Bob Jensen's Document on Executory Contracts, Purchase Contracts, and Loan Commitments

Unfortunately, FAS 133 defined a newly-invented (in FAS 133) equity account called "Firm Commitment" that differs from the definition of a "firm commitment contract."

The main difference in these two items is that a firm commitment contract may have an estimated and unbooked obligation of $1 billion where the Firm Commitment account may be much, much smaller. The Firm Commitment account is only based on value changes over time rather than the full fair value of an unbooked executory contract. The Firm Commitment account as defined in FAS 133 is only used for hedge accounting for fair value hedges of unbooked hedged items such as purchase/sales contracts and unbooked loan commitments.

Purchase and sales contracts are not generally booked until title passes. An example is a contract to purchase inventory in eight months at a fixed price. Such contracts are usually not booked until title changes hands. But value changes in those contracts may be hedged and the hedging contracts themselves must be carried at full fair value under FAS 133. Firm commitments contracts may also be unbooked in foreign currency situations such as explained in Paragraph 37 of FAS 133.

In other instances, executory contracts must be booked and carried at estimated fair values. SAB 105, FAS 133, and FAS 149 require that loan commitments meeting the definitions of a derivative in FAS 133 be booked before the loans are actually executed. Some, but not all, loan commitments executory contracts are to be carried as assets or liabilities as derivative financial instruments under FAS 133 rules --- http://www.sec.gov/interps/account/sab105.htm
Loan commitments not scoped into FAS 133 are discussed in Paragraph 291 of FAS 133 and SAB 105.
Bob Jensen's FAS 133 tutorials are at http://www.trinity.edu/rjensen/caseans/000index.htm

Booked loan commitments may be speculative, i.e., not hedged. The FASB and SEC require that changes in fair value of these loan commitments be charged to current earnings even though the value changes are unrealized --- http://www.sec.gov/interps/account/sab109.htm

Booked loan commitment fair value may be hedged. Since FAS 133 does not allow derivative financial instruments to get hedge accounting if they hedge other derivative financial instruments, FAS 133 technically makes it impossible to get hedge accounting when the booked loan commitments are hedged with other derivatives such as forward contracts. However, since the changes in value in a loan commitment and changes in value of its hedge pass simultaneously through earnings, the two changes offset to the extent that the hedge is effective. The net result is equivalent to getting hedge accounting without all the complexities of hedge accounting under FAS 133.

In summary, some executory contracts (like inventory and fixed asset purchase commitments) are not booked but they may be hedged with derivative contracts that get hedge accounting treatment under complicated FAS 133 rules. Other executory contracts (like loan commitments) are booked as derivative financial instruments and may get hedge accounting relief even though they are defined as derivative financial instruments such as when SAB 105 defined loan commitments as derivative financial instruments subject to FAS 133 accounting rules.

An executory contract is a contract that is not yet fully performed. Examples include purchase/sales contracts, leasing commitments before the lease goes into effect, and loan commitments. If the notional (quantity) and underlying (price or interest rate) are both specified in advance, the contract is called a "firm commitment." If the underlying is not specified in advance but is to be based on spot rates at the time of executing all or part of the contract, the contract is called a "forecasted transaction" under definitions of FAS 133 in the U.S. and IAS 39 internationally. Firm commitments and forecasted transactions are explained and linked to paragraph numbers under the "F-terms" by scrolling down at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms

For example, if Southwest Airlines signs a purchase contract to buy one million gallons (notional) of jet fuel in eight months from Exxon, the contract is a forecasted transaction if the price (underlying) of the jet fuel is to be the spot rate on the date the fuel is delivered. If the price (underlying) is specified in advance at $3.46 per gallon before delivery takes place, then the contract is a firm commitment. Similarly, if there's a loan commitment to to lend $10 million in six months, the loan is a firm commitment if the interest rate is contracted in advance and a forecasted transaction if the interest rate is to be the current market (spot) rate on the date funds change hands.

Firm commitment contracts give rise to fair value risk, and forecasted transaction contracts give rise to cash flow risk. Fair value risk and cash flow risk are defined at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Such risks can be hedged by converting fair value risk into cash flow risk or converting cash flow risk into fair value risk. Hedging usually takes place by acquiring derivative financial instruments (forward, futures, or swap contracts) that counter the executory contract risk. Risk can be changed by hedging but it's impossible to simultaneously eliminate both fair value and cash flow risk. One of these types of risks is inevitable in unhedged or hedged contracts.

In Accounting 101 we explain that executory contracts are not generally booked as assets or liabilities until they are executed in some form such as the passage of title or delivery of a leased item. There are complications such as timing of revenue recognition issues and frauds --- http://www.trinity.edu/rjensen/ecommerce/eitf01.htm
For example, when an item is purchased/sold the purchase and sale are generally booked when title (not necessarily cash) changes hands. But there are added complications such as Bill and Hold booking rules --- http://www.trinity.edu/rjensen/ecommerce/eitf01.htm#BillAndHold
In this document we will assume that contracts are actually booked as purchases/sales when title changes hands.

