FASB Scope Exceptions Derivatives That Incorporate an Underlying on the Issuer's Equity Price

FASB: Scope Exceptions: Derivatives That Incorporate an Underlying on the Issuer's Equity Price

Derivatives Implementation Group

Statement 133 Implementation Issue No. C8

Title: Scope Exceptions: Derivatives That Are Indexed to Both an Entity's Own Stock and Currency Exchange Rates
Paragraph references:

11, 12, 18, 286

Date cleared by Board: May 17, 2000

QUESTION

Does a forward contract that is indexed to both an entity's own stock and currency exchange rates qualify for the exception in paragraph 11(a) of Statement 133, under which the forward contract would not be considered a derivative instrument by that entity?

BACKGROUND

For example, assume that Company A, whose functional currency is the US dollar (USD), and the Counterparty enter into a one-year forward contract that is indexed to Company A's common share price translated into euros (EUR) at spot rates and that will be settled in net shares of Company A. If the value of Company A's common stock in EUR appreciates, then Company A will receive from the Counterparty a number of shares of Company A stock equal to the appreciation. If the value of Company A's stock in EUR depreciates, then Company A will pay Counterparty a number of shares of Company A stock equal to the depreciation. Thus, the forward contract is indexed both to Company A's common stock and the USD/EUR currency exchange rates.

Assume further that Company A's common stock price at inception is 100 USD per share, and the forward exchange rate of USD to EUR is 1:1.2. The strike price of the forward contract is then set at 120 EUR. One year later, the share price of Company A rises to 150 USD, and the spot exchange rate of USD to EUR is 1:1. Then, the share price of Company A translated is 150 EUR. At settlement, Company A will receive from the Counterparty 20 shares of its own common stock according to the following calculation:

(150 EUR - 120 EUR) X 100 shares = 3,000 EUR

3,000 EUR / 150 EUR per share = 20 shares

Paragraph 11(a) of Statement 133 states that "contracts issued or held by that reporting entity that are both (1) indexed to its own stock and (2) classified in stockholders' equity in its statement of financial position" shall not be considered derivative instruments under Statement 133. However, paragraph 11 also states the following:

   ...a contract that an entity either can or must settle by issuing its own equity instruments but that is indexed in part or in full to something other than its own stock can be a derivative instrument for the issuer under paragraphs 6-10, in which case it would be accounted for as a liability or an asset in accordance with the requirements of this Statement.

RESPONSE

No. A forward contract that is indexed to both an entity's own stock and currency exchange rates does not qualify for the exception in paragraph 11(a) of Statement 133 with respect to that entity's accounting because the forward contract is indexed in part to something other than that entity's own stock (namely, currency exchange rates). That forward contract should be accounted for as a derivative instrument in its entirety by both parties to the contract if the contract in its entirety meets the definition of a derivative in paragraphs 6-9. Paragraph 286 of Statement 133 provides the rationale for why contracts that provide for settlement in shares of an entity's stock but that are indexed in part or in full to something other than the entity's stock are to be accounted for as derivative instruments if the contracts satisfy the criteria in paragraphs 6-9 of Statement 133. Paragraph 286 makes it clear that paragraph 11(a)(1) should be understood as being applicable to contracts that are indexed only to the issuer's own stock.

Paragraph 18 of Statement 133 prohibits separating a derivative into components based on different risks. Consequently, it would be inappropriate to bifurcate the forward contract described in the above example according to its differing exposures to changes in Company A's stock price and changes in the USD/EUR exchange rate and then attempt to apply paragraph 11(a) only to the exposure to changes in Company A's stock price. Paragraph 11(a) must be applied to an entire contract.

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.