Deloitte's Roadmap: Derivatives

Preface

We are pleased to present the 2024 edition of Derivatives. This Roadmap provides a comprehensive discussion of the guidance in ASC 8151 on the identification, classification, measurement, and presentation and disclosure of derivative instruments, including embedded derivatives. The 2024 edition includes several short videos that highlight certain aspects of derivative accounting.

Accounting for derivatives in accordance with ASC 815 is one of the most complex areas of U.S. GAAP, primarily because of the nuances involved in evaluating whether an instrument meets the definition of a derivative and whether a scope exception is available. The identification of possible embedded derivatives in a host contract also requires careful evaluation. This Roadmap is intended to help entities navigate the applicable accounting and financial reporting guidance and arrive at supportable accounting conclusions. It is assumed in this Roadmap that an entity has adopted ASU 2016-02 (on leases), ASU 2017-12 (on targeted improvements to accounting for hedging activities), ASU 2018-12 (on targeted improvements to accounting for long-duration contracts), and ASU 2020-06 (on an issuer’s accounting for convertible debt); however, these ASUs do not have a significant impact on the guidance discussed in this publication.

Please note that hedge accounting is not addressed in this Roadmap. For a comprehensive discussion of that topic, see Deloitte’s Roadmap Hedge Accounting.

Be sure to check out On the Radar (also available as a stand-alone publication), which briefly summarizes emerging issues and trends related to the accounting and financial reporting topics addressed in the Roadmap.

We hope you find this Roadmap a useful resource, and we welcome your suggestions for future improvements. If you need assistance with applying the guidance or have other questions about this topic, we encourage you to consult our technical specialists and other professional advisers.

Footnotes

For a list of abbreviations used in this publication, see Appendix B. For the full titles of standards, topics, and regulations used in this publication, see Appendix A.

On the Radar

Contacts

Chapter 1 — Introduction

1.1 Overview

ASC 815 is the source of authoritative literature in U.S. GAAP on derivatives and hedging. The main principles of ASC 815 were derived from FASB Statement 133, which established comprehensive accounting and reporting requirements for derivatives (as defined in the standard) and qualifying hedging activities. Shortly after the issuance of Statement 133 in June 1998, the FASB established a Derivatives Implementation Group (DIG) to provide interpretive guidance, which became authoritative once formally cleared by the FASB. The FASB issued more than 130 DIG Issues (excluding transition issues). When the FASB Accounting Standards Codification (the “Codification”) was released in 2009, ASC 815 became the primary home of the collective guidance.

ASC 815-10

05-1 The Derivatives and Hedging Topic includes the following Subtopics:

Overall
Embedded Derivatives
Hedging — General
Fair Value Hedges
Cash Flow Hedges
Net Investment Hedges
Contracts in Entity’s Own Equity
Weather Derivatives.

05-2 The first six Subtopics address the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and hedging activities. The last two Subtopics provide guidance on accounting for contracts that have characteristics of derivative instruments but that are not accounted for as derivative instruments under this Subtopic.

05-4 This Topic requires that an entity recognize derivative instruments, including certain derivative instruments embedded in other contracts, as assets or liabilities in the statement of financial position and measure them at fair value. If certain conditions are met, an entity may elect, under this Topic, to designate a derivative instrument in any one of the following ways:

A hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk (referred to as a fair value hedge)
A hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk (referred to as a cash flow hedge)
A hedge of the foreign currency exposure of any one of the following:
1. An unrecognized firm commitment (a foreign currency fair value hedge)
2. An available-for-sale debt security (a foreign currency fair value hedge)
3. A forecasted transaction (a foreign currency cash flow hedge)
4. A net investment in a foreign operation.

10-1 Four fundamental decisions serve as cornerstones underlying the guidance in this Topic:

Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.
Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments. Derivative instruments should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (that is, gains or losses) that are attributable to the risk being hedged and that arise while the hedge is in effect.
Only items that are assets or liabilities should be reported as such in financial statements.
Special accounting for items designated as being hedged should be provided only for qualifying items. One aspect of qualification should be an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged.

ASC 815 establishes the accounting and reporting standards for derivative instruments, including certain derivatives embedded in other contracts, and hedging activities.1 A foundational principle of ASC 815 is that an entity should recognize derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Fair value is the most relevant measure for derivative contracts.

