FASB: Determining Whether Separate Transactions Should Be Viewed as a Unit

Derivatives Implementation Group

Statement 133 Implementation Issue No. K1

Title: Miscellaneous: Determining Whether Separate Transactions Should Be Viewed as a Unit

Paragraph reference: None

Date cleared by Board: February 17, 1999

QUESTION

Under what circumstances should two individual transactions be viewed as a unit in order to determine whether the combination of the transactions meets the definition of a derivative under Statement 133?

BACKGROUND

Statement 133 is designed to be applied to an individual transaction to determine whether it in its entirety, or a portion thereof, should be accounted for as a derivative under the Statements provisions. However, in some circumstances, an entity could enter into two or more legally separate transactions that, if combined, would generate a result that is economically similar to entering into a single transaction that would be accounted for as a derivative under Statement 133. Two examples follow:

Example 1
Company A enters into a forward contract to purchase 1,500,000 units of a particular commodity in 3 months for $10 per unit. Simultaneously, Company A enters into a forward contract to sell 1,400,000 units of the same commodity in 3 months for $10 per unit. The purchase and sale contracts are with the same counterparty. There is no market mechanism to facilitate net settlement of the contracts and both contracts require physical delivery of the commodity at the same location in exchange for the forward price. On a gross basis, neither contract is readily convertible to cash because the market cannot rapidly absorb the specified quantities without significantly affecting the price. However, on a net basis, Company A has a forward purchase contract for 100,000 units of the commodity, a quantity that can be rapidly absorbed by the market and thus is readily convertible to cash.

Example 2
Company C loans $100 to Company B. The loan has a 5-year bullet maturity and an 8 percent fixed interest rate, payable semi-annually. Company B simultaneously loans $100 to Company C. The loan has a five-year bullet maturity and a variable interest of LIBOR, payable semi-annually and reset on a semi-annual basis. Company B and Company C enter into a netting arrangement that permits each party to offset its rights and obligations under the agreements. The netting arrangement meets the criteria for offsetting in FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts. The net effect of offsetting the contracts for both Company B and Company C is the economic equivalent of an interest rate swap arrangement, that is, one party receives a fixed interest rate from, and pays a variable interest rate to, the other.

RESPONSE

If two or more separate transactions may have been entered into in an attempt to circumvent the provisions of Statement 133, the following indicators should be considered in the aggregate and, if present, should cause the transactions to be viewed as a unit and not separately:

  1. The transactions were entered into contemporaneously and in contemplation of one another.

  2. The transactions were executed with the same counterparty (or structured through an intermediary).

  3. The transactions relate to the same risk.

  4. There is no apparent economic need nor substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.

In both examples, the transactions were entered into with the same counterparty, were executed simultaneously, and relate to the same risk. In Example 1, it appears that there is no clear business purpose for structuring the transactions separately. Therefore, the facts point to the conclusion that the purchase and sale were done as a structured transaction with one counterparty to circumvent the definition of a derivative under Statement 133. However, if the facts indicated that both contracts required physical delivery of the commodity at different locations that are significantly distant from one another and each counterparty is expected to deliver the gross amount of the commodity to the other, those facts may reflect a valid substantive business purpose for the transaction.

In Example 2, based on the facts presented, there is no clear business purpose for the separate transactions, and they should be accounted for as an interest rate swap under Statement 133. However, in other cases, a clear substantive business purpose for entering into two separate loan transactions may exist (for example, as a means to overcome foreign currency expatriation restrictions).

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.