 815-10-15-73 excludes from the exemption in ASC-815-10-15-72 any IO or PO strip that is issued in connection with a securitization of financial assets if the cash flows on the underlying assets are also used to pay guarantee fees or to pay a servicer more than adequate compensation, as defined in ASC 860-50. Thus, unless the investor intends to classify the security as a trading security in accordance with ASC 320-10-25-1, an IO or PO strip investor who is unrelated to the servicer will have to analyze whether (1) there is a guarantee of payments involving the trust assets or (2) the fee paid to a servicer represents more than adequate compensation.

Example 2-21

Servicing Fees in Excess of Adequate Compensation

A securitization trust owns mortgage loans. The servicing agreement entitles the servicer, who is also the transferor, to more than adequate compensation. In accordance with ASC 860-50, the transferor/servicer records a servicing asset representing the excess of the fair value of its servicing fees over adequate compensation. Among the interests that the trust issues is an IO strip entitled to 50 basis points on the outstanding principal amount of the securities in the trust and an interest entitled to 100 percent of the principal payments and contractual interest payments from the underlying mortgage loans (net of payments related to the IO and servicing). Because the servicing agreement provides for servicing fees in excess of adequate compensation, the IO strip would not be exempt from the provisions of ASC 815 (i.e., it must be analyzed to determine whether it is a freestanding derivative or embeds a derivative in accordance with ASC 815-15-25-1).

2.3.11 Certain Contracts Involving an Entity’s Own Equity

ASC 815-10

15-74 Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Subtopic:

Contracts issued or held by that reporting entity that are both:
1. Indexed to its own stock (see Section 815-40-15)
2. Classified in stockholders’ equity in its statement of financial position (see Section 815-40-25).
Contracts issued by the entity that are subject to Topic 718. If any such contract ceases to be subject to Topic 718 in accordance with paragraphs 718-10-35-9 through 35-14, the terms of that contract shall then be analyzed to determine whether the contract is subject to this Subtopic. An award that ceases to be subject to Topic 718 in accordance with those paragraphs shall be analyzed to determine whether it is subject to this Subtopic.
Any of the following contracts:
1. A contract between an acquirer and a seller to enter into a business combination
2. A contract to enter into an acquisition by a not-for-profit entity
3. A contract between one or more NFPs to enter into a merger of not-for-profit entities.
Forward contracts that require settlement by the reporting entity’s delivery of cash in exchange for the acquisition of a fixed number of its equity shares (forward purchase contracts for the reporting entity’s shares that require physical settlement) that are accounted for under paragraphs 480-10-30-3 through 30-5, 480-10-35-3, and 480-10-45-3.

Pending Content (Transition Guidance: ASC 805-60-65-1)

15-74 Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Subtopic:

Contracts issued or held by that reporting entity that are both:
1. Indexed to its own stock (see Section 815-40-15)
2. Classified in stockholders’ equity in its statement of financial position (see Section 815-40-25).
b. Contracts issued by the entity that are subject to Topic 718. If any such contract ceases to be subject to Topic 718 in accordance with paragraphs 718-10-35-9 through 35-14, the terms of that contract shall then be analyzed to determine whether the contract is subject to this Subtopic. An award that ceases to be subject to Topic 718 in accordance with those paragraphs shall be analyzed to determine whether it is subject to this Subtopic.
Any of the following contracts:
1. A contract between an acquirer and a seller to enter into a business combination
2. A contract to enter into an acquisition by a not-for-profit entity
3. A contract between one or more NFPs to enter into a merger of not-for-profit entities
4. In a joint venture’s separate financial statements, a contract between a joint venture and its venturers related to the formation of the joint venture accounted for in accordance with Subtopic 805-60.
Forward contracts that require settlement by the reporting entity’s delivery of cash in exchange for the acquisition of a fixed number of its equity shares (forward purchase contracts for the reporting entity’s shares that require physical settlement) that are accounted for under paragraphs 480-10-30-3 through 30-5, 480-10-35-3, and 480-10-45-3.

15-75 The scope exceptions in paragraph 815-10-15-74 do not apply to either of the following:

The counterparty in those contracts. For example, the scope exception in (b) in the preceding paragraph related to share-based compensation arrangements does not apply to equity instruments (including stock options) received by nonemployees as compensation for goods and services.
A contract that an entity either can or must settle by issuing its own equity instruments but that is indexed in part or in full to something other than its own stock. That contract can be a derivative instrument for the issuer under paragraphs 815-10-15-13 through 15-139, in which case it would be accounted for as a liability or an asset in accordance with the requirements of this Subtopic. For example, a forward contract that is indexed to both an entity’s own stock and currency exchange rates does not qualify for the exception in (a) in the preceding paragraph with respect to that entity’s accounting because the forward contract is indexed in part to something other than that entity’s own stock (namely, currency exchange rates).

