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3.2 Contracts excluded from ASC 815’s scope
Publication date: 30 Nov 2020
us Derivatives & hedging guide
Figure DH 3-1 summarizes the scope exceptions provided in ASC 815 with literature references and relevant section references within this chapter of the guide and other PwC guides.
Figure DH 3-1
ASC 815 scope exceptions
ASC 815 scope exceptions
Scope exception |
ASC reference |
Section reference |
Certain contracts involving an entity’s own equity |
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3.2.1 Asymmetric accounting treatment
The criteria for a contract to meet the definition of a derivative are the same for both parties to an agreement. However, the scope exceptions are unique to each party. Therefore, while all of the parties to an agreement should come to the same conclusion as to whether a contract meets the definition of a derivative, they may arrive at different conclusions as to whether a scope exception under ASC 815 applies. For example, if the seller sold commodities that it produced in the normal course of business and the buyer purchased them for trading purposes, a commodity contract may meet the normal purchases and normal sales criteria for the seller, but not the buyer.
3.2.2 Revisiting application of scope exceptions
Reporting entities should revisit the use of a scope exception at each reporting period. The terms of the contract or customary practices may change, thereby affecting the determination of whether a contract meets a particular scope exception.
Figure DH 3-2 provides guidance for accounting for contracts that move in or out of the scope of ASC 815.
Figure DH 3-2
Revisiting scope exceptions
Revisiting scope exceptions
Type of change
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Guidance
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A contract is initially accounted for as a derivative, but subsequently meets one of the scope exceptions in ASC 815
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The contract is initially recorded at fair value, with changes in fair value recorded in earnings.
When the contract qualifies for a scope exception, the fair value at that date remains as an asset or liability and is recognized in income when the items underlying the contract are recognized in income.
The contract is subsequently accounted for in accordance with applicable GAAP.
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A contract that meets the definition of a derivative initially qualifies for a scope exception in ASC 815. Upon reassessment, the contract no longer qualifies for a scope exception.
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The contract is initially accounted for in accordance with applicable GAAP.
Once the contract no longer meets a scope exception, it is recorded at fair value with changes in fair value recorded in earnings (unless it is designated in a hedging relationship).
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3.2.3 Regular-way security trades
Regular-way security trades are contracts that provide for delivery of a security within the period of time (after the trade date) generally established by regulations or conventions in the marketplace or exchange in which the transaction is executed. These trades often are recorded as completed purchases or sales of securities on the trade date.
Regular-way security trades are exempted from being accounted for as derivatives. The scope exception is not elective. It applies to trades in securities that (1) require the delivery of securities that are readily convertible to cash (this may be through a market mechanism outside of the contract) and (2) customarily do not settle on the trade date but shortly thereafter, but still within a normal settlement period.
3.2.3.1 Normal settlement period
Settlement periods vary depending on the instrument. A US government security trade typically settles in one day and an equity security trade on the New York Stock Exchange (NYSE) settles within two days, while a secondary market trade of an equity security in foreign markets settles in three to twenty days. Contracts containing provisions that allow for settlement extending beyond the minimum period for the applicable market would be considered derivatives that do not qualify for this scope exception.
3.2.3.2 Forward contracts on securities that do not yet exist
This scope exception would also apply to forward purchases and sales of when-issued and other securities that do not yet exist (to-be-announced or TBA securities) if a reporting entity is required to, or has a continuing policy of, accounting for those contracts on a trade-date basis rather than a settlement date basis (because it is required by other relevant GAAP, like an AICPA Industry Accounting and Audit Guide). Thus, the reporting entity recognizes the acquisition or disposition of the securities at the inception of the contract on a gross basis, with an offsetting payable for the settlement amount.
The scope exception for forward purchases and sales is available to reporting entities that use settlement-date accounting as long as the three requirements have been satisfied. Even though an outright exception may not be available to a reporting entity because it is not required to account for the contract on a trade-date basis, or does not have a policy of trade-date accounting, the contract may still be eligible for this scope exception, provided that all of the following conditions are met: (1) there is no other way to purchase or sell that security, (2) delivery of that security and settlement will occur within the shortest period possible for that type of security, and (3) 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 of a security when it is issued. The reporting entity should document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.
Shortest time period
A TBA security may be available under multiple settlement periods. As illustrated in Example 9 beginning in ASC 815-10-55-118, the regular-way security trade exception may be applied only to forward contracts for the TBA security that requires delivery in the shortest period permitted for that type of security. For example, if a TBA security provides for a choice of settlement dates in November, December, and January, only the security that settles in November is eligible for the regular-way security exception.
Net settlement
Net settling contracts that were previously considered eligible for this scope exception would call into question application of the scope exception to other similar contracts.
3.2.4 Normal purchases and normal sales
Normal purchases and normal sales contracts 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. ASC 815 includes an elective scope exception for such contracts because they are viewed as similar to binding purchase orders or other similar contracts to which the guidance in ASC 815 was not intended to apply.
To designate one or more contracts as normal purchases or normal sales, the reporting entity should evaluate the contracts within the context of its business and operational requirements. In addition, each contract should be further evaluated to ensure that it meets the technical requirements for designation under the scope exception. ASC 815-10-15-25 and ASC 815-10-15-26 summarize the key elements needed to qualify for the normal purchases and normal sales scope exception, and discuss the types of contracts that may have unique considerations. Figure DH 3-3 highlights these requirements.
Figure DH 3-3
Requirements for the normal purchases and normal sales scope exception
Requirements for the normal purchases and normal sales scope exception
Element |
Key considerations |
Normal terms (DH 3.2.4.1) |
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Clearly and closely related underlying (DH 3.2.4.2) |
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Probable physical settlement (DH 3.2.4.3) |
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Designation and documentation (DH 3.2.4.4) |
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Type of contract |
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All of the relevant criteria should be met to qualify for the normal purchases and normal sales scope exception. Each is further discussed in the following sections.
