Net Settlement and FAS 133
By Linda Cavanaugh, CPA - To be a derivative under FAS 133, a contract must meet three criteria: 1) have a notional and underlying, 2) have little or no net investment, and 3) net settle.
Most contracts have the first two characteristics, i.e. they have a price and a quantity and generally you do not pay for item under contract until it is delivered. It is the net settlement criteria in paragraph 6 that causes all the problems when trying to determine if a contract is a derivative.
Paragraph 9 of FAS 133 gives three methods that a contract can net settle.
1. Contractually net settle
This means that there is a clause in the contract that allows the parties to settle the contract without delivering the underlying commodity. This is usually detailed in the default clause. A symmetrical default clause is equivalent to net settlement, while an asymmetrical default clause does not permit net settlement. (An asymmetrical default clause means that the defaulting party can not profit from defaulting.)
If the contract does not net settle, then you have to determine if there is a market mechanism that would facilitate net settlement.
2. Market Mechanism
Derivative Implementation Group Issue A3 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.”
Per DIG issue A21, the four primary characteristics of a market mechanism must be met for there to be a market mechanism:
1) There is a means to settle a contract that enables one party to readily liquidate its net position under the contract.
This means that there is access to potential counter parties regardless of the seller’s size or market position and there is a standard contract that enables a market maker to transfer a contract without repackaging the original contract.
2) The counterparties are fully relieved of their rights and obligations.
This means there are multiple market participants willing and able to enter into a transaction at market prices and there are binding market prices available.
3) Liquidation of the net position does not require significant transaction costs.
This includes transportation cost and excess legal costs.
4) Liquidation of the net position occurs without significant negotiation and due diligence and occurs within a time frame that is customary for settlement of this type of contract.
This means there is a standard contract that can be signed without excessive due diligence.
DIG Issue A15, states that an offsetting contract is not a market mechanism if the parties are not relieved of all rights and obligations under the contract. So, just because you can enter into an offsetting contract to flatten out your position, does not mean there is a market mechanism to facilitate net settlement.
If there isn't a market mechanism, then you have to determine if the asset under the contract is readily convertible to cash.
3. Readily Convertible to Cash
As discussed in DIG A10, “An asset can be considered to be readily convertible to cash, only if the net amount of cash that would be received from a sale of the asset in an active market is either equal to or not significantly less than the amount an entity would typically have received under a net settlement provision (i.e. The costs to transport the asset from your plant to a liquid delivery point, should not be more than 10% of the gross proceeds of the contract.)
Paragraph 83(a) of FASB Concept Statement No. 5, defines readily convertible to cash as an asset that is fungible and in an active market that can rapidly absorb the quantity held by the entity.
1) Fungible means a standardized product. Gold is fungible because one ounce of 14K gold is the same as another ounce of 14K gold.
2) An active market is not defined in the FASB literature, however, a rule of thumb is that in an active market it should not take longer than 3 to 7 days to complete a transaction.
3) Rapidly absorb the quantity held by the entity means that you can sell out of a contract without affecting the market price of the asset. This is assessed on a contract by contract basis and generally if the contract volume is greater than 10% of the daily market volume, the contract can not be rapidly absorb and is not readily convertible to cash. Under this criterion, you could have some contracts that fail this test, while a smaller contract would pass the test and be considered a derivative.
If you determine that the contract is a derivative instrument and must be marked to market each reporting period or you have to go through the whole hedging process, you should take a look at paragraphs 10 and 58 of FAS 133 to see if the contract will qualify for a scope exception.
Linda is a CPA living in Southwestern Ohio, working as a research accountant for an investor-owned publicly traded utility company. She specializes in implementing new FASB and SEC requirements and FAS 133 derivative issues. In her role at the utility she has encountered many issues and written many memos, so send in your implementation and derivative issues and Linda will help figure out an answer.