Recommended Glossaries
Bob
Jensen's FAS 133 Glossary on Derivative Financial Instruments and Hedging
Activities
Also see comprehensive
risk and trading glossaries such as the ones listed below that provide
broader coverage of derivatives instruments terminology but almost nothing in
terms of FAS 133, FAS 138, and IAS39:
Why There Are New Rules for
Accounting for Derivative Financial Instruments
What is the thinking behind the need for FAS 133?
What was the problem with hedge accounting prior to FAS 133?
The new FAS
133 standard entitled Accounting
for Derivative Financial Instruments
and Hedging Activities was released in 1998 after an Exposure Draft
162-B circulated for two years around the U.S. and a temporary FAS 119 standard
required disclosures in footnotes while FAS 133 was being written. It was
followed soon thereafter by IAS 39 that imposed similar requirements for
international reporting and CICA 39 for Canadian reporting of the same types of
derivative instruments. These and the similar new standards in some other
nations differ only in minor ways.
What was new in all of these standards was that derivative
financial instruments have to be booked initially at fair value and then
adjusted to fair value on all reporting dates, especially for quarterly and
annual audited financial statements released to the public. Most
derivatives, other than options and futures contracts covered by FAS 80, were
not booked or even disclosed in financial reports prior to these newer
standards. The really problematic derivatives were forward contracts and
swaps. Swaps were not even invented until the early 1980s, and firms were
not reporting enormous risks and off-balance-sheet-financing as swaps and
forward contracts exploded in popularity in the late 1980s and early
1990s. For example, companies that formerly managed cash with Treasury
Bills, shifted to interest rate swaps for managing interest rate risk on
trillions of dollars.
Futures contracts were accounted for pretty well under FAS 80
since these contracts settle in cash frequently (usually daily) prior to
expiration. Options contracts were not accounted for well at all since
only the initial cost (premium) was booked and amortized over the life of each
option. The problem was that the booked value of the option was generally
small and irrelevant relative to the much larger fair value of the option.
In the early 1990s, enormous frauds using derivative financial
instruments were coming to light. Both governmental (e.g., Orange County)
and corporate (e.g., Proctor and Gamble) scandals revealed how investment banks
were writing misleading and immensely complicated derivative contracts to dupe
organizations out of billions of dollars. Many of the scandals are in
derivative financial instruments are documented at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
In particular, note Frank Partnoy's truly sickening revelations of intentional
frauds perpetrated by virtually all the world's leading investment banks.
Paragraphs 212 and 213 of FAS 133 read as follows at http://www.fasb.org/st/index.shtml#fas150
212. Concern has grown about the
accounting and disclosure requirements for derivatives and hedging activities
as the extent of use and the complexity of derivatives and hedging activities
have rapidly increased in recent years. Changes in global financial markets
and related financial innovations have led to the development of new
derivatives used to manage exposures to risk, including interest rate, foreign
exchange, price, and credit risks. Many believe that accounting standards have
not kept pace with those changes. Derivatives can be useful risk management
tools, and some believe that the inadequacy of financial reporting may have
discouraged their use by contributing to an atmosphere of uncertainty. Concern
about inadequate financial reporting also was heightened by the publicity
surrounding large derivative losses at a few companies. As a result, the
Securities and Exchange Commission, members of Congress, and others urged the
Board to deal expeditiously with reporting problems in this area. For example,
a report of the General Accounting Office prepared for Congress in 1994
recommended, among other things, that the FASB "proceed expeditiously to
develop and issue an exposure draft that provides comprehensive, consistent
accounting rules for derivative products. . . ." \30/ In addition, some
users of financial statements asked for improved disclosures and accounting
for derivatives and hedging. For example, one of the recommendations in the
December 1994 report published by the AICPA Special Committee on Financial
Reporting, Improving Business Reporting-A Customer Focus, was to address the
disclosures and accounting for innovative financial instruments.
213. Because of the urgency of improved financial information about
derivatives and related activities, the Board decided, in December 1993, to
redirect some of its efforts toward enhanced disclosures
and, in October 1994, issued FASB
Statement No. 119, Disclosure about Derivative Financial
Instruments and Fair Value of Financial Instruments. This Statement
supersedes Statement 119.
Even when the derivative contracts are used for economic hedges,
the risk exposures prior to expiration of the hedge can be huge since many
hedges are highly ineffective prior to expiration of the derivative
contracts. What makes derivative financial instruments unique relative to
other financial instruments is that derivatives customarily have either zero
initial cost (e.g., for forwards, futures and swap contracts) or exceedingly
small initial premiums for options. Hence the traditional historical cost
accounting standards were meaningless for derivative instruments. For FAS
133, the Financial Accounting Standards Board (FASB) decided to require
continuous fair market value booking and adjustments (commonly called
Mark-To-Market (MTM) adjustments.
What the FASB wanted was to simply adjust derivatives to fair
value as assets or liabilities and to charge current earnings with the
incremental unrealized gains or losses. All hell broke loose, however,
when this was proposed to the business community, because such adjustments
sometimes resulted in enormous fluctuations of reported earnings. These
fluctuations were especially troublesome in theory and in practice for firms who
were only using derivatives to hedge risk. Unless there was some way to
adjust hedging derivatives to fair value without impacting current earnings,
firms who hedged were actually going to look more risky than if they were not
hedging risk.
This forced the FASB, the IASB, and other standard setters to
adopt hedge accounting relief in the newer standards that require that
derivative financial instruments be carried at fair value. What might have
been a relatively simple FAS 133 thus exploded to way over 500 paragraphs of
technical jargon and complex accounting rules like the world as ever
known. At the time I am writing this in February 2004, most European
nations have agreed to implement all IAS standards in January of 2005 except for
IAS 39 which business firms in Europe refuse to accept at this juncture.
FAS 133 has been in effect in the U.S. since Year 2000 and has caused enormous
confusion and reporting errors, most notable of which is Freddie Mac --- http://www.trinity.edu/rjensen/caseans/000index.htm#FreddieMac
The new standards also create immense problems for auditors,
some of which are dealt with in SAS 92.
Auditing Derivative Instruments, Hedging Activities, and
Investments in Securities
http://www.aicpa.org/members/div/auditstd/riasai/sas92.htm
Hedge accounting affords companies opportunities to book and
adjust derivative financial instruments to fair value at all times.
However, many business firms are upset because the required hedge effectiveness
tests cause them to lose part or all their hedge accounting.
Fair Value Exposure Draft
FAS 133 is arguably the most complex, controversial, and tentative standard ever
issued by the FASB. It is not tentative in terms of required
implementation, but it may fade in prominence if and when the FASB issues its
proposed fair value standard for all financial instruments. The first
exposure draft on this even more controversial proposal is given in Exposure
Draft 204-B entitled Reporting
Financial Instruments and Certain Related Assets and Liabilities at Fair Value.
See
updated information on this at
http://www.fasb.org/project/fv_measurement.shtml
The DIG
In the meantime, the FASB formed the FAS 133 Derivatives Implementation Group
(DIG) to help resolve particular implementation questions, especially in areas
where the standard is not clear or allegedly onerous. The FASB's DIG
website (that contains its mission and pronouncements) is at http://www.fasb.org/derivatives/
DIG issues are also summarized (in red borders) at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin.
Overview of Hedge Effectiveness Testing
One particular area of interest is Ineffectivness as defined at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
|
Ineffectiveness
=
degree ex
ante to which a hedge fails to meet its
goals in protecting against risk (i.e., degree to which the hedge
fails to correlate perfectly with the underlying
value changes or forecasted
transaction prices. According to Paragraphs 20 on Page 11
and 30 on Page 21 of FAS 133, ineffectiveness is to be defined ex
ante at the time the hedge is undertaken. Hedging strategy
and ineffectiveness definition with respect to a given hedge defines
the extent to which interim adjustments affect interim earnings.