3.2.4.1 Normal terms
To qualify for the normal purchases and normal sales scope exception, management should evaluate the reasonableness of the contract quantities and terms in relation to the reporting entity’s underlying business requirements. This evaluation requires judgment and a two-step conclusion that (1) the reporting entity intends to take physical delivery and (2) the quantity delivered will be used in its normal business activities.
ASC 815 provides a series of relevant factors that should be considered when making these determinations.
In making those judgments, an entity should consider all relevant factors, including all of the following:
- The quantities provided under the contract and the entity’s need for the related assets
- The locations to which delivery of the items will be made
- The period of time between entering into the contract and delivery
- The entity’s prior practices with regard to such contracts.
In addition to these factors, ASC 815-10-15-29 provides further examples of evidence that may assist in identifying contracts that qualify for the normal purchases and normal sales scope exception, including: past trends, expected future demand, other contracts for delivery of similar items, the entity’s practice for acquiring and storing the related commodities, and operating locations.
To designate a contract under the normal purchases and normal sales scope exception, the reporting entity should be able to assert that it is buying or selling goods as part of its normal business activities. In making this assessment, a reporting entity should consider all of its sources of supply of the item provided by the contract in relation to its needs for that item.
3.2.4.2 Clearly and closely related underlying
Another criterion in the evaluation of the normal purchases and normal sales scope exception is that the pricing in the contract must be indexed to an underlying that is clearly and closely related to the asset that is being purchased or sold.
The guidance on clearly and closely related for the normal purchases and normal sales scope exception is included in ASC 815-10-15-30 through ASC 815-10-15-34 and requires both qualitative and quantitative considerations. ASC 815-10-15-32 states that a pricing adjustment would not be clearly and closely related to the asset being sold in certain specified circumstances.
The underlying in a price adjustment incorporated into a contract that otherwise satisfies the requirements for the normal purchases and normal sales scope exception shall be considered to be not clearly and closely related to the asset being sold or purchased in any of the following circumstances:
- The underlying is extraneous (that is, irrelevant and not pertinent) to both the changes in the cost and the changes in the fair value of the asset being sold or purchased, including being extraneous to an ingredient or direct factor in the customary or specific production of that asset.
- If the underlying is not extraneous as discussed in (a), the magnitude and direction of the impact of the price adjustment are not consistent with the relevancy of the underlying. That is, the magnitude of the price adjustment based on the underlying is significantly disproportionate to the impact of the underlying on the fair value or cost of the asset being purchased or sold (or of an ingredient or direct factor, as appropriate).
- The underlying is a currency exchange rate involving a foreign currency that meets none of the criteria in paragraph 815-15-15-10(b) for that reporting entity.
ASC 815-10-15-33 provides further guidance for evaluating contracts in which the price adjustment focuses on changes in the fair value of the asset being purchased or sold. In accordance with this guidance, a price adjustment should be expected, at contract inception, to impact the price in a manner comparable to the outcome that would be obtained if, at each delivery date, the parties were to reprice under then-existing conditions. This guidance can be applied to the cost or fair value of the asset being sold or purchased.
In addition to these pricing factors, ASC 815-15-15-10(b) states that the purchase or sale contract must be denominated in a currency that is:
- the functional currency of one of the substantial parties to the contract,
- a currency in which such contracts are routinely denominated in international commerce,
- the local currency of any substantial party to the contract, or
- the currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary.
A contract in any other currency is a compound derivative comprising (1) a functional currency forward purchase of the commodity and (2) an embedded foreign currency swap. Since a compound derivative cannot be separated into its components, the entire contract must be accounted for as a single derivative under ASC 815 and is not eligible for the normal purchases and normal sales scope exception.
Question DH 3-1 discusses the interpretation of clearly and closely related for embedded derivatives and normal purchases and sales scope exception.
Question DH 3-1
How does the interpretation of clearly and closely related for embedded derivatives relate to the clearly and closely related criterion applied in the normal purchases and normal sales scope exception?
How does the interpretation of clearly and closely related for embedded derivatives relate to the clearly and closely related criterion applied in the normal purchases and normal sales scope exception?
PwC response
ASC 815-10-15-30 through ASC 815-10-15-34 establish a qualitative and quantitative approach for assessing whether a pricing feature is clearly and closely related in application of the normal purchases and normal sales scope exception. However, it also clarifies that the phrase conveys a different meaning than in the embedded derivative analysis.
Excerpt from ASC 815-10-15-31
The phrase not clearly and closely related…with respect to the normal purchases and normal sales scope exception is used to convey a different meaning than in paragraphs 815-15-25-1(a) and 815-15-25-16 through 25-51 with respect to the relationship between an embedded derivative and the host contract in which it is embedded.
In general, the normal purchases and normal sales scope exception establishes a more structured approach compared to the analysis performed in the embedded derivative evaluation. Specifically, the clearly and closely related analysis for purposes of applying the normal purchases and normal sales scope exception requires a qualitative and quantitative analysis of pricing features within the contract. To apply the exception, at contract inception the price adjustment should be expected to impact the price in a manner comparable to the outcome that would be obtained if, at each delivery date, the parties were to reprice the contract under then-existing conditions. In contrast, the analysis of potential embedded derivatives (discussed in DH 4) does not require explicit comparison of the pricing but instead focuses on the overall economic risks and characteristics of the potential embedded derivative and the host.
3.2.4.3 Probable physical settlement
Another criterion for application of the normal purchases and normal sales scope exception is that physical delivery should be probable at inception and throughout the term of the contract. As a result, this criterion should be evaluated at the time the contract is initially designated as a normal purchase or normal sale as well as on an ongoing basis throughout the life of the contract. This section discusses considerations in assessing physical settlement and the impact if net settlement occurs (referred to as tainting).
Contract characteristics
Some contracts require physical delivery by their contract terms (i.e., those contracts meet the net settlement criterion because they require delivery of an asset that is readily convertible to cash). However, other contracts permit physical or financial settlement. Therefore, to qualify for the normal purchases and normal sales scope exception, ASC 815-10-15-35 has specific requirements for contracts that meet the characteristic of net settlement because of the terms of the contract itself or because there is a market mechanism to facilitate net settlement.