15-75A For purposes of evaluating whether a financial instrument meets the scope exception in paragraph 815-10-15-74(a)(1), a down round feature shall be excluded from the consideration of whether the instrument is indexed to the entity’s own stock.

15-76 Temporary equity is considered stockholders’ equity for purposes of the scope exception in paragraph 815-10-15-74(a) even if it is required to be displayed outside of the permanent equity section.

15-77 For guidance on determining whether a freestanding financial instrument or embedded feature is not precluded from qualifying for the first part of the scope exception in paragraph 815-10-15-74(a), see the guidance beginning in paragraph 815-40-15-5. For guidance on determining whether a freestanding financial instrument or embedded feature qualifies for the second part of the scope exception in paragraph 815-10-15-74(a), see the guidance beginning in paragraph 815-40-25-1.

15-78 Paragraph 815-40-25-39 explains that, for purposes of evaluating under this Subtopic whether an embedded derivative indexed to an entity’s own stock would be classified in stockholders’ equity if freestanding, the additional considerations necessary for equity classifications beginning in paragraph 815-40-25-7 do not apply if the hybrid contract is a convertible debt instrument in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer).

One of the most commonly evaluated scope exceptions involves certain contracts on an entity’s own equity. For example, an entity may issue (1) warrants that it can exercise into its own equity or (2) a convertible preferred stock or convertible debt instrument that contains embedded conversion features that are settleable in shares of its own equity.

These freestanding instruments or embedded features may otherwise meet the definition of a derivative before consideration of whether the scope exception in ASC 815-10-15-74(a) applies. See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for a comprehensive discussion of the relevant guidance.

2.3.12 Leases

ASC 815-10

15-79 Leases that are within the scope of Topic 842 are not derivative instruments subject to this Subtopic, although a derivative instrument embedded in a lease may be subject to the requirements of paragraph 815-15-25-1.

ASC 815 provides a scope exception for leases that are in the scope of ASC 842, and therefore lease contracts are not accounted for as freestanding derivative instruments. However, lease contracts need to be analyzed to determine whether they include embedded derivatives that require separate accounting.

Components of a lease agreement that might be considered embedded derivatives include, but are not limited to:

Option arrangements, such as purchase or renewal options.
Indexed rental payments.
Additional rental payments that are contingent on the occurrence of an outside event or achievement of a certain threshold.
Rental payments denominated in a foreign currency.

The terms of any lease arrangement containing these or similar provisions must be analyzed to determine whether the provision meets the definition of a derivative and, if so, whether ASC 815 requires separate accounting for the embedded derivative.

2.3.12.1 Inflation-Indexed Lease Payments

Generally, inflation-indexed payments are considered clearly and closely related to a lease host contract unless (1) a significant leverage factor is involved or (2) the inflation index is unrelated to the economic environment of the lessee or lessor (see Example 4-7).

2.3.12.2 Lease Payments Denominated in a Foreign Currency

Entities may structure a lease contract such that lease payments are adjusted on the basis of changes in foreign currency rates. Because ASC 815-15-15-10 provides a scope exception for embedded derivatives whose features involve certain currencies, most such arrangements are not likely to require bifurcation of the embedded feature.

See Section 4.3.5.5 for a discussion of this scope exception for embedded derivatives, including Example 4-11, which specifically contemplates foreign-currency adjusted lease payments.

See also Section 2.3.2 of Deloitte’s Roadmap Leases for a discussion of embedded derivatives in leases.

2.3.13 Residual Value Guarantees

ASC 815-10

15-80 Residual value guarantees that are subject to the requirements of Topic 842 on leases are not subject to the requirements of this Subtopic.

15-81 A third-party residual value guarantor shall consider the guidance in this Subtopic for all residual value guarantees that it provides to determine whether they are derivative instruments and whether they qualify for any of the scope exceptions in this Subtopic. The guarantees described in paragraph 842-10-15-43 for which the exceptions of paragraphs 460-10-15-7(b) and 460-10-25-1(a) do not apply are subject to the initial recognition, initial measurement, and disclosure requirements of Topic 460.

Residual value guarantees that are accounted for under ASC 842, including any residual value guarantee between the lessee and the lessor, are not subject to the derivative accounting guidance in ASC 815-10. However, a third-party guarantor must assess whether any residual value guarantee that it writes on an underlying leased asset is subject to the guidance in ASC 815-10.

A leased asset subject to a third-party residual value guarantee will always be a nonfinancial asset (i.e., financial assets cannot be leased). Accordingly, a third-party guarantor may seek to avoid fair value measurement of the guarantee and instead use the scope exception in ASC 815-10-15-59(b) for contracts that are not traded on an exchange and are settled on the basis of the price or value of a nonfinancial asset. Third-party guarantors will generally meet the second condition in ASC 815-10-15-59(b) because increases in the fair market value of the underlying nonfinancial asset reduce the third-party guarantor’s exposure and, therefore, the asset’s owner would not benefit from such an increase in value under the contract.