Hedge effectiveness requirements and accounting are summarized in
Paragraphs 62-103 beginning on Page 44 of FAS 133. An
illustration of intrinsic value versus time
value accounting is given in Example 9 of FAS 133, Pages
84-86, Paragraphs 162-164. In Example 9, the definition of
ineffectiveness in terms of changes in intrinsic value of a call option
results in changes in intrinsic value each period being posted to
other comprehensive income rather than earnings. In Examples 1-8
in Paragraphs 104-161, designations as to fair value versus cash flow
hedging affects the journal entries.
See Intrinsic Value Versus Full Value Hedge Accounting --- http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm
One means of documenting hedge
effectiveness is to compare the cumulative
dollar offset defined as the cumulative value over a succession
of periods (e.g., quarters) in which the cumulative gains and losses
of the derivative instrument are compared with the cumulative gains
and losses in value of the hedged item. When assessing the
effectiveness of a hedge, an enterprise will generally need to
consider the time value of money according to FAS 133 Paragraph 64 and
IAS 39 Paragraph 152.
Neither the FASB nor the IASC specify a
single method for either assessing whether a hedge is expected to be
highly effective or measuring hedge ineffectiveness.
Tests of hedge effectiveness should be conducted at least quarterly
and on financial statement dates. The appropriateness of
a given method can depend on the nature of the risk being hedged and
the type of hedging instrument used. See FAS 133 Appendix A,
Paragraph 62 and IAS 39 Paragraph 151.
A Great Article!
"A Consistent Approach to Measuring Hedge Effectiveness," by
Bernard Lee, Financial Engineering News --- http://www.fenews.com/fen14/hedge.html
A number of common effectiveness testing criteria used when
implementing FAS 133 include the following from Quantitative Risk
Management, Inc. --- http://www.qrm.com/products/mb/Rmbupdate.htm
|
To provide the maximum flexibility in
testing hedge effectiveness, we now offer the following
methods:
- Dollar Offset (DO) calculates the ratio of dollar
change in profit/loss for hedge and hedged item
- Relative Dollar Offset (RDO) calculates the ratio of
dollar change in net position to the initial MTM value
of hedged item
- Variability Reduction Measure (VarRM) calculates the
ratio of the squared dollar changes in net position to
the squared dollar changes in hedged item
- Ordinary Least Square (OLS) measures the linear
relationship between the dollar changes in hedged item
and hedge. OLS calculates the coefficient of
determination (R2) and the slope coefficient (ß) for
effectiveness measure and accounts for the historical
performance
- Least Absolute Deviation (LAD) is similar to OLS, but
employs median regression analysis to calculate R2 and
ß.
|
-
Minimum value and Paragraph 63 of FAS 133
The minimum value of an American option is zero or its intrinsic
value since it can be exercised at any time. The same cannot
be said for a European option that has to be held to maturity.
If the underlying is the price of corn, then the minimum value of
an option on corn is either zero or the current spot price of corn
minus the discounted risk-free present value of the strike price.
In other words if the option cannot be exercised early, discount
the present value of the strike price from the date of expiration
and compare it with the current spot price. If the
difference is positive, this is the minimum value. It can
hypothetically be the minimum value of an American option, but in
an efficient market the current price of an American option will
not sell below its risk free present value.
Of course the value may actually be greater due to volatility that
adds value above the risk-free discount rate. In other
words, it is risk or volatility that adds value over and above a
risk free alternative to investing. However, it is possible
but not all that common to exclude volatility from risk assessment
as explained in Sub-paragraph b of Paragraph 63 of FAS 133 quoted
below.
a. If the effectiveness of a hedge with
an option contract is assessed based on changes in the option's
intrinsic value, the change in the time value of the contract
would be excluded from the assessment of hedge effectiveness.
b. If the effectiveness of a hedge with
an option contract is assessed based on changes in the option's
minimum value, that is, its intrinsic value plus the effect of
discounting, the change in the volatility value of the contract
would be excluded from the assessment of hedge effectiveness.
c. If the effectiveness of a hedge with a
forward or futures contract is assessed based on changes in fair
value attributable to changes in spot prices, the change in the
fair value of the contract related to the changes in the
difference between the spot price and the forward or futures price
would be excluded from the assessment of hedge effectiveness.
|
TIME VALUE / VOLATILITY VALUE
Time value is the option premium less intrinsic value
Intrinsic value is the beneficial difference between
the strike price and the price of the underlying
Volatility value is the option premium less the minimum
value
Minimum value is present value of the beneficial
difference between the strike price and the price of the
underlying
FEATURES OF OPTIONS
Intrinsic Value: Difference between the strike price
and the underlying price, if beneficial; otherwise zero
Time Value: Sensitive to time and volatility; equals
zero at expiration
Sub-paragraph b(c) of Paragraph 63 of
FAS 133
c. If the effectiveness of a hedge with a forward or
futures contract is assessed based on changes
in fair value attributable to changes in spot prices,
the change in the fair value of the contract related to
the changes in the difference between the spot price and
the forward or futures price would be excluded from the
assessment of hedge effectiveness.
Sub-paragraph b(a) of Paragraph 63 of
FAS 133
a. If the effectiveness of a hedge with an option
contract is assessed based on changes in the option's
intrinsic value, the change in the time value
of the contract would be excluded from the assessment of
hedge effectiveness.
Sub-paragraph b(b) of Paragraph 63 of
FAS 133
b. If the effectiveness of a hedge with an option
contract is assessed based on changes in the option's minimum
value, that is, its intrinsic value plus the effect
of discounting, the change in the
volatility value of the contract would be excluded
from the assessment of hedge effectiveness .
Minimum Value
If the underlying is the price of corn, then the
minimum value of an option on corn is either zero or the
current spot price of corn minus the discounted
risk-free present value of the strike price. In
other words if the option cannot be exercised early,
discount the present value of the strike price from the
date of expiration and compare it with the current spot
price. If the difference is positive, this is the
minimum value. It can hypothetically be the
minimum value of an American option, but in an efficient
market the current price of an American option will not
sell below its risk free present value.
Minimum (Risk Free) Versus Intrinsic Value
European Call Option
X = Exercise (Strike) Price in n
periods after current time
P = Current Price (Underlying) of Commodity
I = P-X>0 is the intrinsic value using the
current spot price if the option is in the money
M = is the minimum value at the
current time
M>I if the option if the intrinsic value I
is greater than zero.
X = $20 Exercise (Strike) Price and Minimum
Value M = $10.741
n = 1 year with risk-free rate r = 0.08
P (Low) = $10 with PV(Low) = $9.259
P = $20 such that the intrinsic value now is I =
P-X = $10.
Borrow P(Low), and Buy at $20 = $9.259+10.741 =
PV(Low)+M
If the ultimate price is low at $10 after one
year, pay off loan at P(Low)=$10 by selling at the
commodity at $10. If we also sold a option for
M=$10.741, ultimately our profit would be zero
from the stock purchase and option sale. If the
actual option value is anything other than
M=$10.741, it would be possible to arbitrage a
risk free gain or loss.
|
Minimum Versus Intrinsic Value
American Call Option
X = Exercise (Strike) Price in n
periods after current time
P = Current Price (Underlying) of Commodity
I = P-X>0 is the intrinsic value using the
current spot price if the option is in the money
M = 0 is the minimum value since option can be
exercised at any time if the option’s
value is less than intrinsic value I.