Excerpt from ASC 815-10-15-35
To qualify for the normal purchases and normal sales scope exception, it must be probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery.
Specific consideration of physical delivery is required for these contracts because the parties to the contract have alternative options for cash settlement (whether through the contract itself or through the ability to be relieved of the contract rights and obligations through a market transaction).
See Subsequent accounting for discussion of the accounting implications if there is a change in the assessment of whether a contract will be physically settled.
Question DH 3-2 discusses whether the normal purchases and normal sales scope exception is available to commodity contracts that require periodic cash settlements of gains and losses.
Question DH 3-2
Is the normal purchases and normal sales scope exception available to commodity contracts that require periodic cash settlements of gains and losses?
Is the normal purchases and normal sales scope exception available to commodity contracts that require periodic cash settlements of gains and losses?
PwC response
No. ASC 815-10-15-36 states that the normal purchases and normal sales scope exception applies to contracts that result in gross delivery of the commodity under the contract, but it should not be applied to contracts that require periodic cash settlements of gains and losses. Futures contracts traded on an exchange are examples of contracts that are derivatives that may result in physical delivery of a commodity (i.e., the contract may be physically settled at termination). However, the exchange typically requires daily cash settlements relative to the net gain or loss on the contract. Such periodic settlements with the futures exchange preclude the contract from qualifying for the normal purchases and normal sales scope exception.
Question DH 3-3 discusses whether take-or-pay contracts qualify for the normal purchases and normal sales scope exception.
Question DH 3-3
Can take-or-pay contracts qualify for the normal purchases and normal sales scope exception?
Can take-or-pay contracts qualify for the normal purchases and normal sales scope exception?
PwC response
Possibly. Each contract must be evaluated based on its own terms. A take-or-pay contract is one in which an entity agrees to (1) purchase a commodity or service from another entity, and (2) pay for the commodity or service even if the entity does not take delivery of the commodity or use the service.
When a take-or-pay contract meets the definition of a derivative, it may qualify for the normal purchases and normal sales scope exception if all of the criteria are met. For example, assume that a contract provides for the delivery of a commodity in an amount that is expected to be used in the normal course of business, and it is probable that the contract at inception and throughout its term will physically settle (not net settle). To qualify for the normal purchases and normal sales scope exception, the purchaser of the commodity must assert that it will both (1) accept the physical delivery of the commodity and (2) use that commodity in the normal course of business.
Subsequent accounting
On an ongoing basis, a reporting entity should monitor whether it continues to expect contracts designated under the normal purchases and normal sales scope exception to result in physical delivery. ASC 815-10-15-41 discusses the impact of net settlement on the normal purchases and normal sales designation.
Excerpt from ASC 815-10-15-41
Net settlement ... 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.
This section discusses factors to consider in monitoring the probability of physical delivery, the timing of recognition if net settlement is expected to occur, and the subsequent accounting if there is a tainting event.
Ongoing monitoring of the physical delivery assertion
One way to support the continued expectation that the transaction will result in physical delivery is to perform back testing of contracts that settled during the period that were designated under the normal purchases and normal sales scope exception. Another approach is to review the forecast of production, or physical purchases and sales, and compare the forecast to the current portfolio of contracts that are designated under the normal purchases and normal sales scope exception. If a reporting entity has multiple contracts for which the normal purchases and normal sales scope exception has been elected, it should ensure that physical delivery of the volumes for all of those contracts is probable.
Factors that may change the assessment that a contract will result in physical delivery include:
- Changes in the reporting entity’s expected production levels
- Changes in markets and demand or supply in the region
- Changes in the reporting entity’s or the counterparty’s creditworthiness
- Macro changes in the overall economy
The ongoing evaluation of whether physical delivery is probable should incorporate information about any changes to the reporting entity’s business, net settlement of any contracts, changes in market conditions, and other relevant factors.
Counterparty creditworthiness
Because gross physical delivery is required for the normal purchases and normal sales scope exception, at inception and throughout the term of the contract, a reporting entity should assess the creditworthiness of its counterparty. Poor counterparty credit quality at the inception of the arrangement, or subsequent deterioration of the counterparty’s credit quality (which may result from issues relating to the counterparty itself and/or broad economic factors) may call into question whether it is probable that the counterparty will fulfill its performance obligations under the contract (i.e., make physical delivery throughout the contract and upon its maturity). As a result, a reporting entity should monitor and consider the impact of the counterparty’s credit risk, as well as its own credit, in assessing whether physical delivery is probable.
Timing of recognition when physical delivery is no longer probable
Once a reporting entity elects the normal purchases and normal sales scope exception, it is irrevocable. However, if a reporting entity determines that it is no longer probable that a contract will result in physical delivery, it may need to discontinue its application. Whether and when a reporting entity should discontinue application of the normal purchases and normal sales scope exception partially depends on the form of net settlement applicable to the contract.
Figure DH 3-4 shows the impact of the form of net settlement on the requirement or ability to discontinue the application of the normal purchases and normal sales scope exception.
Figure DH 3-4
Impact of the form of net settlement on the requirement or ability to discontinue the application of the normal purchases and normal sales scope exception
Impact of the form of net settlement on the requirement or ability to discontinue the application of the normal purchases and normal sales scope exception
Method of net settlement
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Timing of change in designation
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Net settlement under contract terms (ASC 815-10-15-99a)
Net settlement through a market mechanism (ASC 815-10-15-99b)
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The normal purchases and normal sales scope exception will cease to apply when physical delivery is no longer probable; this could occur prior to the actual net settlement.
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Net settlement by delivery of asset that is readily convertible to cash (ASC 815-10-15-99c)
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The normal purchases and normal sales scope exception will continue to apply until the contract is financially settled, even if management intends or otherwise knows that physical delivery is no longer probable.
