Fundamentals of Hedging - Silicon Valley · PDF fileFundamentals of Hedging By Helen Kane,...

Fundamentals of Hedging

For Corporations with Foreign Exchange Risk

By Helen Kane, President Hedge Trackers, LLC

Hedge Trackers ● (408) 350-8580 ● www.hedgetrackers.com ® Hedge Trackers, LLC, 2011. This publication contains general information and does not represent the

rendering of accounting advice and is not a substitute for such professional advice or services.

Functional Currency Defines Accounting Exposure

Foreign exchange exposure for a corporation has everything to do with where you sit. From an economic perspective, a US corporation experiences foreign exchange exposure from any activity of the business that is not wholly US dollar denominated: capital, financing, sourcing, selling, etc. Any US dollar denominated activity the company engages in outside of the United States has currency implications and thereby exposes the company. In addition, having international customers or vendors that are procuring or selling, or exposed in some other way, exposes a company. Even having competitors with international exposures exposes the company. There are a few companies out there that have no exposure, perhaps the local dairy or fitness center, but as global economies grow more intertwined, companies grow more and more exposed to foreign exchange exposure. Given that your corporation is exposed to foreign exchange, we need to reduce the focus to those exposures that will impact your company, and, conceivably, your job. The emphasis therefore will be on the exposures 1) you can do something about and 2) that impact you the most directly. Interestingly enough, identifying what exposures you can do something about and which impact you again depends on where you sit. The focus of most private companies will be on cash and future cash flows—a traditional economic perspective. Public companies, on the other hand, are generally P&L results and P&L volatility oriented. As a result, the actions taken to address a public company’s concerns are rarely employed by private companies.

The Private Company Perspective - It’s All About Cash Flow

A private company often takes a more comprehensive view of their foreign exchange exposures. Margin exposure arising from sales in one currency and costs in another, or even sales and costs in a single foreign currency, are concerns to a private company as the value of the cash flows related to margin are at risk. Even private companies, who sell abroad exclusively in US dollars, will be concerned about the risk of change in any foreign operating expenses. The private company will keep focused on what the US dollar value of Euro, Yen or other currency denominated cash balances are, irrespective of where they are located. That same attention will be focused on the ultimate USD value of foreign denominated receivables and payables. A private company will be more focused on the US dollar cash outflows associated with the monthly funding of a subsidiary and less concerned about the subsequent changes in value of the resultant intercompany, especially if they don’t anticipate repayment in the near term. In looking at currency risk, aka foreign exchange risk, the private corporation considers cash flow, King.

The Private Company Perspective - It’s All About Earnings

A public company often begins its foreign exchange risk “identification” based on an aversion to talking to “The Street” about volatility resident in the Foreign Exchange Gains and Loss, a subcomponent of Other Income and Expense. Once that risk is addressed, they often start working their way up the income statement, becoming sensitive to the impact that currency fluctuations (specifically negative fluctuations) may have on the US dollar equivalent of revenue reported in a period. Ditto for Cost of Sales. When operating margins are under pressure around the globe, no CFO wants to explain “we made our revenue forecast in foreign currency units, but missed our bottom line due to changes in currency values,” or “period over period expenses went down in foreign currency terms, it’s just that the weakening US dollar masks those savings.” CEO’s and CFO’s don’t ever want to give their analysts a lesson in foreign exchange fundamentals. So while private companies are focused on current and anticipated cash flows, public companies remain motivated by current period earnings volatility.



Before a company expands outside the US the private company and public company distinctions are relatively minor. The divergence of the public and the private perspectives are driven by accounting decisions surrounding the concept of a functional currency. Interestingly, functional currency decisions, which can strategically align a company’s earnings and cash flow perspectives or obfuscate the exposures, are often made by outside auditors, foreign subsidiary bookkeepers, or at best by mid-level tax or accounting managers.

