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When is a Derivative Not a Derivative? When is a Derivative Not a Derivative? The answer is: of course......

When is a Derivative

Not a Derivative?

by Mark Kirkland, Vice President Treasury, Bombardier Transportation.

The answer is: of course, when it’s an embedded derivative (at least sometimes)!

I am, of course, talking about foreign currency contracts with suppliers and customers, which are in a currency which differs from both your functional currency and that of the third party. According to US GAAP and IFRS these are deemed, in some cases, as embedded derivatives and the fair value of these contracts needs to be re-valued, with changes in fair value going to the P&L. Thus, if my functional currency is Euro and my customer has a Swedish Krona functional currency then if the contract is denominated in Sterling, this in many cases would be deemed as an embedded derivative. If my client happened to be in the UK with Sterling as their functional currency, then the same contract would be not an embedded derivative and thus not re-valued through income from the outset.

I believe that a foreign currency contract with a supplier or customer is not a derivative and should never be an embedded derivative.

I keep implying that in some cases the contract in Sterling would not be deemed an embedded derivative. The rules are unfortunately rather vague and open to all types of interpretation. The lack of clarity is further clouded by accounting consultants, who are (always) keen to help. There are exceptions for certain currency contracts in combination with certain functional currency third parties. Thus, it is generally accepted that a US Dollar contract with a Chinese Reminbi third party is not an embedded derivative, while a US Dollar contract to a Thai Baht functional currency third party is sometimes an embedded derivative and sometimes not. Certain products, like oil, are generally traded in US Dollars, so this is exempted from these rules, whereas other products are not.

I believe that a foreign currency contract with a supplier or customer is not a derivative and should never be an embedded derivative. Here are my main reasons:

1. Accounting Rules should be applied in a consistent manner, ensuring the user of the statement understands the figures.

Having discussed the issue with three of the ‘big four’ accounting firms, the advice is far from consistent. Different application of rules could lead to two different companies with exactly the same contracts and functional currencies reporting different results depending on who their auditors happen to be. Thus, the user of the statements would need to fully understand the position of all the particular audit firms on each relevant currency pair for each corporate to understand the income statement. I know that users of statements need to be experts these days, but this seems rather excessive.

2. Accounting Rules should be in place for a reason.

I believe that the original reason for implementing this rule was to stop companies speculating on foreign exchange by using these contracts. It seems to me that choosing the currency of a contract with a third party is an extremely roundabout way of taking a position on that currency. There are much easier ways of hiding risk from your shareholder, if this is your game. Just ask the shareholders of a bank with a large portfolio of asset backed structured securities, who actually believed the Value at Risk figures in the 2007 annual reports.

After discussion of this issue with a few auditors, I conclude that there is no evidence that corporates speculate or have ever speculated in this way.

3. The results of a company should not depend on the accounting framework of another non affiliated company.

I have now worked in a Treasury department of two reasonably complex companies for nearly eleven years. Those of you in the same position will immediately recognise that the topic of functional currencies is very far from fun. I have had many a jolly discussion with legal entities on what their functional currency is or should be. Now, I need to know not only the functional currency of my own legal entities, but also the functional currency of the legal entities of all my trading partners. I need to keep track of them and any changes. I find this rather ridiculous and of limited added value, if any.

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