Constant Currency Reporting: Year-Over-Year Challenges
Many public corporations report earnings, revenues and expenses on a “constant currency” basis. The objective is to present financials year-over-year (YoY) for comparative purposes without the effects of currency movements.
To quote a few public disclosures:
- “We use results on a foreign currency-neutral basis as one measure to evaluate our performance…”
- “Segment reporting details constant currency effect…”
- “Total company sales, increased 6.3 percent in 2017 and 17.1 percent in 2016, excluding the impact of foreign exchange…”
- “We manage our global businesses on a constant currency basis, and we manage market risk from currency exchange rate changes at the corporate level…”
Calculating Constant Currency
Companies want to calculate constant currency by taking the last period’s exchange rates and applying them to this period’s results. At first glance, the process seems easy enough to apply. Take each month’s exchange rates and use them to calculate this period’s results in USD.
The thing is, companies don’t really do this calculation. For example, let’s assume that a company uses a weekly exchange rate to record transactions for accounting purposes. When calculating YoY results, most companies take certain shortcuts or simplifications to arrive at constant currency reporting. It takes time to apply weekly rates against weekly transaction volumes when calculating reporting, so most companies use the monthly (or quarterly or annual) average rate and apply it to the same period in the current year. By doing this, certain risks and weaknesses occur.
Constant Currency Risks & Weaknesses
Exchange Rates Matter – When exchange rates not used in preparing accounting results are used to calculate constant currency reporting, the reporting contains rate impacts not experienced by the company. Exchange rates actually used in prior and current year reporting are the only exchange rates that would reliably create YoY reporting on a constant currency basis. Otherwise, management is reporting more about the markets and not the company’s financials. In reading corporate disclosures, there are many examples of companies using generic market movements rather than company-specific rates.
Seasonality – When transactions are lumpy due to seasonality or other timing differences, the impact of using a simple average exchange rate from the past skews the rate impact applied to this year’s results. An appropriately weighted average prior period rate should be applied to the current period’s financials to depict an accurate constant currency comparison.
Appropriate Measure – YoY currency impacts may be very relevant and insightful for some companies and irrelevant to others. Companies should evaluate the appropriateness of reporting YoY impacts, especially when the reported foreign pricing/costs are dollar-driven.
SEC Concerns – The SEC warns of misleading non-GAAP reporting: “Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading.” If the exchange rates used for constant currency reporting do not align with GAAP accounting rates, then non-GAAP reporting may be considered misleading. The SEC has invited corporates reporting YoY results to detail their calculations. The calculations disclosed highlight the discrepancies between external reporting and corporate accounting as they continue to measure currency impacts in broad strokes that have little or nothing to do with the recording of currency activity in the financials.
Hedge Program Disconnects – The disconnect between financial reporting and currency hedge programs occurs when treasury hedges currency risk based on smoothing currency impacts in margin while management reports YoY changes in revenues and expenses in constant currency.
Constant currency is a common non-GAAP reporting technique. Most companies would benefit from properly calculating YoY results based on weighted average GAAP exchange rates. When seasonality, simplifications and different exchange rates exist in non-GAAP reporting, non-GAAP results may vary significantly from actual results.
Lastly, hedge programs can make YoY reporting more complicated rather than less, which begs the question: “If reporting in constant currency is the objective, how can currency hedge programs support management’s goal?”