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If a reporting entity determines it is no longer probable that a contract will result in physical delivery and the contract allows for net settlement via the contract or through a market mechanism, the reporting entity should immediately cease to apply the normal purchases and normal sales scope exception to the contract. Once it is no longer able to make this assertion, the contract no longer meets the criteria for the exception. Accordingly, the contract would be recorded at fair value in the financial statements in the period in which it no longer meets the probability requirement, with an immediate impact to earnings. In addition, subsequent changes in fair value of the derivative would also be recognized in earnings.
If, however, the contract meets the net settlement criterion of the definition of a derivative because it requires delivery of an asset that is readily convertible to cash, then the contract will not be accounted for as a derivative unless a financial settlement occurs. This type of contract requires gross physical delivery under the contract terms; therefore, physical delivery is presumed in assessing whether the normal purchases and normal sales scope exception applies. Because the normal purchases and normal sales scope exception is irrevocable, a reporting entity cannot change the designation of a contract even if it determines that physical delivery is no longer probable. However, if such a contract is financially settled, it is immediately tainted and should be recorded at fair value through earnings.
If a reporting entity determines that one contract no longer qualifies for the normal purchases and normal sales scope exception, this may call into question its ability to assert probable physical delivery for other similar contracts or contracts within a group. It may also call into question the entity’s initial election of the normal purchases and normal sales scope exception.
Subsequent impact of net settlement (tainting)
The normal purchases and normal sales scope exception applies solely to contracts that result in gross physical delivery of nonfinancial items. Therefore, net settlement of a particular contract would preclude application of the normal purchases and normal sales scope exception to that contract (i.e., the contract should be recorded at fair value in earnings at the time the exception is no longer applicable. In addition, it may “taint” the ability to apply the normal purchases and normal sales scope exception to other similar contracts and to the business in its entirety.
To assess whether net settlement of a contract taints other similar contracts, a reporting entity should evaluate the reasons that led to the net settlement. Net settlement or cancellation of a contract as a result of events that are reasonably unexpected at inception of the contract and outside the reporting entity’s control (e.g., a force majeure event) likely would not taint other contracts unless they are similarly impacted by the same event. In contrast, net settlement as a result of a discretionary decision to net settle would result in tainting. For example, if a reporting entity decides to net settle a contract to take advantage of a favorable price change, application of the normal purchases and normal sales scope exception to other similar contracts would no longer be appropriate.
3.2.4.4 Designating and documenting normal purchases and normal sales
Reporting entities electing the normal purchases and normal sales scope exception should maintain appropriate documentation to distinguish those contracts designated as normal purchases and normal sales. In accordance with ASC 815-10-15-38, failure to comply with the documentation requirements precludes application of the exception, even if the contract would otherwise qualify. ASC 815-10-15-37 specifies the minimum documentation requirements for a contract designated as a normal purchase or normal sale.
For contracts that qualify for the normal purchases and normal sales exception under any provision of paragraphs 815-10-15-22 through 15-51, the entity shall document the designation of the contract as a normal purchase or normal sale, including either of the following:
- For contracts that qualify for the normal purchases and normal sales exception under paragraph 815-10-15-41 or 815-10-15-42 through 15-44, the entity shall document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.
- For contracts that qualify for the normal purchases and normal sales exception under paragraphs 815-10-15-45 through 15-51, the entity shall document the basis for concluding that the agreement meets the criteria in that paragraph, including the basis for concluding that the agreement is a capacity contract.
Designation method
ASC 815-10-15-38 specifies that the documentation required to designate a contract as normal purchases and normal sales can be applied to individual contracts or to groups of contracts. Designation of individual contracts may provide more flexibility; however, it also increases the documentation requirements.
Potential bases for global designation include chronology, time of year, and trading point. However, the global designation policy should be based on objectively-determinable criteria with sufficient specificity such that there is no ambiguity in the classification of a particular contract. A reporting entity that applies a global methodology of electing contracts for the normal purchases and normal sales scope exception should do so consistently for similar contracts.
The rationale a reporting entity uses in its grouping of contracts for purposes of designating the normal purchases and normal sales scope exception is important because it could impact decisions about tainting.
Timing of election
Although application of the normal purchases and normal sales scope exception is elective, once made, the election is irrevocable.
Excerpt from ASC 815-10-15-39
The normal purchases and normal sales scope exception could effectively be interpreted as an election in all cases. However, once an entity documents compliance with the requirements of paragraphs 815-10-15-22 through 15-51, which could be done at the inception of the contract or at a later date, the entity is not permitted at a later date to change its election and treat the contract as a derivative instrument.
In accordance with ASC 815-10-15-23, the assessment of whether a contract qualifies for the normal purchases and normal sales scope exception should be performed only at the inception of the contract; however, a reporting entity may designate and document the exception at inception or a later date. Although ASC 815 does not specify documentation requirements, we believe the documentation must be completed contemporaneously with application of the exception.
Failure to complete the documentation requirements would preclude application of the scope exception, even if the contract would otherwise qualify. If a reporting entity designates a contract subsequent to inception, the normal purchases and normal sales scope exception will apply as of the date of designation.
Question DH 3-4 discusses what the accounting is for the carrying value of a contract that is designated under the normal purchases and normal sales scope exceptions on a date subsequent to inception.
Question DH 3-4
What is the accounting for the carrying value of a contract that is designated under the normal purchases and normal sales scope exception on a date subsequent to inception?
What is the accounting for the carrying value of a contract that is designated under the normal purchases and normal sales scope exception on a date subsequent to inception?
PwC response
If a contract qualifies as a derivative and is designated as a normal purchase or normal sale subsequent to the contract execution date, the reporting entity will have an asset or liability on its balance sheet equal to the fair value of the contract on the date the election is made. After designation as a normal purchase or normal sale, the contract will no longer be recorded at fair value. The pre-existing fair value, however, will remain as an asset or liability and should be recognized in income at the same time as the items underlying the contract. The carrying value of the contract is subject to impairment analysis.
Question DH 3-5 discusses whether the normal purchases and normal sales scope exception can be elected for a contract that is not a derivative at inception but could be one in the future.
Question DH 3-5
Can the normal purchases and normal sales scope exception be elected for a contract that is not a derivative at inception but could potentially become one in the future (conditional designation)?