I. FUNCTIONAL CURRENCY DECISIONS

In 1981 the Financial Accounting Standards Board (FASB) released guidance (Generally Accepted Accounting Practices) on how all foreign currency values would be represented on US financial statements. The standard, entitled FAS 52 Foreign Currency Translation introduced the concept of a “functional currency”. This is a designation or assignment made by a corporation, on an entity basis (however, under the guidelines the functional currency could actually be assigned down to the division level). This designation fundamentally defines how a company will perceive its exposures, and how those exposures will be reflected in the financials. Under even more recent guidance by the FASB, this designation will also define what are “hedgeable” exposures for the corporation.

Before going into great length about what criteria management must consider when selecting a functional currency for each legal entity, you need to know what criteria are irrelevant to that decision: the functional currency designated for tax purposes (the currency in which statutory books are kept); the currency in which the financial activity is booked; the ERP or accounting “system’s limitations”, or the lack of sophisticated finance personnel at foreign locations.

The FASB wanted companies to distinguish between operating units of a corporation that were operationally independent in the foreign economy, and those units which were truly just extensions of the parent organization. This distinction is better exemplified than defined:

Example 1: A US pharmaceutical company acquires a hospital in Canada. This Canadian subsidiary operates independent of the parent, all of its revenue are in Canadian Dollars (CAD) from local residents, its costs are predominantly CAD (with the possible exception of pharmaceutical purchases and an occasional capital and), pricing is CAD (and affected by what CAD prices the government reimburses hospitals for treatment), short term financing is managed with CAD borrowings, all alternative providers denominate services in CAD, and there are no regular intercompany transactions (any pharmaceutical transactions were handled outside the parent sub relationship) beyond the parent’s initial investment. This entity is clearly a CAD operation from any perspective. Contrast this CAD operation with the following German (EUR) entity.

Example 2: A US widget manufacturer establishes a sales office in Germany. One hundred percent of the product is sourced from the parent, and is to be sold throughout Europe (principally within the Eurozone). The parent manufactures the product in the US, and in fact there are no competitive producers outside the US. Sales management insists that a price list and sales be denominated in Euros, so the US dollar price list has been converted into Euros for this market. The price list is updated every six to twelve months. Transfer pricing assures that most of the product margin will return to the parent, or its tax equivalent. Subsidiary personnel and all local operating expenses are denominated in Euros, however most of the funding for these expenses are advanced by the parent and the substantial Intercompany payable to the parent is denominated in Euros to avoid taxation issues on the statutory books. A superficial view of this subsidiary would suggest that because the entity “generates and



expends” Euro cash that it, like the CAD subsidiary, should be Euro functional. However, a close review of the criteria outlined in FAS 52 “Appendix A: Determination of the Functional Currency” will lead to the opposite conclusion: the German subsidiary should be USD functional.

Foreign currency exposures exist under FAS52 for entities with transactions, assets or liabilities that are denominated in a currency other than the entities functional currency (a non-functional currency). So much then is riding on the determination of a functional currency it is imperative to review the designation criteria.

The first criteria the guidance establishes centers on cash flows. The focus, however, is on the impact the entity cash flows have on the parent company, not only their currency denomination. If the Germany entity’s receivables represent cash flows to the parent (for repayment of the Intercompany) or its liabilities reflect substantial funding of the subsidiary by the parent, and if any subsidiary cash is available for remittance to the parent, this would suggest the subsidiary’s functional currency should be the parent’s currency (US dollar). However, if the sub’s receivables will be used to pay down local currency debt and short term financing needs are addressed in the local economy that would suggest a local currency functional subsidiary. This criterion suggests that when a company first enters a foreign market with a sales subsidiary into which it invests resources, that generally the cash flows would suggest a US dollar functional subsidiary.

The second criterion for determining functional currency revolves around the pricing of the goods or services. When pricing is based on the parent’s US dollar price, or if it is based on worldwide competition, rather than local competition from resident market players, the indicator suggests a US dollar functional entity. Alternatively, when pricing is determined by local competition or local government regulation, the entity would more closely reflect the characteristics of a local currency functional sub. A familiar example of this concept might be US subsidiaries of Japanese car manufacturers. As the yen has moved dramatically over the last few decades, Japanese car prices (Honda, Toyota, etc.) have not responded by increasing or decreasing dramatically. Rather, pricing decisions have been driven by the local competition (Ford, Chrysler, GM) pricing. On the other hand it would be difficult to make the case that a subsidiary of a disk drive manufacturer (until now a dollar denominated industry around the globe) should be local currency functional, based on sales price indicators.

