Hedging foreign currency risks.

This month's column lists 1991 and 1992 Financial Accounting Standards Board emerging issues task force (EITF) consensuses adopted through the March 19, 1992, meeting (see the sidebar on page H6). In addition, we are summarizing two of these consensuses on hedging foreign currency risks.

EITF Abstracts, copyrighted by the FASB, is available in soft-cover and loose-leaf versions and may be obtained by contacting the FASB order department at 401 Merritt 7, P.O. Box 5116, Norwalk, Connecticut 06856-5116. Telephone: [phone], ext. 10.

ISSUE NO. 91-1

EITF issue no. 91-1, Hedging Intercompany Foreign Currency Risks, discusses whether hedge accounting is appropriate for hedges of intercompany transactions denominated in foreign currencies. In hedge accounting, realized and unrealized gains or losses on the hedging instrument are deferred and recognized in the same period as the transactions being hedged. The EITF consensus was hedge accounting may be used if the intercompany transactions are denominated in different functional currencies and if the hedging instrument has certain characteristics.

The required characteristics vary with the hedging instrument. If forward exchange contracts (or any such similar instruments) or foreign currency futures are used as hedging instruments,

* They must be designated as, and effective as, a hedge of the intercompany transactions.

* The intercompany foreign currency commitments must involve a third party. If there is no third party, performance must be probable due to sufficiently large disincentives for nonperformance (for example, fiduciary responsibilities, legal requirements or significant economic penalties to the consolidated entity for nonperformance).

The EITF consensus was that if purchased foreign currency options are used to hedge these intercompany transactions, the hedge accounting provisions of EITF Issue no. 90-17, Hedging Foreign Currency Risks with Purchased Options, should be followed. (For a discussion of Issue no. 90-17, see Recent EITF Actions, JofA, Feb. 92, pages 87-90.)

ISSUE NO. 91-4

EITF Issue no. 91-4, Hedging Foreign Currency Risks with Complex Options and Similar Transactions, was intended to supplement Issue no. 90-17, which addresses only purchased foreign currency options with little or no intrinsic value (the option's exercise price is equal to or greater than the underlying currency's spot rate). Issue no. 91-4 addresses complex options (purchased options with significant intrinsic value, written options and various types of combination options, purchased and written as a unit) and similar instruments.

When these options are used as hedging instruments, the question is, Should the appropriate accounting be guided by FASB Statement no. 52, Foreign Currency Translation, Issue no. 90-17 or some other approach? Most controversial was how appropriate hedge accounting is for anticipated (but not firmly committed) transactions.

Securities and Exchange Commission involvement. The evolution of Issue no. 91-4 illustrates the SEC's involvement in EITF proceedings. The EITF had planned to discuss a summary of recommendations prepared by the working group for this issue at the November 21, 1991, EITF meeting; however, the discussion was deferred so disclosure issues raised by the SEC observer could be addressed. The EITF consensus was footnote disclosure should be provided for

* The accounting method used for currency options, option combinations and similar instruments, including a description of the events or transactions resulting in gain or loss recognition in the income statement.

* Information on any hedges of anticipated, but not firmly committed, transactions involving complex-option hedging instruments, specifically the following:

1. The nature of the anticipated transactions.

2. The maximum number of years over which such anticipated transactions are hedged.

3. The combined realized and unrealized net gain or loss deferred as of each balance sheet date on these hedging instruments.

The E ITF also noted these disclosure requirements apply to options accounted for under the consensuses reached in Issue no. 90-17.

At the March 19, 1992, EITF meeting, the EITF again had planned to attempt a consensus on the accounting issues. However, the SEC observer presented a letter saying, for transactions entered into after March 20, 1992, the SEC staff would object to any defence of

* Realized or uurealized gains or losses arising from complex options for hedges of anticipated foreign currency transactions.

* Losses on written foreign currency options because they increase, rather than reduce, risk.

The E ITF was not asked to reach a consensus on the accounting issues because it might have been at variance with the SEC's position, creating two sets of generally accepted accounting principles--one for public companies (the SEC position) and one for nonpublic companies (the EITF consensus).

These issues probably will resurface during the FASB's project on recognition and measurement of financial instruments.

EXECUTIVE SUMMARY

EITF Issue no. 91-1

Accounting problem: May hedge accounting be used for hedges of intercompany transactions denominated in foreign currencies?

Consensus: Yes, if certain conditions are met.

EITF Issue no. 91-4

Accounting problem: What is the appropriate accounting for complex options and similar instruments used to hedge foreign currency risks?

Consensus: No consensus requested on this accounting issue, but consensus reached on required disclosures.