FASB Definition of a Derivative Application of Market Mechanism and Readily Convertible to Cash Subsequent to the Inception or Acquisition of a Contract

FASB: Definition of a Derivative: Application of Market Mechanism and Readily Convertible to Cash Subsequent to the Inception or Acquisition of a Contract

Derivatives Implementation Group

Statement 133 Implementation Issue No. A18

Title: Definition of a Derivative: Application of Market Mechanism and Readily Convertible to Cash Subsequent to the Inception or Acquisition of a Contract
Paragraph references: 6(c), 9(b), 9(c), 57
Date cleared by Board: September 19, 2001
Date posted to website: October 10, 2001
Date latest revision posted to website: June 10, 2003
Affected by: FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity
(Revised May 27, 2003)

QUESTIONS

  1. Does the evaluation of whether a market mechanism exists (under paragraph 9(b)) and whether items to be delivered under a contract are readily convertible to cash (under paragraph 9(c)) have to be performed only at inception or acquisition of a contract or continuously during the contract's life?
  2. If those evaluations must be performed continuously during the contract's life, what is the accounting at the subsequent date when it is determined that the contract then meets, or ceases to meet, the definition of a derivative in Statement 133?

BACKGROUND

Paragraph 57(c)(2), as amended by Statement 149, states, “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.” In addition, the footnote to paragraph 57(c)(3), added by Statement 149, states, “The evaluation of readily convertible to cash shall be applied to a contract throughout its life.”

Statement 133 Implementation Issue No. A10, "Assets That Are Readily Convertible to Cash," addresses how the significance of transaction costs should be evaluated when determining if an asset is readily convertible to cash in an active market. Implementation Issue A10 establishes a 10 percent threshold but indicates that the threshold should be applied "only at inception of the contract" in determining the significance of transaction costs.

The following examples are relevant to the above two questions:

Example 1

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 is consistent with the characteristics of a market mechanism discussed in Statement 133 Implementation Issue No. A21, “Existence of an Established Market Mechanism That Facilitates Net Settlement under Paragraph 9(b).” Accordingly, the purchase contract will have the characteristics of net settlement as defined by paragraph 9(b) of Statement 133 as broker-dealer networks develop.

Example 2

A nontransferable forward contract on a nonpublic company'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 company, at some point in the future, accomplishes an initial public offering (IPO) 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). Question 1 asks whether this subsequent evaluation of the contract should be made, thereby causing a contract that was not previously accounted for as a derivative to meet the definition of a derivative.

Example 3

A nontransferable forward contract on a public company'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 company'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 company'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. Question 1 asks whether this subsequent evaluation of the readily-convertible-to-cash-criterion has to be made.

Example 4

A nontransferable forward contract on a public company's stock meets the net settlement criteria in paragraph 9(c) 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 company 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. Question 1 asks whether the subsequent evaluation should be made, resulting in the contract ceasing to meet the definition of a derivative.

RESPONSE

Question 1

As required by paragraph 57(c)(3), as amended by Statement 149, 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. If events occur subsequent to the inception or acquisition of a contract that cause the contract to meet the definition of a derivative instrument, then that contract must be accounted for at that later date as a derivative under Statement 133. For example, if a market develops, if a company effects an IPO, or if daily trading volume changes for a sustained period of time, then those events need to be considered in re-evaluating whether the contract meets the definition of a derivative. An entity should refer to the guidance in Implementation Issue A10 when determining whether such a contract meets the definition of a derivative. Similarly, if events occur subsequent to the inception or acquisition of a contract that would cause a contract that previously met the definition of a derivative to cease meeting the criteria (for example, a company becomes delisted from a national stock exchange), then that contract cannot continue to be accounted for under Statement 133. The guidance in Implementation Issue A10 about assessing the significance of transaction costs is not relevant when determining whether such a contract no longer meets the definition of a derivative.

Question 2

In accordance with the provisions of Statement 133, a contract that both meets the definition of a derivative and is subject to Statement 133 must be carried at fair value. Accordingly, if a contract meets the definition of a derivative subsequent to acquisition by an entity, the contract must be immediately recorded at its then-current fair value with the offsetting entry recorded in earnings. (Statement 133 does not provide guidance about the classification in the income statement of a derivative's gains or losses, including the adjustment to fair value for a contract that newly meets the definition of a derivative.) The contract may then be designated as a hedging instrument, provided that the hedge criteria of Statement 133 are met.

During the period in which the contract does not meet the definition of a derivative, that contract cannot be designated as the hedging instrument in any hedging relationship. (However, it should be noted that the contract could potentially be the hedged item in a fair value hedge or its cash flows could potentially be the hedged transactions in a cash flow hedge.) The contingent designation of a hedging relationship in which the hedging instrument is not currently a derivative but may become one cannot justify the application of hedge accounting to fair value changes occurring prior to inception of the hedge; the inception of that hedging relationship would be the date on which the contract meets the definition of a derivative. If an entity had anticipated that a contract that was not a derivative at inception might later meet the definition of a derivative and has made a contingent designation of an "all-in-one" hedging relationship (as discussed in Statement 133 Implementation Issue No. G2, "Hedged Transactions That Arise from Gross Settlement of a Derivative ('All-in-One" Hedges')") to be effective upon the date that the contract meets the definition of a derivative, only the changes in the fair value of the new derivative contract occurring after the date the contract became a derivative would be recognized in other comprehensive income pursuant to paragraph 30(b). As noted above, when the contract's carrying amount is adjusted to fair value on the date that the contract meets the definition of a derivative, the offsetting entry must be recorded in current period earnings.

If a contract ceases to be a derivative pursuant to Statement 133 and an asset or liability had been recorded for that contract, the carrying amount of that contract becomes its cost basis and the entity should apply other generally accepted accounting principles that are applicable to that contract prospectively from the date that the contract ceased to be a derivative. If the derivative contract had been designated in a cash flow hedging relationship and a gain or loss is recorded in accumulated other comprehensive income, then provisions of paragraphs 31 and 32 of Statement 133 should be applied accordingly.

EFFECTIVE DATE

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of its first 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.

REFERENCE

FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, was issued in May 2003. The Statement requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances).

Statement 150 does not impact the responses in this Implementation Issue. Under Statement 150, forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s equity shares in exchange for cash are measured initially at the amount of cash that would be paid under the conditions specified in the contract if the exchange occurred immediately. Those contracts are not considered to be derivative instruments of the reporting entity for purposes of Statement 133 (refer to paragraph 11(d), as amended by Statement 150). Therefore, those forward purchase contracts would not be subject to the requirements of Implementation Issue A18.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.