Fx currency transactions: hidden costs

Fx currency transactions: hidden costs

Carlos A. DaCunha

This article presents the case for adjusting an importer’s acquisition cost of inventory for the amount of gains or losses derived from foreign exchange currency transaction exposure.

The unprecedented growth of multinational business activity in the past decade has led to an increasing number of small American companies competing against foreign firms, even as they sell to or are supplied by them. Transactions with some countries have become so common that the companies involved may not even see themselves as doing business in the international marketplace. Calls are made, deals are arranged, products are shipped, and money is exchanged despite different languages, borders, or currencies.

To make it easier to do business with American companies, many foreign businesses handle the exchange of currency to and from U.s. dollars. Often without realizing it, American business owners give away financial control; someone else decides when to exchange the funds, takes advantage of fluctuations in currency value, and is even likely to charge a premium for handling the exchange. On the other hand, an increasing number of small American companies have recognized that changes in foreign exchange rates, when properly managed, can lead to opportunities for increased profit.

Foreign Exchange Market

Geographically, the foreign exchange market spans the globe, with prices moving and currencies traded somewhere every minute of every day. It “plays the indispensable role of providing the essential machinery for making payments across borders, transferring funds and purchasing power from one currency to another, and determining that singularly important price, the exchange rate.” (1)

Exchange rate risk is the uncertainty that unanticipated changes in foreign currency rates can create in expected cash flows in a domestic currency. It is viewed and measured differently by accountants and financial analysts, because accounting rules are designed to measure the effect of exchange rate changes on current book income and book values of assets and liabilities on the balance sheet. On the other hand, financial analysts are much more interested in the effects of exchange rate changes on actual historical, current, and future cash flows and their respective impact on the value or financial capacity of the firm.

The accounting theory. From an accounting standpoint, “transaction exposure” generally refers to gains or losses that arise from the settlement of transactions whose terms are stated in a foreign currency. Typical transactions include the following:

* Purchasing or selling goods or services on credit when their prices are stated in foreign currencies.

* Becoming a party to an unsettled forward foreign exchange contract.

* Borrowing or lending funds that are denominated in foreign currencies.

* Acquiring assets or incurring liabilities denominated in foreign currencies.

In essence, “transaction exposure” is the potential positive or negative impact of settling outstanding obligations entered into before a change in foreign exchange rates, but settled after the change in those foreign exchange rates.

The Financial Accounting Standards Board (FASB) in June 1988 issued Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” which permits special accounting for a hedge of a foreign-currency-forecasted transaction with a derivative.

Generally, derivatives such as forward foreign exchange contracts represent a mutual exchange of promises, without an initial exchange of tangible consideration. As such, the derivative transaction would have been recorded off balance sheet prior to the issuance of FASB 133, thus potentially obscuring the representation of the firm’s capacity to settle the transaction at a gain or loss, at maturity. FASB 133 states that if an agreement to buy a nonfinancial asset requires payment in a currency that is not the buyer’s functional currency, the buyer may hedge its exposure to foreign currency risk under the “cash flow hedging model.” In using this model, the firm reports in the “other comprehensive income” (OCI) section of its Income Statement the change in fair value of the foreign exchange hedging derivative instrument such that the balance in OGI is equal to the lesser of (1) the cumulative gain or loss on the derivative or (2) the cumulative change in expected future cash flows on the hedged foreign exchange currency transaction. The firm would initially record the hedging instrument’s fair value changes on the balance sheet with the net amount of corresponding gains or losses subsequently recorded to OCI. At the end of the reporting period, the net result is that the excess cumulative gain or loss on the foreign exchange currency-hedging instrument is posted in OCI.

OCI is represented below the firm’s EBIT line and normally flows onto the Statement of Cash Flows as a product of Gash Flows from Investing Activities, rather than from Cash Flows from Operating Activities. From a financial analysis standpoint, this representation can lead to an imprecise indication of the level of the firm’s actual cash flows from operations. It also can cloud an analyst’s understanding of the amount the firm actually paid in cash to the foreign-currency-denominated suppliers for the acquisition cost of its inventory.