Value of option exceeds M and I due to
volatility value |
|
The point here is that options are certain to be
effective in hedging intrinsic value, but are uncertain in terms of
hedging time value at all interim points of time prior to expiration.
As a result, accounting standards require that effectiveness for hedge
accounting be tested at each point in time when options are adjusted
to fair value carrying amounts in the books even though ultimate
effectiveness is certain. Potential gains from options are
uncertain prior to expiration. Potential gains or losses from
other types of derivative contracts are uncertain both before
expiration and on the date of expiration.
Paragraph 69 of FAS 133 reads as
follows [also see (IAS 39 Paragraph 152)]:
The fixed rate on a
hedged item need not exactly match the fixed rate on a swap
designated as a fair value hedge. Nor does the variable rate on an
interest-bearing asset or liability need to be the same as the
variable rate on a swap designated as a cash flow hedge. A swap's
fair value comes from its net settlements. The fixed and variable
rates on a swap can be changed without affecting the net settlement
if both are changed by the same amount. That is, a swap with a
payment based on LIBOR and a receipt based on a fixed rate of 5
percent has the same net settlements and fair value as a swap with a
payment based on LIBOR plus 1 percent and a receipt based on a fixed
rate of 6 percent.
Paragraph 10c of
IAS 39 also addresses net settlement. IASC does not require
a net settlement provision in the definition of a derivative.
To meet the criteria for being a derivative under FAS 133, there must
be a net settlement provision.
The following Section c
in Paragraph 65 on Page 45 is of interest with respect to a premium
paid for a forward or futures contract:
c. Either the change
in the discount or premium on the forward
contract is excluded from the assessment of effectiveness and
included directly in earnings pursuant to Paragraph 63 or the change
in expected cash flows on the forecasted transaction is based on the
forward price for the commodity.
Delta ratio D
= (D option value)/ D
hedged item value)
range [.80 < D <
1.25] or [80% < D%
< 125%] (FAS 133
Paragraph 85)
Delta-neutral strategies are discussed at various points (e.g., FAS
133 Paragraphs 85, 86, 87, and 89)
A hedge is
normally regarded as highly effective if, at inception and throughout
the life of the hedge, the enterprise can expect changes in the fair
value or cash flows of the hedged item to be almost fully offset by
the changes in the fair value or cash flows of the hedging instrument,
and actual results are within a range of 80-125%
(SFAS 39 Paragraph 146). The FASB requires that an entity
define at the time it designates a hedging relationship the method it
will use to assess the hedge's effectiveness in achieving offsetting
changes in fair value or offsetting cash flows attributable to the
risk being hedged (FAS 133 Paragraph 62). In defining how hedge
effectiveness will be assessed, an entity must specify whether it will
include in that assessment all of the gain or loss on a hedging
instrument. The Statement permits (but does not require) an
entity to exclude all or a part of the hedging instrument's time value
from the assessment of hedge effectiveness. (FAS 133 Paragraph 63).
Hedge ineffectiveness would result from
the following circumstances, among others:
a) difference between the basis of
the hedging instrument and the hedged item or hedged transaction, to
the extent that those bases do not move in tandem.
b) differences in critical terms of the hedging instrument and
hedged item or hedged transaction, such as differences in notional
amounts, maturities, quantity, location, or delivery dates.
c) part of the change in the fair value of a derivative is
attributable to a change in the counterparty's creditworthiness (FAS
133 Paragraph 66).
The method an
enterprise adopts for assessing hedge effectiveness will depend on its
risk management strategy. In some cases, an enterprise will
adopt different methods for different types of hedges. For
instance, an interest rate swap is likely to be an effective hedge if
the notional and principal amounts, term, repricing dates, dates of
interest and principal receipts and payments, and basis for measuring
interest rates are the same for the hedging instrument and the hedge
item (IAS 39 Paragraph 147).
Sometimes the hedging instrument will offset the hedged risk only
partially. For instance, a hedge would not be fully effective if
the hedging instrument and hedged item are denominated in different
currencies and the two do not move in tandem.
(IAS 39 Paragraph 148).
Ira Kawaller explains that the common 80/25 rule
described above is not statistically correct. See "The
80/125 Problem," Derivatives Strategy, March 2001
Flow Chart for
FAS 133 and IAS 39 Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Differences between FAS 133
and IAS 39 --- http://www.trinity.edu/rjensen/caseans/canada.htm
Intrinsic Value Versus Full Value Hedge Accounting --- http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm
The above document discusses Delta hedging
October 11, 2002 message from
Ira [kawaller@lb.bcentral.com]
If you,
your colleagues, or your customers have hedge effectiveness testing
requirements under FAS 133, and you're having difficulty designing
regression tests for this purpose, this article (co-authored with my
friend and client, Reva Steinberg of BDO Seidman, and originally
published in "AFPExchage")should be of interest:
http://www.kawaller.com/pdf/AFP_Regression.pdf
In either
case, visit the Kawaller & Company website to find other
articles/information dealing with a host of issues relating to
derivatives.
I hope
you'll find this material to be useful and would welcome your
questions, comments, or suggestions.
Ira
Kawaller
Kawaller & Company, LLC
http://www.kawaller.com
kawaller@kawaller.com
(718)694-6270
For interest rate swaps, especially
note the section of Short-Cut Method for
Interest Rate Swaps.
See further paragraphs 73-103 for
illustrations of assessing effectiveness and measuring
ineffectiveness:
Example 1: Fair Value Hedge of
Natural Gas Inventory with Futures Contracts (FAS 133 Paragraphs
73-77)
Example 2: Fair Value Hedge of Tire
Inventory with a Forward Contract
(FAS 133 Paragraphs 78-80)
Example 3: Fair Value Hedge of
Growing Wheat with Futures Contracts
(FAS 133 Paragraphs 81-84)
Example 4: Fair Value Hedge of Equity
Securities with Option Contracts
(FAS 133 Paragraphs 85-87)
Example 5: Fair Value Hedge of a
Treasury Bond with a Put Option Contract
(FAS 133 Paragraphs 88-90)
Example 6: Fair Value Hedge of an
Embedded Purchased Option with a Written Option
(FAS 133 Paragraphs 91-92)
Example 7: Cash Flow Hedge of a
Forecasted Purchase of Inventory with a Forward Contract
(FAS 133 Paragraphs 93-97)
Example 8: Cash Flow Hedge with a
Basis Swap
(FAS 133 Paragraphs 98-99)
Example 9: Cash Flow Hedge of
Forecasted Sale with a Forward Contract
(FAS 133 Paragraphs 100-101)
Example 10: Attempted Hedge of a
Forecasted Sale with a Written Call Option
(FAS 133 Paragraphs 102-103)
|
| DIG Issue E7 at http://www.fasb.org/derivatives/
Title: Hedging—General: Methodologies to Assess Effectiveness of
Fair Value and Cash Flow Hedges
Paragraph references: 20(b), 22, 28(b), 62, 86, 87
Date released: November 1999
QUESTION
Since Statement 133 provides an entity with flexibility in choosing
the method it will use in assessing hedge effectiveness, must an
entity use a dollar-offset approach in assessing effectiveness?
BACKGROUND
Paragraph 20(b) of Statement 133 states, in part:
Both at inception of the [fair value] hedge and on an ongoing
basis, the hedging relationship is expected to be highly effective in
achieving offsetting changes in fair value attributable to the hedged
risk during the period that the hedge is designated. An assessment of
effectiveness is required whenever financial statements or earnings
are reported, and at least every three months. Paragraph 28(b)
indicates a similar requirement that the hedging relationship be
expected to be highly effective in achieving offsetting changes in
cash flows attributable to the hedged risk during the period that the
hedge is designated.
