What is a Derivative Part 5 Net Settlement continued

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Last week I discussed net settlement by means of contractual net settlement and by a market mechanism. Today I will talk about the characteristic called readily convertible to cash.

Under readily convertible to cash, 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 (FASC 815-10-15-122). For example, a stock traded on the NYSE (New York Stock Exchange) or a commodity forward sold on the ICE (Intercontinental Exchange).

In deciding whether an asset is readily convertible to cash, you need to calculate the conversion cost. Conversion costs are the costs that would be incurred to get the asset to a physical market to be sold. These costs are mostly going to be transportation cost. For example, if you had a forward contract for a type of coal that is only used in India, you would need to calculate the costs of getting it from the mine to India. These transportation costs would like by over the 10% of the gross sales proceeds and the derivative would not be considered readily convertible to cash. However, a type of coal that is used frequently within the United States would probably qualify as the mine probably ships to these locals on a regular basis. (The company I worked for had this situation when they needed to ship coal to a foreign subsidiary.)

If you have a forward contract to purchase power over a five-year period, you would need to look at each delivery date to determine if an active market exists for the asset.

For instance, if forward prices do not exist for years 3 to 5 of the contract, but a spot market is likely to exist out that far, then the asset would still be considered readily convertible to cash even though the outlying years do not have any quoted forward prices.

The determination of whether an asset is readily converted to cash must be re-addressed each reporting period. Therefore, if a market evolves for the asset under contract, the contract could become a derivative in the future.

For example, shares from a new IPO may not have an active market at the time of the IPO, but the market could evolve as the company becomes more profitable. Also, if a certain type of coal is not considered readily convertible to cash because of its impurity content, it could become readily convertible to cash when new environmental equipment is developed.

Net settlement is very nuanced and often hard to figure out. The best you can do is document a reasoned argument and try to get your auditor to agree with you. Sometimes it is interesting to walk in the gray area of the accounting rules.

This is the last post on determining whether a contract is a derivative or not. Not week I may talk about embedded derivatives or maybe hedge accounting. So many fun concepts to talk about.