Derivatives Implementation Group

Statement 133 Implementation Issue No. J17

QUESTION

Should the transition adjustment resulting from adopting Statement 133 for the hedge of a foreign-currency-denominated intercompany "firm commitment" with a forward exchange contract (or net purchased forward currency option) be reported as a cumulative-effect-type adjustment of net income as a fair-value-type hedge or as a cumulative-effect-type adjustment appropriate for a cash-flow-type hedge?

BACKGROUND

A multinational U.S. parent has several foreign subsidiaries. The subsidiaries use forward exchange contracts (or net purchased forward currency option contracts) to hedge intercompany "firm commitments" denominated in currencies other than their own functional currencies. The hedging relationships meet the requirements of pre-Statement 133 GAAP, specifically EITF Issue No. 91-1, "Hedging Intercompany Foreign Currency Risks," and No. 95-2, "Determination of What Constitutes a Firm Commitment for Foreign Currency Transactions Not Involving a Third Party." Accordingly, the entity is deferring the gains and losses on the forward exchange contracts (or net purchased forward currency option contracts) and amortizing the premiums and discounts (or premiums on the purchased options) to earnings over the life of the contracts. At the date of initial application of Statement 133, however, the hedging relationships will not qualify as hedges of firm commitments because the definition of a firm commitment within paragraph 540 requires that the agreement must be with an unrelated party and the commitments in this fact pattern are intercompany agreements. Accordingly, provided all the requirements are met, the entity would have to designate these hedging relationships as cash flow hedges at the date of initial application.

The following example illustrates the hedging relationships:

    Euro-functional-currency Subsidiary A has a firm commitment to sell its finished product to Yen-functional-currency Subsidiary B in April 2001 and receive Yen for the sale. On July 1, 2000, Subsidiary A enters into a receive Euro/pay Yen forward exchange contract maturing in April 2001. The contract has a total premium of Euro 450. On January 1, 2001 (that is, the date of Statement 133 adoption), the forward contract has a deferred loss of Euro 10,000 and an unamortized premium of Euro 150. The forward contract's fair value under Statement 133 on January 1, 2001 is a liability of Euro 9,800. Pre-Statement 133, the entity has made the following cumulative journal entries:

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¹Prior to being amended by Statement 133, paragraphs 18 and 21 of Statement 52 did not require amortization of the forward premium or discount when the gain or loss on the forward contract is deferred as the contract is intended to hedge an identifiable foreign currency commitment. Instead, Statement 52 permitted the forward contract's discount or premium that related to the commitment period to be included in the measurement of the basis of the related foreign currency transaction when recorded.

Paragraph 52 of Statement 133 indicates that the reporting of the transition adjustment is based on the type of hedging relationship (either fair-value-type or cash-flow-type) that existed for the derivative instrument and that was the basis for accounting under generally accepted accounting principles before the date of initial application of Statement 133. Prior to adopting Statement 133, the entity was hedging an intercompany "firm commitment" as indicated in EITF Issue Nos. 91-1 and 95-2. Applying the notions of a fair-value-type hedge or a cash-flow-type hedge in that circumstance is confusing because the aforementioned EITF issues permit an entity to hedge the foreign currency risk inherent in a foreign-currency-denominated intercompany "firm commitment" (which appears to be more akin to a fair-value-type hedge), yet Statement 133 does not consider an intercompany commitment to be firm because it is not an agreement with an unrelated party; consequently, the foreign currency risk inherent in an intercompany agreement can only be hedged under the cash flow model under Statement 133.

RESPONSE

The transition adjustment for the derivative at the date of adoption should be allocated between the cumulative-effect-type adjustment of net income and the cumulative-effect-type adjustment of accumulated other comprehensive income, as discussed in Statement 133 Implementation Issue No. J15, "Pre-Existing Hedge Ineffectiveness of a Derivative," for cash-flow-type hedges. Although using a forward exchange contract (or net purchased forward currency option contract) to hedge a foreign-currency-denominated intercompany "firm commitment" prior to adopting Statement 133 may initially appear to be akin to a fair value hedge, the prohibition in Statement 133 against considering an intercompany agreement as a "firm commitment" requires that, for transition purposes, the hedge of a foreign-currency-denominated intercompany "firm commitment" with a forward exchange contract (or net purchased forward currency option contract) be considered to be akin to a cash flow hedge of the variability of the functional-currency-equivalent cash flows under that intercompany agreement.

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.