Paragraph 22 of Statement 133 states, in part:
The measurement of hedge ineffectiveness for a particular hedging
relationship shall be consistent with the entity’s risk management
strategy and the method of assessing hedge effectiveness that was
documented at the inception of the hedging relationship, as discussed
in paragraph 20(a). Nevertheless, the amount of hedge ineffectiveness
recognized in earnings is based on the extent to which exact offset is
not achieved. Paragraph 62 emphasizes that each entity must
"define at the time it designates a hedging relationship the
method it will use to assess the hedge’s effectiveness in achieving
offsetting changes in fair value or offsetting cash flows attributable
to the risk being hedged." It also states, "This Statement
does not specify a single method for either assessing whether a hedge
is expected to be highly effective or measuring hedge
ineffectiveness."
RESPONSE
No. Statement 133 requires an entity to consider hedge
effectiveness in two different ways-in prospective considerations and
in retrospective evaluations.
Prospective considerations. Upon designation of a hedging
relationship (as well as on an ongoing basis), the entity must be able
to justify an expectation that the relationship will be highly
effective over future periods in achieving offsetting changes in fair
value or cash flows. That expectation, which is forward-looking, can
be based upon regression or other statistical analysis of past changes
in fair values or cash flows as well as on other relevant information.
Retrospective evaluations. At least quarterly, the hedging entity
must determine whether the hedging relationship has been highly
effective in having achieved offsetting changes in fair value or cash
flows through the date of the periodic assessment. That assessment can
be based upon regression or other statistical analysis of past changes
in fair values or cash flows as well as on other relevant information.
If an entity elects at the inception of a hedging relationship to
utilize the same regression analysis approach for both prospective
considerations and retrospective evaluations of assessing
effectiveness, then during the term of that hedging relationship those
regression analysis calculations should generally incorporate the same
number of data points. Electing to utilize a regression or other
statistical analysis approach instead of a dollar-offset approach to
perform retrospective evaluations of assessing hedge effectiveness may
affect whether an entity can apply hedge accounting for the current
assessment period as discussed below.
Paragraph 62 requires that at the time an entity designates a
hedging relationship, it must define and document the method it will
use to assess the hedge’s effectiveness. That paragraph also states
that ordinarily "an entity should assess effectiveness for
similar hedges in a similar manner; use of different methods for
similar hedges should be justified." Furthermore, it requires
that an entity use that defined and documented methodology
consistently throughout the period of the hedge. If an entity elects
at the inception of a hedging relationship to utilize a regression
analysis approach for prospective considerations of assessing
effectiveness and the dollar-offset method to perform retrospective
evaluations of assessing effectiveness, then that entity must abide by
the results of that methodology as long as that hedging relationship
remains designated. Thus, in its retrospective evaluation, an entity
might conclude that, under a dollar-offset approach, a designated
hedging relationship does not qualify for hedge accounting for the
period just ended, but that the hedging relationship may continue
because, under a regression analysis approach, there is an expectation
that the relationship will be highly effective in achieving offsetting
changes in fair value or cash flows in future periods. In its
retrospective evaluation, if that entity concludes that, under a
dollar-offset approach, the hedging relationship has not been highly
effective in having achieved offsetting changes in fair value or cash
flows, hedge accounting may not be applied in the current period.
Whenever a hedging relationship fails to qualify for hedge accounting
in a certain assessment period, the overall change in fair value of
the derivative for that current period is recognized in earnings (not
reported in other comprehensive income for a cash flow hedge) and the
change in fair value of the hedged item would not be recognized in
earnings for that period (for a fair value hedge).
If an entity elects at the inception of a hedging relationship to
utilize a regression analysis (or other statistical analysis) approach
for either prospective considerations or retrospective evaluations of
assessing effectiveness, then that entity must periodically update its
regression analysis (or other statistical analysis). For example, if
there is significant ineffectiveness measured and recognized in
earnings for a hedging relationship, which is calculated each
assessment period, the regression analysis should be rerun to
determine whether the expectation of high effectiveness is still
valid. As long as an entity reruns its regression analysis and
determines that the hedging relationship is still expected to be
highly effective, then it can continue to apply hedge accounting
without interruption.
In all instances, the actual measurement of hedge ineffectiveness
to be recognized in earnings each reporting period is based on the
extent to which exact offset is not achieved as specified in paragraph
22 of Statement 133 (for fair value hedges) or paragraph 30 (for cash
flow hedges). That requirement applies even if a regression or other
statistical analysis approach for both prospective considerations and
retrospective evaluations of assessing effectiveness supports an
expectation that the hedging relationship will be highly effective and
demonstrates that it has been highly effective, respectively.
The application of a regression or other statistical analysis
approach to assessing effectiveness is complex. Those methodologies
require appropriate interpretation and understanding of the
statistical inferences.
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DIG Issue F5 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuef5.html
Basing the Expectation of Highly Effective Offset on a Shorter Period
Than the Life of the Derivative
(Cleared 11/23/99) |
Intrinsic Value Versus Full Value Hedge Accounting --- http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm
Net Settlement and
Normal Purchase NormalSale (NPNS) Issues
|
Net
Settlement =
a contract
provision that allows for netting out payables and receivables in
terms of cash or items that can be readily converted to cash in an
established market. Net settlement criteria for FAS 133 are not
satisfied if an asset such as land or a liability such as a personal
note can be delivered to satisfy the contractual obligation. In
swaps where items are swapped, it must be possible to net out the swap
obligations and transfer only the net difference in cash.
Details of net settlements are discussed in SFAS 13 Paragraphs 6c, 9,
and 57c. According to Paragraphs 10 and 275-276, "regular-way
security trades" are contracts with no net settlement provisions
and not market mechanism to facilitate net settlements. Paragraph
10c of IAS 39 also addresses net settlement. IASC does not require
a net settlement provision in the definition of a derivative.
Paul Pacter states the following
at http://www.iasc.org.uk/news/cen8_142.htm
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IAS 39
A derivative is a financial instrument—
(a) - whose value
changes in response to the change in a specified interest
rate, security price, commodity price, foreign exchange
rate, index of prices or rates, a credit rating or credit
index, or similar variable (sometimes called the
‘underlying’);
(b) - that requires no
initial net investment or little initial net investment
relative to other types of contracts that have a similar
response to changes in market conditions; and
(c) - that is settled
at a future date.
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FAS 133
(a) – same as IAS 39
(b) – same as IAS 39
(c) – FASB definition requires that the
terms of the derivative contract require or permit net
settlement.
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To meet the
criteria for being a derivative under FAS 133, there must be a net
settlement provision.
The issue in a
regular-way trade arises because of differences between trading dates
and settlement dates. Paragraph 294 on Page 141 of FAS 133
states the following:
Requiring that all
forward contracts for purchases and sales of financial instruments
that are readily convertible to cash be accounted for as derivatives
would effectively require settlement date accounting for all such
transactions. Resolving the issue of trade date versus settlement
date accounting was not an objective of the project that led to this
Statement. Therefore, the Board decided to explicitly exclude
forward contracts for "regular-way" trades from the scope
of this Statement.
For example, the
forward sale requiring delivery of a mortgaged-backed security
is a regular-way trade if delivery of these types of securities
normally take 30 days or 60 days. Paragraph 10 excudes
regular-way, normal purchases, and normal sales. Also see
Paragraphs 57c, 274, and 259-266. See also dollar
offset method and transition
settlements.
