FASB Scope Exceptions Can Option Contracts and Forward Contracts with Optionality Features Qualify for the Normal Purchases and Normal Sales Exception?

FASB: Scope Exceptions: Can Option Contracts and Forward Contracts with Optionality Features Qualify for the Normal Purchases and Normal Sales Exception?

Derivatives Implementation Group

Statement 133 Implementation Issue No. C10

Title: Scope Exceptions: Can Option Contracts and Forward Contracts with Optionality Features Qualify for the Normal Purchases and Normal Sales Exception?
Paragraph references: 10(b), 58(b)
Date cleared by Board: March 21, 2001
Date posted to website: April 10, 2001
Date latest 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

In what instances can the normal purchases and normal sales exception in paragraph 10(b) (as amended) be applied to (1) purchased option contracts (including net purchased options) and written option contracts (including net written options) that would require delivery of the related asset at an established price under the contract only if exercised, and, (2) forward contracts with optionality features?

BACKGROUND

Paragraph 10(b) of Statement 133 (as amended by Statement 149) states, in part:

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. The following guidance should be considered in determining whether a specific type of contract qualifies for the normal purchases and normal sales exception:

(1)   Forward contracts (non-option-based contracts). Forward contracts are eligible to qualify for the normal purchases and normal sales exception. However, forward contracts that contain net settlement provisions as described in either paragraph 9(a) or paragraph 9(b) are not eligible for the normal purchases and normal sales exception unless it is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery.* 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.

(2)   Freestanding option contracts. Option contracts that would require delivery of the related asset at an established price under the contract only if exercised are not eligible to qualify for the normal purchases and normal sales exception, except as indicated in paragraph 10(b)(4) below.

(3)   Forward contracts that contain optionality features. Forward contracts that contain optionality features that do not modify the quantity of the asset to be delivered under the contract are eligible to qualify for the normal purchases and normal sales exception. Except for power purchase or sales agreements addressed in paragraph 10(b)(4), if an option component permits modification of the quantity of the assets to be delivered, the contract is not eligible for the normal purchases and normal sales exception, unless the option component permits the holder only to purchase or sell additional quantities at the market price at the date of delivery. In order for forward contracts that contain optionality features to qualify for the normal purchases and normal sales exception, the criteria discussed in paragraph 10(b)(1) must be met.

(4)   Power purchase or sales agreements. Notwithstanding the criteria in paragraph 10(b)(1) and 10(b)(3), a power purchase or sales agreement (whether a forward contract, option contract, or a combination of both) that is a capacity contract also qualifies for the normal purchases and normal sales exception if it meets the criteria in paragraph 58(b).

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Contracts that are subject to unplanned netting (referred to as a “book out” in the electricity utility industry) do not qualify for this exception except as specified in paragraph 58(b).

The contracts addressed in this Issue do not have a price based on an underlying that is not clearly and closely related to the asset being purchased, nor do they require cash settlement of gains or losses as stipulated in paragraph 10(b).

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

RESPONSE

Paragraph 10(b) of Statement 133, as amended by Statement 149, indicates that purchased option contracts (including net purchased options) and written option contracts (including net written options) that would require delivery of the related asset at an established price under the contract only if exercised are generally not eligible to qualify for the normal purchases and normal sales exception, except as indicated in paragraph 10(b)(4) and the related guidance in paragraph 58(b), as amended, and Statement 133 Implementation Issue No. C15, “Normal Purchases and Normal Sales Exception for Option-Type Contracts and Forward Contracts in Electricity.” The normal purchases and normal sales exception applies only to 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. Option contracts only contingently provide for such purchase or sale since exercise of an 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 option contracts) are not eligible to qualify for the normal purchases and normal sales exception. Furthermore, because of the contingent nature of an option contract (whose potential exercise is typically dependent upon future changes in the underlying), an entity cannot determine at the inception of the option contract that it will be probable throughout the term of the contract that physical delivery will result. Thus, option contracts cannot meet the requirement in paragraph 10(b) that it be “probable at inception and throughout the term of the individual contract that the contract … will result in physical delivery.” The normal purchases and normal sales exception applies only to forward contracts. However, as indicated in paragraph 10(b)(3), forward contracts that contain optionality features would be eligible to qualify for the normal purchases and normal sales exception only if the optionality feature could not modify the quantity of the asset to be delivered under the contract. (Refer to the following discussion.)

The following are examples of forward contract with optionality features:

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

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

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

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

In cases in which the optionality feature in the forward contract can modify the quantity of the asset to be delivered under the contract, if that option feature has expired or has been completely exercised (even if delivery has not yet occurred), there is no longer any uncertainty as to the quantity to be delivered under the forward contract. Accordingly, following such expiration or exercise, the forward contract would be eligible for designation as a normal purchase or normal sale, provided that that the other conditions in paragraph 10(b) are met.

In Example 1, the optionality feature cannot modify the quantity to be delivered; thus, the contract is eligible to qualify for the normal purchases and normal sales exception.

Similarly, the contract in Example 2 is also eligible to qualify for the normal purchases and normal sales exception because the optionality feature in the contract cannot modify the quantity to be delivered.

The contract in Example 3 is not eligible to qualify for the normal purchases and normal sales exception since the optionality feature in the contract can modify the quantity of the asset to be delivered under the contract.

EFFECTIVE DATE

The effective date of the revised implementation guidance in this Issue for each reporting entity is the first day of its first fiscal quarter beginning after June 29, 2001, the date that the Board-cleared revised guidance was posted on the FASB website. The revisions made on March 26, 2003, do not affect the effective date.

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.