Definition relating to hedge accounting
A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.
An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:
- The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity’s functional currency or of foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
- The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the non-defaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.
Application of the Definition
This implementation guidance discusses whether certain items meet the definition as included above.
A firm commitment that represents an asset or liability that a specific accounting standard prohibits recognising (such as a lessor’s non cancellable operating lease or an unrecognised mortgage servicing right) may nevertheless be designated as the hedged item in a fair value hedge.
A mortgage banker’s unrecognised interest rate lock commitment does not qualify as a firm or best effort commitment (because as an option it does not obligate both parties) and thus is not eligible for fair value hedge accounting as the hedged item. (However, a mortgage banker’s forward sale commitments, which are derivative instruments that lock in the prices at which the mortgage loans will be sold to investors, may qualify as hedging instruments in cash flow hedges of the forecasted sales of mortgage loans.)
Examples of firm commitments that could be eligible for designation as hedged items include:
- an agreement to purchase a specified quantity of assets at a specified price and date;
- an agreement to purchase a particular machine in one year at a specified price; and
- a royalty agreement that provides for fixed periodic payments at specific time intervals; if no minimum amount is specified, the agreement would not meet the definition of a firm commitment because the quantity to be exchanged would be unknown.
Agreement is between two unrelated parties
A firm commitment must be between two unrelated parties. As a result, transactions with parties such as equity method investees, affiliates, unconsolidated joint ventures, consolidated entities, shareholders and directors are excluded from being firm commitments.
Agreement is binding or (legally) enforceable on both parties
To meet the definition of a firm commitment, the agreement must be binding on both parties. The IASB noted that an agreement that is binding on one party but not the other is an option rather than a firm commitment. They believe the fundamental nature of a financial instrument should not be ignored. Firm commitments that meet the definition of a derivative (e.g. options) are not eligible to be designated in a fair value hedge.
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