FAS 133 leaves out the issue of trade date versus
settlement date accounting and, thereby, excluded forward contracts
for regular-way security trades from the scope of FAS 133 (See
Appendix C Paragraph 274).
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
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IAS 39
If an enterprise has a contractual obligation that it can settle
either by paying out a financial assets or its own equity
securities, and if the number of equity securities required to
settle the obligation varies with changes in their fair value so
that the total fair value of the equity securities paid always
equals the amount of the contractual obligation, the obligation
should be accounted for as a financial liability, not as equity.
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FAS 133
FASB standards do not require that such an obligation be classified
as a liability.
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DIG Implementation Issue A3 --- http://www.fasb.org/derivatives/
QUESTION
Does the liquidity of the market for a group of
contract affect the determination of whether under paragraph 9(b)
there is a market mechanism that facilitates net settlement under
paragraph 9(b)? For example, assume a company contemporaneously enters
into 500 futures contracts, each of which requires delivery of 100
shares of an exchange-traded equity security on the same date. The
contracts fail to meet the criterion in paragraph 9(a) because
delivery of an asset related to the underlying is required. The
futures contracts trade on an exchange, which constitutes a market
mechanism under which the company can be relieved of its rights and
obligations under the futures contracts. However, the quantity of
futures contracts held by the company cannot be rapidly absorbed in
their entirety without significantly affecting the quoted price of the
contracts.
RESPONSE
No. The lack of a liquid market for the group of
contracts does not affect the determination of whether under paragraph
9(b) there is a market mechanism that facilitates net settlement
because the test in paragraph 9(b) focuses on a singular contract. The
exchange offers a ready opportunity to sell each contract, thereby
providing relief of the rights and obligations under each contract.
Paragraph 57(c)(2) elaborates on the phrase market
mechanism that facilitate net settlement and states that "any
institutional arrangement or other agreement that enables either party
to be relieved of all rights and obligations under the contract and to
liquidate its net position without incurring a significant transaction
cost is considered net settlement." The possible reduction in
price due to selling a large futures position is not considered to be
a transaction cost under that paragraph.
Whether the number of shares deliverable under the
group of futures contracts exceeds the amount of shares that could
rapidly be absorbed by the market without significantly affecting the
price is not relevant to applying the criterion in paragraph 9(b).
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DIG Implementation Issue A5 --- http://www.fasb.org/derivatives/
QUESTION
Does a contract contain a net settlement provision
under paragraphs 9(a) and 57(c)(1) if it contains both (a) a variable
penalty for nonperformance based on changes in the price of the items
that are the subject of the contract and (b) a fixed incremental
penalty for nonperformance that is sufficiently large to make the
possibility of net settlement remote?
BACKGROUND
Certain contracts may require payment of (a) a
variable penalty for nonperformance based on changes in the price of
the items that are the subject of the contract and (b) an incremental
penalty for nonperformance stated as a fixed amount or fixed amount
per unit. The contract may or may not characterize the incremental
payment upon nonperformance as a penalty.
Paragraph 57(c)(1) elaborates on the criterion in
paragraph 6(c) regarding whether the terms of a contract require or
permit net settlement which is discussed in paragraph 9(a). Paragraph
57(c)(1) states:
Its terms implicitly or explicitly require or permit
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. Net settlement may be made in cash or by
delivery of any other asset, whether or not it is readily convertible
to cash. A fixed penalty for nonperformance is not a net settlement
provision. RESPONSE
No. 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
under paragraphs 9(a) and 57(c)(1) 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. Thus, the contract does not meet the
criterion for net settlement under paragraphs 9(a) and 57(c)(1) of
Statement 133. The assessment of the fixed incremental penalty in the
manner described above should be performed only at the contract's
inception.
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.
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DIG Implementation Issue A7 --- http://www.fasb.org/derivatives/
QUESTION
Does the existence of a contractual requirement that
one party obtain the other's permission to assign rights or
obligations to a third party under a contract, in and of itself,
preclude a contract from meeting the definition of a derivative
because it would not possess the net settlement characteristic
described in paragraph 9(b) of Statement 133 as a market mechanism?
For the purposes of this question, assume that (1) if
the contract did not contain an assignment clause, an established
market mechanism that facilitates net settlement outside the contract
exists, (2) the contract does not satisfy the criteria for net
settlement under the provisions of paragraph 9(a), (3) the asset that
is required to be delivered under the contract is readily convertible
to cash as described under paragraph 9(c), and (4) the contract would
qualify for the normal purchases and sales exception under paragraph
10(b) if it is considered not to possess the net settlement
characteristic described in paragraph 9(b).
BACKGROUND
Some commodity contracts contain a provision that
allows one or both parties to a contract to assign its rights or
obligations to a third party only after obtaining permission from the
counterparty. Under the assignment clause addressed in this issue,
permission shall not be unreasonably withheld. The primary purpose of
an assignment clause is to ensure that the non-assigning counterparty
is not unduly exposed to credit or performance risk if the assigning
counterparty is relieved of all of its rights and obligations under
the contract. Accordingly, a counterparty could withhold consent only
in limited circumstances, such as when the contract would be assigned
to a third party assignee that has a history of defaulting on its
obligations or has a lower credit rating than the assignor.
Paragraph 9(b) of Statement 133 indicates that the net
settlement characteristic of the definition of a derivative may be
satisfied if "One of the parties is required to deliver an asset
of the type described in paragraph 9(a), but there is a market
mechanism that facilitates net settlement, for example, an exchange
that offers a ready opportunity to sell the contract or to enter into
an offsetting contract." Paragraph 57(c) of Statement 133
elaborates on that notion. It states:
...a contract that meets any one of the following
criteria has the characteristic described as net settlement [in
paragraph 9(b)]….(2) There is an established market mechanism that
facilitates net settlement outside the contract. The term market
mechanism is to be interpreted broadly. Any institutional
arrangement or other agreement that enables either party to be
relieved of all rights and obligations under the contract and to
liquidate its net position without incurring a significant
transaction cost is considered net settlement. [Emphasis added.]
RESPONSE
No. The existence of an assignment clause does not, in
and of itself, preclude the contract from possessing the net
settlement characteristic described in paragraph 9(b) as a market
mechanism. Once the determination is made that a market mechanism that
facilitates net settlement outside of the contract exists, then an
assessment of the substance of the assignment clause is required in
order to determine whether that assignment clause precludes a party
from being relieved of all rights and obligations under the contract
through that existing market mechanism. Although permission to assign
the contract shall not be unreasonably withheld by the counterparty in
accordance with the terms of the contract, the assignment feature
cannot be viewed simply as a formality because it may be invoked at
any time to prevent the non-assigning party from being exposed to
unacceptable credit or performance risk. Accordingly, the existence of
the 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 should not preclude the contract from possessing the net
settlement characteristic described in paragraph 9(b) 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
non-assigning party. Consideration should 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 is precluded from possessing the net
settlement characteristic described in paragraph 9(b) as a market
mechanism. In that circumstance, even if the asset under the contract
were readily convertible to cash as described under paragraph 9(c),
the contract could qualify for the normal purchases and normal sales
exception under paragraph 10(b) because there is no net settlement
provision in the contract and no market mechanism that facilitates net
settlement exists (as described in paragraphs 9(a) and 9(b)).
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DIG Implementation Issue A8 --- http://www.fasb.org/derivatives/
QUESTION
Does an asymmetrical default provision, which provides
the defaulting party only the obligation to compensate its
counterparty's loss but not the right to demand any gain from its
counterparty, give a commodity forward contract the characteristic of
net settlement under paragraph 9(a) of Statement 133?