The financial analysis perspective. The following basic assumptions were made in constructing these illustrations:

* A bank client is a U.S. distributor of specialty inventory imported from Europe. It is referred to hereinafter as the “Importer.”

* The Importer has a seasoned supply chain relationship with a major European vendor that offers the Importer “net 45” payment terms.

* All invoices are denominated in euros ([euro]), which is the European vendor’s functional currency. The Importer took the following general steps in its product operating cycle:

1. The Importer purchased 100 units of widgets at [euro]1,000/ unit on 2/1/2002 (note that one thousand euros is normally written as [euro]1,000; however, we have elected to present it as [euro]1,000 for simplicity). On that date, the euro/dollar spot exchange rate was [euro]0.8586/ $1.00, which pursuant to Generally Accepted Accounting Principles (GAAP) became the foreign currency translation basis of the acquisition cost of the inventory. The corresponding accounting entries would have been as follows:

Debit Credit

Inventory $116,468.67

Accounts Payable $116,468.67

2. The Importer then sold this inventory to a U.S. customer with a 25% gross margin (for simplicity, it is understood that there were no further direct costs associated with this product). The corresponding accounting entries would have been as follows:

Debit Credit

Accounts Receivable $155,291.56

Sales $155,291.56

Cost of Goods Sold $116,468.67

Inventory $116,468.67

3. Pursuant to the Importer’s “Net 45” payment terms, a payment was made to the European vendor on the due date (03/15/2002) in the vendor’s functional currency (i.e., 6), when the spot rate was 60.88270/$1.00. The corresponding accounting entries would have been as follows:

Debit Credit

Accounts Payable $116,468.67

Cash $113,288.77

Gain in FX $3,179.90

4. The Importer offered its U.S. customer “Net 60” receivable terms and got paid in cash (i.e., US $) on the due date. The corresponding accounting entries would have been as follows:

Debit Credit

Cash $155,291.56

Accounts Receivable $155,291.56

At the end of the operating cycle for this product, the Importer’s Income Statement and Balance Sheet for accounting purposes would have been represented as follows (for simplicity, there were G&A expenses of $5,000 and we applied an income tax rate of 40% to EBT, both of which were charged to earnings during the period but accrued for payment in a subsequent fiscal period–see Figure 1).

A targeted analysis of the Income Statement for this product’s operating cycle offers the following perspective:

Sales $155,291.56

Cost of Good Sold $116,468.67

Gross Profit $38,822.89

Gross Profit Margin 25%

From a cash flow analysis perspective, however, the amount the Importer actually paid to the European vendor versus the cash received by the Importer client from its U.S.-based customer would have led to the following slightly different “cash margin” point of view:

Cash Received from Customer $155,291.56

Cash Paid to Vendor $133,288.77

Gross Cash Profit $42,002.79

Gross Cash Margin 27.05%

Consequently, financial analysis reliance on FASB 133 in accounting for foreign exchange transaction exposure can lead to a material variation in the understanding of an Importer’s actual operating cash flows. This conclusion holds true for both positive transaction exposure (i.e., gains) as well as negative transaction exposure (i.e., losses).

As long as an importer seeks to capture a normal business profit on the product operating cycle by using a foreign exchange hedging instrument to neutralize the risk of a sudden change in exchange rates, a reasonable case can be made that the foreign exchange currency transaction gain or loss is actually an element of “operating cash flows” and not of “investment cash flows.” In this narrow sense, the allocation of the “gain/loss from foreign currency exchange” against the Importer’s cost of goods sold provides the financial analyst a much more refined and reliable understanding of the firm’s actual cost of its product sold.