The next indicator, sales market, is closely related to the sales price indicator discussed above. Here we are looking for an active local market to support a local currency functional approach. If the global sales market for your products are concentrated in the parent’s country, or if sales contracts are denominated in (or reference) the parent currency, the implications are for a US dollar functional subsidiary. If we refer back to the hospital subsidiary example we see a clear example of an active local market. There is an active local supply and demand. Local competitors may be exporting into the global economy without compromising a local currency functional indication, as long as there is an established local market for the goods/services.

The currency that labor, materials and other costs of the product or services are denominated in serve as the basis of the next indicator. In the widget example above, the German entity was sourcing the entire product from the USD parent and only adding the sales effort at the local level. The guidance suggests that, even if there is some local value-add, if the majority of product/service cost elements are obtained from the country of the parent, the sub should be parent currency functional. Many corporations look at local operating expenses only to conclude that they should be local currency



functional, but it is clear from the text of the standard that the product/service cost base is the key to determining the currency indicator.

The source and denomination of financing is the next factor to evaluate in the functional currency decision. When a subsidiary is not generating sufficient cash to service existing or anticipated debt obligations (often manifested by a growing Intercompany balance) or if the financing is primarily from the parent or other source but denominated in US dollars, the US dollar would be the relevant functional currency. Local financing of an entity’s short and long term requirements would recommend a local functional designation. (A USD bank line of the parent that makes local currency available to a subsidiary for short term needs would not suggest a local currency functional indicator).

Beyond these six indicators, the FASB further indicated that a subsidiary that is a, “device or shell corporation for holding investments, obligations, intangible assets, etc., that could readily be carried on the parent’s or an affiliate’s books,” should have the parents currency as the functional currency. This would seem to apply to intellectual property holding subsidiaries established offshore and other international tax structures.

Slipping back to the little-read Basis for Conclusions in FASB’s Appendix C they summarized the type of foreign operations that should have the parent’s currency as the functional currency as, “primarily a direct and integral component or extension of the parent company’s operations.” (para 81.)

After identifying all the criteria relevant to the selection of a functional currency and suggesting that the functional currency is a matter of fact, the FASB admitted that each case would require management review and weighing of potentially contradictory facts. They then assigned “management” the task of reviewing the entity in light of the indicators above and assigning a functional currency that is not “contradicted by the facts”.

It is not uncommon for “management” involved in designating a functional currency to defer to “how it was done at their last company,” or “how the other subs are designated,” or “what the new entity’s bookkeeper is capable (or incapable) of,” or, far too often, “how the system was set up,” rather than to the FASB’s guidance. It is also not uncommon for an audit team member to make year-end adjustments that change the entity’s functional currency without any “management” involvement.

All the indicators and judgments are designed to distinguish between international operations whose cash flows directly affect the parent’s cash flows and those whose cash flows do not directly impact the parent. Why that distinction is important to the company’s management practices, its accounting, and its ability to hedge will be addressed next.

Why Functional Currency Designations are Critical

The functional currency decision will impact the oversight of the foreign entity because it will determine the subsidiary’s role in currency management and it will define for external reporting purposes (read here earnings volatility) what is an exposure to the company. All non-functional currency monetary assets and liabilities of an entity are revalued monthly to reflect the current exchange rates. The impact of any rate changes hit the P&L below the line in Other Income and Expense. As you well know, anything that hits the P&L, especially in an unpredictable fashion, generates much interest throughout the company, all the way up to the CEO level.

