What is a Derivative? Part 3 Net Settlement and NPNS

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In Parts 1 and 2, we discussed the underlying (price), the notional (quantity), and the initial net investment. These three characteristics of a contract being a derivative are generally easy to find and most contracts will pass the first three tests.

If these three characteristics are in almost every contract, why aren't more contracts considered derivatives? The fourth characteristic and the one that pulls most contracts out of derivative accounting is net settlement.

Per FASC 815 net settlement is the means by which the contract terms require or permit settlement in a net form. In non-financial terms, the entity in a loss position pays the entity in a gain position. Under FASC 815, there are three ways a contract can net settle.

1. Contractually, meaning the contract states that the parties will net settle on the settlement date of the contract. This is how most interest rate swaps and foreign exchange swaps work. If the entity is on the fixed side of the swap, and the rate goes down, they will owe the counterparty the difference between the current rate and the contract rate. In essence they have a loss because they could have financed debt at a lower rate without the swap. (This is a simplified explanation, they would actually finance debt at the lower rate, but they would also owe the loss on the swap, so they end up paying the higher rate. More to come when we discuss hedging.)

2. By delivery of an asset that puts the recipient in a position not substantially different from net settlement. This one is not common. It involves settling the contract in some way not related to the underlying. The example FASB uses is a structured payout of the gain or loss. The payment is not given immediately but paid over a specified amount of time.

3. Settlement is made with an asset that is readily converted to cash. This is very common in commodity contracts. The entity does not receive cash, but the commodity they receive can be easily sold to get cash. For example: gold or oil. Even if the commodity that you are buying or selling, is considered readily convertible to cash, you may still be able to avoid derivative accounting. (I will discuss what "derivative accounting" involves in later posts.) FASB gives us a scope exception called "Normal Purchase Normal Sale (NPNS)"

The normal purchase normal sale scope exception requires 4 conditions.

1. The contract must be for a nonfinancial item that the entity normally uses in its business. Example, you are a paper manufacturer, and you have a contract to buy lumber to turn into paper.

2. It must be probable that the entity will take physical delivery of the asset. If the paper manufacturer sometimes sells the lumber before taking physical delivery because they have enough lumber on hand, then they would fail this condition and the contract might be considered a derivative. (I say might, because there are so many exceptions, that you really have to read the contract to make a definitive decision.) This condition is an issue in the energy markets because the different companies' contracts will be net settled during the transmitting phase. (There is a scope exception for this also.)

3. Any price adjustments must be clearly and closely related to the asset being sold. For example, a fuel surcharge would be considered clearly and closely related because fuel is required to get the asset to the purchasing entity. A price adjustment related to the Consumer Price Index would be considered clearly and closely related because it is tied to inflation. However, if you are buying lumber and the price adjustment is related to the price of gold, it is not clearly and closely related. This price adjustment would have to be bifurcated (separated) from the rest of the contract and would receive derivative accounting. We call this an "embedded derivative". (More on this later.)

4. Documentation. Document, document, document. If it isn't documented, it didn't happen. The normal purchase normal sale scope exception is a policy choice. You don't get it automatically under US GAAP, so you have to formally document that you are taking the exception for a contract or for a group of similar contracts. (If you have a lot of lumber contracts, you don't have to document each one, you can do a blanket policy.) Important note: once you elect the normal purchase normal sale exception, you can not reverse the election.

Whoosh, that was a lot and we haven't even started delving into net settlement. I never know where the blog is going to take me. I just go wherever the blog is leading me.

Remember, if you need a bookkeeper, please go to my website at www.codexbookkeepingservices.com.