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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.