BACKGROUND
Paragraph 6(c) of Statement 133 describes the
following derivative characteristic:
Its terms require or permit net settlement, it can
readily be settled net by a means outside the contract, or it
provides for delivery of an asset that puts the recipient in a
position not substantially different from net settlement.
Paragraph 9(a) provides the following additional
guidance regarding the derivative characteristic in paragraph 6(c):
Neither party is required to deliver an asset that
is associated with the underlying or 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).
Paragraph 57(c) and related subparagraph (1) provide
the following additional guidance regarding the derivative
characteristic in paragraphs 6(c) and 9(a):
A contract that meets any one of the following
criteria has the characteristic described as net settlement:
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Its terms implicitly or explicitly require or
permit 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. Net settlement may be made
in cash or by delivery of any other asset, whether or not it is
readily convertible to cash. A fixed penalty for nonperformance
is not a net settlement provision.
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:
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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.
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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.
For example, Buyer agreed to purchase 100 units of a
commodity from Seller at $1.00 per unit:
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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)).
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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)).
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. 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. Similarly, if Seller defaults when the market price is $0.80,
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.
RESPONSE
No. A nonperformance penalty provision that requires
the defaulting party to compensate the nondefaulting party for any
loss incurred but does not allow the defaulting party to receive the
effect of favorable price changes (herein referred to as an
asymmetrical default provision) does not give a commodity forward
contract the characteristic described as net settlement under
paragraph 9(a) of Statement 133.
A derivative instrument can be described, in part, as
allowing the holder to participate in the changes in an underlying
without actually making or taking delivery of the asset related to
that underlying. 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 (a) by taking delivery
of the physical commodity or (b) in the event of default by Seller,
which is an event beyond the control of Buyer. Similarly, Seller
cannot realize favorable changes in the intrinsic value of the forward
contract except (a) by making delivery of the physical commodity or
(b) in the event of default by Buyer, which is an event beyond the
control of Seller. However, if there was a pattern of using the
asymmetrical default provisions as a means to net settle certain kinds
of an entity's commodity purchase or sales contracts, that behavior
would indicate that the asymmetrical default provision would give
those kinds of commodity contracts the characteristic described as net
settlement under paragraph 9(a).
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 6(c) and discussed in
paragraph 9(a) 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 above example contract since 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.
If the commodity forward contract does not have the
characteristic of net settlement under paragraphs 9(a) and 9(b) but
has the characteristic of net settlement under paragraph 9(c) because
it requires delivery of a commodity that is readily convertible to
cash, the commodity forward contract may nevertheless be eligible to
qualify for the normal purchases and normal sales exception in
paragraph 10(b) and if so, would not be subject to the accounting
requirements of Statement 133 for the party to whom it is a normal
purchase or normal sale.
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| DIG Implementation Issue A10 --- http://www.fasb.org/derivatives/
Title: Definition of a Derivative: Assets That Are Readily
Convertible to Cash
Paragraph references: 6(c), 9(c), Footnote 5 (to paragraph 9), 265
Date released: November 1999
QUESTION
Is an asset considered readily convertible to cash, as that phrase
is used in paragraph 9(c), if the net amount of cash that would be
received from a sale in an active market is not the equivalent amount
of cash that an entity would typically have received under a net
settlement provision? The net amount of cash that would be received
from a sale in an active market may be impacted by various factors,
such as sales commissions and costs to transport the asset (such as a
commodity) to the delivery location specified for that active market.
BACKGROUND
Paragraph 9(c) of Statement 133 provides that a contract that
requires delivery of the assets associated with the underlying has the
characteristic of net settlement if those assets are readily
convertible to cash. Footnote 5 to that paragraph makes explicit
reference to the use of the phrase readily convertible to cash in
paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and
Measurement in Financial Statements of Business Enterprises.
This issue addresses whether a contract has the net settlement
characteristic described in paragraph 9(c). This issue presumes there
is no net settlement provision in the contract and no market mechanism
that facilitates net settlement that would cause the contract to meet
the criteria in paragraphs 9(a) and 9(b). A contract that is a
derivative solely because it has the net settlement characteristic
described in paragraph 9(c) (since the asset to be delivered under the
contract is readily convertible to cash) may yet qualify for the
normal purchases and normal sales exception under paragraph 10(b) or
the other exclusions provided in paragraph 10.
RESPONSE
It depends. An asset can be considered to be readily convertible to
cash, as that phrase is used in paragraph 9(c), only if the net amount
of cash that would be received from a sale in an active market is 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.
Paragraph 6(c) of Statement 133 defines net settlement, in part, as
“…or it provides for delivery of an asset that puts the recipient
in a position not substantially different from net settlement”
(emphasis added). The basis for conclusions also comments in paragraph
265 that “…the parties generally should be indifferent as to
whether they exchange cash or the assets associated with the
underlying,” although the term indifferent was not intended to imply
an approximate equivalence between net settlement and proceeds from
sale in an active market. Based on the foregoing Statement 133
references, 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
must evaluate, in part, the significance of the estimated costs of
converting the asset to cash in determining whether those assets are
considered to be readily convertible to cash. For purposes of
assessing significance of such costs, an entity should 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. The
assessment of the significance of those conversion costs should be
performed only at inception of the contract.
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See also DIG Issue A9 under interest
rate swap
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Normal Purchases and Normal Sales
A portion of Paragraph 8 in FAS 133 reads as follows:
b. Normal purchases and normal
sales. Normal purchases and normal sales
are contracts with no net settlement provision and no market mechanism
to facilitate net settlement (as described
in paragraphs 9(a) and 9(b)). They 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.
A portion of Paragraph 58 of FAS 133 reads as
follows:
b. Normal purchases and normal
sales.
The exception in paragraph 10(b) applies only to a contract that
requires future delivery of assets (other than financial instruments or
derivative instruments) that are readily convertible to cash and only if
there is no market mechanism to facilitate net settlement outside the
contract. To qualify for the exception, a contract's terms also 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 will require judgment. In making those judgments,
an entity should consider all relevant factors, such as
(1) the quantities provided under
the contract and the entity's need for the related assets,
(2) the locations to which delivery of the items will be made,
(3) the period of time between entering into the contract and delivery,
and
(4) the entity's prior practices with regard to such contracts.
Evidence such as 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, and an entity's operating locations should help in
identifying contracts that qualify as normal purchases or normal sales.
Paragraphs 271 and 272 of FAS 133 read as follows:
271. The Board decided that contracts that
require delivery of nonfinancial assets that are readily convertible
to cash need not be accounted for as derivative instruments under this
Statement if the assets constitute normal purchases or normal sales of
the reporting entity unless those contracts can readily be settled
net. The Board believes contracts for the acquisition of assets in
quantities that the entity expects to use or sell over a reasonable
period in the normal course of business are not unlike binding
purchase orders or other similar contracts to which this Statement
does not apply. The Board notes that the normal purchases and normal
sales exemption is necessary only for contracts based on assets that
are readily convertible to cash.
272. The Board understands that the normal
purchases and normal sales provision 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 (and therefore not a derivative instrument) but not for ordinary
purchases by the counterparty (and therefore a derivative instrument).
The Board considered requiring both parties to account for a contract
as a derivative instrument if the purchases or sales by either party
were other than ordinary in the normal course of business. However,
that approach would have required that one party to the contract
determine the circumstances of the other party to that same contract.
Although the Board believes that the accounting by both parties to a
contract generally should be symmetrical, it decided that symmetry
would be impractical in this instance and that a potential
asymmetrical result is acceptable.
IAS 138 Implementation Guidance
"Implementation of SFAS 138, Amendments to SFAS 133," The
CPA Journal, November 2001. (With Angela L.J. Huang and John S.