Can the normal purchases and normal sales scope exception be elected for a contract that is not a derivative at inception but could potentially become one in the future (conditional designation)?
PwC response
Yes. Provided the normal purchases and normal sales criteria are met, a contract could be designated under the exception prior to the time it becomes a derivative.
We believe the ability to conditionally designate a contract is reasonable in consideration of the guidance in ASC 815-10-55-84 through ASC 815-10-55-89, which allows for conditional hedging designations. If a conditionally-designated normal purchases and normal sales contract meets the definition of a derivative at a later date, it would be accounted for as a normal purchases and normal sales contract from the time the contract becomes a derivative. Absent such a designation, the reporting entity would be required to initially fair value the contract when it meets the definition of a derivative. However, the reporting entity may subsequently designate the contract as a normal purchase or normal sale if all of the requirements for the scope exception have been met.
From a practical perspective, often the reporting entity will not know the exact date a contract meets the definition of a derivative. As a result, the contract could meet the definition of a derivative prior to a contemporaneous election of the normal purchases and normal sales scope exception. A conditional designation avoids this issue and allows for continued accounting for the contract as an executory contract. If a reporting entity conditionally designates one or more contracts, it should maintain appropriate documentation to distinguish those contracts designated as normal purchases and normal sales. In addition, all documentation requirements to qualify for the election should be met. Contracts that are conditionally designated under this scope exception should not be net settled. Net settlement of a conditionally-designated contract would result in the specific contract no longer qualifying for the normal purchases and normal sales scope exception and could result in tainting of other designated contracts that are considered similar.
Question DH 3-6 discusses whether a component of a contract that does not meet the definition of a derivative in its entirety can qualify for the normal purchases and sales scope exception.
Question DH 3-6
Can a component of a contract that does not meet the definition of a derivative in its entirety qualify for the normal purchases and normal sales scope exception?
Can a component of a contract that does not meet the definition of a derivative in its entirety qualify for the normal purchases and normal sales scope exception?
PwC response
Yes. A contract that is not a derivative in its entirety should be assessed to determine if it includes certain components that require separation and accounting as derivatives. An embedded derivative should be separated from the host contract and accounted for as a derivative only if all of the criteria in ASC 815-15-25-1 are met. One of these requirements is that a separate instrument with the same terms as the embedded derivative would meet the requirements to be accounted for as a derivative. However, a reporting entity may elect to apply the normal purchases and normal sales scope exception to an embedded derivative if all of the criteria for election are met. The embedded derivative would not be subject to the accounting requirements of ASC 815 if the reporting entity elects the normal purchases and normal sales scope exception. See ASC 815-15-55-15 to ASC 815-15-55-22 for an example of the application of the normal purchases and normal sales scope exception to an embedded derivative that would otherwise require separation from the host contract.
3.2.4.5 Contracts that may qualify for normal purchases and normal sales
ASC 815-10-15-40 through ASC 815-10-15-51 describe the types of contracts that may qualify for the normal purchases and normal scope exception, as summarized in Figure DH 3-5.
Figure DH 3-5
Applicability of normal purchases and normal sales scope exception to certain types of contracts
Applicability of normal purchases and normal sales scope exception to certain types of contracts
Type of contract |
Key considerations |
Freestanding option contracts |
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Forward contracts (non-option-based) |
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Forward contracts with optionality features |
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Power purchase or sale agreements |
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The considerations for applying the normal purchases and normal sales scope exception to each of these types of contracts are discussed in UP 3.3.1.5.
3.2.5 Certain insurance contracts
This scope exception applies to certain insurance contracts. Generally, insurance contracts that are within the scope of ASC 944, Financial Services—Insurance, would qualify. A contract is eligible for this scope exception for both the issuer and the holder only if the holder is compensated as a result of an identifiable insurable event (e.g., damage to insured property). ASC 815-10-15-52 provides guidance for assessing whether an insurance contract meets this scope exception.
A contract is not subject to the requirements of this Subtopic if it entitles the holder to be compensated only if, as a result of an identifiable insurable event (other than a change in price), the holder incurs a liability or there is an adverse change in the value of a specific asset or liability for which the holder is at risk. Only those contracts for which payment of a claim is triggered only by a bona fide insurable exposure (that is, contracts comprising either solely insurance or both an insurance component and a derivative instrument) may qualify for this scope exception. To qualify, the contract must provide for a legitimate transfer of risk, not simply constitute a deposit or form of self-insurance.
Traditional life insurance and traditional property and casualty contracts meet this scope exception.
Certain property and casualty contracts
A property and casualty contract that compensates the holder as a result of both an identifiable insurable event and changes in a variable is in its entirety exempt from the requirements of ASC 815, provided that all of the following conditions are met:
- Benefits or claims are paid only if an identifiable insurable event occurs (e.g., theft or fire)
- The amount of the payment is limited to the amount of the policyholder’s incurred insured loss
- The contract does not involve essentially assured amounts of cash flows (regardless of the timing of those cash flows) based on insurable events highly probable of occurrence because the insured would nearly always receive the benefits (or suffer the detriment) of changes in the variable
This is illustrated in an example in ASC 815-10-55-134.
Excerpt from ASC 815-10-55-134
Insured Entity has received at least $2 million in claim payments from its insurance entity (or at least $2 million in claim payments were made by the insurance entity on the insured entity’s behalf) for each of the previous 5 years related to specific types of insured events that occur each year. That minimum level of coverage would not qualify for the insurance contract scope exclusion.
Contracts with actuarially-determined minimum amount of expected claim payments
If a contract includes an actuarially-determined minimum amount of expected claim payments from insurable events that are highly probable of occurring, that portion of the contract does not qualify for this scope exception if the following conditions are met:
- The minimum payment cash flows are indexed to or altered by changes in a variable
- The minimum payment amounts are expected to be paid either each policy year or on another predictable basis
3.2.6 Certain financial guarantee contracts
Financial guarantee contracts are not subject to ASC 815 if they meet all of the conditions in ASC 815-10-15-58.
