Derivatives Implementation Group

Statement 133 Implementation Issue No. B33

QUESTION

Is an embedded foreign currency option that merely introduces a cap or floor on the functional currency equivalent price under a purchase contract eligible for the exclusion in paragraph 15 that requires, in certain circumstances, that an embedded foreign currency derivative instrument not be separated from a host nonfinancial instrument contract (and considered a derivative instrument) under paragraph 12?

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.

Paragraph 311 of the basis for conclusions indicates that "the Board decided that it was important that the payments be denominated in the functional currency of at least one substantial party to the transaction to ensure that the foreign currency is integral to the arrangement and thus considered to be clearly and closely related to the terms of the lease." Statement 133 Implementation Issue No. B4, "Foreign Currency Derivatives," further clarifies "it follows that the exception provided by paragraph 15 implicitly requires that the other aspects of the embedded foreign currency derivative must be clearly and closely related to the host."

Paragraph 195 of Appendix B describes an example of the scope application of Statement 133 for a short-term loan with a foreign currency option. Paragraph 195 states:

    A U.S. lender issues a loan at an above-market interest rate. The loan is made in U.S. dollars, the borrower's functional currency, and the borrower has the option to repay the loan in U.S. dollars or in a fixed amount of a specified foreign currency.

    Scope Application: This instrument can be viewed as combining a loan at prevailing market interest rates and a foreign currency option. The lender has written a foreign currency option exposing it to changes in foreign currency exchange rates during the outstanding period of the loan. The premium for the option has been paid as part of the interest rate. Because the borrower has the option to repay the loan in U.S. dollars or in a fixed amount of a specified foreign currency, the provisions of paragraph 15 are not relevant to this example. Paragraph 15 addresses foreign-currency-denominated interest or principal payments but does not apply to foreign currency options. Because a foreign currency option is not clearly and closely related to issuing a loan, the embedded option should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Statement. In contrast, if both the principal payment and the interest payments on the loan had been payable only in a fixed amount of a specified foreign currency, there would be no embedded foreign currency derivative pursuant to this Statement.

Example

On March 1, 20X0, Company A enters into a Japanese yen-denominated forward purchase agreement to purchase a specified quantity of widgets in six months from Company B. Company A's functional currency is USD and Company B's functional currency is JPY. The spot JPY/USD foreign exchange rate at the inception of the agreement is USD1.00 equals JPY110. Company A wishes to collar its foreign exchange rate risk by ensuring that it will never pay more than the JPY equivalent to USD11.00 per widget in return for committing to Company B that it will never pay less than the JPY equivalent to USD8.80 per widget. The agreement defines the price according to the following schedule:

Company A is exposed to foreign exchange risk in the range between JPY100 and JPY125 whereas Company B is exposed outside that range. The following are various scenarios:

In essence, Company A has not locked in a USD price or a JPY price for the purchased widgets. Instead, as desired, Company A has locked in a price range in its functional currency (USD) between $8.80 and $11.00 for the purchased widgets. The final price to be paid within this range will be determined based upon the JPY/USD foreign exchange rate. Based on the terms, the contract contains an embedded cap and floor (options). For purposes of this example, assume that the combination of options represents a net purchased option for Company A.

RESPONSE

Yes. The discussion in paragraph 15 relating to embedded foreign currency derivative instruments within nonfinancial contracts was intended to relate to all embedded foreign currency caps or floors within such contracts.

The embedded foreign currency cap or floor (or combination thereof) within a nonfinancial contract would be considered clearly and closely related to the host nonfinancial contract, and thus not be accounted for separately as a derivative, only if (1) the nonfinancial contract requires payment(s) denominated in any of the currencies permitted by paragraphs 15(a)–(d), (2) the embedded cap or floor (or combination thereof) does not contain leverage features, and (3) the embedded cap or floor (or combination thereof) does not represent a written or net written option.

In the example provided in the background section, since (1) the options are denominated in JPY/USD (the functional currencies of both parties to the contract), (2) there is no leverage feature within the option contracts, and (3) the combination of foreign currency options represents a net purchased option, the embedded foreign currency options within Company A's purchase contract would qualify for the exclusion for purposes of Company A's accounting.

However, when an embedded cap or floor (or combination thereof) represents a purchased or net purchased option to one party to the contract, it would represent a written or net written option to the counterparty to that contract. In that case, that counterparty could not qualify for the paragraph 15 exclusion because criterion #3 above would not be met (due to the embedded foreign currency cap or floor (or combination thereof) representing a written or net written option). However, if the embedded derivative represented a zero-cost collar (as described in Statement 133 Implementation Issues No. E2, "Hedging-General: Combination of Options," or No. E5, "Hedging-General: Complex Combinations of Options," as appropriate), both parties to the contract would meet criterion #3 above and be eligible to qualify for the exclusion.

The example provided in paragraph 195 illustrates a financial instrument that contains an embedded foreign currency option contract that permits repayment of the loan in a fixed amount of a specified currency that is not the functional currency of either party to the contract. In contrast, the options in the example for this Issue are embedded within a nonfinancial instrument and are denominated in JPY/USD (the functional currencies of both parties to the contract). Consequently, the example in paragraph 195 is not relevant to this Issue.

In addition, if a financial or nonfinancial contract contained an option that allowed the payer to remit funds in an equivalent amount of a currency other than the functional currency of a substantial party to the contract at the payment date, that option would not need to be separated from the host contract because the option merely allows the payer to make an equivalent payment in a choice of currencies (based on current spot prices).

The discussion in paragraph 15 relating to embedded foreign currency derivative instruments within nonfinancial contracts was not intended to relate to all embedded foreign currency options within such contracts. The guidance in this issue is not meant to address every possible type of foreign currency option that may be embedded in a nonfinancial contract and an analogy to the response included in this issue may not be appropriate for such foreign currency options.

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.