When subsidiaries consolidate their financials with their parent organization, the amount of foreign exchange gain or loss booked by each sub, is added to any gains or losses of the parent and presented



cumulatively. This accounting treatment and subsequent visibility has prompted many companies to declare their subsidiary’s local currency functional-thus eliminating most “non-functional” currency balances (local currency cash, accounts receivables, trade, and wage and tax payables) from impacting earnings in a capricious manner. This decision will often result in management ignoring the economic impact of foreign currencies on the company altogether. Additionally, management will be convinced to evaluate international management on local currency results because “local management can’t control currencies”. The argument that local management can’t control currencies is certainly valid, however as a result, no one will be watching, no less managing, the foreign exchange exposures represented by the local currency functional subs. When all the entities “make their plan” but reported earnings don’t translate at plan, no one will own the problem. As a result, the company’s cash position globally may be consistent from quarter to quarter on a functional currency basis (held 1B yen in cash last month end and this month end), but the USD value of those currencies may deteriorate clearly eroding the future cash flows (and thus the value) of the company. The tax strategy of holding increasing amounts of cash offshore for tax purposes, and keeping it in a currency other than the dollar for “exposure management purposes,” is a common strategy that ignores the economics of the currency exposure situation.

Although it is absolutely valid to conclude that foreign entity management has no control over the local currency, I would like to share the following anecdote regarding local management’s ability to “manage” exchange risk:

At one global corporation, where the “widgets” were US sourced, compensation packages were as varied as the subsidiary management and cultures of the countries they represented. One unusual compensation agreement rewarded the Japanese general manager if he kept his expenses in USD equivalents below his annual budget in USD terms. Revenue growth on the other hand was measured in year to year yen growth.

During year one of this compensation agreement, the Japanese yen strengthened substantively. This Japanese manager against all odds kept the USD equivalent of his expenses below the USD budget while his year to year yen revenues grew and the currency strengthened wildly. In contrast a Euro (legacy currency at that time) manager was compensated on year over year euro sales growth only and interestingly as the currencies strengthened and sales value grew, so did expenses (at a faster pace than revenue). In fact year over year expense growth outpaced currency appreciation.

The corporation benefited from the strengthening yen, but got no benefit from the strengthening European currencies. Interesting to note is in subsequent years of euro weakening the same manager blamed currency rates for his inability to perform against plan. In my experience, no manager has ever blamed revenue growth or positive performance against a plan on currency.

This example is meant only to demonstrate what we know to be true to about human nature and management; people will manage to whatever number they are compensated on, irrespective of the capricious nature of currency markets. If a corporation must deliver USD results because there shareholders only care about USD earnings and USD valuations, then perhaps management, on many levels, should be looking after the USD return on their efforts. Selection of the USD as the functional currency keeps managements’ eye on the USD ball at all times.

A secondary impact of assigning local currency as the functional currency has arisen as US corporations have moved intangible assets (intellectual property, generally) offshore in an effort to reduce their



exposure to the IRS. Generally this is achieved by creating a foreign sub which acquires capital from the parent in exchange cash, which cash is used to acquire the intellectual property. The accountants generally rush to make this entity local currency functional, thereby eliminating all manner of P&L impacts as this entity licenses its assets thereby generating non-USD revenues. In this rush to save the FX Gain and Loss line of Other Income and Expense, these companies inadvertently preclude the company from protecting the USD value of margins. US GAAP in the guise of FAS133 Accounting for Derivative Instruments and Hedging Activities only makes hedge accounting available to entities hedging non-functional currency risk. The structure outlined above limits the amount of intercompany activity between the parent and sub often to a small R&D cost sharing exposure, that isn’t even close to the margin exposure. This means no hedging to lock down the USD value of foreign revenues; therefore, as the international component of your company grows, the ability to protect and therefore predict your international revenues will decline.

If USD functional aligns the economics with the accounting, which it clearly does, why do so many, in fact an overwhelming majority of corporations, choose the local currency as the functional currency (and stretch the facts to arrive at that conclusion) for their subsidiaries? Because it’s easier on the accounting department—the very group making the decision. Most foreign governments, like our own, require their statutory (tax) books to be reported in their sovereign currency. Ireland and the Netherlands, both very tax friendly regimes, actually allow taxpayers to declare the currency in which they elect to report their books, however, that is the exception, not the rule. Therefore, a subsidiary generally needs to keep a set of entries in local currency. To meet the parent companies requirements, these books need to be converted to USD for consolidation which leaves a couple of choices. One that is rarely considered is keeping a separate/duplicate set of books in the parent currency: twice the manpower effort, twice the opportunity for error. Usually this only happens if the entity is so small that their entries are re-input directly into the parent’s books, e.g. a branch. However, modern ERP systems, when properly configured (big if), can maintain historical local and USD values. More common, is the practice of translating the results into USD at period end for consolidation purposes. In some companies this happens at the local level, at others at the corporate level, and for others it happens within their ERP system.