Excerpt from ASC 815-10-15-58
- They provide for payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a nonderivative contract, either:
- At prespecified payment dates
- At accelerated payment dates as a result of either the occurrence of an event of default (as defined in the financial obligation covered by the guarantee contract) or notice of acceleration being made to the debtor by the creditor.
- Payment under the financial guarantee contract is made only if the debtor’s obligation to make payments as a result of conditions as described in (a) is past due.
- The guaranteed party is… exposed to the risk of nonpayment both at inception of the financial guarantee contract and throughout its term…
A reporting entity should consider the following when assessing whether a financial guarantee contract qualifies for this scope exception:
- The contract must specify that the guaranteed party will be entitled to compensation as a result of an identifiable insurable event, i.e., it is entitled to be compensated for failure to pay on specific assets for which the holder is at risk, rather than as a result of a credit event. If the terms of the contract require payment to the guaranteed party, irrespective of whether the guaranteed party is exposed to a risk of non-payment on the reference asset, the contract will not qualify.
- A guaranteed party must demand payment from the debtor prior to collecting any payment from the guarantor.
- The guarantor must either receive the rights to any payments subsequently advanced to the guaranteed party or delivery of the defaulted receivable. A contract that promises to pay the guaranteed party the difference between the post-credit-event fair value and the book value would not qualify.
- Financial guarantee contracts that guarantee performance under derivatives (e.g., as a result of a decrease in a specified debtor’s creditworthiness) do not qualify for this scope exception.
3.2.7 Certain contracts that are not traded on an exchange
Certain non-exchange-traded contracts are not subject to the requirements of ASC 815 if the underlying on which settlement of the contract is based is any of the following:
- A climatic or geological variable or other physical variable
- The price or value of a nonfinancial asset that is not readily convertible to cash
- The price or value of a nonfinancial liability if the liability does not require delivery of an asset that is readily convertible to cash
- Specified volumes of sales or service revenues of one of the parties to the contract
3.2.7.1 Climatic or geological variables
This scope exception applies to non-exchange-traded contracts with an underlying based on a climatic, geological, or other physical variable.
Excerpt from ASC 815-10-15-59(a)
Climatic, geological, and other physical variables include things like the number of inches of rainfall or snow in a particular area and the severity of an earthquake as measured by the Richter scale.
Physical variables include temperature, wind speed, or other weather-related factors. For example, a power contract with pricing based on cooling-degree days would meet the exception. Market-related volumes of a commodity (e.g., the total volume on NYMEX) would not qualify because the volume on an exchange or other market is not a physical variable.
Figure DH 3-6 includes considerations on how to distinguish between physical and financial variables. See additional discussion beginning in ASC 815-10-55-135.
Figure DH 3-6
Distinguishing between physical and financial variables
Distinguishing between physical and financial variables
Contract contains
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Considerations
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Physical and financial variable
Contract specifies that the issuer will pay the holder $10 million if aggregate property damage from all hurricanes in Florida exceeds $50 million during 20X7.
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Contract contains two underlyings: physical variable (occurrence of at least one hurricane) and financial variable (aggregate property damage exceeding a specified dollar limit).
Because of the presence of the financial variable as an underlying, the derivative does not qualify for the scope exception in ASC 815-10-15-59(a).
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Physical variable only
Contract specifies that the issuer will pay the holder $10 million in the event that a hurricane occurs in Florida in 20X7.
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In this case, the payment provision is triggered if a hurricane occurs in Florida in 20X7. The underlying is a physical variable (the occurrence of a hurricane); therefore, the contract qualifies for the scope exception in ASC 815-10-15-59(a).
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Financial variable only
Contract requires payment only if the holder incurs a decline in revenue or an increase in expense as a result of an event (e.g., a hurricane) and the amount of the payoff is solely compensation for the amount of the holder’s loss.
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This type of contract is a traditional insurance contract that is provided a scope exception in ASC 815-10-15-52. See DH 3.2.5.
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Weather contracts
The scope exception for non-exchange-traded contracts with an underlying based on a climatic or geological variable includes weather-related contracts with pricing based on the number of cooling-degree days. Consistent with this exception, derivative accounting is only applicable to weather-related contracts traded on an exchange.
ASC 815-45 provides specific nonderivative guidance on accounting for non-exchange-traded weather derivatives. The guidance includes two different accounting models, depending on the reporting entity’s purpose for executing the contracts. The models are summarized in Figure DH 3-7.
Figure DH 3-7
Weather derivative contract accounting models
Weather derivative contract accounting models
Intent
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Product
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Initial accounting
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Subsequent accounting
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Nontrading activity
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Forward contract
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Typically no day one accounting
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Apply the intrinsic value method (ASC 815-45-35-1)
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Purchased option
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Recognize an asset measured initially at the amount of premium paid (ASC 815-45-30-1)
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Use the intrinsic value method at each measurement date
Amortize the option premium to expense in a rational and systematic manner (ASC 815-45-35-4)
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Written option
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Recognize a liability measured initially based on the option premium received (ASC 815-45-30-2)
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Recognize any subsequent changes in fair value in earnings
Do not amortize the option premium (ASC 815-45-35-5)
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Trading or speculative activity
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Forwards and options
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Account for all contracts as assets or liabilities at fair value (ASC 815-45-30-4)
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Recognize all subsequent changes in fair value in earnings (ASC 815-45-35-7)
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As illustrated in Figure DH 3-7, the accounting model applied largely depends on whether a non-exchange-traded weather derivative was executed as part of a reporting entity’s trading activities. ASC 815-45-55-1 through ASC 815-45-55-6 provides guidance on identifying trading activities relating to weather derivatives, including fundamental and secondary indicators, and the entity’s intent for entering into a weather derivative contract.
Overall, a reporting entity is considered to be involved in trading activities related to weather derivatives if it enters into the contracts with an objective of generating short-term profits from the contracts. In accordance with ASC 815-45-55-1, reporting entities should evaluate trading versus nontrading based on the activities of an organization or legal entity. However, if a reporting entity conducts both trading and nontrading activities and those activities are not segregated in such a manner, it should evaluate the contracts at inception in accordance with the indicators outlined in ASC 815-45-55-1 through ASC 815-45-55-6 to determine if they are trading or nontrading.
