Derivatives Implementation Group

Statement 133 Implementation Issue No. B4

QUESTION

Two entities enter into a long-term service contract whereby one entity (A) agrees to provide a service to the other entity (B), at market rates over a three-year period. Entity B forecasts it will pay 1,000 kroner to Entity A at the end of the three-year period for all services rendered under the contract. Entity A's functional currency is the kroner and Entity B's is the U.S. dollar. In addition to providing the terms under which the service will be provided, the contract includes a foreign currency exchange provision. The provision requires that over the term of the contract, Entity B will pay or receive an amount equal to the fluctuation in the exchange rate of the U.S. dollar and the kroner applied to a notional amount of 100,000 kroner (that is, if the U.S. dollar appreciates versus the kroner, Entity B will pay the appreciation, and if the U.S. dollar depreciates versus the kroner, Entity B will receive the depreciation). The host contract is not a derivative and will not be recorded in the financial statements at market value. For the purpose of applying paragraph 15, is the embedded foreign currency derivative considered to be clearly and closely related to the terms of the service contract?

BACKGROUND

Paragraph 12 of Statement 133 requires that an embedded derivative instrument be separated from the host contract and accounted for as a derivative instrument pursuant to the Statement if certain criteria are met. Paragraph 15, as amended by Statement 149, provides that an embedded foreign currency derivative instrument is not to be separated from the host contract and considered a derivative pursuant to paragraph 12 if the host contract is not a financial instrument and specifies payments denominated in any of the following currencies:

1. The functional currency of any substantial party to that contract
2. The currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce
3. The local currency of any substantial party to the contract
4. 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).

Paragraph 15 provides the exclusion to paragraph 12 on the basis that if a host contract is not a financial instrument and it is denominated in one of the aforementioned currencies, then the embedded foreign currency derivative is considered to be clearly and closely related to the terms of the service contract.

RESPONSE

No, the foreign currency derivative instrument embedded in the long-term service contract should be separated from the host and considered a derivative instrument under paragraph 12. (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 contracts that require the delivery of services.)

In paragraph 311, "the Board decided that it was important that the payments be denominated in the functional currency of at least one substantial party to the transaction to ensure that the foreign currency is integral to the arrangement and thus considered to be clearly and closely related to the terms of the lease." It follows that the exception provided by paragraph 15 implicitly requires that the other aspects of the embedded foreign currency derivative must be clearly and closely related to the host.

In the example discussed above, because the contract is leveraged by requiring the computation of the payment based on a 100,000 kroner notional amount, the contract is a hybrid instrument that contains an embedded derivative—a foreign currency swap with a notional amount of 99,000 kroner. That embedded derivative is not clearly and closely related to the host contract and under paragraph 12 of Statement 133 must be recorded separately from the 1,000 kroner contract. Either party to the contract can designate the bifurcated foreign currency derivative instrument as a hedging instrument pursuant to Statement 133 if applicable qualifying criteria are met.

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.

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