If certain conditions are met, ASC 815 allows an entity to designate a derivative in a specialized hedge accounting relationship. The accounting for changes in a derivative’s fair value (i.e., gains and losses) depends on the intended use of the derivative and the resulting designation.2 For a derivative that is not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change unless the derivative qualifies for a scope exception under ASC 815.

Footnotes

See Deloitte’s Roadmaps Hedge Accounting and Contracts on an Entity’s Own Equity for authoritative and interpretive guidance on these topics. The guidance within this Roadmap is related to other ASC 815 matters.

See Deloitte’s Roadmap Hedge Accounting for more information about the different types of hedging arrangements and the resulting accounting consequences.

1.3 Concept of Embedded Derivatives

ASC 815-15

05-1 Contracts that do not in their entirety meet the definition of a derivative instrument (see paragraphs 815-10-15-83 through 15-139), such as bonds, insurance policies, and leases, may contain embedded derivatives. The effect of embedding a derivative instrument in another type of contract (the host contract) is that some or all of the cash flows or other exchanges that otherwise would be required by the host contract, whether unconditional or contingent on the occurrence of a specified event, will be modified based on one or more underlyings.

15-2 The guidance in this Subtopic applies only to contracts that do not meet the definition of a derivative instrument in their entirety.

A contract that itself does not meet the definition of a derivative in its entirety may have implicit or explicit terms that affect the cash flows or the value of the contract in a manner similar to a derivative. Those implicit or explicit terms may qualify as “embedded derivatives” under the guidance in ASC 815-15. A contract in which the derivative is embedded is referred to as the “host contract”; when combined, the host contract and the embedded derivative are referred to as a “hybrid instrument.”

An embedded feature will only require separate accounting treatment as a derivative if it meets the following three conditions in ASC 815-15-25-1:

The embedded derivative is “not clearly and closely related” to the host contract (see Section 4.3.2).
The instrument is not subject to recurring fair value measurement, with changes in fair value recorded through earnings (see Section 4.3.3).
The embedded derivative would meet the definition of a derivative within the scope of ASC 815 if it were issued on a freestanding (stand-alone) basis (see Section 1.4).

In developing the derivative accounting requirements that are now located in ASC 815 (such as the requirement to measure derivatives at fair value on a recurring basis), the FASB concluded that an entity should not be able to circumvent those requirements by incorporating derivatives into the contractual terms of nonderivative contracts (e.g., outstanding debt or equity). Accordingly, it decided that when certain criteria are met (described above), derivatives embedded in the terms of nonderivative contracts should be accounted for as derivatives separately from the contracts in which they are embedded. An entity is thus unable to avoid the recognition and measurement requirements of ASC 815 merely by embedding a derivative instrument in a nonderivative financial instrument or another contract.

1.4 Definition of a Derivative

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

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

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

ASC 815-10

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

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

ASC 815-10 — Glossary

Financial Instrument

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

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

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

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

Pending Content (Transition Guidance: ASC 105-10-65-9)

Financial Instrument

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

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

The use of the term financial instrument in this definition is recursive (because the term financial instrument is included in it), though it is not circular. The definition requires a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument. Contractual rights and contractual obligations encompass both those that are conditioned on the occurrence of a specified event and those that are not. Some contractual rights (contractual obligations) that are financial instruments may not be recognized in financial statements — that is, they may be off-balance-sheet — because they fail to meet some other criterion for recognition. For some financial instruments, the right is held by or the obligation is due from (or the obligation is owed to or by) a group of entities rather than a single entity.

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

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

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

1.4.1 Underlying, Notional Amount, and Payment Provision

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

1.4.1.1 Underlying

ASC 815-10 — Glossary

Underlying

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

ASC 815-10

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

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

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

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

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

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

ASC 815-10

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

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

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

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

Case A: Fixed-Price Commodity Contract

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

Case B: Variable-Price Commodity Contract

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

Case C: Mixed-Price Commodity Contract

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

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

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

Example 1-1

Identifying Underlyings in a Litigation Funding Arrangement

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

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

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

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

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

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

The agreement contains the following underlyings:

