Derivatives Implementation Group

Statement 133 Implementation Issue No. J18

QUESTION

How should the adjustment upon adoption of Statement 133 related to a company's foreign-currency-denominated debt and foreign-currency-denominated royalty that were being accounted for pursuant to the provisions of EITF Issue No. 88-18, "Sales of Future Revenues," be presented in the financial statements? Specifically, in the fact pattern that follows, is Company X required to record a cumulative-effect-type adjustment in earnings or in other comprehensive income to reflect the outstanding balance on the yen-based loan (and the yen-based receivable for the previous month's royalty paid in arrears) at the current yen/dollar exchange rate upon adoption of Statement 133?

BACKGROUND

Company X, whose functional currency is the U.S. dollar, had an area license agreement with its Japanese area licensee (Company Y) pursuant to which Company X receives yen-denominated royalties from Company Y on a monthly basis based on Company Y's sales. Company X and Company Y are related parties in that they share a common parent company.

Subsequent to the inception of this area license agreement, Company X had borrowed yen from third-party lenders and assigned the royalty stream from Company Y as a basis for repayment. The debt is nonrecourse to Company X. The yen-denominated royalty had been designated as a hedge of the future yen-denominated principal and interest payments due on the yen-denominated loan for accounting purposes (pursuant to the provisions of Issue 88-18 as discussed below). Payments of interest and principal on the yen-denominated loan have been consistently made over past years from the yen-denominated royalty. There are no indications that this situation will not continue as Company Y's sales have continued to increase on an annual basis.

Company X had historically accounted for the yen-denominated loan and royalty pursuant to the provisions of Issue 88-18. As such, foreign currency transaction gains and losses on the debt (and the royalty) have not been recognized. The yen-denominated loan (and the related interest expense) have been consistently translated at the rate in effect upon inception of the debt (and the designation of the royalty as a hedge of foreign currency fluctuation exposure on the debt). The yen-denominated royalties have also been consistently recorded in Company X's financial statements based on the yen/dollar exchange rate in effect upon inception of the debt.

Statement 133 has superseded the provisions of Issue 88-18 that relate to the hedge-type accounting treatment previously afforded Company X in this situation. Thus, in spite of the existence of a perfect economic hedge of foreign currency exposure on the yen-denominated based loan, Company X will be required, upon the adoption of Statement 133, to begin recognizing foreign currency gains and losses on the yen-denominated loan in its financial statements. Additionally, upon adoption of Statement 133, Company X will be required to record a material cumulative effect adjustment to reflect the outstanding balance on the yen-denominated loan (and the yen-denominated receivable for the previous month's royalty (paid one month in arrears)) at the current yen/dollar exchange rate.

Paragraph 52 of Statement 133 specifies whether the transition adjustments resulting from adopting that Statement should be reported as a cumulative-effect-type adjustment of net income or accumulated other comprehensive income. Under that paragraph, cumulative-effect-type adjustments of accumulated other comprehensive income are appropriate only for certain transition adjustments related to a derivative instrument.

RESPONSE

The adjustment related to a company's foreign-currency-denominated debt and foreign-currency-denominated royalty that had been accounted for pursuant to Issue 88-18 should be reported in net income as the effect of a change in accounting principle and presented in a manner similar to the cumulative effect of a change in accounting principle as described in paragraph 20 of APB Opinion No. 20, Accounting Changes (that is, presented as a cumulative-effect-type adjustment of net income). As noted above, the yen-denominated royalty had historically been accounted for in a manner similar to a hedge of the yen-denominated loan pursuant to the provisions of Issue 88-18. Thus, the carrying value of the yen-denominated loan in Company X's financial statements has been based on the exchange rate in effect at inception of the loan. Despite this historical hedge-type accounting treatment, upon adoption of Statement 133 Company X should record a cumulative-effect-type adjustment (through earnings) to adjust the carrying value of the yen-denominated loan and the yen-denominated receivable for the previous month's royalty to the current yen/dollar exchange rate in effect. This will be necessary to effectively "zero out" the U.S. dollar balance of the yen-denominated loan over time as payments on the debt will need to be recorded at current exchange rates in effect at that time pursuant to the provisions of FASB Statement No. 52, Foreign Currency Translation (absent hedge-type accounting treatment).

EFFECTIVE DATE

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of its first fiscal quarter beginning after July 10, 2001, the date that the Board-cleared guidance was posted on the FASB website.

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.