2.3.14 Registration Payment Arrangements

ASC Master Glossary

Registration Payment Arrangement

An arrangement with both of the following characteristics:

It specifies that the issuer will endeavor to do either of the following:
1. File a registration statement for the resale of specified financial instruments and/or for the resale of equity shares that are issuable upon exercise or conversion of specified financial instruments and for that registration statement to be declared effective by the U.S. Securities and Exchange Commission (SEC) (or other applicable securities regulator if the registration statement will be filed in a foreign jurisdiction) within a specified grace period
2. Maintain the effectiveness of the registration statement for a specified period of time (or in perpetuity).
It requires the issuer to transfer consideration to the counterparty if the registration statement for the resale of the financial instrument or instruments subject to the arrangement is not declared effective or if effectiveness of the registration statement is not maintained. That consideration may be payable in a lump sum or it may be payable periodically, and the form of the consideration may vary. For example, the consideration may be in the form of cash, equity instruments, or adjustments to the terms of the financial instrument or instruments that are subject to the registration payment arrangement (such as an increased interest rate on a debt instrument).

ASC 815-10

15-82 Registration payment arrangements within the scope of Subtopic 825-20 are not subject to the requirements of this Subtopic. The exception in this paragraph applies to both the issuer that accounts for the arrangement pursuant to that Subtopic and the counterparty.

A registration payment arrangement within the scope of ASC 825-20 should not be evaluated under ASC 815. Instead, it is accounted for as a separate unit of account under ASC 825-20. See Section 3.3.3.2 of Deloitte’s Roadmap Issuer’s Accounting for Debt for additional discussion on this topic.

Example 2-22

Registration Payment Arrangement Scope Exception

Company Y, a publicly traded entity, owns and operates gaming and racing facilities in the United States. On May 1, 20X0, Y issues $330 million of convertible senior notes that are due in 2026. The notes were not registered under the Securities Act and were offered in a private placement to QIBs under Rule 144A of the Securities Act.

The notes bear interest at a rate of 2.75 percent per year. Interest is payable semiannually in arrears on May 1 and November 1 of each year, commencing November 1, 20X0.

Company Y agrees to seek registration of 3.5 million shares of Y’s common stock. If Y is unable to fulfill its registration commitment by October 31, 20X0 (i.e., there is a “registration lapse”), the interest rate will increase by 0.50 percent per annum in each successive six-month period of noncompliance, capped at 5.0 percent per annum.

The requirement to pay additional interest upon a registration lapse represents a registration payment arrangement that, in this fact pattern, is not subject to any of the scope exceptions in ASC 825-20-15-4. Therefore, the additional interest feature is within the scope of ASC 825-20.

Arrangements within the scope of ASC 825-20 should be accounted for separately on the basis of the recognition and measurement principles of ASC 450-20 at inception, and subsequently thereafter. That is, amounts payable under the additional interest feature should be recognized if those amounts are probable and reasonably estimable. Specifically, ASC 825-20 states the following:

30-1 An entity shall measure a registration payment arrangement as a separate unit of account from the financial instrument(s) subject to that arrangement.

30-3 The contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement shall be measured separately in accordance with Subtopic 450-20.

30-4 If the transfer of consideration under a registration payment arrangement is probable and can be reasonably estimated at inception, the contingent liability under the registration payment arrangement shall be included in the allocation of proceeds from the related financing transaction using the measurement guidance in Subtopic 450-20. The remaining proceeds shall be allocated to the financial instrument(s) issued in conjunction with the registration payment arrangement based on the provisions of other applicable GAAP. A financial instrument issued concurrently with a registration payment arrangement might be initially measured at a discount to its principal amount under this allocation methodology. For example, if the financial instruments issued concurrently with the registration payment arrangement are a debt instrument and an equity-classified warrant, the remaining proceeds after recognizing and measuring a liability for the registration payment arrangement under that Subtopic would be allocated on a relative fair value basis between the debt and the warrant pursuant to paragraph 470-20-25-3.

35-1 If the transfer of consideration under a registration payment arrangement becomes probable and can be reasonably estimated after the inception of the arrangement or if the measurement of a previously recognized contingent liability increases or decreases in a subsequent period, the initial recognition of the contingent liability or the change in the measurement of the previously recognized contingent liability (in accordance with Subtopic 450-20) shall be recognized in earnings.

2.3.15 Certain Fixed-Odds Wagering Contracts

ASC 815-10

15-82A Fixed-odds wagering contracts for an entity operating as a casino and for the casino operations of other entities are within the scope of Topic 606 on revenue from contracts with customers. See paragraph 924-815-15-1.

Certain fixed-odds wagering contracts that are accounted for as revenue transactions by an entity with casino operations are eligible for a scope exception under ASC 815.