Derivatives Implementation Group

Statement 133 Implementation Issue No. H5

QUESTION

If an agreement to sell a nonfinancial asset that qualifies as a normal sale in accordance with paragraph 10(b) of Statement 133 requires payment in a foreign currency, may the seller choose to hedge its exposure to foreign currency risk under the cash flow hedging model if the agreement meets Statement 133's definition of a firm commitment? If the agreement does not meet Statement 133's definition of a firm commitment but contains a foreign-currency-denominated fixed price, may the seller hedge the exposure to foreign currency risk under either the fair value hedging model or the cash flow hedging model?

Examples of the alternative structures are described below:

Scenario 1-A Firm Commitment
On January 1, an entity enters into an agreement to sell 1,000 tons of a nonfinancial asset to an unrelated party on June 30. The agreement meets the definition of a firm commitment in paragraph 540 of Statement 133. The firm commitment is denominated in the buyer's functional currency, which is not seller's functional currency. Accordingly, the firm commitment exposes the seller to foreign currency risk. It is clear under Statement 133 that the seller may hedge the foreign currency exposure arising from the firm commitment under the fair value hedging model. May the seller choose to hedge that foreign currency exposure under the cash flow hedging model?

Scenario 2-A Fixed-Price Agreement
On January 1, an entity enters into an agreement to sell 1,000 tons of a nonfinancial asset to an unrelated party on June 30. Although the agreement in this scenario does not meet the definition of a firm commitment in paragraph 540 of Statement 133, the seller's assessment of the observable facts and circumstances is that performance under the agreement is probable. The agreement is denominated in the buyer's functional currency, which is not seller's functional currency. Accordingly, the foreign-currency-denominated fixed-price agreement exposes the seller to foreign currency risk. May the seller choose to hedge that foreign currency risk under either the fair value hedging model or cash flow hedging model?

BACKGROUND

Paragraph 540 of Statement 133 includes the following definitions:

Firm commitment

An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

1. 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 a foreign currency. It may also be expressed as a specified interest rate or specified effective yield.

    

2. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.

Forecasted transaction

A transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices.

Paragraph 442 elaborates on the definition of a firm commitment:

     The definition of a firm commitment in this Statement requires that the fixed price be specified in terms of a currency (or an interest rate) rather than an index or in terms of the price or a number of units of an asset other than a currency, such as ounces of gold. 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. To avoid such a situation, the Board decided that it was necessary to require that the fixed price in a firm commitment be specified in terms of a currency or a rate. A similar situation can exist for a firm commitment that is denominated in a foreign currency if the price of the item to be purchased or sold varies with changes in exchange rates. The Board accepted that possibility because it had been accepted under Statement 52, and it did not want to undertake a complete reconsideration of the hedging provisions of that Statement at this time. Therefore, the price may be specified in any currency-it need not be in the entity's functional currency.

RESPONSE

Scenario 1-A Firm Commitment
The seller may hedge its exposure to foreign currency risk under the cash flow hedging model even though the agreement meets Statement 133's definition of a firm commitment. Although that definition of a firm commitment requires a fixed price, it permits the fixed price to be denominated in a foreign currency. Consequently, a firm commitment can expose the parties to variability in their functional-currency-equivalent cash flows. The reference in Statement 133's definition of a forecasted transaction indicating that a forecasted transaction is not a firm commitment focuses on firm commitments that have no variability. The reference is not intended to preclude a cash flow hedge of the variability in functional-currency-equivalent cash flows when the commitment's fixed price is denominated in a foreign currency. The definition of a forecasted transaction also indicates that the transaction or event will occur at the prevailing market price. From the perspective of the hedged risk (foreign exchange risk), the translation of the foreign currency proceeds from the sale of the nonfinancial assets will occur at the prevailing market price (that is, current exchange rate). Accordingly, in Scenario 1, the seller may hedge the foreign currency exposure arising from the firm commitment to sell 1,000 tons of the nonfinancial asset under the cash flow hedging model, even though the seller has previously hedged its foreign currency exposure arising from another similar firm commitment under the fair value hedging model.

Scenario 2-A Fixed-Price Agreement
If the agreement does not meet Statement 133's definition of a firm commitment, but contains a fixed foreign-currency-denominated price, the seller may not hedge the foreign currency risk relating to the agreement to sell the nonfinancial asset under the fair value hedging model because the agreement is not a recognized asset, a recognized liability, or a firm commitment (as defined in Statement 133), which are the only items that can be designated as the hedged item in a fair value hedge.

However, the seller may hedge the foreign currency risk relating to the agreement under the cash flow hedging model. The agreement is by definition a forecasted transaction because the sale of the nonfinancial assets will occur at the prevailing market price, that is, the fixed foreign-currency-denominated market price converted into the seller's functional currency at the prevailing exchange rate when the transaction occurs. Therefore, because the agreement includes a fixed foreign-currency-denominated price, the agreement exposes the seller to variability in the functional-currency-equivalent cash flows. Accordingly, in Scenario 2, the seller may not hedge the foreign currency risk relating to the agreement to sell 1,000 tons of the nonfinancial asset under the fair value hedging model but may hedge the foreign currency risk under the cash flow hedging model.

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.