What MBA School Doesn’t Teach You About Currencies

Currency and risk management has long been a “black box” for the C-suite. It’s time for treasurers to try to change that.

That’s no easy task, of course. But bringing to the table a thorough understanding of how currencies have and will impact financial statements goes a long way toward accomplishing that goal.

So what does that mean? What should treasurers be delivering to the corporation? And what key decisions and interactions drive their ability to deliver it? Let’s find out.

Currency Accounting 101

It’s no secret that finance, through treasury, should be providing insights into the currency environment in which the company will be operating — and how that environment will impact margins. Likewise, after dramatic movements in currencies, treasury should be communicating the relevance, financial statement geography and timing of those currency movements in earnings.

To do this, finance professionals need to expand their understanding of currency and uncover the currency inputs to their international sales and purchasing processes. Once this is accomplished, they must then dive into the nuances of accounting that frustrate their cash flow hedge programs and drive uneconomic (that is, “speculative”) hedges into their balance sheet hedge programs.

Complicating matters, however, is one widely accepted truth. The accounting framework driving how currencies impact financial statements is often driven by decisions made early in a company’s life by individuals swayed less by thoughtful consideration of the long-term implications of the decision, and more by how they did something at their last company, or for a past client.

This pivotal decision determines if a firm will be able to clearly manage and understand the impact of currency from foreign operations, or if currency impacts will be cloaked in uncertainty for years to come. To explain, we will contrast companies that took different routes early in their evolutions.

An Example in Contrast

Let’s say that both Company A and Company B have large amounts of deferred revenue in foreign subsidiaries, and both hedge revenue. But there are several significant differences in their approaches.

Company A knows the USD value of that revenue for every future period in which it is reclassified to income. Company B, meanwhile, knows the foreign currency value of that revenue and must wait until the period is reclassified to income to determine the USD value.

Company A delivers 100 percent of hedged revenue into consolidated earnings in USD at the hedge rate. This means that while Company A will be able to repatriate cash at the hedge rate, Company B will not, as derivative gain/loss timing is not aligned with revenue reporting.

Let’s also assume that Company A and Company B each have substantive depreciation costs that consolidate from foreign subsidiaries. Company A has a predictable expense flow through earnings for years to come. Company B reported expense will vary month to month and quarter to quarter with the currency. This means that hedging will bring USD depreciation costs into earnings at the hedge rate for Company A, but once again not Company B.

Both companies will receive goods from the parent to resell into the foreign entity’s local market. While these goods sit in foreign locations, the USD value of the product held at Company B will shift, up or down, depending on the currency markets. The cost of goods sold (COGS) will not reflect USD costs – contrary to what Company B expects from its USD global perpetually inventory systems. Company A will report COGS at the expected USD value.

Examining Company B’s Hedge Strategy

At Company B, FX gains and losses are driven by inter-company balances, and frequently bear little resemblance to the company’s economic exposure to currency. In essence, hedges at Company B may actually create economic risk rather than mitigate it. This is especially true for “cost-plus” arrangements, and the bigger the foreign entity, the larger the likely uneconomic hedge.

For instance, let’s assume that Company B has a large R&D operation in India, which is compensated on a cost plus basis. The plus grows ever larger as treasury fears accumulating cash in India, and tax is fending off The D Word (“dividend”). So Company B hedges the ballooning payable that generates FX gains or losses. Of course, if Company B were to look through the consolidation for third-party INR assets or liabilities, they would find them nominal (compared to the intercompany payable). But no one is looking through the consolidation at the economics.

Meanwhile, at Company A, the smaller — and clearly economic — third-party net INR monetary liability position is hedged. Hedges mature into currency conversions for payables incurred. Tax’s cost-plus strategy doesn’t create exposures, and treasury doesn’t hedge them.

Consolidation Methodology

The difference between Company A and Company B is that Company B’s framework for accounting (not tax, and not anything but accounting) defines the entity as an independent company — the parent is more of a holding company. Company A’s similar situation is managed for accounting purposes as an extension of the parent company.

This pivotal representation is captured in the functional currency decision: a consolidation methodology. It’s a decision that accounting departments often embrace for reasons that hearken back to spreadsheet-based consolidations; ERP implementers and auditors often prefer it because that is how they set up the last company; and treasury departments support it because it’s easier to hedge inter-company activity than to figure out what is going on in the real business.

Company B is local currency functional in most of its international operations. How the accounting world came to accept that most subsidiaries of foreign operations are independent companies when they clearly look like extensions of the parent company is a discussion for another day. However, the implications of that reality need further clarification: The result is foreign functional operations that are not intuitive running through the consolidation.

Let’s take the case above of a manufacturing entity sending $100 of inventory to a EUR functional sub for resale. The parent entity manufactures the unit for $100 and sells the unit to the EUR functional subsidiary for $130 ($30 profit in inventory). At the date of transfer to the sub, the EUR rate is 1.30, and we expect to sell the goods for EUR200 and a cost of EUR100 = margin EUR 100 – $30 profit in inventory. That translates in USD at time of inventory transfer to an expectation of $260 revenue and $130 cost plus $30 profit in inventory = margin $160, or 61.5% margin.