Putoubas), pp. 54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm
The normal purchases and normal sales
exception is expanded to certain commodity contracts. The risk that
can be hedged in an interest rate hedge is redefined. Recognized
foreign currency-denominated assets and liabilities may be hedged with
a single cross-currency compound hedge. Net hedging of certain
intercompany derivatives may be designated as cash flow hedges of
foreign currency risk. Normal Purchases and Normal Sales Exception
In their normal course of business, companies
that consume or produce commodities often enter contracts to
physically deliver nonfinancial assets, such as electricity, natural
gas, oil, aluminum, wheat, or corn. Although these physical contracts
are typically settled by the delivery of the commodity, they often
include cash settlement provisions in case one party does not deliver
or accept delivery of the goods, although these provisions are not
intended as derivatives. Historically, the accounting principles for
executory contracts applied to physical contracts.
FASB decided contracts that permit but do not
require settlement by delivery of a commodity are often used
interchangeably with other derivatives and present similar risks;
therefore, they should be considered derivatives. As a result, the “normal
purchases and normal sales” exception in paragraph 10(b) of SFAS 133
did not apply to these commodities contracts because they could be
settled at net or liquidated through a market mechanism that would
facilitate net settlement. Normal purchases and sales provide
commodities that the reporting entity would use or sell in a
reasonable period of time during the normal course of business.
In response to concerns that SFAS 133
inappropriately classified such physical contracts as derivatives,
SFAS 138 amends paragraph 10(b) by expanding the normal purchases and
normal sales exception to contracts that contain net settlement
provisions if it is probable (at inception and throughout the term of
the individual contract) that the contract will not settle at net and
will result in physical delivery. The entity must document this
conclusion. While this amendment will affect many forward contracts,
exchange-traded futures that require periodic cash settlements do not
qualify for the exception.
A portion of Paragraph 4 of FAS 138 reads as follows:
4. Statement 133 is amended as follows:
Amendment Related to Normal Purchases and
Normal Sales
a. Paragraph 10(b) of FAS 133 is replaced by
the following:
Normal purchases and normal sales. 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. However, contracts that have a price based on an underlying
that is not clearly and closely related to the asset being sold or
purchased (such as a price in a contract for the sale of a grain
commodity based in part on changes in the S&P index) or that are
denominated in a foreign currency that meets neither of the criteria
in paragraphs 15(a) and 15(b) shall not be considered normal purchases
and normal sales. Contracts that contain net settlement provisions as
described in paragraphs 9(a) and 9(b) may qualify for the normal
purchases and normal sales 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. Net settlement (as
described in paragraphs 9(a) and 9(b)) 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 this
exception. For contracts that qualify for
the normal purchases and normal sales exception, the entity shall
document the basis for concluding that it is probable that the
contract will result in physical delivery. The documentation
requirements can be applied either to groups of similarly designated
contracts or to each individual contract.
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DIG Implementation Issue A2 --- http://www.fasb.org/derivatives/
Statement 133 Implementation Issue No. A2,
"Existence of a Market Mechanism That Facilitates Net
Settlement," was rescinded upon the clearance of Statement 133
Implementation Issue No. A21, "Existence of an Established Market
Mechanism That Facilitates Net Settlement under Paragraph 9(b),"
which was posted on April 10, 2002
QUESTION
Two entities enter into a commodity forward
contract that requires delivery and is not exchange-traded; however,
there are brokers who stand ready to buy and sell the commodity
contracts. Either entity can be relieved of its obligation to make (or
right to accept) delivery of the commodity and its right to receive
(or obligation to make) payment under the contract by arranging for a
broker to make or accept delivery and paying 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 is not
significant. Based on those facts, is the criterion for net settlement
in paragraph 6(c) satisfied because of the existence of a market
mechanism that facilitates net settlement as described in paragraph
9(b)?
RESPONSE
Yes. The criterion for net settlement would be
satisfied because the entity can be relieved of its rights and
obligations under the contract without incurring a substantial fee due
to its arrangement with a broker. Paragraph 57(c)(2) states that the
term market mechanism is to be interpreted broadly, and any
institutional arrangement or side agreement that enables either party
to be relieved of all rights and obligations under the contract and to
liquidate its net position without incurring a significant transaction
cost is considered net settlement. The fact that brokers stand ready
to relieve entities of their rights and obligations under a particular
type of contract indicates that a market mechanism that facilitates
net settlement exists for that type of contract.
In contrast, if the arrangement between the
entity and the broker (a) is simply an agreement whereby the broker
will make (or accept) delivery on behalf of an entity and (b) does not
relieve the entity of its rights and obligations under the contract,
the arrangement does not constitute a market mechanism that
facilitates net settlement under paragraph 9(b) and the criterion for
net settlement in paragraph 6(c) is not satisfied.
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A
message concerning Normal
Purchases and Normal Sales (NPNS)
I
received a very long message and received permission to quote the message below
regarding the Normal Purchases and Normal Sales (NPNS) amendment in FAS 138::
Hello
Professor Jensen,
Great
website! However, I have to disagree with your comment regarding the issue of
NPNS.
I
work for the Bonneville Power Administration (Bonneville), a federal based
Electric Wholesale Power Marketer, we sell the output from the 29 federally
owned dams on the Columbia and Snake River system in the Pacific Northwest.
I am the project manager for Bonneville responsible for implementing FAS
133. More on Bonneville at the end
of this email - postscript.
Regarding
the NPNS issue: This
issue is of big concern to the Energy industry as it relates to our normal sales
and purchases activities. I am most
familiar with the Electric Utility
industry and the sales and
delivery practices that are prevalent throughout the industry.
I would argue that Bonneville was
much better off under the original statement para 10 (b) because the statement
was silent on the practice I describe below referred to as "Bookouts".
Specifically,
in the electric utility industry it is necessary and is considered best utility
and business practice to perform a type of transaction called a
"Bookout"
whereby several transactions with the same Counterparty in the same month - a
purchase and a sale - are offset and
not scheduled for physical delivery.
For example, Bonneville may sell forward 200 MWs for the month of August
2000 in January 2000 based on our most current hydro forecasts and subsequently
in May 2000 our most current forecasts now show a deficit and we have to
purchase 200 MWs for the same month to cover our obligations.
We may from time to time find ourselves with both purchases and sales
with the same counterparty in the same month at the same delivery location.
Just prior to delivery, we look at our schedule and try and match up
transactions --- the "Bookout" procedure.
This
"Bookout" procedure is common in the electric utility industry as a
scheduling convenience when two utilities happen to have offsetting
transactions. If this procedure is not used, both counterparties
incur transmission costs in order to make deliveries to each other. The
Bookout procedure avoids the energy scheduling process (an administrative burden
as well) which would trigger payment of transmission costs.
We do not plan for this event or know in advance what we will bookout and
we do not "Bookout" to capture a margin.
Rather, we find ourselves in this situation because of our inventory
management constraints, maintenance schedules, and dependency on factors outside
our control such as the weather and streamflows or environmental constraints
placed upon us by other federal agencies or federal courts.
We
lobbied
the FASB and the DIG to clarify and revise the NPNS language to allow for this
practice, but the FASB position was very restrictive -- if you do not deliver
then it is considered net settled.
It seems to me and other industry participants that bookouts do not fit
into the net settlement definition as it was described and intended in FAS 133.
Rather it is a utility best practice that results in no physical delivery.
In addition, when we bookout the cash settling is done at the agreed upon
contract prices - not at the market pricing.
We would argue that the Board's original intent was to capture net
settlement mechanisms that require "market" settlement.
