FASB Embedded Derivatives Purchase Contracts with a Selling Price Subject to a Cap and a Floor

FASB: Embedded Derivatives: Purchase Contracts with a Selling Price Subject to a Cap and a Floor

Derivatives Implementation Group

Statement 133 Implementation Issue No. B14

Title: Embedded Derivatives: Purchase Contracts with a Selling Price Subject to a Cap and a Floor
Paragraph references:

12, 61(f), 304-311

Date cleared by Board: May 17, 2000
Date revision posted to website: May 1, 2003
Affected by: FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
(Revised March 26, 2003)

QUESTION

Are the economic characteristics and risks of a floor and cap on the price of an asset embedded in a contract to purchase that asset clearly and closely related to the economic characteristics and risks of the purchase contract? Specifically, are the embedded floor and cap in the illustrative purchase contract below clearly and closely related to the host contract and thus do not warrant separate accounting as derivatives under paragraph 12 of Statement 133?

BACKGROUND

A manufacturer enters into a long-term contract to purchase a specified quantity of certain raw materials from a supplier. Under the contract, the supplier will provide the manufacturer with the materials at the then current list price but within a specified range. For example, the purchase price may not exceed a cap of $120 per ton or fall below a floor of $100 per ton, and the current list price at inception of the contract is $110 per ton. The purchase contract in its entirety does not meet the definition of a derivative due to the absence of a net settlement characteristic (that is, the contract requires delivery of a raw material that is not readily convertible to cash). In addition, the purchase contract is not measured at fair value under other applicable generally accepted accounting principles.

From the manufacturer's perspective, the embedded derivatives contained in the purchase contract are two options: a purchased call with a strike price of $120 per ton and a written put with a strike price of $100 per ton. Those options would meet the definition of a derivative under Statement 133 if they were freestanding because they have a notional amount, have an underlying (the price per ton), require a small or no initial net investment, and can be net settled. Those options have the characteristic of net settlement under paragraph 9(a) because they represent an adjustment (that is, either a premium or rebate) of the current list price in an amount equal to the difference between that current list price and the applicable strike amount (of either $120 per ton or $100 per ton). (Paragraph 9(c) does not apply to the options because they have no provision for delivery.) The host contract can be considered a purchase contract that requires delivery of the raw materials at a price equal to the current list price.

RESPONSE

Yes. The economic characteristics and risks of the two options are clearly and closely related to the purchase contract, because the options are indexed to the purchase price of the asset that is the subject of the purchase contract. Although the example purchase contract economically contains embedded derivatives, those derivatives should not be accounted for separately because they are clearly and closely related to the host contract.

In addition, the economic features of the example purchase contract could be viewed as being somewhat similar to that of an interest-bearing debt instrument with a cap and floor on interest rates. Paragraph 61(f) of Statement 133 provides that with respect to debt hosts, interest rate caps and floors are considered to be clearly and closely related unless the conditions in either paragraph 13(a) or paragraph 13(b) are met, in which case the floors or the caps are considered to be not clearly and closely related. However, when deciding whether the economic characteristics and risks of the embedded derivative are clearly and closely related to the host contract for other nonfinancial hybrid contracts, it may not be appropriate to analogize to the guidance in paragraph 61. The guidance in paragraph 61 is not meant to address every possible feature that may be included in a hybrid instrument but, instead, that paragraph covers common features present in financial hybrid contracts.

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.