The example that I will use in this document is a long-term contract by Dow Jones to buy paper (newsprint) from St. Regis Paper Company for the next 50 years. This is called a long-term purchase/sales contract or commitment. Assume the following hypothetical facts (although there was a similar purchase/sales contract between these two companies).

Contract Date: June 1, 1986
Contract Term: 50 years
Present Value of Purchase/Sales Commitment: $1 billion on contract date (based on estimated future spot prices of forecasted transactions)

In Accounting 101 we explain that the estimated $1 billion is not booked as an asset by St. Regis or a liability by Dow Jones until paper is actually delivered on a particular date. Then part of the contract is executed and Dow Jones books the inventory and St. Regis books the sale. This begs the question of why the $1 billion is not booked as a liability by Dow Jones on June 1, 1986. The main reason is that there are so many contingencies over the life of this executory contract that the $1 billion obligation is too soft to book. If the contract is broken after being signed, the companies or courts negotiate a settlement that may be only a small fraction of $1 billion. Settlements are generally based upon estimated damages at the time the contract is broken. Certainly the damages are nowhere near $1 billion if the trees to be harvested for paper are not even planted.

Years ago the AICPA put out an obscure ARB 43 LCM ruling regarding the booking for large losses that highly appear likely under executory contracts. Under the Principle of Conservatism, companies must book anticipated losses that are deemed highly probable. Prior to FAS 133, the LCM rules for purchase commitments were prescribed by Accounting Research Bulletin (ARB) No. 43 (AICPA, Chapter 4, Paragraph 17) which reads as follows: "The net loss on such commitments should be measured the same way as inventory losses and, if material, should be recognized in the [financial statements]."
The ARB 43 LCM rules were controversial. See M.R. Gujarathi and S.F. Biggs, "Accounting for Purchase Commitments: Some Issues and Recommendations," Accounting Horizons, September 1988, pp. 75-82.

For example, journal-entry solutions before and after FAS 133 are illustrated in the quiz0107.xls Excel workbook at http://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/answers/WeeklyAssignments/quiz0107a.xls
For example look at the Problem 1 spreadsheet that compares pre-FAS 133 accounting (with and without discounting) versus post-FAS 133 accounting. Since this is illustrates a forward contract fair value hedge of a firm commitment contract to buy chromium, hte use of the "Firm Commitment" account is also illustrated in the post-FAS 133 solution. Of course the forward contract that is required to be booked after FAS 133 was not required to be booked prior to FAS 133. This is one of the main selling points of FAS 133.

We then ask how Problem 1 would differ for a loan commitment hedged item rather than a purchase contract to buy chromium. First we not the main paragraph of SAB 105 --- --- http://www.sec.gov/interps/account/sab105.htm

In summary, the loan commitment must in some instances be booked at fair value and in other instances it may be booked at fair value under the Fair Value Option (FVO) in FAS 159. However, FAS 159 makes fair value booking optional when it is not required under SAB 105, FAS 133, and FAS 149.

Now consider the case where the loan commitment is booked. In other words, the loan commitment is booked before the contract is executed (unlike the purchase commitment to buy chromium in the future). Unrealized changes in value of a booked loan commitment go to current earnings. A forward contract hedge of a booked loan commitment cannot get hedge accounting treatment because FAS 133 does not allow hedge accounting when the hedging item hedges another derivative, and loan commitments that are booked are deemed derivatives under SAB 105, FAS 133, and FAS 149.

If the booked loan commitment is hedged with a forward contract, changes in the fair value of the forward contract also go to current earnings. However, since changes in fair value of the loan commitment are ideally offset exactly by changes in value of the forward contract, the net change in earnings for the hedged item plus the hedge contract should be a zero change in earnings levels. This will not be the case only to the extent where the hedge is deemed ineffective. I think it is possible to net the two changes in value in one journal entry. For example, suppose the forward contract hedge of a booked loan commitment is only 90% effective:

If there was no forward contract hedge, the journal entry would be as follows for a booked loan commitment under SAB 105, FAS 133, and FAS 149:

If the loan commitment had instead never been booked (e.g., because it has no net settlement provision under Paragraph 37 of FAS 133), the following entry might be made to record a forward contract hedge that is 90% effective (recall that the FASB invented the "Firm Commitment" account as an equity item to keep changes in value of a fair value hedging derivative out of current earnings if the hedge qualifies under FAS 133 for fair value hedge accounting):

Cash flow hedges would use OCI instead of the Firm Commitment account used for fair value hedges.

If there was no forward contract hedge, the journal entry might have been as follows under ARB 43:

Although the IAS 39 international equivalent was initially silent about loan commitments in 1998, my reading of subsequent happenings in international standards is that loan commitments are more likely to be booked at fair value even if they do not have net settlement provisions. You can read the following at http://www.cfainstitute.org/centre/issues/comment/2002/02improve_ias32-39.html

Part of a November 26, 2007 email question from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU]