Derivatives Implementation Group
Statement 133 Implementation Issue No. B21
| Title: |
Embedded Derivatives: When
Embedded Foreign Currency Derivatives Warrant Separate
Accounting |
| Paragraph
reference: |
15 |
| Date cleared by
Board: |
June 28, 2000 |
| Date revision posted to website: |
May 1, 2003 |
| Affected by: |
FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
(Revised March 26, 2003) |
QUESTIONS
- How does the bifurcation exception for foreign
currency derivatives in paragraph 15(a) of Statement 133 apply when
the contract's payments are denominated in a currency that is not
the functional currency of any substantial party to the contract
but is used pursuant to paragraph 11 of FASB Statement No. 52,
Foreign Currency Translation, as if it were the functional
currency to remeasure the financial statements of a substantial
party to the contract due to that party's primary economic
environment being highly inflationary? What is the impact on the
application of paragraph 15(a) if the economy of that primary
economic environment later ceases to be highly inflationary? (See
Examples 1 and 1A below)
- Is a guarantor a substantial party to the
contract under paragraph 15(a)? (See Example 2 below)
- How should the phrase routinely denominated in international
commerce in paragraph 15(b) be applied? Should the application
of that phrase be based on how similar transactions for a certain
product or service in international commerce are routinely
structured around the world or just within the local area of one of
the substantial parties to the contract? How does that phrase apply
to Example 3, in which the lease payments for private lease
transactions for real or personal property are denominated in U.S.
dollars even though the substantial parties to the lease do not
have the U.S. dollar as their functional currencies?
BACKGROUND
Paragraph 15 of Statement 133, as amended by Statement 149, states:
An embedded foreign currency derivative instrument shall not be separated from the host contract and considered a derivative instrument under paragraph 12 if the host contract is not a financial instrument and it requires payment(s) denominated in (a) the functional currency of any substantial party to that contract, (b) the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions)*, (c) the local currency of any substantial party to the contract, or (d) the currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary (as discussed in paragraph 11 of Statement 52). The evaluation of whether a contract qualifies for the exception in this paragraph should be performed only at inception of the contract. Unsettled foreign currency transactions, including financial instruments, that are monetary items and have their principal payments, interest payments, or both denominated in a foreign currency are subject to the requirement in Statement 52 to recognize any foreign currency transaction gain or loss in earnings and shall not be considered to contain embedded foreign currency derivative instruments under this Statement. The same proscription applies to available-for-sale or trading securities that have cash flows denominated in a foreign currency.
_____________________
*If similar transactions for a certain product or service are routinely denominated in international commerce in various different currencies, the transaction does not qualify for the exception.
Statement 52 defines functional currency as
the currency of the primary economic environment in which the
entity operates; normally, that is the currency of the environment
in which an entity primarily generates and expends cash. Paragraph
11 of Statement 52 requires the financial statements of foreign
entities in highly inflationary economies to be remeasured as
if the functional currency were the reporting currency. For
example, if a U.S. parent company (for which the U.S. dollar is
both the functional currency and the reporting currency) had
concluded that the Venezuelan bolivar was the functional currency
of its Venezuelan subsidiary but the Venezuelan economy was
considered highly inflationary under the criteria in paragraph 11,
the subsidiary's financial statements would be remeasured as though
the U.S. dollar were its functional currency.
The following examples are relevant to the questions
posed:
Example 1: The payments are denominated in a
currency that, while not the functional currency, is used as if it
were the functional currency due to a highly inflationary
economy
A U.S. parent company for which the U.S. dollar is both the
functional currency and the reporting currency has a Venezuelan
subsidiary. The subsidiary's sales, expenses and financing are
primarily denominated in the Mexican peso and therefore the
subsidiary considers the peso to be its functional currency as
required by Statement 52. However, assume that the economy in
Mexico is highly inflationary and therefore Statement 52 requires
that the parent company's reporting currency (that is, the U.S.
dollar) be used as if it were the subsidiary's functional currency.
The subsidiary enters into a lease with a Canadian company for
property in Venezuela that requires the subsidiary to make lease
payments in U.S. dollars. Further, assume that the Canadian
company's functional currency is the Canadian dollar. The
Venezuelan subsidiary's local currency is the bolivar.
Example 1A: The economy of the primary economic
environment ceases to be highly inflationary after the inception of
the contract
Assume the same facts as discussed in Example 1 except that during
the term of the property lease, the Mexican economy ceases to be
highly inflationary. Therefore, the Venezuelan subsidiary's
financial statements cease to be remeasured as if the U.S. dollar
were the functional currency and, instead, those financial
statements are remeasured using the subsidiary's functional
currency, the Mexican peso.
Example 2: A guarantor as a substantial party to
the contract
A U.S. parent company for which the U.S. dollar is the functional
currency has a French subsidiary with a Euro functional currency.
The subsidiary enters into a lease with a Canadian company for
which the Canadian dollar is the functional currency that requires
lease payments denominated in U.S. dollars. The parent company
guarantees the lease.
Example 3: Understanding the application of the
phrase routinely denominated in international
commerce
A real estate lease negotiated privately between companies
involved in international commerce in certain South American
economies would routinely require U.S. dollar payments. Real estate
leases negotiated privately between companies involved in
international commerce in European economies would routinely not
require U.S. dollar payments. The lessee is a Canadian company that
uses the Canadian dollar as its functional currency. The lessor is
a Venezuelan company whose functional currency is the Mexican peso.
The lease payments are denominated in U.S. dollars.
RESPONSE
Question 1
Paragraph 15 of Statement 133, as amended by Statement 149, states that an
embedded foreign currency derivative instrument should not be
separated from the host contract and considered a derivative
instrument under paragraph 12 if the host contract is not a
financial instrument and it requires payment(s) denominated in one
of the following currencies:
- The functional currency of any substantial party to that contract
- The currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions)
- The local currency of any substantial party to the contract
- The currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary (as discussed in paragraph 11 of Statement 52).
If a contract's payments are denominated in one of
those currencies, then that foreign currency is integral to the
arrangement and thus considered to be clearly and closely related
to the terms of the contract. The evaluation of whether a contract
qualifies for the exception in paragraph 15 is performed only at
inception of the contract.
The exception in paragraph 15 applies to the
contract in Example 1 because the subsidiary uses the U.S. dollar
as if it were the functional currency. The conclusion is not
affected by the fact that the U.S. dollar is not the currency of
the primary economic environment in which either the Venezuelan
subsidiary or the Canadian lessor operates (that is, the U.S.
dollar is not the functional currency of either party to the
lease). The forward contract to deliver U.S. dollars embedded in
the lease contract should not be bifurcated from the lease host.
The exception in paragraph 15 would apply to the lease contract
in Example 1 if the payments under that contract were denominated
in any of the following four currencies: (1) the U.S. dollar, (2)
the Mexican peso, (3) the Venezuelan bolivar, or (4) the Canadian
dollar. The exception applies to both of the substantial parties to
the contract, the lessor and the lessee.
In Example 1A, when the lease was entered into, the
subsidiary used the U.S. dollar as if it were the functional
currency; therefore, the foreign currency embedded derivative would
have qualified for the exception in paragraph 15 for both the
lessor and the lessee. The fact that the subsidiary subsequently
ceased using the U.S. dollar as if it were the functional currency
and, instead, now uses the peso (which was outside the control of
management of the entity because it is contingent upon a change in
the Mexican economy) does not affect the application of the
exception because the subsidiary qualified for the exception at the
inception of the contract. However, if the subsidiary would enter
into an extension of the lease or a new lease that required
payments in the U.S. dollar, the exception would not apply because
at the time the new or extended lease was entered into, the
subsidiary no longer used the U.S. dollar as if it were the
functional currency.
Question 2
No, the exception in paragraph 15(a) does not apply to the contract
in Example 2. The substantial parties to a lease contract are the
lessor and the lessee; a third-party guarantor is not a substantial
party to a two-party lease, even when it is a related party (such
as a parent company). Thus, the functional currency of a guarantor
is not relevant to the application of paragraph 15(a).
Question 3
The application of the phrase routinely denominated in
international commerce in paragraph 15(b) should be based on
how similar transactions for a certain product or service are
routinely structured around the world, not just in one local area.
Therefore, if similar transactions for a certain product or service
are routinely denominated in international commerce in various
different currencies, the exception in paragraph 15(b) does not
apply to any of those similar transactions (as noted in the footnote to paragraph 15). The evaluation of
whether a contract qualifies for the exception in paragraph 15(b)
is performed only at inception of the contract.
In Example 3, because real estate leases around the
world are not routinely denominated in U.S. dollars, the leasing
transaction would not qualify for the exception in paragraph
15(b).
At its June 28, 2000 meeting, the Board reached the
above answers.
The above response has been authored by the FASB
staff and represents the staff's views, although the Board has
discussed the above response at a public meeting and chosen not to
object to dissemination of that response. Official positions of the
FASB are determined only after extensive due process and
deliberation.
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