Unfortunately, the FASB made their decision about a practice without
doing more homework on the nature of the transaction.
I understand the pressures the
FASB was under to get the statement amended and implemented.
Unfortunately, the industry participants and practitioners are left to
deal with the Board's end product.
The final 138 was not clear in its guidance either as it relates to these
types of transactions and what this meant to our "similar" contracts
that we want to qualify for NPNS. I
continue, along with our auditors, to hold discussions with FASB staff.
What
I am afraid may happen is that because of the "One size fits all approach
by the FASB", Bonneville and
other regulated utilities will be forced into adopting a FV accounting approach
on transactions that are simple sales and purchases.
Applying mark to market treatment to these transactions is more
misleading to the financial statement reader not clearer - the original intent
of 133. I believe the
interpretation of the final written words by individuals unfamiliar with the
Energy industry is driving us into misleading and confusing presentation.
Any
advice or encouragement you can provide would be appreciated.
We adopt October 1 and I have a deadline to meet and I still do not have
final clear and convincing guidance. I
am ahead of most folks on this issue since we do have an earlier adoption date
than most utilities. Thanks for
your time. This is a complex issue
and I apologize for the length of this email and I imagine I still have not
described the issues in the most succinct and clear fashion.
Regards,
Sanford
Menashe
Project Manager, FAS 133
Bonneville Power Administration
phone: 503-230-3570
email: smmenashe@bpa.gov
Postscript:
About
Bonneville Power Administration:
Bonneville
is a federal agency under the Department of Energy, which was established over
60 years ago to market power from 29 federal dams and one non-federal nuclear
plant in the Pacific Northwest. BPA’s energy sales are governed by federal
legislation (e.g. the Northwest Power Act) and other regional mandates to
maintain the benefits of power sales for the Pacific Northwest region and to
manage its environmental and safety obligations relative to operating the
federal hydroelectric system. Its primary objective is to provide low-cost
electricity to the region by offering cost-based rates for its power and
transmission services to eligible publicly owned and investor-owned utilities in
the Pacific Northwest (including Oregon, Washington, Idaho, western Montana and
small parts of Wyoming, Nevada, Utah, California and eastern Montana).
Sanford
Menashe, Manager, FAS 133 Project.
Project
Manager, FAS 133
Bonneville Power Administration
phone: 503-230-3570
email: smmenashe@bpa.gov
Email:
smmenashe@bpa.gov
Updates in September 2001 and March
2003:
The DIG addressed Mr. Menasche's concerns, especially in Dig Issue C16. But this did not go far enough to satisfy energy
firms with respect to bookouts.
| Statement 133 Implementation Issue No. C16
Title: Scope Exceptions: Applying the Normal Purchases and Normal Sales
Exception to Contracts That Combine a Forward Contract and a Purchased
Option Contract
May 1, 2003
Affected by: FASB Statement No. 149,
Amendment of Statement 133 on Derivative Instruments and Hedging
Activities
(Revised March 26, 2003)
QUESTION
If a purchased option that would, if exercised, require delivery of the
related asset at an established price under the contract is combined with
a forward contract in a single supply contract and that single supply
contract meets the definition of a derivative, is that single supply
contract eligible to qualify for the normal purchases and normal sales
exception in paragraph 10(b)?
BACKGROUND
Some utilities and independent power producers (also called IPPs) 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 in order
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). Those fuel supply contracts are not
requirements contracts that are addressed in Statement 133 Implementation
Issue No. A6, "Notional Amounts of Commodity Contracts."
Many of those contracts meet the definition of a derivative 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). For purposes of applying
Statement 133 to contracts that meet the definition of a derivative, it is
necessary to determine whether the fuel supply contract qualifies for the
normal purchases and normal sales exception, whether bifurcation of the
option is permitted if it does not qualify for the normal purchases and
normal sales exception, or whether the entire contract is accounted for as
a derivative.
Statement 133 Implementation Issue No. C15, "Normal Purchases and
Normal Sales Exception for Certain Option-Type Contracts and Forward
Contracts in Electricity," indicates that power purchase or sales
agreements (including combinations of a forward contract and an option
contract) that meet the criteria in that Implementation Issue qualify for
the normal purchases and normal sales exception in paragraph 10(b).
Although the above background information discusses utilities and
independent power producers, this Implementation Issue 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.
RESPONSE
The inclusion of a purchased option that would, if exercised, require
delivery of the related asset at an established price under the contract
within the single supply contract that meets the definition of a
derivative disqualifies the entire derivative fuel supply contract from
being eligible to qualify for the normal purchases and normal sales
exception in paragraph 10(b) except as provided in paragraph 10(b)(4) of
Statement 133, as amended, and Implementation Issue C15 with respect to
certain power purchase or sales agreements. Statement 133 Implementation
Issue No. C10, “Can Option Contracts and Forward Contracts with
Optionality Features Qualify for the Normal Purchases and Normal Sales
Exception,” states? “Option contracts only contingently provide for
such purchase or sale since exercise of the option contract is not
assured. Thus, in accordance with paragraph 10(b)(2) of Statement 133, as
amended, freestanding option contracts (including in-the-money options
contracts) are not eligible to qualify for the normal purchases and normal
sales exception.” Paragraph 10(b)(3) of Statement 133, as amended, and
Implementation Issue C10 further indicate that forward contracts with
embedded optionality can qualify for the normal purchases and normal sales
exception only if the embedded optionality (such as price caps) does not
affect the quantity to be delivered. 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.
An entity is not permitted to bifurcate the forward contract component
and the option contract component of a fuel supply contract that in its
entirety meets the definition of a derivative and then assert that the
forward contract component is eligible to qualify for the normal purchases
and normal sales exception. Paragraph 18 indicates that an entity is
prohibited from separating a compound derivative in components
representing different risks. (The provisions of paragraph 12 require that
certain derivatives that are embedded in non-derivative hybrid instruments
must be split out from the host contract and accounted for separately as a
derivative; however, paragraph 12 does not apply to a contract that meets
the definition of a derivative in its entirety.)
An entity may wish to enter into two separate contracts—a forward
contract and an option contract—that economically achieve the same
results as the single derivative contract described in the background
section and determine whether the exception in paragraph 10(b) applies to
the separate forward contract.
Similar to the option contracts discussed in Implementation Issue C10,
this Issue addresses option components that would require delivery of the
related asset at an established price under the contract. 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.
If an entity’s single supply contract included at its inception both
a forward contract and an option contract 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 contract 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 under paragraph 10(b), whereas the new option contract would not
be eligible for that exception. From the inception of that new separate
option contract, it would be accounted for under Statement 133. However,
the guidance in this Implementation Issue would not retroactively affect
the accounting for the combination derivative contract that was negated
prior to the effective date of this Implementation Issue.
If on the effective date of this Implementation Issue, an entity was
party to a combination derivative contract that included both a forward
contract and an option contract but the entity had not been accounting for
that derivative contract under Statement 133 because it had documented an
asserted compliance with paragraph 10(b), that combination derivative
contract would be reported at its fair value on the effective date of this
Implementation Issue, with the offsetting entry recorded in current period
earnings. The combination derivative contract cannot be bifurcated into a
forward contract that would have been eligible to qualify for the normal
purchases and normal sales exception and an option contract.
EFFECTIVE DATE
The effective date of the implementation guidance in this Issue for
each reporting entity is the first day of its second fiscal quarter
beginning after October 10, 2001, the date that the Board-cleared guidance
was posted on the FASB website. The revisions made on March 26, 2003, do
not affect the effective date.
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Bob Jensen's home page is at http://www.trinity.edu/rjensen/
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