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January 23, 2011

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Scott Green

Tom:

Your post elicited a few thoughts-

I think one reason accountants have gotten tripped up about how to account for "executory contracts" is that they coopted this legal term to describe situations in which the parties have not begun fulfilling performance obligations under sales & service contracts. When the parties are in the initial position, theoretically they could just call the contract off. Therefore, it might be reasonable to not record assets or liabilities yet—everyone is even at zero until one party starts performing. The FASB's revenue recognition exposure draft has some thinking down these lines.

But the accountants then took the term "executory contract" that they adapted & began to circle back to the broader legal meaning, while retaining the accounting treatment for the narrower situation of contractual terms not begun on sales & service contracts.

For example, financing transactions (including many repo arrangements) have characteristics of executory contracts from a lawyer's perspective. However, the substance, which is what should concern accountants, is a financing transaction. Accountants are challenged to look beyond the legal form of a transaction to its substance, but borrowing a legal term for use in describing situations for accounting purposes does not help with this.

This is where your former accounting policymaker friend gets tripped up with the oil & t-shirt forward purchase commitments. As you point out, the key point is whether the contract can be settled net. If it can, this is a financial arrangement & the only future ("executory") matters might be a bit of paper suffling & transfer of a net payment at the time of settlement. (US GAAP literature tries to sort out this specific matter of whether purchase commitments are derivative instruments to be recorded on the balance sheet in its definition of derivative instruments & in the concept of "normal purchases & normal sales".)

BTW, I don't consider a lease to be an executory contract. Once the lessor turns the property over for use by the lessee, it has, in subtance, performed. It is not continuously turning over the property (how would you do that?) & it has no right to take it back, except in exceptional instances of default by the lessee. Leasing is purely a financial transaction. Of course, lessors often provide ancillary services, but these are distinct from the "lease part" of the arrangement.

Scott

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