Derivatives Implementation Group

Statement 133 Implementation Issue No. B37
[Previously No. C9]

QUESTION

Does mandatorily redeemable preferred stock issued by the reporting entity with payments that are denominated in either a precious metal or a foreign currency contain an embedded derivative under paragraphs 12, 15, 188, and 195 of Statement 133 that is required to be identified and separately accounted for as a derivative by the issuer?

BACKGROUND

A reporting entity issues $100,000 of mandatorily redeemable preferred stock whose preferred dividends are payable in cash but that requires redemption at the end of 1 year for a payment of 312 ounces of gold. Alternatively, the reporting entity issues $100,000 of mandatorily redeemable preferred stock whose redemption at the end of 1 year is payable only in a fixed amount of a specified foreign currency.

Paragraph 11(a) of Statement 133 provides that a reporting entity should not consider a contract to be a derivative instrument for purposes of Statement 133 if the contract is both (1) indexed to the reporting entity’s own stock and (2) classified in stockholders’ equity in the reporting entity’s statement of financial position. FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, was issued in May 2003. Statement 150 requires that mandatorily redeemable financial instruments in the form of shares, as defined in that Statement, be classified as liabilities, and not as temporary equity (which had been done previously). Consequently, this Issue does not address the application of paragraph 11(a).

Paragraph 15 of Statement 133 states, "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 [FASB Statement No. 52, Foreign Currency Translation,] 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."

Paragraph 188 of Statement 133 provides an example of a note contract with an embedded derivative linked to the price of gold. The gold-linked bull note, which is issued at par, has a fixed below-market 3 percent coupon interest rate and guarantees repayment of principal at maturity with upside potential if the price of gold increases. The gold-linked bull note can be viewed as combining an interest-bearing instrument with a call option contract. By purchasing the note at par rather than at the discount typically associated with the note’s below-market interest rate, the investor is effectively purchasing the call option that provides the investor with potential gains resulting from increases in gold prices. (That is, the difference between the typical discount and par is the premium paid for the call option.) Paragraph 188 states that because the option contract is indexed to the price of gold, it is not clearly and closely related to an investment in an interest-bearing note. Therefore, the embedded call option contract should be separated from the host contract and accounted for by both parties pursuant to the provisions of Statement 133. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. However, Statement 155 does not apply to hybrid instruments that are not financial instruments, such as nonfinancial instruments that require payments in a commodity, for example, gold. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.)

Paragraph 195 of Statement 133 provides an example of debt with an embedded foreign currency option. A U.S. lender makes a loan in U.S. dollars, the borrower's functional currency, and receives a note payable that bears an above-market interest rate and gives the borrower the option to repay the loan's principal in U.S. dollars or in a fixed amount of a specified foreign currency. The note payable can be viewed as combining a loan at prevailing market interest rates and a foreign currency option. In purchasing the borrower's note at par rather than at the premium typically associated with the note's above-market interest rate, the lender is being compensated for writing a foreign currency option exposing it to changes in foreign currency exchange rates during the outstanding period of the loan. Because the borrower has the option to repay the loan either 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 Statement 133 unless a fair value election is made pursuant to Statement 155. 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 Statement 133.

RESPONSE

Mandatorily Redeemable Preferred Stock Payable in Gold

The mandatorily redeemable preferred stock payable in gold contains an embedded derivative whose underlying is the price of gold. That embedded derivative should be separated from the host contract and accounted for as a derivative because the embedded derivative is not clearly and closely related to the host contract.

Foreign-Currency-Denominated Mandatorily Redeemable Preferred Stock

Mandatorily redeemable preferred stock whose periodic preferred "dividend" payments, redemption payment, or both are payable only in a stipulated amount of a specified foreign currency contain no embedded foreign currency derivative that warrants separate accounting under Statement 133. Instead, the reporting entity must apply the provisions of Statement 52 to the foreign-currency-denominated mandatorily redeemable preferred stock.

In contrast, if the holder of the mandatorily redeemable preferred stock had the choice of receiving, or the issuer had the choice of making, the redemption payment, the "dividend" payments, or both in either a stipulated amount of U.S. dollars or a stipulated amount of a specified currency, then that instrument contains an embedded foreign currency option that is subject to Statement 133. Because the reporting entity has the option to make payments in U.S. dollars or in a specified foreign currency, the provisions of paragraph 15 of Statement 133 are not relevant to that instrument. That embedded foreign currency option should be separated from the host contract and accounted for as a derivative because the embedded foreign currency option is not clearly and closely related to issuing preferred stock unless a fair value election is made pursuant to Statement 155.

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.