This sort of dilemma is prevalent in supply-chain relationships that require payments in a foreign currency, which is not the buyer’s functional currency. By contrast, purchase discounts extended within U.S.-based supply chain relationships and taken in the normal course of dealing by an enterprise such as the Importer’s would have been recognized by the buyer as a deduction from the acquisition cost of its inventory.

Figure 2 presents the final Income Statement and Balance Sheet for the same example as above, but with a key variation that the bank client (Importer) had purchased the product from a U.S.-based vendor that extended a purchase discount comparable to the change in the foreign exchange currency spot rate above.

Another targeted analysis of the Income Statement for this product’s operating cycle offers the following point of view:

Sales $155,291.56

Cost of Good Sold $113,288.77

Gross Profit $42,002.79

Gross Profit Margi 27.05%

Coincidently, the gross profit margin of 27.05% in this example is the same as the gross cash margin of 27.05% in the previous example, validating the thesis that gains or losses derived from foreign exchange exposure incurred in supply chain relationships that require payments in a foreign currency should be treated like a purchase discount (or premium) and deducted (or added) from (or, to) the acquisition cost of the inventory for financial analysis purposes.

Figure 1

Income Statement

Debit Credit

Sales $155,291.56

Cost of Goods Sold $116,468.67

Gross Profit $38,822.89

G&A Expenses $5,000.00

Earnings Before Interest/Taxes S33,822.89

Other Comprehensive Income $3,179.90

Earnings Before Taxes $37,002.79

Income Taxes (@40%) $14,801.11

Net Profit $22,201.67

Balance Sheet

Debit Credit

Assets:

Cash $42,002.79

Total Assets $42,002.79

Liabilities:

Accrued Expenses $5,000.00

Accrued Taxes $14,801.11

Total Liabilities $19,801.11

Stockholder Equity:

Retained Earnings $22,201.67

Total Stockholder Equity $22,201.67

Liabilities & Stockholder Equity $42,002.79

Figure 2

Debit Credit

Income Statement

Sales $155,291.56

Cost of Goods Sold $116,468.67

Less: Purchase Discounts $3,179.90

Gross Profit $42,002.79

G&A Expenses $5,000.00

Earnings Before Interest/Taxes $37,002.79

Other Comprehensive Income 0

Earnings Before Taxes $37,002.79

Income Taxes (@40%) $14,801.11

Net Profit $22,201.67

Balance Sheet

Assets:

Cash $42,002.79

Total Assets $42,002.79

Liabilities:

Accrued Expenses $5,000.00

Accrued Taxes $14,801.11

Total Liabilities $19,801.11

Stockholder Equity:

Retained Earnings $22,201.67

Total Stockholder Equity $22,201.67

Liabilities & Stockholder $42,002.79

Equity

Notes

(1.) Federal Reserve Bank of New York, www.ny.frb.org/pihome/addpub/usfxm/chap1.pdf.

References

David K. Eitman and Arthur I. Stonehill, Multinational Business Finance, Addison-Wesley Publishing Company, 1982.

Aswath Damadoran, Corporate Finance: Theory & Practice, Johnson Wiley & Sons, Inc., 1997.

Loren A. Nikolai, John D. Bazley, Richard G. Schroder and Isaac N. Reynolds, Intermediate Accounting. Third Edition, Boston: Kent Publishing, 1985.

Reviewed reference writings are available at: * http://www.fasb.org, the Internet site of the Financial Accounting Standards Board; and

* www.ny.frb.org, the Internet site of the Federal Reserve Bank of New York.

Foreign currency exchange quotes were obtained from http://www.oanda.com/convert/fxhistory.

[c] 2003 by RMA. Carlos A. DaCunha, MBA, is Business Banking vice president and team leader at Sovereign Bank, New Bedford, Massachusetts. The author thanks Charles H. McInerney Jr. and Jonathan A. Barnes of Sovereign Bank for their valued input.

Contact DaCunha at CDaCunha@sovereignbank.com

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