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

1.4.1.2 Notional Amount or Payment Provision

1.4.1.2.1 Notional Amount

ASC 815-10 — Glossary

Notional Amount

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

ASC 815-10

Notional Amount

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

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

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

ASC 815-10

Notional Amount — Identifying a Commodity Contract’s Notional Amount

55-5 Many commodity contracts specify a fixed number of units of a commodity to be bought or sold under the pricing terms of the contract (for example, a fixed price). However, some contracts do not specify a fixed number of units. For example, consider the following four contracts that require one party to buy the following indicated quantities:

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

55-6 Generally, the anticipated number of units covered by a requirements contract is equal to the buyer’s needs. When a requirements contract is negotiated between the seller and buyer, both parties typically have the same general understanding of the buyer’s estimated needs. Given the buyer’s often exclusive reliance on the seller to supply all its needs of the commodity, it is imperative from the buyer’s perspective that the supplier be knowledgeable with respect to anticipated volumes. In fact, the pricing provisions within requirements contracts are directly influenced by the estimated volumes.

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

Contract 1 — requirements contract. The identification of a requirements contract’s notional amount may require the consideration of volumes or formulas contained in attachments or appendixes to the contract or other legally binding side agreements. The determination of a requirements contract’s notional amount must be performed over the life of the contract and could result in the fluctuation of the notional amount if, for instance, the default provisions reference a rolling cumulative average of historical usage. If the notional amount is not determinable, making the quantification of such an amount highly subjective and relatively unreliable (for example, if a contract does not contain settlement and default provisions that explicitly reference quantities or provide a formula based on historical usage), such contracts are considered not to contain a notional amount as that term is used in this Subtopic. One technique to quantify and validate the notional amount in a requirements contract is to base the estimated volumes on the contract’s settlement and default provisions. Often the default provisions of requirements contracts will specifically refer to anticipated quantities to utilize in the calculation of penalty amounts in the event of nonperformance. Other default provisions stipulate penalty amounts in the event of nonperformance based on average historical usage quantities of the buyer. If those amounts are determinable, they shall be considered the notional amount of the contract.
Contract 2 — requirements contract with a specified maximum quantity. Whether the contract has a notional amount depends. The same considerations discussed in (a) with respect to Contract 1 also apply to Contract 2; however, the notional amount cannot exceed 100 units.
Contract 3 — requirements contract with a specified minimum quantity. The contract has a notional amount. The same considerations discussed in (a) with respect to Contract 1 also apply to Contract 3; however, the notional amount of Contract 3 cannot be less than 60 units. A contract that specifies a minimum number of units always has a notional amount at least equal to the required minimum number of units. Only that portion of the requirements contract with a determinable notional amount would be accounted for as a derivative instrument under this Subtopic.
Contract 4 — requirements contract with a specified maximum and minimum quantities. The contract has a notional amount. The same considerations discussed in (a) with respect to Contract 1 also apply to Contract 4; however, the notional amount of Contract 4 cannot be less than 60 units or greater than 100 units. A contract that specifies a minimum number of units always has a notional amount at least equal to the required minimum number of units. Only that portion of the requirements contract with a determinable notional amount would be accounted for as a derivative instrument under this Subtopic.

Example 1-2

Identifying the Notional Amount in a Contract

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

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

1.4.1.2.2 Payment Provision

ASC 815-10 — Glossary

Payment Provision

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

ASC 815-10

Payment Provision

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

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

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

1.4.2 Initial Net Investment

ASC 815-10

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1.4.2.1 Smaller Initial Net Investment