In general, nontrading purchased weather derivatives are accounted for using the intrinsic value method described in ASC 815-45-35-2. ASC 815-45-55-7 through ASC 815-45-55-11 provide application examples, including sample calculations and accounting assuming that the contracts were executed as part of a reporting entity’s nontrading operations. In addition, reporting entities should recognize subsequent changes in the fair value of nontrading written option contracts instead of following the intrinsic value method.
3.2.7.2 Price or value of a nonfinancial asset or nonfinancial liability
This scope exception applies to non-exchange-traded contracts with an underlying based on the price or value of a nonfinancial asset or nonfinancial liability of one of the parties to the contract if the asset is not readily convertible to cash.
Excerpt from ASC 815-10-15-59(b)
This scope exception applies only if both of the following are true:
- The nonfinancial assets are unique.
- The nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset.
This scope exception may apply to unique works of art or certain custom manufactured goods. As markets evolve and new markets develop (e.g., online markets), the reporting entity’s determination that an asset is not readily convertible to cash may change.
Question DH 3-7 discusses whether a fixed-price purchase option for a property underlying an operating lease or a capital/finance lease is accounted for as a derivative.
Question DH 3-7
Is a fixed-price purchase option for a property underlying an operating lease or a capital/finance lease accounted for as a derivative?
Is a fixed-price purchase option for a property underlying an operating lease or a capital/finance lease accounted for as a derivative?
PwC response
Generally, no. ASC 815-10-15-59 through ASC 815-10-15-62 state that contracts that are not exchange traded do not fall within the scope of ASC 815 when the underlying on which the settlement is based is the price or value of a nonfinancial asset of one of the parties to the contract, provided that the asset is not readily convertible to cash. In most situations of this kind, the contracts are not exchange traded, and the property underlying the lease represents a nonfinancial asset that would not be considered readily convertible to cash; therefore, such contracts are excluded from the scope of ASC 815.
3.2.7.3 Specified volumes of sales or service revenues
This exception is intended to apply to contracts providing for settlements that are based on the volume of items sold or services rendered (e.g., royalty agreements or leases stipulating that rental payments be based on sales volume), not those based on changes in sales or revenues due to changes in market prices.
This exception may also be extended to net income or EBITDA unless the income measure is due predominantly to the movement of the fair value of a portfolio of assets. The exception is not intended to apply to contracts with settlements based on changes that are due principally to changes in market prices. Accordingly, a contract to pay a counterparty 3% of its net sales of gold would qualify for the scope exception, but a contract to pay a counterparty 3% of a price increase that raises the market price of gold to above $1,000 per ounce would not qualify.
Royalties
Royalty agreements can vary significantly and may include any number of variables in the calculation of the royalty payment. For instance, in the mining industry, royalties may be calculated as a percentage of the total mineral extraction at a preset dollar rate per extraction unit. In other cases, the rate that is to be applied to the percentage of the total extraction may be based on actual sales prices for that mineral, making the royalty a function of the units extracted as well as a variable price. In the technology industry, a royalty may be calculated as a stated percentage of sales (e.g., a combination of units sold and the price per unit).
Question DH 3-8 discusses whether royalty payments that vary based on revenues qualify for the specified volumes of sales or service revenue scope exception.
Question DH 3-8
Do royalty payments that vary based on revenues (that in turn vary because of movements in market prices and the number of units sold) qualify for the specified volumes of sales or service revenues scope exception?
Do royalty payments that vary based on revenues (that in turn vary because of movements in market prices and the number of units sold) qualify for the specified volumes of sales or service revenues scope exception?
PwC response
Yes. We believe that the conditions for this scope exception can be satisfied by royalty agreements that provide for payments based on changes in either sales or revenues that are due to both changes in the market price per unit and changes in the number of units. We believe that by including the phrase “changes in sales or revenues due to changes in market prices,” the FASB did not intend to exclude royalty agreements with payment based on changes in revenues due to changes in market prices when those changes are applied to the volume of items sold or services rendered from the ASC 815-10-15-59(d) scope exception.
The FASB’s intention was to prohibit entities from applying the scope exception to (1) contracts that have as their sole variable the change in sales or revenues that is due to changes in market prices, and (2) contracts that have variables based on (a) a change in market prices and (b) a trivial change in the number of units. Reporting entities should consider the guidance in ASC 815-10-15-60 for contracts with more than one underlying when evaluating the type of contract described in item (2). The purpose of this guidance is to prevent entities from circumventing the requirements of ASC 815 merely by establishing payment terms in their royalty agreements that are based predominantly on market price with insignificant change in volume.
3.2.7.4 Derivative contracts with more than one underlying
Many derivative contracts have more than one underlying. A derivative contract might have some underlyings that qualify for a scope exception while also having other underlyings that do not qualify (e.g., a structured insurance contract with an interest rate swap and a climatic variable). The guidance in ASC 815-10-15-60 indicates that in a situation such as this, the holder of the derivative should evaluate the contract based on its predominant characteristics. That is, if a derivative contract’s value, when considering the underlyings in combination, is expected to behave in a manner similar to how the underlyings that do not meet the scope exception would behave, the derivative would not qualify for the scope exception.
3.2.8 Derivatives that impede sale accounting
ASC 815-10-15-63 through ASC 815-10-15-64 provide a scope exception for certain instruments that impede sale accounting. For example, if a call option were to prevent a transfer of receivables from being accounted for as a sale under ASC 860, Transfers and Servicing, the call option would be excluded from the scope of ASC 815 and accounted for under ASC 860 as a component of the financing.
ASC 815-10-15-64 clarifies that a derivative held by a transferor that relates to assets transferred in a transaction accounted for as a financing under ASC 860, but that does not itself serve as an impediment to sale accounting, is not subject to ASC 815 if recognizing both the derivative and either the transferred asset or the liability arising from the transfer would result in counting the same transaction twice in the transferor’s balance sheet. However, if recognizing both the derivative and either the transferred asset or the liability arising from the transfer would not result in counting the same transaction twice in the transferor’s balance sheet, the derivative should be accounted for in accordance with ASC 815.