The mechanics required to translate locally maintained books into US dollars depends on whether the entity is USD functional or local currency functional, local currency being a good deal easier. For local currency companies, the accountants first convert the entire income statement into dollars using a “weighted average rate” (rate setting covered later). For balance sheet conversion, all the local currency assets and liabilities, are converted using a current rate, and the local currency equity is maintained at historical rates: the exchange rate when the currency was originally acquired for the initial investment of capital, and at the historical rates associated with retained earnings (the historical weighted average rate for gains/losses in each period). All of the changes in the value of those translated assets and liabilities are then hung up in an equity account (so that assets = liabilities + equity).

On the other hand, for USD functional subs this translation process is substantially more complex and error prone. First, the accountant must distinguish between monetary and non-monetary assets and liabilities. The monetary items convert into dollars the same as described above, using current rates; however, the change in value of those monetary assets and liabilities are pushed to current earnings. The non-monetary items must be tracked at their historical USD value. What this means is that inventory, fixed assets, prepaids and other non-monetary items detailed in FAS52 Appendix B must be tracked at their historical US dollar value. How does an entity keeping their books in local currency manage this? Think about this from a US perspective: imagine you received inventory worth 100JPY and booked it into your US dollar inventory system at $1. The yen strengthens, but what do you care, you “paid” $1; it remains at $1 in your inventory. When you relieve it from inventory, you will move $1



to COS. Now imagine your parent company saying, I don’t really care what you booked your inventory in at in dollar terms, I want you to report on your GAAP books the 100JPY value in inventory at each month end, and when it is relieved, I want you to move 100 yen at current exchange rates, let’s say $1.10 through Cost of Sales. Same complexity exists for your fixed assets, prepaids, etc. The impact of these historical value balance items carries over to the income statement: depreciation must be relieved at historical values, deferred revenue at historical, prepaids, etc. Don’t forget that for statutory purposes you must be relieving inventory, depreciating assets, etc. at historical local currency values.

Now let’s talk about where the complex translation from local currency to USD is taking place. If you are a rational reader you will assume that this process is automated (not likely) or handled by the corporate consolidations folks, where the company has generally invested in heavy accounting artillery. If that was your guess, you are wrong. It seems the more complicated the translation process the more likely subsidiary is responsible because that is where we are hiring our most sophisticated accounting resources, right? Well fortunately, at least most of the subsidiaries understand translation concepts. However, when it comes to translating those local currency statutory books into a USD functional approach, it is not uncommon for local management (General Manager types) to claim voodoo accounting if the results that effect her/his bonus don’t exactly equal the books his controller maintains. To overcome local managements concerns, the differences are often “stored in the balance sheet” until someone can explain them. The explanation is that holding monetary assets and liabilities in USD functional currency causes P&L impacts on every non-USD monetary asset and liability on the books—and that is a much different P&L impact than just revaluing non-local currency monetary assets and liabilities. In fact a local currency gain may “translate” to a USD loss.

The downside to USD functional, rather than local currency functional subsidiaries, is the very visible P&L impact as monetary assets and liabilities (Cash, A/R, A/P) revalue, not to mention the increased risk of incorrect translation. Even subs or a corporate treasury group that hedges is easily at risk if they do not constantly monitor the exposure and adjust hedges. Although the economic impact is no different, local currency functional subs can mask the exposure impact by diverting the gains and losses to equity, where no one is watching—or hedging. For more information on the topic of Fundamentals of Hedging, contact Helen Kane, [email protected] or 408.350.8580.

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