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

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

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

Example 1-3

Determining Whether There Is a Smaller Initial Net Investment

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

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

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

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

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

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

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

Example 1-4

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

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

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

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

1.4.2.2 Concept of Effective Notional Amount

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

ASC 815-10

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

Example 16: Prepaid Interest Rate Swap

Case A: Prepaid Interest Rate Swap

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

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

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

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

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

Case B: Prepaid Interest Rate Swap That Must Be Bifurcated

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

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

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

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

ASC 815-10

Example 16: Prepaid Interest Rate Swap

Case C: Prepaid Interest Rate Swap Variation

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

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

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

Connecting the Dots

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

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

1.4.3 Net Settlement

1.4.3.1 Background

ASC 815-10

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

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

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

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

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

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

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

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

1.4.3.2 Net Settlement Under Contract Terms

ASC 815-10

Net Settlement Under Contract Terms

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

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

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

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

Example 1-5

Net Settlement of Interest Rate Swaps

Company XYZ enters into an interest rate swap with a counterparty that requires XYZ to pay a fixed rate of 8 percent and receive three-month LIBOR, reset on a quarterly basis. The fixed and variable amounts are determined on the basis of a $100 million notional amount. Company XYZ (1) pays the fixed-rate amount on a semiannual basis to the counterparty and (2) receives the variable amount on a quarterly basis from the counterparty. The interest payments are not settled on a net basis. Thus, the interest rate swap constitutes a series of forward contracts to exchange and receive cash on potentially favorable or unfavorable terms. Each of the forward contracts is a derivative instrument. (Although the interest rate swap represents a series of forward contracts, it would be accounted for as a single unit of account. See Section 1.6 for further discussion of the unit of account to apply for derivative instruments.)

1.4.3.2.1 Net Share Settlement

ASC 815-10

Net Share Settlement

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

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

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

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

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

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

Example 1-6

Impact of Restrictions on the Net Settlement Determination

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

Example 1-7

Cashless Exercise and Net Settlement

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

1.4.3.2.2 Net Settlement in the Event of Nonperformance or Default

ASC 815-10

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

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

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

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

Example 1-8

Fixed Versus Variable Penalty for Nonperformance

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

Case A — $10

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

Case B — 1 Percent of the Price

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

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

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

1.4.3.2.3 Asymmetrical Default Provision Does Not Constitute Net Settlement

ASC 815-10

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

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

Asymmetrical Default Provision Does Not Constitute Net Settlement

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Example 1-9

Asymmetrical Liquidating Damages Provisions

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

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

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

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

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

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

1.4.3.2.4 Structured Settlement as Net Settlement

ASC 815-10

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

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

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

Determining Whether a Structured Payout Constitutes Net Settlement

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

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

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

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

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

ASC 815-10

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

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

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

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

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

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

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

1.4.3.2.6 Contractual Net Settlement Only in Contingent Scenarios

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

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

Example 1-10

Contingent Net Settlement

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

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

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

1.4.3.3 Net Settlement Through a Market Mechanism

ASC 815-10

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Case A: Market Mechanism Develops After Contract Inception

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

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

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

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

Example 1-11

Determining Whether a Market Mechanism Exists

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

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

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

1.4.3.3.1 Contracts With Market Makers

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

Example 1-12

Market Mechanism and Market Maker Contracts

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

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

1.4.3.3.2 Market Mechanism on Non-Exchange-Traded Contracts

ASC 815-10

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

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

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

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

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

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

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

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

ASC 815-10 — Glossary

Readily Convertible to Cash

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

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

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

Pending Content (Transition Guidance: ASC 105-10-65-9)

Readily Convertible to Cash

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

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

ASC 815-10

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

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

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

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

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

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

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

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

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

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

ASC 815-10

Determining Whether Shares of Stock Are Readily Convertible to Cash

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

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

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

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

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

Case A: Single Bond With Multiple Conversion Options

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

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

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

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

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

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

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

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

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

Case B: Multiple Bonds Each Having Single Conversion Option

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

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

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

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

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

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

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

Example 1-13

Shares of Stock Are RCC

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

Example 1-14

Shares of Stock May Not Be RCC

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

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

ASC 815-10

Contracts Involving Multiple Deliveries

15-128 For contracts that involve multiple deliveries of the asset, the phrase in an active market that can rapidly absorb the quantity held by the entity in the definition of readily convertible to cash shall be applied separately to the expected quantity in each delivery.

Example 8: Net Settlement — Effect of Multiple Deliveries

55-111 This Example illustrates the effect of multiple deliveries on the consideration of net settlement described in Section 815-10-15. An entity has a five-year supply contract that obligates it to deliver at a specified price each month a specified quantity of a commodity that has interchangeable (fungible) units and for which quoted prices are available in an active market. However, the quoted prices that are available are for either a spot sale or a forward sale of the commodity with a maturity of 12 months or less. In other words, the forward market for the commodity beyond the next 12 months does not currently exist and is not expected to develop. There are brokers who are willing to take over the rights and obligations relating to the next 12 months of the supply contract, but not for periods beyond the next 12 months. With respect to the active spot market for the commodity, it can rapidly absorb the quantity specified in the supply contract for each individual month but not the total quantity for the entire five-year period in a single transaction (or in multiple transactions over the course of a day or so).

