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.