If the EUR value has climbed to 1.40 when the sale takes place, the EUR200 – EUR100 + $30 will come through consolidation as $280 – $140 + $30 = $170, or 60.7% margin. (Note: Lowering profit in inventory values reduces the impact on margin, and zero profit in inventory would result in zero changes in margin post inventory transfer). Of course, a similar decline in currency rates will lead to a decline in dollars but an uptick in margin ($240 – $130 + $30 = $140, or 62.5% margin).

All told, in spite of the smoke and mirrors, the company paid out cash of $100 for the inventory and will, at point of sale, be receiving either $280 or $240 for the goods. So the where does the difference in the cash equivalent $180 in the first scenario and the amount reported in consolidations of $170 end up? Or the $140 in cash from the second scenario compared to the reported margin of $150? The answer can be found hidden away in the little understood and rarely evaluated Cumulative Translation Adjustment in Other Comprehensive Income. When will it resurface into income? Upon substantial liquidation of the subsidiary … in other words, not on your watch.

Foreign Functional Subsidiaries’ Financial Impact

So how well does your organization (treasury, FPA and the C-suite) understand the concepts detailed above? Who is keeping an eye on inventory held in foreign functional subs and how that will impact your financials when currencies strengthen (higher $ margin, lower margin %) or weaken? And who can explain the P&L-vs.-cash implications when the foreign sub’s functional currency strengthens, or the cash shortfall vs. reported income when the currency weakens while holding inventory?

(One frustrated CFO, when educated on the source of his margin slippage, created a USD functional entity just to hold inventory between receipt in the foreign country and the sale of that inventory. We’ll get back to him in just a bit.)

Let’s go back to our example companies. Company A is shipping inventory to its USD functional subsidiary, where it will hold its USD value and all variations in margin dollars and percent will directly reflect the change in value of the EUR revenue while the entity held the inventory. The entire value change will also impact cash. Unlike Company B, Company A’s financial results are intuitive, and all levels of finance can quickly understand (and calculate on the back of an envelope) the impact of currency changes on the operation. Meanwhile, too many executives from Company B structures try understanding their financial statements using the back of the envelope math for Company A. It doesn’t work.

Deferred Revenue

Similar concepts apply to the deferred income and depreciation cases introduced above. If deferred revenue of EUR100 was initially recorded at 1.30 and amortized out of income over the following periods at an average rate of 1.20, there would be a deterioration in income of $10, but with no additional cash (assuming receivable/cash were not held over the period). The offset to that $10 loss would be found in Cumulative Translation Adjustment.

Depreciation Expense

The same rule applies to depreciation. If a fixed asset was acquired when the rate was 1.30 but depreciated during the year at an average rate of 1.40, the depreciation expense would flow through income at a higher rate — again, with no cash impact.

Fortunately, Company B can calculate the impacts of currency movements on depreciation and deferred revenue using back of the envelope math – but only after the period income statement rates are identified. Even more fortunately, Company A won’t need any math, as those values were fixed in USD when recorded and can be confidently projected and forecast in USD once the deferred revenue or fixed asset is acquired.

Adding Hedge Concepts

The Company B cases and scenarios described above are further complicated by hedging. In the case of the deferred revenue and depreciation expense, the only hedging available would be through a proxy exposure, and the hedge might be considered speculative. The “exposure” is the reported value in consolidations of that revenue or expense — a translation exposure. However, by selecting the local currency as the functional currency, Company B declared it was a EUR company. EUR results are what a EUR company is focused on, and the accounting supports that. Those deferred revenues and depreciation expenses are not hedge-able exposures to that company, but net investment hedging is available for the parent to protect its investment (impact of hedge in CTA, not earnings) in Company B.

Products are being proposed to companies to affect a hedge of translation exposures because bankers want to give Company B what it wants — predictable revenues/costs. However, management should be leery of using corporate cash for paper (and decidedly not economic) exposures. Much like hedging, the “plus” that will only be paid back to the corporate parent these hedges are expensive and speculative window dressings covering for a poor accounting framework decision.

Hedging FX Revenues in Foreign Functional Subsidiaries

For hedging foreign currency revenues in foreign functional subs, things can get a little tricky. Remember the CFO who ended up creating the USD inventory holding entity? Part of his frustration was the fact that his treasury department (like innumerable treasury departments) was hedging foreign revenues. However, they weren’t familiar with how currency hedges lose their effectiveness in protecting earnings (they still work great for cash protection) when associated with inventory transfers.

Hedge accounting for margin protection is limited to hedges of non-functional transactions. Company B, when sending inventory to foreign subs, can invoice in either USD or the sub’s functional currency. If invoicing in the sub’s functional currency, the Company holds the gain/loss on the hedge in the U.S. in USD until the intercompany inventory sale hits COGS. That fixed USD hedge result (the currency change between hedge rate and the intercompany ship rate), does not provide protection for any changes while the inventory is held by the subsidiary. This USD amount released to earnings when the inventory turns is applied to a totally unrelated revenue rate.