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

55-113 The 5-year commodity supply contract does not meet the net settlement characteristic in paragraph 815-10-15-110 at its inception because there is no market mechanism to net settle the entire 5-year contract — the forward market exists only for the next 12 months while the contract period is for the next 5 years. Accordingly, there is no market mechanism for the entity to settle the entire contract on a net basis. However, if the contract contained contractually separable increments that individually met the net settlement criteria, those contractually separable increments may be embedded derivatives. In this instance, the brokers in the market will not assume the rights and obligations of the entire contract. Note that the market mechanism in the net settlement characteristic in paragraph 815-10-15-110 relates to whether a party to the contract can be relieved of its rights and obligations under the entire contract, not merely whether an independent broker in the market stands ready to assume the selected rights and obligations.

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

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

55-116 The five-year commodity supply contract meets the net settlement characteristic as discussed beginning in paragraph 815-10-15-119. The criterion discussed beginning in that paragraph is met because an active spot market for the commodity exists today and is expected to be in existence in the future for each delivery date (for example, for quantities to be delivered each day or each month for the next five years) under the multiple delivery supply contract. The spot market can rapidly absorb the quantities specified for each monthly delivery without significantly affecting the price. The fact that the spot market may not be able to absorb within a few days the quantity specified in the entire five-year contract is irrelevant because the performance of the contract is spread out over a five-year period and, therefore, is not expected to occur within a few days.

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

1.4.3.4.2 Evaluating the Impact of Conversion Costs on the RCC Assessment

ASC 815-10

Effect of Conversion Costs

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

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

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

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

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

1.4.3.4.3 Evaluating the Impact of Transfer Restrictions on the RCC Assessment

ASC 815-10

Determining Whether Shares of Stock Are Readily Convertible to Cash

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Example 1-15

Assessment of RCC Criterion When Restrictions Exceed 31 Days

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

Example 1-16

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

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

See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for more information about the scope exception that could be available to Y as the issuer of the warrant. Company X would not be able to apply that exception as the holder of the warrant.

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

Example 1-17

Impact of Contract Costs on the Assessment of RCC Criterion

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

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

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

1.4.3.4.5 Ongoing Evaluation

ASC 815-10

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

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

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

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

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

Case A: Market Mechanism Develops After Contract Inception

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

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

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

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

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

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

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

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

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

1.5 Application of the ASC 815 Definition of a Derivative to Specific Contracts

The table below illustrates the application of the ASC 815 definition of a derivative to different types of contracts (before any scope exceptions are considered).

Contract	Does the contract have an underlying?	Does the contract have a notional amount or payment provision?	Does the contract involve no or a smaller initial net investment?	Does the contract require or permit net settlement?	Does the contract need to be accounted for as a derivative?3
1,000 warrants to purchase 1,000 shares of an entity’s common stock at a fixed exercise price	Yes, the price of the common stock.	Yes, the number of shares.	Yes, if the price paid for each warrant is at least 10 percent less than the fair value of a share of the entity’s common stock.	Yes, (1) for contracts that provide for cashless exercise (even if only contingently exercisable4) or whose settlement involves the delivery of shares that are RCC or (2) if a market mechanism exists to net settle the contract.	Warrants would typically meet the definition of a derivative if net settlement is present.
Contract to pay a fixed dollar amount if the company’s common stock rises above $10	Yes, the price of the common stock.	Yes, the fixed dollar amount is a payment provision.	Yes, if the price paid for the instrument is at least 10 percent less than the fixed dollar amount (i.e., the payoff from the instrument).	Yes, the contract provides for a one-way transfer of cash, so it is contractually net settled.	Typically, yes.
Short sales of securities (contract under which the short seller borrows a security with a promise to return it to the lender)	Yes, the price of the security.	Yes, the face amount of the security or the number of shares.	No, the short seller received the fair value of the security.	Yes, if the underlying securities are RCC.	No.
Managers’ options or overallotment provisions	Yes, the price of the underlying security.	Typically, yes.	Yes, if the price paid for the option is at least 10 percent less than the fair value of the instrument underlying the option.	Yes, if the underlying securities are RCC. No, if the underlying securities are not RCC.	It depends, typically on the basis of whether the underlying securities are RCC.
Banker’s acceptance agreement	Yes, the fair value of the receivable.	Yes, the aggregate dollar value of the receivable.	Typically, no, because the initial investment in the instrument is not lower than 90 percent of the receivable’s fair value.	No, there is typically no market mechanism to net settle the contract, and the underlying is not RCC.	Typically, no, because it does not provide for net settlement.
Irrevocable letter of credit	Yes, the fair value of the receivable.	Yes, the dollar value of the receivable.	It depends.	No, the receivable generally is not RCC and there is no market mechanism.	Typically, no. A letter of credit would not meet the definition of a derivative because it does not provide for de facto net settlement.