The guidance in ASC 815-10-55-41 illustrates the application of this scope exception when the transferor accounts for the transfer as financing.
3.2.9 Investments in life insurance
ASC 815-10-15-67 addresses a scope exception for investments in life insurance. Under this guidance, a policyholder’s investment in a life insurance contract (e.g., a corporate-owned life insurance policy) that is accounted for under ASC 325-30, Investments—Other, Investments in Insurance Contracts, is not subject to ASC 815. This scope exception is provided to the policyholder and does not affect the accounting by the issuer of the life insurance contract.
3.2.10 Certain investment contracts
ASC 815-10-15-68 provides a scope exception for certain investment contracts held by defined benefit pension plans. Contracts that are accounted for under either ASC 960-325-35-1 (plan investments) or ASC 960-325-35-3 (insurance contracts) are not subject to ASC 815. This scope exception applies only to the party that accounts for the contract under ASC 960, Plan Accounting—Defined Benefit Pension Plans.
3.2.11 Certain loan commitments
ASC 815-10-15-69 through ASC 815-10-15-71 address a scope exception for certain loan commitments. The ASC Master Glossary defines a loan commitment.
Definition from ASC Master Glossary
Loan Commitment: Loan commitments are legally binding commitments to extend credit to a counterparty under certain prespecified terms and conditions.
Examples of loan commitments include residential mortgage loan commitments, commercial loan commitments, credit card lines of credit, automobile financing, and subprime lending. Understanding certain characteristics of loan commitments is necessary to apply this exception appropriately. Questions that are useful to consider include:
- Is the entity the issuer or the holder of the loan commitment?
- Is the loan commitment related to loans that will be held for sale or held for investment?
- Is the loan commitment originated or purchased?
- Is the loan commitment related to a mortgage loan or a nonmortgage loan?
Whether the commitment is accounted for as a derivative depends on the type of loan that will be originated under the loan commitment and how the loan will be classified once it is originated. Figure DH 3-8 summarizes which loan commitments are accounted for as derivatives by the issuer (the potential lender) under the guidance in ASC 815. For the holder of a commitment to originate a loan (the potential borrower), that commitment is not subject to the requirements of ASC 815.
Figure DH 3-8
Application of ASC 815 in the context of loan commitments
Application of ASC 815 in the context of loan commitments
Originated loan will be held for sale |
Originated loan will be held for investment |
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This scope exception does not affect the accounting for loan commitments to purchase or sell mortgage loans (or other types of loans) at a future date. Such commitments must be evaluated under the definition of a derivative to determine whether they should be accounted for in accordance with ASC 815. If they do, they are not afforded any scope exception.
3.2.12 Certain interest-only and principal-only strips
This scope exception is designed to be narrow and only applies to the simplest separations of interest payments and principal payments if the instrument is not a derivative in its entirety. The exception is limited to interest-only strips (IOs) and principal-only strips (POs) that (1) represent a right to receive specified contractual interest or principal cash flows of a specific debt instrument and (2) do not incorporate any terms not included in that debt instrument.
For example, the allocation of a portion of the interest and principal cash flows of a debt instrument to compensate another entity for stripping (i.e., separating the principal and interest cash flows) or servicing the instrument would meet the exception, as long as the servicing compensation was not greater than “adequate compensation,” as defined in the ASC Master Glossary. If the allocation of a portion of the interest or principal cash flows to provide for a guarantee or for servicing is greater than adequate compensation, the IO/PO would not meet the exception.
3.2.13 Leases
Per ASC 815-10-15-79, leases that are within the scope of ASC 840, Leases (ASC 842 after its effective date) are not derivatives subject to ASC 815. However, a lease may contain an embedded derivative feature that requires separate accounting under ASC 815-15-25-1. See a discussion of embedded derivatives in lease hosts in DH 4.6.3.
3.2.14 Residual value guarantees
A residual value guarantee is a guarantee made to a lessor that the value of an underlying asset returned to the lessor at the end of a lease will be at least a specified amount. A residual value guarantee contract meets the definition of a derivative because it:
- has an underlying and a notional amount,
- requires no initial net investment, and
- calls for net settlement in that the insured (the lessor) will receive a net payment for any difference between the residual value of the leased asset and the guaranteed amount.
However, ASC 815-10-15-80 exempts residual value guarantees that are subject to ASC 840 (ASC 842 after its effective date) from the requirements of ASC 815.
As stated in ASC 815-10-15-81, all other residual value guarantees need to be evaluated to determine whether they (1) are derivatives and (2) qualify for any of the scope exceptions in ASC 815. Certain residual value guarantee contracts issued by third-party guarantors, such as insurance companies, may qualify for the financial guarantee contracts scope exception discussed in DH 3.2.6; however, many may not meet the scope exception if they reference bluebook value or some other valuation not specific to the asset. If the guarantee obligation is not accounted for as a derivative within the scope of ASC 815, it is accounted for in accordance with ASC 460, Guarantees, which is discussed in FG 2.
3.2.15 Registration payment arrangements
Registration rights allow the holder to require that a reporting entity file a registration statement for the resale of specified instruments. They may be provided to lenders in the form of a separate agreement, such as a registration rights agreement, or included as part of an investment agreement, such as an investment purchase agreement, warrant agreement, debt indenture, or preferred stock indenture. These arrangements may require the issuer to pay additional interest if a registration statement is not filed or is no longer effective.
A contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement may meet the definition of a derivative. A payment provision could disallow the associated instrument or conversion feature from being afforded the scope exception for certain contracts for indexed to a reporting entity’s own equity.
To address this, the FASB provided a scope exception for such arrangements that are instead required to be separately recognized and measured in accordance with ASC 450-20-25. This scope exception applies to both the issuer of the arrangement and the counterparty. For further discussion of registration payment arrangements, see FG 1.7.1.
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