Footnotes

The discussion in the table does not consider the applicability of any of the scope exceptions from derivative accounting provided by ASC 815-10. In practice, more analysis would typically be necessary before concluding that such instruments must be accounted for as derivatives.

See Section 1.4.3.2.6 for additional guidance on how to evaluate contingent net settlement provisions.

Chapter 2 — Scope and Scope Exceptions

2.1 Overview

ASC 815-10

15-1 This Subtopic applies to all entities. Some entities, such as not-for-profit entities (NFPs) and defined benefit pension plans, do not report earnings as a separate caption in a statement of financial performance. The application of this Subtopic to those entities is set forth in paragraphs 815-10-35-3, 815-20-15-1, 815-25-35-19, and 815-30-15-3.

15-2 The scope of this Subtopic relates primarily to whether a contract meets the definition of a derivative instrument (see paragraph 815-10-15-83). However, as discussed in this Subsection, some contracts that meet the definition of derivative instrument are not within the scope of this Subtopic, while other contracts that do not meet the definition of derivative instrument are within the scope of this Subtopic. Some of the disclosure requirements in Section 815-10-50 apply to nonderivative instruments that are designated and qualify as hedging instruments pursuant to paragraphs 815-20-25-58 and 815-20-25-66.

The guidance in ASC 815 applies to all entities. Entities that do not report earnings separately in their financial statements (e.g., nonprofit entities and defined benefit pension plans) must recognize the gain or loss on a nonhedging derivative instrument as a change in their net assets.

ASC 815 focuses on instruments and contracts that meet the definition of a derivative (see Chapter 1). However, certain instruments and contracts meet the definition of a derivative as described in ASC 815-10-15-83 but are appropriately excluded from the scope of the guidance in ASC 815 if any of the available scope exceptions apply (see Section 2.3). Conversely, certain instruments that do not meet the definition of a derivative are actually included in the scope of ASC 815 and therefore subject to its requirements (see Section 2.2).

2.3 Scope Exceptions

ASC 815-10

Instruments Not Within Scope

15-13 Notwithstanding the conditions in paragraphs 815-10-15-83 through 15-139, the following contracts are not subject to the requirements of this Subtopic if specified criteria are met:

Regular-way security trades
Normal purchases and normal sales
Certain insurance contracts and market risk benefits
Certain financial guarantee contracts
Certain contracts that are not traded on an exchange
Derivative instruments that impede sales accounting
Investments in life insurance
Certain investment contracts
Certain loan commitments
Certain interest-only strips and principal-only strips
Certain contracts involving an entity’s own equity
Leases
Residual value guarantees
Registration payment arrangements
Certain fixed-odds wagering contracts.

This section addresses the various scope exceptions provided by ASC 815. If any of the available scope exceptions apply, it would be appropriate for the entity to not apply the guidance within this topic, even if the definition of a derivative was otherwise met. Each of these scope exceptions is discussed in more detail in the subsequent sections.

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

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

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.)

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.

	Jonathan Howard Audit & Assurance Partner Deloitte & Touche LLP +1 203 761 3235 jonahoward@deloitte.com		Ashley Carpenter Audit & Assurance Partner Deloitte & Touche LLP +1 203 761 3197 ascarpenter@deloitte.com
	Jamie Davis Audit & Assurance Partner Deloitte & Touche LLP +1 312 486 0303 jamiedavis@deloitte.com